# FDIC FIL-15-2000: CAPITAL STANDARDS

> Federal · Agency guidance · Superseded

URL: https://www.frixlaw.com/law-library/statutes/FDIC_FIL00015

## Section

- **Citation:** FDIC FIL-15-2000
- **Heading:** CAPITAL STANDARDS
- **Jurisdiction:** Federal
- **Kind:** Agency guidance
- **Status:** Superseded
- **Text as of:** August 14, 2026
- **Source:** Compiled text
- **Location:** FDIC Financial Institution Letters / CAPITAL STANDARDS

## Text

Wednesday,
March 8, 2000
Part II
Department of the
Treasury
Office of the Comptroller of the
Currency
Office of Thrift Supervision
Federal Reserve
System
Federal Deposit
Insurance
Corporation
12 CFR Parts 3, 208, 225, 325 and 567
Risk-Based Capital Standards; Recourse
and Direct Credit Substitutes; Proposed
Rule
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Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the
Currency
12 CFR Part 3
[Docket No. 00–06]
RIN 1557–AB14
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R–1055]
FEDERAL DEPOSIT INSURANCE
CORPORATION
12 CFR Part 325
RIN 3064–AB31
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Part 567
[Docket No. 2000–15]
RIN 1550–AB11
Risk-Based Capital Standards;
Recourse and Direct Credit Substitutes
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), the Board of
Governors of the Federal Reserve
System (Board), the Federal Deposit
Insurance Corporation (FDIC), and the
Office of Thrift Supervision (OTS)
(collectively, the agencies) are
proposing changes to their risk-based
capital standards to address the
regulatory capital treatment of recourse
obligations and direct credit substitutes
that expose banks, bank holding
companies, and thrifts (collectively,
banking organizations) to credit risk.
The proposal treats recourse obligations
and direct credit substitutes more
consistently than under the agencies’
current risk-based capital standards
nges to their risk-based
capital standards to address the
regulatory capital treatment of recourse
obligations and direct credit substitutes
that expose banks, bank holding
companies, and thrifts (collectively,
banking organizations) to credit risk.
The proposal treats recourse obligations
and direct credit substitutes more
consistently than under the agencies’
current risk-based capital standards. In
addition, the agencies would use credit
ratings and certain alternative
approaches to match the risk-based
capital requirement more closely to a
banking organization’s relative risk of
loss in asset securitizations. The
proposal also requires the sponsor of a
revolving credit securitization that
involves an early amortization feature to
hold capital against the amount of assets
under management, i.e. the off-balance
sheet securitized receivables.
This proposal is intended to result in
more consistent treatment of recourse
obligations and similar transactions
among the agencies, more consistent
risk-based capital treatment for certain
types of transactions involving similar
risk, and capital requirements that more
closely reflect a banking organization’s
relative exposure to credit risk.
DATES: Your comments must be received
by June 7, 2000.
ADDRESSES: Comments should be
directed to:
OCC: You may send comments
electronically to regs.comments@
occ.treas.gov or by mail to Docket No.
00–06, Communications Division, Third
Floor, Office of the Comptroller of the
Currency, 250 E Street, SW,
Washington, DC 20219. In addition, you
may send comments by facsimile
transmission to (202) 874–5274. You
can inspect and photocopy comments at
that address.
Board: Comments, which should refer
to Docket No. R–1055, may be mailed to
Jennifer J. Johnson, Secretary, Board of
Governors of the Federal Reserve
System, 20th Street and Constitution
Avenue, NW, Washington, DC 20551.
Comments may also be delivered to
Room B–2222 of the Eccles Building
between 8:45 a.m. and 5:15 p.m
ssion to (202) 874–5274. You
can inspect and photocopy comments at
that address.
Board: Comments, which should refer
to Docket No. R–1055, may be mailed to
Jennifer J. Johnson, Secretary, Board of
Governors of the Federal Reserve
System, 20th Street and Constitution
Avenue, NW, Washington, DC 20551.
Comments may also be delivered to
Room B–2222 of the Eccles Building
between 8:45 a.m. and 5:15 p.m.
weekdays, or to the guard station in the
Eccles Building courtyard on 20th Street
between Constitution Avenue and C
Street, NW, at any time. Comments may
be inspected in Room MP–500 of the
Martin Building between 9 a.m. and 5
p.m. weekdays, except as provided in 12
CFR 261.8 of the Board’s Rules
Regarding Availability of Information.
FDIC: Written comments should be
addressed to Robert E. Feldman,
Executive Secretary, Attention:
Comments/OES, Federal Deposit
Insurance Corporation, 550 17th Street,
NW, Washington, DC 20429. Comments
may be hand delivered to 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.
(Fax number: (202) 898–3838; Internet
address: comments@fdic.gov).
Comments may be inspected and
photocopied in the FDIC Public
Information Center, Room 100, 801 17th
Street, NW, Washington, DC, between 9
a.m. and 4:30 p.m. on business days.
OTS: Send comments to Manager,
Dissemination Branch, Records
Management and Information Policy,
Office of Thrift Supervision, 1700 G
Street, NW, Washington, DC 20552,
Attention Docket No. 2000–15. These
submissions may be hand-delivered to
1700 G Street, NW, from 9 a.m. to 5 p.m.
on business days or may be sent by
facsimile transmission to FAX number
between 9
a.m. and 4:30 p.m. on business days.
OTS: Send comments to Manager,
Dissemination Branch, Records
Management and Information Policy,
Office of Thrift Supervision, 1700 G
Street, NW, Washington, DC 20552,
Attention Docket No. 2000–15. These
submissions may be hand-delivered to
1700 G Street, NW, from 9 a.m. to 5 p.m.
on business days or may be sent by
facsimile transmission to FAX number
(202) 906–7755; or by e-mail:
public.info@ots.treas.gov. Those
commenting by e-mail should include
their name and telephone number.
Comments will be available for
inspection at 1700 G Street, NW, from
9 to 4 p.m. on business days.
FOR FURTHER INFORMATION CONTACT:
OCC: Roger Tufts, Senior Economic
Advisor or Amrit Sekhon, Risk
Specialist, Capital Policy Division, (202)
874–5070; Laura Goldman, Senior
Attorney, Legislative and Regulatory
Activities Division, (202) 874–5090,
Office of the Comptroller of the
Currency, 250 E Street, SW,
Washington, DC 20219.
Board: Thomas R. Boemio, Senior
Supervisory Financial Analyst, (202)
452–2982, or Norah Barger, Assistant
Director (202) 452–2402, Division of
Banking Supervision and Regulation.
For the hearing impaired only,
Telecommunication Device for the Deaf
(TDD), Diane Jenkins, (202) 452–3544,
Board of Governors of the Federal
Reserve System, 20th Street and
Constitution Avenue, NW, Washington,
DC 20551.
FDIC: Robert F. Storch, Chief,
Accounting Section, Division of
Supervision, (202) 898–8906; or Jamey
Basham, Counsel, Legal Division, (202)
898–7265, Federal Deposit Insurance
Corporation, 550 17th Street, NW,
Washington, DC 20429.
OTS: Michael D. Solomon, Senior
Program Manager for Capital Policy,
Supervision Policy, (202) 906–5654; or
Karen Osterloh, Assistant Chief Counsel
Washington,
DC 20551.
FDIC: Robert F. Storch, Chief,
Accounting Section, Division of
Supervision, (202) 898–8906; or Jamey
Basham, Counsel, Legal Division, (202)
898–7265, Federal Deposit Insurance
Corporation, 550 17th Street, NW,
Washington, DC 20429.
OTS: Michael D. Solomon, Senior
Program Manager for Capital Policy,
Supervision Policy, (202) 906–5654; or
Karen Osterloh, Assistant Chief Counsel
(202) 906–6639, Office of Thrift
Supervision, 1700 G Street, NW,
Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
I. Introduction
The agencies are proposing to amend
their risk-based capital standards to
change the treatment of certain recourse
obligations, direct credit substitutes,
and securitized transactions that expose
banking organizations to credit risk.
This proposal amends the agencies’ risk-
based capital standards to align more
closely the risk-based capital treatment
of recourse obligations and direct credit
substitutes and to vary the capital
requirements for positions in securitized
transactions (and certain other credit
exposures) according to their relative
risk. The proposal also requires the
sponsor of a revolving credit
securitization that involves an early
amortization feature to hold capital
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Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules
1 See 60 FR 17986 (April 10, 1995) (OCC); 60 FR
8177 (February 13, 1995) (Board); 60 FR 15858
(March 28, 1995) (FDIC).
2 See 60 FR 45618 (August 31, 1995.)
3 International Convergence of Capital
Measurement and Capital Standards (July 1988).
4 For purposes of this discussion, references to
‘‘securitization’’ also include structured finance
transactions or programs that generally create
stratified credit risk positions, which may or may
not be in the form of a security, whose performance
is dependent upon a pool of loans or other credit
exposures
95.)
3 International Convergence of Capital
Measurement and Capital Standards (July 1988).
4 For purposes of this discussion, references to
‘‘securitization’’ also include structured finance
transactions or programs that generally create
stratified credit risk positions, which may or may
not be in the form of a security, whose performance
is dependent upon a pool of loans or other credit
exposures.
5 As used in this proposal, the terms ‘‘credit
enhancement’’ and ‘‘enhancement’’ refer to both
recourse arrangements and direct credit substitutes.
against the amount of assets under
management in that securitization.
This proposal builds on the agencies’
earlier work with respect to the
appropriate risk-based capital treatment
for recourse obligations and direct credit
substitutes. On May 25, 1994, the
agencies published in the Federal
Register a proposal to reduce the capital
requirement for banks for low-level
recourse transactions, to treat first-loss
(but not second-loss) direct credit
substitutes like recourse, and to
implement definitions of ‘‘recourse,’’
‘‘direct credit substitute,’’ and related
terms. 59 FR 27116 (May 25, 1994) (the
1994 Notice). The 1994 Notice also
contained, in an advance notice of
proposed rulemaking, a proposal to use
credit ratings to determine the capital
treatment of certain recourse obligations
and direct credit substitutes. The OCC,
the Board, and the FDIC subsequently
implemented the capital reduction for
low-level recourse transactions, thereby
satisfying the requirements of section
350 of the Riegle Community
Development and Regulatory
Improvement Act, Public Law 103–325,
sec. 350, 108 Stat. 2160, 2242 (1994)
(CDRI Act).1 The OTS risk-based capital
regulation already included the low-
level recourse treatment required by the
statute.2 The agencies did not issue a
final regulation on the remaining
elements of the 1994 Notice.
On November 5, 1997, the agencies
published another notice of proposed
rulemaking. 62 FR 59943 (1997
Proposal)
vement Act, Public Law 103–325,
sec. 350, 108 Stat. 2160, 2242 (1994)
(CDRI Act).1 The OTS risk-based capital
regulation already included the low-
level recourse treatment required by the
statute.2 The agencies did not issue a
final regulation on the remaining
elements of the 1994 Notice.
On November 5, 1997, the agencies
published another notice of proposed
rulemaking. 62 FR 59943 (1997
Proposal). In the 1997 Proposal, the
agencies proposed to use credit ratings
from nationally recognized statistical
rating organizations to determine the
capital requirement for recourse
obligations, direct credit substitutes,
and senior asset-backed securities.
Additionally, the 1997 Proposal
requested comment on a series of
options and alternatives to supplement
or replace the ratings-based approach.
In June 1999, the Basel Committee on
Banking Supervision issued a
consultative paper, ‘‘A New Capital
Adequacy Framework, that sets forth
possible revisions to the 1988 Basel
Accord.3 The Basel consultative paper
discusses potential modifications to the
current capital standards, including the
capital treatment of securitizations. The
suggested changes in the Basel
consultative paper move in the same
direction as this proposal by looking to
external credit ratings issued by
qualifying external credit assessment
institutions as a basis for determining
the credit quality and the resulting
capital treatment of securitizations.
