RISK-BASED CAPITAL RULES

Monday,

August 4, 2003

Part II

Department of the

Treasury

Office of the Comptroller of the

Currency

12 CFR Part 3

Federal Reserve System

12 CFR Parts 208 and 225

Federal Deposit Insurance

Corporation

12 CFR Part 325

Department of the Treasury

Office of Thrift Supervision

12 CFR Part 567

Risk-Based Capital Guidelines;

Implementation of New Basel Capital

Accord; Internal Ratings-Based Systems

for Corporate Credit and Operational

Risk Advanced Measurement Approaches

for Regulatory Capital; Proposed Rule and

Notice

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Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

DEPARTMENT OF THE TREASURY

Office of the Comptroller of the

Currency

12 CFR Part 3

[Docket No. 03–14]

RIN Number 1557–AC48

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R–1154]

FEDERAL DEPOSIT INSURANCE

CORPORATION

12 CFR Part 325

RIN 3064–AC73

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 567

[No. 2003–27]

RIN 1550–AB56

Risk-Based Capital Guidelines;

Implementation of New Basel Capital

Accord

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: Advance 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 setting

forth for industry comment their current

views on a proposed framework for

implementing the New Basel Capital

Accord in the United States

RY: 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 setting

forth for industry comment their current

views on a proposed framework for

implementing the New Basel Capital

Accord in the United States. In

particular, this advance notice of

proposed rulemaking (ANPR) describes

significant elements of the Advanced

Internal Ratings-Based approach for

credit risk and the Advanced

Measurement Approaches for

operational risk (together, the advanced

approaches). The ANPR specifies

criteria that would be used to determine

banking organizations that would be

required to use the advanced

approaches, subject to meeting certain

qualifying criteria, supervisory

standards, and disclosure requirements.

Other banking organizations that meet

the criteria, standards, and requirements

also would be eligible to use the

advanced approaches. Under the

advanced approaches, banking

organizations would use internal

estimates of certain risk components as

key inputs in the determination of their

regulatory capital requirements.

DATES: Comments must be received no

later than November 3, 2003.

ADDRESSES: Comments should be

directed to: OCC: Please direct your

comments to: Office of the Comptroller

of the Currency, 250 E Street, SW.,

Public Information Room, Mailstop 1–5,

Washington, DC 20219, Attention:

Docket No. 03–14; fax number (202)

874–4448; or Internet address:

regs.comments@occ.treas.gov. Due to

delays in paper mail delivery in the

Washington area, we encourage the

submission of comments by fax or e-

mail whenever possible. Comments may

be inspected and photocopied at the

OCC’s Public Information Room, 250 E

Street, SW., Washington, DC. You may

make an appointment to inspect

comments by calling (202) 874–5043.

Board: Comments should refer to

Docket No. R–1154 and may be mailed

to Ms

ys in paper mail delivery in the

Washington area, we encourage the

submission of comments by fax or e-

mail whenever possible. Comments may

be inspected and photocopied at the

OCC’s Public Information Room, 250 E

Street, SW., Washington, DC. You may

make an appointment to inspect

comments by calling (202) 874–5043.

Board: Comments should refer to

Docket No. R–1154 and may be mailed

to Ms. Jennifer J. Johnson, Secretary,

Board of Governors of the Federal

Reserve System, 20th Street and

Constitution Avenue, NW., Washington,

DC 20551. However, because paper mail

in the Washington area and at the Board

of Governors is subject to delay, please

consider submitting your comments by

e-mail to

regs.comments@federalreserve.gov., or

faxing them to the Office of the

Secretary at (202) 452–3819 or (202)

452–3102. Members of the public may

inspect comments in Room MP–500 of

the Martin Building between 9 a.m. and

5 p.m. weekdays pursuant to § 261.12,

except as provided by § 261.14, of the

Board’s Rules Regarding Availability of

Information, 12 CFR 261.12 and 261.14.