II. Background
A. Asset Securitization
Asset securitization is the process by
which loans or other credit exposures
are pooled and reconstituted into
securities, with one or more classes or
positions, that may then be sold.
Securitization 4 provides an efficient
mechanism for banking organizations to
buy and sell loan assets or credit
exposures and thereby to make them
more liquid.
Securitizations typically carve up the
risk of credit losses from the underlying
assets and distribute it to different
parties
ures
are pooled and reconstituted into
securities, with one or more classes or
positions, that may then be sold.
Securitization 4 provides an efficient
mechanism for banking organizations to
buy and sell loan assets or credit
exposures and thereby to make them
more liquid.
Securitizations typically carve up the
risk of credit losses from the underlying
assets and distribute it to different
parties. The ‘‘first dollar,’’ or
subordinate, loss position is first to
absorb credit losses; the most ‘‘senior’’
investor position is last; and there may
be one or more loss positions in
between (‘‘second dollar’’ loss
positions). Each loss position functions
as a credit enhancement for the more
senior loss positions in the structure.
For residential mortgages sold
through certain Federally-sponsored
mortgage programs, a Federal
government agency or Federal
government sponsored enterprise (GSE)
guarantees the securities sold to
investors. However, many of today’s
asset securitization programs involve
nonmortgage assets or are not Federally
supported in any way. Sellers of these
privately securitized assets therefore
often provide other forms of credit
enhancement—first and second dollar
loss positions—to reduce investors’ risk
of credit loss.
A seller may provide this credit
enhancement itself through recourse
arrangements. As defined in this
proposal, ‘‘recourse’’ refers to the risk of
credit loss that a banking organization
retains in connection with the transfer
of its assets. Banking organizations have
long provided recourse in connection
with sales of whole loans or loan
participations; today, recourse
arrangements frequently are associated
with asset securitization programs.
A seller may also arrange for a third
party to provide credit enhancement 5 in
an asset securitization. If the third-party
enhancement is provided by another
banking organization, that organization
assumes some portion of the assets’
credit risk
in connection
with sales of whole loans or loan
participations; today, recourse
arrangements frequently are associated
with asset securitization programs.
A seller may also arrange for a third
party to provide credit enhancement 5 in
an asset securitization. If the third-party
enhancement is provided by another
banking organization, that organization
assumes some portion of the assets’
credit risk. In this proposal, all forms of
third-party enhancements, i.e., all
arrangements in which a banking
organization assumes risk of credit loss
from third-party assets or other claims
that it has not transferred, are referred
to as ‘‘direct credit substitutes.’’ The
economic substance of a banking
organization’s risk of credit loss from
providing a direct credit substitute can
be identical to its risk of credit loss from
transferring an asset with recourse.
Depending on the type of
securitization transaction, the sponsor
of a securitization may provide a
portion of the total credit enhancement
internally, as part of the securitization
structure, through the use of spread
accounts, overcollateralization, retained
subordinated interests, or other similar
forms of on-balance sheet assets. When
these or other types of internal
enhancements are provided, the
enhancements are considered a form of
recourse for risk-based capital purposes.
Many asset securitizations use a
combination of internal enhancement,
recourse, and third-party enhancement
to protect investors from risk of credit
loss.
B. Risk Management of Exposures
Arising From Securitization Activities
While asset securitization can
enhance both credit availability and a
banking organization’s profitability,
managing the risks associated with this
activity can pose significant challenges.
This is because the risks involved, while
not new to banking organizations, may
be less obvious and more complex than
the risks of traditional lending
agement of Exposures
Arising From Securitization Activities
While asset securitization can
enhance both credit availability and a
banking organization’s profitability,
managing the risks associated with this
activity can pose significant challenges.
This is because the risks involved, while
not new to banking organizations, may
be less obvious and more complex than
the risks of traditional lending.
Specifically, securitization can involve
credit, liquidity, operational, legal, and
reputational risks in concentrations and
forms that may not be fully recognized
by management or adequately
incorporated into a banking
organization’s risk management
systems.
The risk-based capital treatment
described in this proposal provides one
important way of addressing the credit
risk presented by securitization
activities, but a banking organization’s
compliance with capital standards
should be complemented by effective
risk management strategies. The
agencies expect that banking
organizations will identify, measure,
monitor and control the risks of their
securitization activities (including
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6 ‘‘Synthetic securitization’’ refers to the bundling
of credit risk associated with on-balance sheet
assets and off-balance sheet items for subsequent
sale into the market.
7 In this regard, the agencies note that one
increasingly important component of the systems
for controlling credit risk at larger banking
organizations is the identification of the gradations
in credit risk among their business loans and the
assignment of internal credit risk ratings to loans
that correspond to these gradations. The agencies
believe that the use of such an internal rating
process is appropriate—indeed, necessary—for
sound risk management at large banking
organizations
ms
for controlling credit risk at larger banking
organizations is the identification of the gradations
in credit risk among their business loans and the
assignment of internal credit risk ratings to loans
that correspond to these gradations. The agencies
believe that the use of such an internal rating
process is appropriate—indeed, necessary—for
sound risk management at large banking
organizations. In particular, those banking
organizations with significant involvement in
securitization activities should have relatively
elaborate and formal approaches for assessing and
managing the associated credit risk.
8 Stress testing usually involves identifying
possible events or changes in market behavior that
could have unfavorable effects on an banking
organization and assessing the organization’s ability
to withstand them. Stress testing should not only
consider the probability of adverse events, but also
potential ‘‘worst case’’ scenarios. Such an analysis
should be done on a consolidated basis and
consider, for example, the effect of higher than
expected levels of delinquencies and defaults. The
analysis should also consider the consequences of
early amortization events that could raise concerns
regarding a banking organization’s capital adequacy
and its liquidity and funding capabilities. Stress test
analyses should also include contingency plans
regarding the actions management might take given
certain situations.
9 Assets transferred with any amount of recourse
in a transaction reported as a financing in
accordance with generally accepted accounting
principles (GAAP) remain on the balance sheet and
are risk-weighted in the same manner as any other
on-balance sheet asset. Assets transferred with
recourse in a transaction that is reported as a sale
under GAAP are removed from the balance sheet
and are treated as off-balance sheet exposures for
risk-based capital purposes
n reported as a financing in
accordance with generally accepted accounting
principles (GAAP) remain on the balance sheet and
are risk-weighted in the same manner as any other
on-balance sheet asset. Assets transferred with
recourse in a transaction that is reported as a sale
under GAAP are removed from the balance sheet
and are treated as off-balance sheet exposures for
risk-based capital purposes.
10 Consistent with statutory requirements, the
agencies’ current rules also provide for special
treatment of sales of small business loan obligations
with recourse. See 12 CFR Part 3, appendix A,
Section 3(c) (OCC); 12 CFR parts 208 and 225,
appendix A, II.B.5 (FRB); 12 CFR part 325,
appendix A, II.B.6 (FDIC); 12 CFR 567.6(E)(3)
(OTS).
11 Section 350 of the CDRI Act required the
agencies to prescribe regulations providing that the
risk-based capital requirement for assets transferred
with recourse could not exceed a banking
organization’s maximum contractual exposure. The
agencies may require a higher amount if necessary
for safety and soundness reasons. See 12 U.S.C.
4808.
synthetic securitizations 6 using credit
derivatives) and explicitly incorporate
the full range of risks into their risk
management systems. Management is
responsible for having adequate policies
and procedures in place to ensure that
the economic substance of their risks is
fully recognized and appropriately
managed. Banking organizations should
be able to measure and manage their
risk exposure from risk positions in the
securitizations, either retained or
acquired, and should be able to assess
the credit quality of the retained
residual portfolio after the transfer of
assets in a securitization transaction.
The formality and sophistication with
which the risks of these activities are
incorporated into a banking
organization’s risk management system
should be commensurate with the
nature and volume of its securitization
activities
either retained or
acquired, and should be able to assess
the credit quality of the retained
residual portfolio after the transfer of
assets in a securitization transaction.
The formality and sophistication with
which the risks of these activities are
incorporated into a banking
organization’s risk management system
should be commensurate with the
nature and volume of its securitization
activities. Banking organizations with
significant securitization activities, no
matter what the size of their on-balance
sheet assets, are expected to have more
elaborate and formal approaches to
manage the risks. Failure to understand
the risks inherent in securitization
activities and to incorporate them into
risk management systems and internal
capital allocations may constitute an
unsafe or unsound banking practice.
Banking organizations must have
adequate systems that evaluate the effect
of securitization transactions on the
banking organization’s risk profile and
capital adequacy. Based on the
complexity of transactions, these
systems should be capable of
differentiating between the nature and
quality of the risk exposures transferred
versus those that the banking
organization retains. Adequate
management systems usually:
• Have an internal system for grading
credit risk exposures, including: (1)
Adequate differentiation of risk among
risk grades; (2) adequate controls to
ensure the objectivity and consistency
of the rating process; and (3) analysis or
evidence supporting the accuracy or
appropriateness of the risk-grading
system.7
• Evaluate the effect of the
transaction on the nature and
distribution of the banking book
exposures that have not been transferred
in connection with securitization. This
analysis should include a comparison of
the banking book’s risk profile before
and after the transaction, including the
mix of exposures by risk grade and by
business or economic sector. The
analysis should also include
identification of any concentrations of
credit risk
the nature and
distribution of the banking book
exposures that have not been transferred
in connection with securitization. This
analysis should include a comparison of
the banking book’s risk profile before
and after the transaction, including the
mix of exposures by risk grade and by
business or economic sector. The
analysis should also include
identification of any concentrations of
credit risk.
• Perform rigorous, forward-looking
stress testing 8 on exposures that have
not been transferred (that is, loans and
commitments remaining in the banking
book), transferred exposures, and
exposures retained to facilitate transfers
(that is, credit enhancements).
• Have an internal economic capital
allocation methodology that provides
the banking organization will have
adequate capitalization to meet a
specific probability that it will not
become insolvent if unexpected credit
losses occur and that readjusts, as
necessary, the sponsoring bank’s
internal economic capital requirements
to take into account the effect of the
securitization transactions.
Banking organizations should ensure
that their capital positions are
sufficiently strong to support all of the
risks associated with these activities on
a fully consolidated basis and should
maintain adequate capital in all
affiliated entities engaged in these
activities.
C. Current Risk-Based Capital
Treatment of Recourse and Direct Credit
Substitutes
Currently, the agencies’ risk-based
capital standards apply different
treatments to recourse arrangements and
direct credit substitutes. As a result,
capital requirements applicable to credit
enhancements do not consistently
reflect credit risk. The current rules of
the OCC, Board, and FDIC (the banking
agencies) are also not entirely consistent
with those of the OTS.
1
d Direct Credit
Substitutes
Currently, the agencies’ risk-based
capital standards apply different
treatments to recourse arrangements and
direct credit substitutes. As a result,
capital requirements applicable to credit
enhancements do not consistently
reflect credit risk. The current rules of
the OCC, Board, and FDIC (the banking
agencies) are also not entirely consistent
with those of the OTS.
1. Recourse
The agencies’ risk-based capital
guidelines prescribe a single treatment
for assets transferred with recourse,
regardless of whether the transaction is
reported as a financing or a sale of assets
in a bank’s Consolidated Reports of
Condition and Income (Call Report), a
bank holding company’s FR Y–9
reports, or a thrift’s Thrift Financial
Report.9 For a transaction reported as a
financing, the transferred assets remain
on the balance sheet and are risk-
weighted. For a transaction reported as
a sale, the entire outstanding amount of
the assets sold (not just the contractual
amount of the recourse obligation) is
converted into an on-balance sheet
credit equivalent amount using a 100%
credit conversion factor. This credit
equivalent amount (less any applicable
recourse liability account recorded on
the balance sheet) is then risk-
weighted.10 If the seller’s balance sheet
includes as an asset any retained
interest in the assets sold, the retained
interest is not risk-weighted separately.
Thus, regardless of the method used to
account for the transfer, risk-based
capital is held against the full, risk-
weighted amount of the transferred
assets, although the transaction is
subject to the low-level recourse rule,
which limits the maximum risk-based
capital requirement to the banking
organization’s maximum contractual
exposure. 11
For leverage capital ratio purposes, if
a transfer with recourse is reported as a
financing, the transferred assets remain
on the transferring banking
organization’s balance sheet and the
banking organization must hold leverage
capital against these assets
low-level recourse rule,
which limits the maximum risk-based
capital requirement to the banking
organization’s maximum contractual
exposure. 11
For leverage capital ratio purposes, if
a transfer with recourse is reported as a
financing, the transferred assets remain
on the transferring banking
organization’s balance sheet and the
banking organization must hold leverage
capital against these assets. If a transfer
with recourse is reported as a sale, the
assets sold do not remain on the selling
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12 The OTS, which already defines the term
‘‘recourse’’ in its rules, would revise its definition
so that it is consistent with the definition adopted
by the other agencies. The OTS is also adding a
definition of ‘‘financial guarantee-type letter of
credit’’ to be consistent with the OCC and the
Board.
13 ‘‘Nationally recognized statistical rating
organization’’ means an entity recognized by the
Division of Market Regulation of the Securities and
Exchange Commission as a nationally recognized
statistical rating organization for various purposes,
including the capital rules for broker-dealers. See
SEC Rule 15c3–1(c)(2)(vi)(E), (F) and (H), 17 CFR
240.15c3–091(c)(2)(vi)(E), (F), and (H).
14 For a description of these approaches, see 62
FR 59944, 59952–59961 (November 5, 1997).
banking organization’s balance sheet
and the banking organization need not
hold leverage capital against these
assets. However, if the seller’s balance
sheet includes as an asset any retained
interest in the assets sold, leverage
capital must be held against the retained
interest.
2. Direct Credit Substitutes
Direct credit substitutes are treated
differently from recourse under the
current risk-based capital standards
s balance sheet
and the banking organization need not
hold leverage capital against these
assets. However, if the seller’s balance
sheet includes as an asset any retained
interest in the assets sold, leverage
capital must be held against the retained
interest.
2. Direct Credit Substitutes
Direct credit substitutes are treated
differently from recourse under the
current risk-based capital standards.
Under the banking agencies’ current
standards, off-balance sheet direct credit
substitutes, such as financial standby
letters of credit provided for third-party
assets, carry a 100% credit conversion
factor. However, only the dollar amount
of the direct credit substitute is
converted into an on-balance sheet
credit equivalent amount, so that capital
is held only against the face amount of
the direct credit substitute. The capital
requirement for a recourse arrangement,
in contrast, generally is based on the full
amount of the assets enhanced.
If a direct credit substitute covers less
than 100% of the potential losses on the
assets enhanced, the current capital
treatment results in a lower capital
charge for a direct credit substitute than
for a comparable recourse arrangement.
For example, if a direct credit substitute
covers losses up to the first 20% of the
assets enhanced, then the on-balance
sheet credit equivalent amount equals
that 20% amount, and risk-based capital
is held against only the 20% amount. In
contrast, required capital for a first-loss
20% recourse arrangement is higher
because capital is held against the full
outstanding amount of the assets
enhanced, subject to the low-level
recourse rule.
Currently, under the banking
agencies’ guidelines, purchased
subordinated interests receive the same
capital treatment as off-balance sheet
direct credit substitutes. That is, the
amount of the purchased subordinated
interest is placed in the appropriate
risk-weight category
because capital is held against the full
outstanding amount of the assets
enhanced, subject to the low-level
recourse rule.
Currently, under the banking
agencies’ guidelines, purchased
subordinated interests receive the same
capital treatment as off-balance sheet
direct credit substitutes. That is, the
amount of the purchased subordinated
interest is placed in the appropriate
risk-weight category. In contrast, a
banking organization that retains a
subordinated interest in connection
with the transfer of its own assets is
considered to have transferred the assets
with recourse. As a result, the banking
organization must hold capital against
the carrying amount of the retained
subordinated interest as well as the
outstanding amount of all senior
interests that it supports, subject to the
low-level recourse rule.
The OTS risk-based capital regulation
treats some forms of direct credit
substitutes (e.g., financial standby
letters of credit) in the same manner as
the banking agencies’ guidelines.
However, unlike the banking agencies,
the OTS treats purchased subordinated
interests (except for certain high quality
subordinated mortgage-related
securities) under its general recourse
provisions. The risk-based capital
requirement is based on the carrying
amount of the subordinated interest
plus all senior interests, as though the
thrift owned the full outstanding
amount of the assets enhanced.
3. Concerns Raised by Current Risk-
Based Capital Treatment
The agencies’ current risk-based
capital standards raise significant
concerns with respect to the treatment
of recourse and direct credit substitutes.
First, banking organizations are often
required to hold different amounts of
capital for recourse arrangements and
direct credit substitutes that expose the
banking organization to equivalent risk
of credit loss. Banking organizations are
taking advantage of this anomaly, for
example, by providing first-loss letters
of credit to asset-backed commercial
paper conduits that lend directly to
corporate customers
ing organizations are often
required to hold different amounts of
capital for recourse arrangements and
direct credit substitutes that expose the
banking organization to equivalent risk
of credit loss. Banking organizations are
taking advantage of this anomaly, for
example, by providing first-loss letters
of credit to asset-backed commercial
paper conduits that lend directly to
corporate customers. This results in a
significantly lower capital requirement
than if the loans had originally been
carried on the banking organizations’
balance sheets and then were sold.
Moreover, the current capital standards
do not recognize differences in risk
associated with different loss positions
in asset securitizations, nor do they
provide uniform definitions of recourse,
direct credit substitute, and associated
terms.
III. Description of the Proposal
This proposal would amend the
agencies’ risk-based capital standards as
follows:
• The proposal defines ‘‘recourse’’
and revises the definition of ‘‘direct
credit substitute’’; 12
• It provides more consistent risk-
based capital treatment for recourse
obligations and direct credit substitutes;
• It varies the capital requirements for
positions in securitized transactions
according to their relative risk exposure,
using credit ratings from nationally
recognized statistical rating
organizations 13 (rating agencies) to
measure the level of risk;
• It permits the limited use of a
banking organization’s qualifying
internal risk rating system, a rating
agency’s or other appropriate third
party’s review of the credit risk of
positions in structured programs, and
qualifying software to determine the
capital requirement for certain unrated
direct credit substitutes; and
• It requires the sponsor of a
revolving credit securitization that
involves an early amortization feature to
hold capital against the amount of assets
under management in that
securitization.
The use of credit ratings in this
proposal is similar to the 1997 Proposal
structured programs, and
qualifying software to determine the
capital requirement for certain unrated
direct credit substitutes; and
• It requires the sponsor of a
revolving credit securitization that
involves an early amortization feature to
hold capital against the amount of assets
under management in that
securitization.
The use of credit ratings in this
proposal is similar to the 1997 Proposal.
Although many commenters expressed
concerns about specific details in the
1997 Proposal, commenters generally
supported the goal of making the capital
requirements associated with asset
securitizations more rational and
efficient, and viewed the 1997 Proposal
as a positive step toward achieving a
more consistent, rational, and efficient
regulatory capital framework. The
agencies have made several changes to
the 1997 Proposal in response to
commenters’ concerns and based on
further agency consideration of the
issues presented.
Several options and alternatives in the
1997 Proposal have been eliminated: the
modified gross-up approach, the ratings
benchmark approach, and the historical
losses approach.14 Commenters
expressed numerous concerns about
these approaches and the agencies agree
that better alternatives exist.
Commenters responding to the 1997
Proposal expressed a number of
concerns about the use of ratings from
rating agencies to determine capital
requirements, especially in the case of
unrated direct credit substitutes.
Commenters noted that banking
organizations actively involved in the
securitization business have their own
internal risk rating systems, that
banking organizations know their assets
better than third parties, and that a
requirement that a banking organization
obtain a rating from a rating agency
solely for regulatory capital purposes is
burdensome. Some commenters also
expressed skepticism about the
suitability of rating agency credit ratings
for regulatory capital purposes
tion business have their own
internal risk rating systems, that
banking organizations know their assets
better than third parties, and that a
requirement that a banking organization
obtain a rating from a rating agency
solely for regulatory capital purposes is
burdensome. Some commenters also
expressed skepticism about the
suitability of rating agency credit ratings
for regulatory capital purposes.
In the opinion of the agencies, ratings
have the advantages of being relatively
objective, widely used, and relied upon
by investors and other participants in
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15 The OTS currently defines the term ‘‘recourse’’
more broadly than the proposal to include
arrangements involving credit risk that a thrift
assumes or accepts from third-party assets as well
as risk that it retains in an asset transfer. Under the
proposal, credit risk that a banking organization
assumes from third-party assets falls under the
definition of ‘‘direct credit substitute’’ rather than
‘‘recourse.’’
the financial markets. Ratings provide a
flexible, efficient, market-oriented way
to measure credit risk. The agencies
recognize, however, that there are
drawbacks to using credit ratings from
rating agencies to set capital
requirements. Moreover, the agencies
agree with some commenters’
observation that credit ratings are most
useful with respect to publicly-traded
positions that would be rated regardless
of the agencies’ risk-based capital
requirements.
To minimize the need for banking
organizations to obtain ratings on
otherwise unrated enhancements that
are provided in asset-backed
commercial paper securitizations, the
proposal permits banking organizations
to use their own qualifying internal risk
rating systems in place of ratings from
rating agencies for risk weighting certain
direct credit substitutes
ncies’ risk-based capital
requirements.
To minimize the need for banking
organizations to obtain ratings on
otherwise unrated enhancements that
are provided in asset-backed
commercial paper securitizations, the
proposal permits banking organizations
to use their own qualifying internal risk
rating systems in place of ratings from
rating agencies for risk weighting certain
direct credit substitutes. The use of
internal risk ratings to assign direct
credit substitutes in asset-backed
commercial paper programs to rating
categories under the ratings-based
approach is dependent upon the
existence of adequate internal risk rating
systems. The adequacy of any internal
risk rating system will depend upon a
banking organization’s incorporation of
the prudential standards outlined in this
proposal, as well as other factors
recommended through supervisory
guidance or on a case-by-case basis.
Finally, the agencies are proposing an
additional measure to address the risk
associated with early amortization
features in certain asset securitizations.
The managed assets approach, described
in Section III.D., would apply a 20%
risk weight to the amount of off-balance
sheet securitized assets under
management in such transactions.
A. Definitions and Scope of the Proposal
1. Recourse
The proposal defines the term
‘‘recourse’’ to mean an arrangement in
which a banking organization retains
risk of credit loss in connection with an
asset transfer, if the risk of credit loss
exceeds a pro rata share of the banking
organization’s claim on the assets. The
proposed definition of recourse is
consistent with the banking agencies’
longstanding use of this term, and
incorporates existing agency practices
regarding retention of risk in asset
transfers into the risk-based capital
standards.15
Currently, the term ‘‘recourse’’ is not
defined explicitly in the banking
agencies’ risk-based capital guidelines.
Instead, the guidelines use the term
‘‘sale of assets with recourse,’’ which is
defined by reference to the Call Report
Instructions
ing use of this term, and
incorporates existing agency practices
regarding retention of risk in asset
transfers into the risk-based capital
standards.15
Currently, the term ‘‘recourse’’ is not
defined explicitly in the banking
agencies’ risk-based capital guidelines.
Instead, the guidelines use the term
‘‘sale of assets with recourse,’’ which is
defined by reference to the Call Report
Instructions. See Call Report
Instructions, Glossary (entry for ‘‘Sales
of Assets for Risk-Based Capital
Purposes’’). Once a definition of
recourse is adopted in the risk-based
capital guidelines, the banking agencies
would remove the cross-reference to the
Call Report instructions from the
guidelines. The OTS capital regulation
currently provides a definition of the
term ‘‘recourse,’’ which would also be
replaced once a final definition of
recourse is adopted.
2. Direct Credit Substitute
The proposed definition of ‘‘direct
credit substitute’’ complements the
definition of recourse. The term ‘‘direct
credit substitute’’ would refer to any
arrangement in which a banking
organization assumes risk of credit-
related losses from assets or other
claims it has not transferred, if the risk
of credit loss exceeds the banking
organization’s pro rata share of the
assets or other claims. Currently, under
the banking agencies’ guidelines, this
term covers guarantee-type
arrangements. As revised, it would also
include explicitly items such as
purchased subordinated interests,
agreements to cover credit losses that
arise from purchased loan servicing
rights, credit derivatives and lines of
credit that provide credit enhancement.
Some commenters responding to the
1997 Proposal suggested that the
definition of ‘‘direct credit substitute’’
should exclude risk positions that are
not part of an asset securitization
e explicitly items such as
purchased subordinated interests,
agreements to cover credit losses that
arise from purchased loan servicing
rights, credit derivatives and lines of
credit that provide credit enhancement.
Some commenters responding to the
1997 Proposal suggested that the
definition of ‘‘direct credit substitute’’
should exclude risk positions that are
not part of an asset securitization.
Although direct credit substitutes
commonly are used in asset
securitizations, enhancements involving
similar credit risk exposure can arise in
other contexts and should receive the
same capital treatment as enhancements
associated with securitizations.
Several commenters objected to the
1997 Proposal’s treatment of direct
credit substitutes as recourse.
Commenters asserted that the business
of providing third-party credit
enhancements has historically been safe
and profitable for banks and objected
that the proposed capital treatment
would impair the competitive position
of U.S. banks and thrifts. As has been
previously described, however, the
current treatment of direct credit
substitutes is not consistent with the
treatment of recourse obligations. The
agencies have concluded that the
difference in treatment between the two
forms of credit enhancement invites
banking organizations to obtain direct
credit substitutes in place of recourse
obligations in order to avoid the capital
requirement applicable to recourse
obligations and on-balance-sheet assets.
For this reason, the agencies are again
proposing, as a general rule, to extend
the current risk-based capital treatment
of asset transfers with recourse,
including the low-level recourse rule, to
direct credit substitutes.
In an effort to address competitive
inequities at the international level,
however, the agencies have raised this
issue with the bank supervisory
authorities from the other countries
represented on the Basel Committee on
Banking Supervision
rule, to extend
the current risk-based capital treatment
of asset transfers with recourse,
including the low-level recourse rule, to
direct credit substitutes.
In an effort to address competitive
inequities at the international level,
however, the agencies have raised this
issue with the bank supervisory
authorities from the other countries
represented on the Basel Committee on
Banking Supervision. The Basel
Committee’s consultative paper, ‘‘A
New Capital Adequacy Framework,’’
acknowledges that the current Basel
Capital Accord, upon which the
agencies’ risk-based capital standards
are based, lacks consistency in its
treatment of credit enhancements.
3. Lines of Credit
One commenter requested
clarification that a line of credit that
provides credit enhancement for the
financial obligations of an account party
could be a direct credit substitute only
if it represented an irrevocable
obligation to the beneficiary. A
revocable line of credit would not be a
direct credit substitute because the
issuer could protect itself against credit
losses at any time prior to a draw on the
line of credit. However, an irrevocable
line of credit could expose the issuer to
credit losses and would constitute a
direct credit substitute, if it met the
criteria in the definitions. Also, any
conditions attached to the issuer’s
ability to revoke the undrawn portion of
a line of credit, or that interfere with the
issuer’s ability to protect itself against
credit loss prior to a draw, will cause
the line of credit to constitute a direct
credit substitute.
4. Credit Derivatives
The proposed definitions of
‘‘recourse’’ and ‘‘direct credit
substitute’’ cover credit derivatives to
the extent that a banking organization’s
credit risk exposure exceeds its pro rata
interest in the underlying obligation.
The ratings-based approach therefore
applies to rated instruments such as
credit-linked notes issued as part of a
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stitute’’ cover credit derivatives to
the extent that a banking organization’s
credit risk exposure exceeds its pro rata
interest in the underlying obligation.
The ratings-based approach therefore
applies to rated instruments such as
credit-linked notes issued as part of a
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Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules
16 ‘‘Synthetic securitization’’ refers to the
bundling of credit risk associated with on-balance
sheet assets and off-balance sheet items for
subsequent sale into the market. Credit derivatives,
and in particular credit-linked notes, are used to
structure a synthetic securitization. For more
information on synthetic securitizations see, Joint
OCC and Federal Reserve Board Issuance on Credit
Derivatives, ‘‘Capital Interpretations—Synthetic
Collateralized Loan Obligations,’’ dated November
15, 1999.
17 Current OTS risk-based capital guidelines
exclude certain high-quality subordinated
mortgage-related securities from treatment as
recourse arrangements due to their credit quality.
synthetic securitization. 16 The agencies
request comment on the inclusion of
credit derivatives in the definitions of
‘‘recourse’’ and ‘‘direct credit
substitute,’’ as well as on the definition
of ‘‘credit derivative’’ contained in the
proposal.
5. Risks Other Than Credit Risks
A capital charge would be assessed
only against arrangements that create
exposure to credit or credit-related risks.
This continues the agencies’ current
practice and is consistent with the risk-
based capital standards’ traditional
focus on credit risk. The agencies have
undertaken other initiatives to ensure
that the risk-based capital standards
take interest rate risk and other non-
credit related market risks into account.
6. Implicit Recourse
The definitions cover all
arrangements that are recourse or direct
credit substitutes in form or in
substance
e and is consistent with the risk-
based capital standards’ traditional
focus on credit risk. The agencies have
undertaken other initiatives to ensure
that the risk-based capital standards
take interest rate risk and other non-
credit related market risks into account.
6. Implicit Recourse
The definitions cover all
arrangements that are recourse or direct
credit substitutes in form or in
substance. Recourse may also exist
when a banking organization assumes
risk of loss without an explicit
contractual agreement or, if there is a
contractual limit, when the banking
organization assumes risk of loss in an
amount exceeding the limit. The
existence of implicit recourse is often a
complex and fact-specific issue, usually
demonstrated by a banking
organization’s actions to support a
securitization beyond any contractual
obligation. Actions that may constitute
implicit recourse include: providing
voluntary support for a securitization by
selling assets to a trust at a discount
from book value; exchanging performing
for non-performing assets; or other
actions that result in a significant
transfer of value in response to
deterioration in the credit quality of a
securitized asset pool.
To date, the agencies have taken the
position that when a banking
organization provides implicit recourse,
it generally should hold capital in the
same amount as for assets sold with
recourse. However, the complexity of
many implicit recourse arrangements
and the variety of circumstances under
which implicit recourse may be
provided raise issues about whether
recourse treatment is always the most
appropriate way to address the level of
risk that a banking organization has
effectively retained or whether a
different capital requirement would be
warranted in some circumstances.
Accordingly, the 1997 Proposal
requested comment on the types of
actions that should be considered
implicit recourse and how the agencies
should treat those actions for regulatory
capital purposes
t is always the most
appropriate way to address the level of
risk that a banking organization has
effectively retained or whether a
different capital requirement would be
warranted in some circumstances.
Accordingly, the 1997 Proposal
requested comment on the types of
actions that should be considered
implicit recourse and how the agencies
should treat those actions for regulatory
capital purposes.
Commenters responding to the 1997
Proposal generally supported the view
that implicit recourse is best handled on
a case-by-case basis, guided by the
general rule that actions that
demonstrate retention of risk will trigger
recourse treatment of affected
transactions. The agencies intend to
continue to address implicit recourse
case-by-case, but may issue additional
guidance if needed to clarify further the
circumstances in which a banking
organization will be considered to have
provided implicit recourse.
7. Subordinated Interests in Loans or
Pools of Loans
The definitions of recourse and direct
credit substitute explicitly cover a
banking organization’s ownership of
subordinated interests in loans or pools
of loans. This continues the banking
agencies’ longstanding treatment of
retained subordinated interests as
recourse and recognizes that purchased
subordinated interests can also function
as credit enhancements. (The OTS
currently treats both retained and
purchased subordinated securities as
recourse obligations.) Subordinated
interests generally absorb more than
their pro rata share of losses (principal
and interest) from the underlying assets
in the event of default. For example, a
multi-class asset securitization may
have several classes of subordinated
securities, each of which provides credit
enhancement for the more senior
classes. Generally, the holder of any
class that absorbs more than its pro rata
share of losses from the total underlying
assets is providing credit protection for
all of the more senior classes. 17
Some commenters questioned the
treatment of purchased subordinated
interests as recourse
y
have several classes of subordinated
securities, each of which provides credit
enhancement for the more senior
classes. Generally, the holder of any
class that absorbs more than its pro rata
share of losses from the total underlying
assets is providing credit protection for
all of the more senior classes. 17
Some commenters questioned the
treatment of purchased subordinated
interests as recourse. Subordinated
interests expose holders to comparable
risk regardless of whether the interests
are retained or purchased. If purchased
subordinated interests were not treated
as recourse, banking organizations could
avoid recourse treatment by swapping
retained subordinated interests with
other banking organizations or by
purchasing subordinated interests in
assets originated by a conduit. The
proposal would mitigate the effect of
treating purchased subordinated
interests as recourse by reducing the
capital requirement on interests that
qualify under the multi-level approach
described in section III.B.
8. Representations and Warranties
When a banking organization transfers
assets, including servicing rights, it
customarily makes representations and
warranties concerning those assets.
When a banking organization purchases
loan servicing rights, it may also assume
representations and warranties made by
the seller or a prior servicer. These
representations and warranties give
certain rights to other parties and
impose obligations upon the seller or
servicer of the assets. The proposal
addresses those particular
representations and warranties that
function as credit enhancements, i.e.
those where, typically, a banking
organization agrees to protect
purchasers or some other party from
losses due to the default or non-
performance of the obligor or
insufficiency in the value of collateral
other parties and
impose obligations upon the seller or
servicer of the assets. The proposal
addresses those particular
representations and warranties that
function as credit enhancements, i.e.
those where, typically, a banking
organization agrees to protect
purchasers or some other party from
losses due to the default or non-
performance of the obligor or
insufficiency in the value of collateral.
Therefore, to the extent a banking
organization’s representations and
warranties function as credit
enhancements to protect asset
purchasers or investors from credit risk
by obligating the banking organization
to protect another party from losses due
to credit risk in the transferred assets,
the proposal treats them as recourse or
direct credit substitutes.
The 1997 Proposal treated as recourse
or a direct credit substitute any
representation or warranty other than a
standard representation or warranty.
Standard representations and warranties
were those referring to facts verified by
the seller or servicer with reasonable
due diligence or conditions within the
control of the seller or servicer and
those providing for the return of assets
in the event of fraud or documentation
deficiencies. Some commenters objected
that the 1997 Proposal would treat as
recourse many industry-standard
warranties that impose only minor
operational risk instead of true credit
risk. Other commenters objected that the
due diligence requirement was
burdensome, and that it would impose
compliance costs on banking
organizations disproportionate to the
risk assumed.
The current proposal focuses on
whether a warranty allocates credit risk
to the banking organization, rather than
whether the warranty is somehow
standard or customary within the
industry. Several commenters suggested
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ing
organizations disproportionate to the
risk assumed.
The current proposal focuses on
whether a warranty allocates credit risk
to the banking organization, rather than
whether the warranty is somehow
standard or customary within the
industry. Several commenters suggested
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Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules
18 Servicer cash advances include disbursements
made to cover foreclosure costs or other expenses
arising from a loan in order to facilitate its timely
collection (but not to protect investors from
incurring these expenses).
that the agencies expressly take
accepted mortgage banking industry
practice into account in determining
whether a warranty should receive
recourse treatment. However, the
agencies are aware of warranties
sometimes characterized as ‘‘standard’’
that effectively function as credit
enhancements. These include
warranties that transferred loans will
remain of investment quality, or that no
circumstances exist involving the loan
collateral or borrower’s credit standing
that could cause the loan to become
delinquent. They may also include
warranties that, for seasoned mortgages,
the value of the loan collateral still
equals the original appraised value and
the borrower’s ability to pay has not
changed adversely.
The proposal is consistent with the
agencies’ longstanding recourse
treatment of representations and
warranties that effectively guaranty
performance or credit quality of
transferred loans. However, the proposal
and the agencies’ longstanding practice
also recognize that banking
organizations typically make a number
of factual warranties unrelated to
ongoing performance or credit quality.
These warranties entail operational risk,
as opposed to the open-ended credit risk
inherent in a financial guaranty
ties that effectively guaranty
performance or credit quality of
transferred loans. However, the proposal
and the agencies’ longstanding practice
also recognize that banking
organizations typically make a number
of factual warranties unrelated to
ongoing performance or credit quality.
These warranties entail operational risk,
as opposed to the open-ended credit risk
inherent in a financial guaranty.
Warranties that create operational risk
include: warranties that assets have
been underwritten or collateral
appraised in conformity with identified
standards, and warranties that provide
for the return of assets in instances of
incomplete documentation or fraud.
Warranties can impose varying
degrees of operational risk. For example,
a warranty that asset collateral has not
suffered damage from hazard entails risk
that is offset to some extent by prudent
underwriting practices requiring the
borrower to provide hazard insurance to
the banking organization. A warranty
that asset collateral is free of
environmental hazards may present
acceptable operational risk for certain
types of properties that have been
subject to environmental assessment,
depending on the circumstances. The
agencies address appropriate limits for
these operational risks through
supervision of a banking organization’s
loan underwriting, sale, and servicing
practices. Also, a banking organization
that provides warranties to loan
purchasers and investors must include
associated operational risks in its risk
management of exposures arising from
loan sale or securitization-related
activities. Banking organizations should
be prepared to demonstrate to
examiners that the operational risks are
effectively managed.
The proposal continues the agencies’
current practice of imposing recourse
treatment on ‘‘early-default’’ clauses.
Early-default clauses typically warrant
that transferred loans will not become
more than 30 days delinquent within a
stated period, such as four months
activities. Banking organizations should
be prepared to demonstrate to
examiners that the operational risks are
effectively managed.
The proposal continues the agencies’
current practice of imposing recourse
treatment on ‘‘early-default’’ clauses.
Early-default clauses typically warrant
that transferred loans will not become
more than 30 days delinquent within a
stated period, such as four months.
Once the stated period has run, the
early-default clause will no longer
trigger recourse treatment, provided that
there is no other provision that
constitutes recourse. One commenter to
the 1997 Proposal stated that early-
default clauses carry minimal risk, and
are intended to deal with inadvertent
transfers of loans that are already 30-day
delinquencies, or to guard against
unsound originations by the loan seller.
Another commenter found recourse
treatment of early-default clauses to be
an appropriate response to the transfer
of credit risk that takes place under
these clauses.
The agencies find that early-default
clauses are often drafted so broadly that
they are indistinguishable from a
guaranty of financial assets. The
agencies have even found recent
examples in which early-default clauses
have been expanded to cover the first
year after loan transfer. Industry
concerns about assets delinquent at the
time of transfer or unsound originations
could be dealt with by warranties
directly addressing the condition of the
asset at the time of transfer and
compliance with stated underwriting
standards or, failing that, exposure caps
permitting the banking organization to
take advantage of the low-level recourse
rule. The proposal also requires
recourse treatment for warranties
providing assurances about the actual
value of asset collateral, including that
the market value corresponds to its
appraised value or that the appraised
value will be realized in the event of
foreclosure and sale.
The agencies invite further comment
on these issues
e banking organization to
take advantage of the low-level recourse
rule. The proposal also requires
recourse treatment for warranties
providing assurances about the actual
value of asset collateral, including that
the market value corresponds to its
appraised value or that the appraised
value will be realized in the event of
foreclosure and sale.
The agencies invite further comment
on these issues. The agencies also invite
comment on whether ‘‘premium
refund’’ clauses should receive recourse
treatment under any final rule. These
clauses require the seller to refund the
premium paid by the investor for any
loan that prepays within a stated period
after the loan is transferred. The
agencies are aware of premium refund
clauses with terms ranging from 90 days
to 36 months.
9. Loan Servicing Arrangements
The proposed definitions of
‘‘recourse’’ and ‘‘direct credit
substitute’’ cover loan servicing
arrangements if the servicer is
responsible for credit losses associated
with the loans being serviced. However,
cash advances made by residential
mortgage servicers to ensure an
uninterrupted flow of payments to
investors or the timely collection of the
mortgage loans are specifically excluded
from the definitions of recourse and
direct credit substitute, provided that
the residential mortgage servicer is
entitled to reimbursement for any
significant advances.18 This type of
advance is assessed risk-based capital
only against the amount of the cash
advance, and is assigned to the risk-
weight category appropriate to the party
obligated to reimburse the servicer.
If a residential mortgage servicer is
not entitled to full reimbursement, then
the maximum possible amount of any
nonreimbursed advances on any one
loan must be contractually limited to an
insignificant amount of the outstanding
principal on that loan in order for the
servicer’s obligation to make cash
advances to be excluded from the
definitions of recourse and direct credit
substitute
servicer.
If a residential mortgage servicer is
not entitled to full reimbursement, then
the maximum possible amount of any
nonreimbursed advances on any one
loan must be contractually limited to an
insignificant amount of the outstanding
principal on that loan in order for the
servicer’s obligation to make cash
advances to be excluded from the
definitions of recourse and direct credit
substitute. This treatment reflects the
agencies’ traditional view that servicer
cash advances meeting these criteria are
part of the normal mortgage servicing
function and do not constitute credit
enhancements.
Commenters responding to the 1997
Proposal generally supported the
proposed definition of servicer cash
advances. Some commenters asked for
clarification of the term ‘‘insignificant’’
and whether ‘‘reimbursement’’ includes
reimbursement payable out of
subsequent collections or
reimbursement in the form of a general
claim on the party obligated to
reimburse the servicer. Nonreimbursed
advances on any one loan that are
generally contractually limited to no
more than one percent of the amount of
the outstanding principal on that loan
would be considered insignificant.
Reimbursement includes reimbursement
payable from subsequent collections
and reimbursement in the form of a
general claim on the party obligated to
reimburse the servicer, provided that
the claim is not subordinated to other
claims on the cash flows from the
underlying asset pool.
Some commenters responding to the
1997 Proposal suggested that the
agencies treat servicer cash advances as
any advances that the servicer
reasonably expects will be repaid. The
agencies believe that a clear, specific
standard is needed to prevent the use of
servicer cash advances to circumvent
the proposed risk-based capital
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ted that the
agencies treat servicer cash advances as
any advances that the servicer
reasonably expects will be repaid. The
agencies believe that a clear, specific
standard is needed to prevent the use of
servicer cash advances to circumvent
the proposed risk-based capital
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12327
Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules
19 The OTS does not have a market risk rule.
20 The Board is also proposing to add language to
its risk-based capital standards that would permit
the Board to adjust the treatment of a capital
instrument that does not fit into the existing capital
categories or that provides capital to a banking
organization at levels that are not commensurate
with the nominal capital treatment of the
instrument. The other agencies already have this
flexibility under their existing rules.
treatment of recourse obligations and
direct credit substitutes.
10. Spread Accounts and
Overcollateralization
Several commenters requested that
the agencies state in their rules that
spread accounts and
overcollateralization do not impose a
risk of loss on a banking organization
and are, therefore, not recourse. By its
terms, the definition of recourse covers
only the retention of risk in a sale of
assets. Overcollateralization does not
ordinarily impose a risk of loss on a
banking organization, so it normally
would not fall within the proposed
definition of recourse. However, a
retained interest in a spread account
that is reflected as an asset on a selling
banking organization’s balance sheet
(directly as an asset or indirectly as a
receivable) is a form of recourse and is
treated accordingly for risk-based
capital purposes.
11. Interaction With Market Risk Rule
Some commenters responding to the
1997 Proposal asked for clarification of
the treatment of a transaction covered
by both the market risk rule and the
recourse rule
as an asset on a selling
banking organization’s balance sheet
(directly as an asset or indirectly as a
receivable) is a form of recourse and is
treated accordingly for risk-based
capital purposes.
11. Interaction With Market Risk Rule
Some commenters responding to the
1997 Proposal asked for clarification of
the treatment of a transaction covered
by both the market risk rule and the
recourse rule. Under the market risk
rule,19 a position properly located in the
trading account is excluded from risk-
weighted assets. The banking agencies
are not proposing to modify this
treatment, so a position that is properly
held in the trading account would not
be included in risk-weighted assets,
even if the position otherwise met the
criteria for a recourse obligation or a
direct credit substitute.
12. Participations in Direct Credit
Substitutes
If a direct credit substitute is
originated by a banking organization
which then sells a participation in that
direct credit substitute to another entity,
the originating banking organization
must apply a 100% conversion factor to
the full amount of the assets supported
by the direct credit substitute. The
originating banking organization would
then risk weight the credit equivalent
amount of the participant’s pro rata
share of the direct credit substitute at
the lower of the risk category
appropriate to the obligor in the
underlying transaction, after
considering any relevant guaranties or
collateral, or the risk category
appropriate to the participant entity.
The remaining pro rata share of the
credit equivalent amount is assigned to
the risk-weight category appropriate to
the obligor in the underlying
transaction, guarantor or collateral.
A banking organization that acquires
a risk participation in a direct credit
substitute must apply a 100%
conversion factor to its percentage share
of the direct credit substitute multiplied
by the full amount of the assets
supported by the credit enhancement
equivalent amount is assigned to
the risk-weight category appropriate to
the obligor in the underlying
transaction, guarantor or collateral.
A banking organization that acquires
a risk participation in a direct credit
substitute must apply a 100%
conversion factor to its percentage share
of the direct credit substitute multiplied
by the full amount of the assets
supported by the credit enhancement.
The credit equivalent amount is then
assigned to the risk category appropriate
to the obligor or, if relevant, the nature
of the collateral or guaranty.
Finally, in the case of the syndication
of a direct credit substitute where each
banking organization is obligated only
for its pro rata share of the risk and
there is no recourse to the originating
banking organization, each banking
organization must hold risk-based
capital against its pro rata share of the
assets supported by the direct credit
substitute.
13. Reservation of Authority
The agencies are proposing to add
language to the risk-based capital
standards that will provide greater
flexibility in administering the
standards. Banking organizations are
developing novel transactions that do
not fit well into the risk-weight
categories and credit conversion factors
set forth in the standards. Banking
organizations also are devising novel
instruments that nominally fit into a
particular risk-weight category or credit
conversion factor, but that impose risks
on the banking organization at levels
that are not commensurate with the
nominal risk-weight or credit
conversion factor for the asset, exposure
or instrument. Accordingly, the agencies
are proposing to add language to the
standards to clarify their authority, on a
case-by-case basis, to determine the
appropriate risk-weight for assets and
credit equivalent amounts and the
appropriate credit conversion factor for
off-balance sheet items in these
circumstances
with the
nominal risk-weight or credit
conversion factor for the asset, exposure
or instrument. Accordingly, the agencies
are proposing to add language to the
standards to clarify their authority, on a
case-by-case basis, to determine the
appropriate risk-weight for assets and
credit equivalent amounts and the
appropriate credit conversion factor for
off-balance sheet items in these
circumstances. Exercise of this authority
by the agencies may result in a higher
or lower risk weight for an asset or
credit equivalent amount or a higher or
lower credit conversion factor for an off-
balance sheet item. This reservation of
authority explicitly recognizes the
agencies retention of sufficient
discretion to ensure that banking
organizations, as they develop novel
financial assets, will be treated
appropriately under the risk-based
capital standards.20 In addition, the
agencies reserve the right to assign risk
positions in securitizations to
appropriate risk categories if the credit
rating of the risk position is deemed to
be inappropriate.
14. Privately-Issued Mortgage-Backed
Securities
Currently, the agencies assign
privately-issued mortgage-backed
securities to the 20% risk-weight
category if the underlying pool is
composed entirely of mortgage-related
securities issued by the Federal National
Mortgage Association (Fannie Mae),
Federal Loan Mortgage Corporation
(Freddie Mac), or Government National
Mortgage Association (Ginnie Mae).
Privately-issued mortgage-backed
securities backed by whole residential
mortgages are now assigned to the 50%
risk-weight category. The agencies
propose to eliminate this ‘‘pass-
through’’ treatment in favor of a ratings
based approach. Because most
mortgage-backed securities usually also
receive the highest or second highest
credit rating, the agencies believe that
‘‘pass-through’’ treatment will be
redundant once the ratings-based
approach is implemented and, therefore,
propose to eliminate it.
B
he 50%
risk-weight category. The agencies
propose to eliminate this ‘‘pass-
through’’ treatment in favor of a ratings
based approach. Because most
mortgage-backed securities usually also
receive the highest or second highest
credit rating, the agencies believe that
‘‘pass-through’’ treatment will be
redundant once the ratings-based
approach is implemented and, therefore,
propose to eliminate it.
B. Proposed Treatment for Rated
Positions
As described in section II.A., each
loss position in an asset securitization
structure functions as a credit
enhancement for the more senior loss
positions in the structure. Currently, the
risk-based capital standards do not vary
the rate of capital requirement for
different credit enhancements or loss
positions to reflect differences in the
relative risk of credit loss represented by
the positions.
To address this issue, the agencies are
proposing a multi-level, ratings-based
approach to assess capital requirements
on recourse obligations, direct credit
substitutes, and senior and subordinated
securities in asset securitizations based
on their relative exposure to credit risk.
The approach uses credit ratings from
the rating agencies and, to a limited
extent, banking organization’s internal
risk ratings and other alternatives, to
measure relative exposure to credit risk
and to determine the associated risk-
based capital requirement. The use of
credit ratings provides a way for the
agencies to use determinations of credit
quality relied upon by investors and
other market participants to differentiate
the regulatory capital treatment for loss
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to determine the associated risk-
based capital requirement. The use of
credit ratings provides a way for the
agencies to use determinations of credit
quality relied upon by investors and
other market participants to differentiate
the regulatory capital treatment for loss
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12328
Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules
21 The example rating designations (‘‘AAA,’’
‘‘BBB,’’ etc.) are illustrative and do not indicate any
preference for, or endorsement of, any particular
rating agency designation system.
22 Similar to the current approach under which
‘‘stripped’’ mortgage-backed securities are not
eligible for risk weighting at 50% on a ‘‘pass-
through’’ basis, stripped mortgage-backed securities
are ineligible for the 20% or 50% risk categories
under the ratings based approach.
23 ‘‘Gross-up’’ treatment means that a position is
combined with all more senior positions in the
transaction. The result is then risk-weighted based
on the nature of the underlying assets. For example,
if a banking organization retains a first-loss position
in a pool of mortgage loans that qualify for a 50%
risk weight, the banking organization would
include the full amount of the assets in the pool,
risk-weighted at 50% in its risk-weighted assets for
purposes of determining its risk-based capital ratio.
The low level recourse rule provides that the dollar
amount of risk-based capital required for assets
transferred with recourse should not exceed the
maximum dollar amount for which a banking
organization is contractually liable. See, 12 CFR
part 3, appendix A, Section 3(d) (OCC); 12 CFR 208
and 225, appendix A, III.D.1(g) (FRB); 12 CFR part
325, appendix A, II.D.1 (FDIC); 12 CFR
567.6(a)(2)(i)(C) (OTS).
positions representing different
gradations of risk
of risk-based capital required for assets
transferred with recourse should not exceed the
maximum dollar amount for which a banking
organization is contractually liable. See, 12 CFR
part 3, appendix A, Section 3(d) (OCC); 12 CFR 208
and 225, appendix A, III.D.1(g) (FRB); 12 CFR part
325, appendix A, II.D.1 (FDIC); 12 CFR
567.6(a)(2)(i)(C) (OTS).
positions representing different
gradations of risk. This use permits the
agencies to give more equitable
treatment to a wide variety of
transactions and structures in
administering the risk-based capital
system.
The fact that investors rely on these
ratings to make investment decisions
exerts market discipline on the rating
agencies and gives their ratings market
credibility. The market’s reliance on
ratings, in turn, gives the agencies
confidence that it is appropriate to
consider ratings as a major factor in the
risk weighting of assets for regulatory
capital purposes. The agencies,
however, would retain their authority to
override the use of certain ratings or the
ratings on certain instruments, either on
a case-by-case basis or through broader
supervisory policy, if necessary or
appropriate to address the risk to
banking organizations.
Under the ratings-based approach, the
capital requirement for a recourse
obligation, direct credit substitute, or
traded asset-backed security would be
determined as follows: 21
Rating category
Examples
Risk weight
Highest or second highest investment grade .........................................
AAA or AA .....................................
20%.
Third highest investment grade ...............................................................
A ....................................................
50%.
Lowest investment grade ........................................................................
BBB ................................................
100%.
One category below investment grade ...................................................
BB ..................................................
200%
.....................................
A ....................................................
50%.
Lowest investment grade ........................................................................
BBB ................................................
100%.
One category below investment grade ...................................................
BB ..................................................
200%.
More than one category below investment grade, or unrated ................
B or unrated ...................................
’’Gross-up’’ treatment.
Many commenters expressed
concerns about the so-called ‘‘cliff
effect’’ that would arise because of the
small number of rating categories—
three—contained in the 1997 Proposal.
To reduce the cliff effect, which causes
relatively small differences in risk to
result in disproportionately large
differences in the capital requirement
for a risk position, the agencies are
proposing to add two additional rating
categories, for a total of five.
Under the proposal, the ratings-based
approach is available for traded asset-
backed securities 22 and for traded and
non-traded recourse obligations and
direct credit substitutes. A position is
considered ‘‘traded’’ if, at the time it is
rated by an external rating agency, there
is a reasonable expectation that in the
near future: (1) The position may be
sold to investors relying on the rating;
or (2) a third party may enter into a
transaction (e.g., a loan or repurchase
agreement) involving the position in
which the third party relies on the
rating of the position. If external rating
agencies rate a traded position
differently, the single highest rating
applies.
An unrated position that is senior (in
all respects, including access to
collateral) to a rated position that is
traded is treated as if it had the rating
given the rated position, subject to the
banking organization satisfying its
supervisory agency that such treatment
is appropriate
f the position. If external rating
agencies rate a traded position
differently, the single highest rating
applies.
An unrated position that is senior (in
all respects, including access to
collateral) to a rated position that is
traded is treated as if it had the rating
given the rated position, subject to the
banking organization satisfying its
supervisory agency that such treatment
is appropriate.
Recourse obligations and direct credit
substitutes not qualifying for a reduced
capital charge and positions rated more
than one category below investment
grade receive ‘‘gross-up’’ treatment, that
is, the banking organization holding the
position would hold capital against the
amount of the position plus all more
senior positions, subject to the low-level
recourse rule.23 This grossed-up amount
is placed into risk-weight categories
according to the obligor and collateral.
The ratings-based approach is based
on current ratings, so that a rating
downgrade or withdrawal of a rating
could change the treatment of a position
under the proposal. However, a
downgrade of a position by a single
rating agency would not affect the
capital treatment of a position if the
position still qualified for the previous
capital treatment under one or more
ratings from a different rating agency.
C. Proposed Treatment for Non-Traded
and Unrated Positions
1. Ratings on Non-Traded Positions
In the 1994 Notice, the agencies
proposed to permit a banking
organization to obtain a rating for a non-
traded recourse obligation or direct
credit substitute in order to permit that
position to qualify for a favorable risk-
weight. In response to the 1994 Notice,
one rating agency expressed concern
that use of ratings by the agencies for
regulatory purposes could undermine
the integrity of the rating process.
Ordinarily, according to the commenter,
there is a tension between the interests
of the investors who rely on ratings and
the interests of the issuers who pay
rating agencies to generate ratings
favorable risk-
weight. In response to the 1994 Notice,
one rating agency expressed concern
that use of ratings by the agencies for
regulatory purposes could undermine
the integrity of the rating process.
Ordinarily, according to the commenter,
there is a tension between the interests
of the investors who rely on ratings and
the interests of the issuers who pay
rating agencies to generate ratings.
Under the ratings-based approach in the
1994 Notice, however, the holder of a
recourse obligation or direct credit
substitute that was not traded or sold
could, in some cases, seek a rating for
the sole purposes of permitting the
credit enhancement to qualify for a
favorable risk weight. The rating agency
expressed a strong concern that, without
the counterbalancing interest of
investors to rely on ratings, rating
agencies may have an incentive to issue
inflated ratings.
In response to this concern, the 1997
Proposal included criteria to reduce the
possibility of inflated ratings and
inappropriate risk weights if ratings are
used for a position that is not traded. A
non-traded position could qualify for
the ratings-based approach only if: (1) It
qualified under ratings obtained from
two different rating agencies; (2) the
ratings were publicly available; (3) the
ratings were based on the same criteria
used to rate securities sold to the public;
and (4) at least one position in the
securitization was traded. In comments
responding to the 1997 Proposal,
banking organizations expressed
concern about the cost and delay
associated with obtaining ratings,
particularly for direct credit substitutes,
that they would not need absent the
agencies’ adoption of a ratings-based
approach for risk-based capital
purposes.
In this proposal, the agencies
continue to permit a non-traded
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cost and delay
associated with obtaining ratings,
particularly for direct credit substitutes,
that they would not need absent the
agencies’ adoption of a ratings-based
approach for risk-based capital
purposes.
In this proposal, the agencies
continue to permit a non-traded
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Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules
recourse obligation or direct credit
substitute to qualify for the ratings-
based approach if the banking
organization obtains ratings for the
position. The agencies have retained the
first three of the 1997 Proposal’s four
criteria for non-traded positions, but
have eliminated the fourth criterion, i.e.,
the requirement that one position in the
securitization be traded.
To address concerns expressed by
commenters on the 1997 Proposal,
however, the agencies have developed,
and are also proposing, alternative
approaches for determining the capital
requirements for unrated direct credit
substitutes, which are discussed in the
following sections. Under each of these
approaches, the banking organization
must satisfy its supervisory agency that
use of the approach is appropriate for
the particular banking organization.
2. Use of Banking Organizations’
Internal Risk Ratings
The proposal would permit a banking
organization with a qualifying internal
risk rating system to use that system to
apply the ratings-based approach to the
banking organization’s unrated direct
credit substitutes in asset-backed
commercial paper programs. Internal
risk ratings could be used to qualify a
credit enhancement (other than a
retained recourse position) for a risk
weight of 100% or 200% under the
ratings-based approach, but not for a
risk weight of less than 100%
sk rating system to use that system to
apply the ratings-based approach to the
banking organization’s unrated direct
credit substitutes in asset-backed
commercial paper programs. Internal
risk ratings could be used to qualify a
credit enhancement (other than a
retained recourse position) for a risk
weight of 100% or 200% under the
ratings-based approach, but not for a
risk weight of less than 100%. This
relatively limited use of internal risk
ratings for risk-based capital purposes is
a step towards potential adoption of
broader use of internal risk ratings as
discussed in the Basel Committee’s June
1999 Consultative Paper. Limiting the
approach to these types of credit
enhancements reflects the agencies’
view, based on industry research and
empirical evidence, that these positions
are more likely than recourse positions
to be of investment-grade credit quality,
and that the banking organizations
providing them are more likely to have
internal risk rating systems for these
credit enhancements that are
sufficiently accurate to be relied on for
risk-based capital calculations.
Most sophisticated banking
organizations that participate
extensively in the asset securitization
business assign internal risk ratings to
their credit exposures, regardless of the
form of the exposure. Usually, internal
risk ratings more finely differentiate the
credit quality of a banking
organization’s exposures than the
categories that the agencies use to
evaluate credit risk during examinations
of banking organizations (pass,
substandard, doubtful, loss). Individual
banking organizations’ internal risk
ratings may be associated with a certain
probability of default, loss in the event
of default, and loss volatility.
The credit enhancements that
sponsors obtain for their commercial
paper conduits are rarely rated
categories that the agencies use to
evaluate credit risk during examinations
of banking organizations (pass,
substandard, doubtful, loss). Individual
banking organizations’ internal risk
ratings may be associated with a certain
probability of default, loss in the event
of default, and loss volatility.
The credit enhancements that
sponsors obtain for their commercial
paper conduits are rarely rated. If an
internal risk ratings approach were not
available for these unrated credit
enhancements, the provider of the
enhancement would have to obtain two
ratings solely to avoid the gross-up
treatment that would otherwise apply to
unrated positions in asset
securitizations for risk-based capital
purposes. However, before a provider of
an enhancement decides whether to
provide a credit enhancement for a
particular transaction (and at what
price), the provider will generally
perform its own analysis of the
transaction to evaluate the amount of
risk associated with the enhancement.
Allowing banking organizations to use
internal credit ratings harnesses
information and analyses that they
already generate rather than requiring
them to obtain independent but
redundant ratings from outside rating
agencies. An internal risk ratings
approach therefore has the potential to
be less costly than a ratings-based
approach that relies exclusively on
ratings by the rating agencies for the
risk-weighting of these positions.
Internal risk ratings that correspond to
the rating categories of the rating
agencies could be mapped to risk
weights under the agencies’ capital
standards in a way that would make it
possible to differentiate the riskiness of
various unrated direct credit substitutes
based on credit risk. However, the use
of internal risk ratings raises concerns
about the accuracy and consistency of
the ratings, especially because the
mapping of ratings to risk-weight
categories will give banking
organizations an incentive to rate their
risk exposures in a way that minimizes
the effective capital requirement
ferentiate the riskiness of
various unrated direct credit substitutes
based on credit risk. However, the use
of internal risk ratings raises concerns
about the accuracy and consistency of
the ratings, especially because the
mapping of ratings to risk-weight
categories will give banking
organizations an incentive to rate their
risk exposures in a way that minimizes
the effective capital requirement.
Banking organizations engaged in
securitization activities that wish to use
the internal risk ratings approach must
ensure that their internal risk rating
systems are adequate. Adequate internal
risk rating systems usually:
(1) Are an integral part of an effective
risk management system that explicitly
incorporates the full range of risks
arising from an organization’s
participation in securitization activities.
The system must also fully take into
account the effect of such activities on
the organization’s risk profile and
capital adequacy as discussed in Section
II.B.
(2) Link their ratings to measurable
outcomes, such as the probability that a
position will experience any losses, the
expected losses on that position in the
event of default, and the degree of
variance in losses given default on that
position.
(3) Separately consider the risk
associated with the underlying loans
and borrowers and the risk associated
with the specific positions in a
securitization transaction.
(4) Identify gradations of risk among
‘‘pass’’ assets, not just among assets that
have deteriorated to the point that they
fall into ‘‘watch’’ grades. Although it is
not necessary for a banking organization
to use the same categories as the rating
agencies, its internal ratings must
correspond to the ratings of the rating
agencies so that agencies can determine
which internal risk rating corresponds
to each rating category of the rating
agencies
sets, not just among assets that
have deteriorated to the point that they
fall into ‘‘watch’’ grades. Although it is
not necessary for a banking organization
to use the same categories as the rating
agencies, its internal ratings must
correspond to the ratings of the rating
agencies so that agencies can determine
which internal risk rating corresponds
to each rating category of the rating
agencies. A banking organization would
have the responsibility to demonstrate
to the satisfaction of its primary
regulator how these ratings correspond
with the rating agency standards used as
the framework for this proposal. This is
necessary so that the mapping of credit
ratings to risk weight categories in the
ratings-based approach can be applied
to internal ratings.
(5) Classify assets into each risk grade,
using clear, explicit criteria, even for
subjective factors.
(6) Have independent credit risk
management or loan review personnel
assign or review credit risk ratings.
These personnel should have adequate
training and experience to ensure that
they are fully qualified to perform this
function.
(7) Periodically verify, through an
internal audit procedure, that internal
risk ratings are assigned in accordance
with the banking organization’s
established criteria.
(8) Track the performance of its
internal ratings over time to evaluate
how well risk grades are being assigned,
make adjustments to its rating system
when the performance of its rated
positions diverges from assigned ratings,
and adjust individual ratings
accordingly.
ernal audit procedure, that internal
risk ratings are assigned in accordance
with the banking organization’s
established criteria.
(8) Track the performance of its
internal ratings over time to evaluate
how well risk grades are being assigned,
make adjustments to its rating system
when the performance of its rated
positions diverges from assigned ratings,
and adjust individual ratings
accordingly.
(9) Make credit risk rating
assumptions that are consistent with, or
more conservative than, the credit risk
rating assumptions and methodologies
of the rating agencies.
The agencies also are considering
whether to develop review and approval
procedures governing their respective
determinations of whether a particular
banking organization may use the
internal risk rating process. The
agencies request comment on the
appropriate scope and nature of that
process.
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If a banking organization’s rating
system is found to no longer be
adequate, the banking organization’s
primary regulator may preclude it from
applying the internal risk ratings
approach to new transactions for risk-
based capital purposes until it has
remedied the deficiencies. Additionally,
depending on the severity of the
problems identified, the primary
regulator may also decline to rely on the
internal risk ratings that the banking
organization has applied to previous
transactions that remain outstanding for
purposes of determining the banking
organization’s regulatory capital
requirements.
3. Ratings of Specific Positions in
Structured Financing Programs
The agencies also propose to
authorize a banking organization to use
a rating obtained from a rating agency or
other appropriate third party of unrated
direct credit substitutes in
securitizations that satisfy specifications
set by the rating agency
purposes of determining the banking
organization’s regulatory capital
requirements.
3. Ratings of Specific Positions in
Structured Financing Programs
The agencies also propose to
authorize a banking organization to use
a rating obtained from a rating agency or
other appropriate third party of unrated
direct credit substitutes in
securitizations that satisfy specifications
set by the rating agency. The banking
organization would need to demonstrate
that the rating meets the same rating
standards generally used by the rating
agency for rating publicly-issued
securities. In addition, the banking
organization must also demonstrate to
its primary regulator’s satisfaction that
the criteria underlying the rating
agency’s assignment of ratings for the
program are satisfied for the particular
direct credit substitute issued by the
banking organization.
The proposal would also allow
banking organizations to demonstrate to
the agencies that it is reasonable and
consistent with the standards of this
proposal to rely on the rating of
positions in a securitization structure
under a program in which the banking
organization participates if the sponsor
of that program has obtained a rating.
This aspect of the proposal is most
likely to be useful to banking
organizations with limited involvement
in securitization activities. In addition,
some banking organizations extensively
involved in securitization activities
already rely on ratings of the credit risk
positions under their securitization
programs as part of their risk
management practices. Such banking
organizations also could rely on such
ratings under this proposal if the ratings
are part of a sound overall risk
management process and the ratings
reflect the risk of non-traded positions
to the banking organizations.
This approach could be used to
qualify a direct credit substitute (but not
a retained recourse position) for a risk
weight of 100% or 200% of the face
value of the position under the ratings-
based approach, but not for a risk
weight of less than 100%.
4
atings
are part of a sound overall risk
management process and the ratings
reflect the risk of non-traded positions
to the banking organizations.
This approach could be used to
qualify a direct credit substitute (but not
a retained recourse position) for a risk
weight of 100% or 200% of the face
value of the position under the ratings-
based approach, but not for a risk
weight of less than 100%.
4. Use of Qualifying Rating Software
Mapped to Public Rating Standards
The agencies are also proposing to
allow banking organizations,
particularly those with limited
involvement in securitization activities,
to rely on qualifying credit assessment
computer programs that the rating
agencies or other appropriate third
parties have developed for rating
otherwise unrated direct credit
substitutes in asset securitizations. To
qualify for use by banking organizations
for risk-based capital purposes, the
computer programs must be tracked to
the rating standards of the rating
agencies. Banking organizations must
demonstrate the credibility of these
programs in the financial markets,
which would generally be shown by the
significant use of the computer program
by investors and market participants for
risk assessment purposes. Banking
organizations also would need to
demonstrate the reliability of the
programs in assessing credit risk.
Banking organizations may use these
programs for purposes of applying the
ratings-based approach under this
proposal only if the banking
organization satisfies its primary
regulator that the programs result in
credit assessments that credibly and
reliably correspond with the rating of
publicly issued securities by the rating
agencies. Sophisticated banking
organizations with extensive
securitization activities generally should
use this approach only if it is an integral
part of their risk management systems
and their systems fully capture the risks
from the banking organizations’
securitization activities
edit assessments that credibly and
reliably correspond with the rating of
publicly issued securities by the rating
agencies. Sophisticated banking
organizations with extensive
securitization activities generally should
use this approach only if it is an integral
part of their risk management systems
and their systems fully capture the risks
from the banking organizations’
securitization activities.
This approach could be used to
qualify a direct credit substitute (but not
a retained recourse position) for a risk
weight of 100% or 200% of the face
value of the position under the ratings-
based approach, but not for a risk
weight of less than 100%.
D. Managed Assets Approach
When assets are securitized, the
extent to which the selling or
sponsoring entity transfers the risks
associated with the assets depends on
the structure of the securitization and
the revolving nature of the assets
involved. To the extent the sponsoring
institution is dependent on future
securitizations as a funding source, as a
practical matter, the amount of risk
transferred often will be limited.
Revolving credits include credit card
and home equity line securitizations as
well as commercial loans drawn down
under long-term commitments that are
securitized as collateralized loan
obligations (CLOs).
The early amortization feature present
in some revolving credit securitizations
ensures that investors will be repaid
before being subject to any risk of
significant credit losses. For example, if
a securitized asset pool begins to
experience credit deterioration to the
point where the early amortization
feature is triggered, then the asset-
backed securities held by investors
begin to rapidly pay down. This occurs
because, after an early amortization
feature is triggered, new receivables that
are generated from the accounts
designated to the securitization trust are
no longer sold to investors, but are
instead retained on the sponsoring
banking organization’s balance sheet
the early amortization
feature is triggered, then the asset-
backed securities held by investors
begin to rapidly pay down. This occurs
because, after an early amortization
feature is triggered, new receivables that
are generated from the accounts
designated to the securitization trust are
no longer sold to investors, but are
instead retained on the sponsoring
banking organization’s balance sheet.
Early amortization features raise
several distinct concerns about risks to
the seller. First, the seller’s interest in
the securitized assets is effectively
subordinated to the interests of the
investors by the payment allocation
formula applied during early
amortization. Investors effectively get
paid first, and the seller’s residual
interest will therefore absorb a
disproportionate share of credit losses.
Second, early amortization can create
liquidity problems for the seller. For
example, a credit card issuer must fund
a steady stream of new credit card
receivables. When a securitization trust
is no longer able to purchase new
receivables due to early amortization,
the seller must either find an alternative
buyer for the receivables or else the
receivables will accumulate on the
seller’s balance sheet, creating the need
for another source of funding.
Third, the first two risks to the seller
can create an incentive for the seller to
provide implicit recourse—credit
enhancement beyond any pre-existing
contractual obligation—to prevent early
amortization. Incentives to provide
implicit recourse are to some extent
present in other securitizations, because
of concerns about damage to the seller’s
reputation and its ability to securitize
assets going forward if one of its
securitizations performs poorly.
However, the early amortization feature
creates additional and more direct
financial incentives to prevent early
amortization through implicit recourse
centives to provide
implicit recourse are to some extent
present in other securitizations, because
of concerns about damage to the seller’s
reputation and its ability to securitize
assets going forward if one of its
securitizations performs poorly.
However, the early amortization feature
creates additional and more direct
financial incentives to prevent early
amortization through implicit recourse.
Because of their concerns about these
risks, the agencies are proposing to
apply a managed assets approach to
securitization transactions that
incorporate early amortization
provisions. The approach would require
a sponsoring banking organization’s
securitized (off-balance sheet)
receivables to be included in risk-
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weighted assets when determining its
risk-based capital requirements. The
securitized, off-balance sheet assets
would be assigned to the 20 percent risk
category, thereby effectively applying a
1.6% risk-based capital charge to those
assets.
The 1.6% capital charge against
securitized assets could be limited in
certain cases. If the sponsoring banking
organization in a revolving credit
securitization provides credit protection
to investors, either in the form of
retained recourse or a direct credit
substitute, the sum of the regulatory
capital requirements for the credit
protection and the 1.6% charge on the
off-balance sheet securitized assets may
not exceed 8% of securitized assets for
that particular securitization
transaction.
A managed assets approach would
require a banking organization to hold
additional capital against the potential
credit and liquidity risks stemming from
the early amortization provisions of
revolving credit securitization
structures
edit
protection and the 1.6% charge on the
off-balance sheet securitized assets may
not exceed 8% of securitized assets for
that particular securitization
transaction.
A managed assets approach would
require a banking organization to hold
additional capital against the potential
credit and liquidity risks stemming from
the early amortization provisions of
revolving credit securitization
structures. This proposed capital charge
would ensure that a banking
organization maintain at least a
minimum level of capital against the
risks that arise when early amortization
provisions are present in securitizations
of revolving credits.
The agencies request comment on the
purpose of early amortization
provisions, the proposed managed
assets approach, and on any potential
effects that the approach will have on
current industry practices involving
revolving credit securitizations. The
agencies also recognize that there may
be concerns that the managed assets
approach may not produce safety and
soundness benefits commensurate with
the additional regulatory burden that
would result from a 20% risk weight on
managed assets, and they request
comment on possible alternative
measures that would address more
effectively the risks arising from early
amortization provisions in revolving
securitizations. For example, one
alternative to the managed assets
approach described here would be to
require greater public disclosure of
securitization performance. This
additional information could allow
market participants and regulators to
better assess the risks inherent in
revolving securitizations with early
amortization provisions and the capital
level appropriate for those risks. The
agencies also request comment on
whether the benefits of greater public
disclosure outweigh the costs associated
with increased reporting.
IV
securitization performance. This
additional information could allow
market participants and regulators to
better assess the risks inherent in
revolving securitizations with early
amortization provisions and the capital
level appropriate for those risks. The
agencies also request comment on
whether the benefits of greater public
disclosure outweigh the costs associated
with increased reporting.
IV. Effective Date of a Final Rule
Resulting From This Proposal
The agencies intend that any final
rules adopted as a result of this proposal
that result in increased risk-based
capital requirements for banking
organizations will apply only to
securitization activities (as defined in
the proposal) entered into or acquired
after the effective date of those final
rules. Conversely, any final rules that
result in reduced risk-based capital
requirements for banking organizations
may be applied to all transactions
outstanding as of the effective date of
those final rules and to all subsequent
transactions. Because some ongoing
securitization conduits may need
additional time to adapt to any new
capital treatments, the agencies intend
to permit banking organizations to apply
the existing capital rules to asset
securitizations with no fixed term, e.g.,
asset-backed commercial paper
conduits, for up to two years after the
effective date of any final rule.
V. Request for Comment
The agencies request comment on all
aspects of this proposal, as well as on
the specific issues described in the
preamble.
VI. Regulatory Flexibility Act
OCC: Pursuant to section 605(b) of the
Regulatory Flexibility Act, the OCC
certifies that this proposal will not have
a significant impact on a substantial
number of small entities. 5 U.S.C. 601
et seq. The provisions of this proposal
that increase capital requirements are
likely to affect large national banks
almost exclusively. Small national
banks rarely sponsor or provide direct
credit substitutes in asset
securitizations. Accordingly, a
regulatory flexibility analysis is not
required
s proposal will not have
a significant impact on a substantial
number of small entities. 5 U.S.C. 601
et seq. The provisions of this proposal
that increase capital requirements are
likely to affect large national banks
almost exclusively. Small national
banks rarely sponsor or provide direct
credit substitutes in asset
securitizations. Accordingly, a
regulatory flexibility analysis is not
required.
Board: Pursuant to section 605(b) of
the Regulatory Flexibility Act, the Board
has determined that this proposal will
not have a significant impact on a
substantial number of small business
entities within the meaning of the
Regulatory Flexibility Act (5 U.S.C. 601
et seq.). The Board’s comparison of the
applicability section of this proposal
with Call Report Data on all existing
banks shows that application of the
proposal to small entities will be the
rare exception. Accordingly, a
regulatory flexibility analysis is not
required. In addition, because the risk-
based capital standards generally do not
apply to bank holding companies with
consolidated assets of less than $150
million, this proposal will not affect
such companies.
FDIC: Pursuant to section 605(b) of
the Regulatory Flexibility Act (Public
Law 96–354, 5 U.S.C. 601 et seq.), the
FDIC certifies that the proposed rule
will not have a significant impact on a
substantial number of small entities.
Comparison of Call Report data on
FDIC-supervised banks to the items
covered by the proposal that result in
increased capital requirements shows
that application of the proposal to small
entities will be the infrequent exception.
OTS: Pursuant to section 605(b) of the
Regulatory Flexibility Act, the OTS
certifies that this proposal will not have
a significant impact on a substantial
number of small entities
of Call Report data on
FDIC-supervised banks to the items
covered by the proposal that result in
increased capital requirements shows
that application of the proposal to small
entities will be the infrequent exception.
OTS: Pursuant to section 605(b) of the
Regulatory Flexibility Act, the OTS
certifies that this proposal will not have
a significant impact on a substantial
number of small entities. A comparison
of TFR data on OTS-supervised thrifts
shows that the proposed rule would
have little impact on the overall level of
capital required at small thrifts, since
capital requirements (other than the
risk-based capital standards) are
typically more binding on smaller
thrifts. Moreover, the provisions of this
proposal that may increase capital
requirements are unlikely to affect small
savings associations. Small thrifts rarely
provide direct credit substitutes in asset
securitizations and do not serve as
sponsors of revolving securitizations.
Accordingly, a regulatory flexibility
analysis is not required.
VII. Paperwork Reduction Act
The Agencies have determined that
this proposal does not involve a
collection of information pursuant to
the provisions of the Paperwork
Reduction Act of 1995 (44 U.S.C. 3501,
et seq.).
VIII. Executive Order 12866
OCC: The OCC has determined that
this proposal is not a significant
regulatory action for purposes of
Executive Order 12866. The OCC
expects that any increase in national
banks’ risk-based capital requirement,
resulting from the proposed treatment of
direct credit substitutes largely will be
offset by the ability of those banks to
reduce their capital requirement in
accordance with the ratings-based
approach. The managed assets position
of the proposal may require a limited
number of national banks to raise
additional capital in order to remain in
the category to which they are assigned
currently under the OCC’s prompt
corrective action framework
ect credit substitutes largely will be
offset by the ability of those banks to
reduce their capital requirement in
accordance with the ratings-based
approach. The managed assets position
of the proposal may require a limited
number of national banks to raise
additional capital in order to remain in
the category to which they are assigned
currently under the OCC’s prompt
corrective action framework. The OCC
believes that the costs associated with
raising this new capital are below the
thresholds prescribed in the Executive
Order. Nonetheless, the impact of any
final rule resulting from this proposal
will depend on factors for which the
agencies do not currently collect
industry-wide information, such as the
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Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules
proportion of bank-provided direct
credit substitutes that would be rated
below investment grade. The OCC,
therefore, welcomes any quantitative
information national banks wish to
provide about the impact they expect
the various portions of this proposal to
have if issued in final form.
OTS: The Director of the OTS has
determined that this proposal does not
constitute a ‘‘significant regulatory
action’’ under Executive Order 12866.
Since OTS already applies a ‘‘gross up’’
treatment for recourse obligations and
for most direct credit substitutes, the
proposal generally is likely to reduce
the risk-based capital requirements for
thrifts. The proposed rule would
increase capital requirements only for
certain direct credit substitutes issued
in connection with asset securitizations
or for thrifts that may serve as sponsors
of revolving securitization programs.
Currently, thrifts rarely participate in
such activities. As a result, OTS has
concluded that the proposal will have
only minor effects on the thrift industry.
IX
for
thrifts. The proposed rule would
increase capital requirements only for
certain direct credit substitutes issued
in connection with asset securitizations
or for thrifts that may serve as sponsors
of revolving securitization programs.
Currently, thrifts rarely participate in
such activities. As a result, OTS has
concluded that the proposal will have
only minor effects on the thrift industry.
IX. OCC and OTS—Unfunded Mandates
Reform Act of 1995
Section 202 of the Unfunded
Mandates Reform Act of 1995, Public
Law 104–4, (Unfunded Mandates Act),
requires that an agency prepare a
budgetary impact statement before
promulgating a rule that includes a
Federal mandate that may result in the
expenditure by state, local, and tribal
governments, in the aggregate, or by the
private sector, of $100 million or more
in any one year. If a budgetary impact
statement is required, section 205 of the
Unfunded Mandates Act also requires
an agency to identify and consider a
reasonable number of regulatory
alternatives before promulgating a rule.
The OCC and OTS have determined that
this proposed rule will not result in
expenditures by state, local, and tribal
governments, or by the private sector, of
more than $100 million or more in any
one year. Therefore, the OCC and OTS
have not prepared a budgetary impact
statement or specifically addressed the
regulatory alternatives considered. As
discussed in the preamble, this proposal
will reduce inconsistencies in the
agencies’ risk-based capital standards
and, in certain circumstances, will
allow banking organizations to maintain
lower amounts of capital against certain
rated recourse obligations and direct
credit substitutes.
X. Plain Language Requirement
Section 722 of the Gramm-Leach-
Bliley Act of 1999 requires the federal
banking agencies to use ‘‘plain
language’’ in all proposed and final
rules published after January 1, 2000.
We invite your comments on how to
make this proposal easier to understand.
For example:
(1) Have we organized the material to
suit your needs?
urse obligations and direct
credit substitutes.
X. Plain Language Requirement
Section 722 of the Gramm-Leach-
Bliley Act of 1999 requires the federal
banking agencies to use ‘‘plain
language’’ in all proposed and final
rules published after January 1, 2000.
We invite your comments on how to
make this proposal easier to understand.
For example:
(1) Have we organized the material to
suit your needs?
(2) Are the requirements in the rule
clearly stated?
(3) Does the rule contain technical
language or jargon that isn’t clear?
(4) Would a different format (grouping
and order of sections, use of headings,

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---

Source: Frix Law Library, https://www.frixlaw.com/law-library/statutes/FDIC_FIL00015. Check the current official text before relying on it. Not legal advice.