FDIC: Written comments should be

addressed to Robert E. Feldman,

Executive Secretary, Attention:

Comments, Federal Deposit Insurance

Corporation, 550 17th Street, NW.,

Washington, DC 20429. Commenters are

encouraged to submit comments by

facsimile transmission to (202) 898–

3838 or by electronic mail to

Comments@FDIC.gov. Comments also

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 8:30 a.m. and 5

p.m. Comments may be inspected and

photocopied at the FDIC’s 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 Regulation

Comments, Chief Counsel’s Office,

Office of Thrift Supervision, 1700 G

Street, NW., Washington, DC 20552,

Attention: No. 2003–27

eet) on

business days between 8:30 a.m. and 5

p.m. Comments may be inspected and

photocopied at the FDIC’s 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 Regulation

Comments, Chief Counsel’s Office,

Office of Thrift Supervision, 1700 G

Street, NW., Washington, DC 20552,

Attention: No. 2003–27. Delivery: Hand

deliver comments to the Guard’s desk,

east lobby entrance, 1700 G Street, NW.,

from 9 a.m. to 4 p.m. on business days,

Attention: Regulation Comments, Chief

Counsel’s Office, Attention: No. 2003–

27. Facsimiles: Send facsimile

transmissions to FAX Number (202)

906–6518, Attention: No. 2003–27. E-

mail: Send e-mails to

regs.comments@ots.treas.gov, Attention:

No. 2003–27, and include your name

and telephone number. Due to

temporary disruptions in mail service in

the Washington, DC area, commenters

are encouraged to send comments by fax

or e-mail, if possible.

FOR FURTHER INFORMATION CONTACT:

OCC: Roger Tufts, Senior Economic

Advisor (202–874–4925 or

roger.tufts@occ.treas.gov), Tanya Smith,

Senior International Advisor (202–874–

4735 or tanya.smith@occ.treas.gov), or

Ron Shimabukuro, Counsel (202–874–

5090 or

ron.shimabukuro@occ.treas.gov).

Board: Barbara Bouchard, Assistant

Director (202/452–3072 or

barbara.bouchard@frb.gov), David

Adkins, Supervisory Financial Analyst

(202/452–5259 or

david.adkins@frb.gov), Division of

Banking Supervision and Regulation, or

Mark Van Der Weide, Counsel (202/

452–2263 or

mark.vanderweide@frb.gov), Legal

Division. For users of

Telecommunications Device for the Deaf

(‘‘TDD’’) only, contact 202/263–4869.

FDIC: Keith Ligon, Chief (202/898–

3618 or kligon@fdic.gov), Jason Cave,

Chief (202/898–3548 or jcave@fdic.gov),

Division of Supervision and Consumer

Protection, or Michael Phillips, Counsel

(202/898–3581 or mphillips@fdic.gov).

OTS: Michael D. Solomon, Senior

Program Manager for Capital Policy

(202/906–5654); David W

ommunications Device for the Deaf

(‘‘TDD’’) only, contact 202/263–4869.

FDIC: Keith Ligon, Chief (202/898–

3618 or kligon@fdic.gov), Jason Cave,

Chief (202/898–3548 or jcave@fdic.gov),

Division of Supervision and Consumer

Protection, or Michael Phillips, Counsel

(202/898–3581 or mphillips@fdic.gov).

OTS: Michael D. Solomon, Senior

Program Manager for Capital Policy

(202/906–5654); David W. Riley, Project

Manager (202/906–6669), Supervision

Policy; or Teresa A. Scott, Counsel

(Banking and Finance) (202/906–6478),

Regulations and Legislation Division,

Office of the Chief Counsel, Office of

Thrift Supervision, 1700 G Street, NW.,

Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

I. Executive Summary

A. Introduction

B. Overview of the New Accord

C. Overview of U.S. Implementation

The A–IRB Approach for Credit Risk

The AMA for Operational Risk

Other Considerations

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Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

1 The leverage ratio measures regulatory capital as

a percentage of total on-balance-sheet assets as

reported in accordance with generally accepted

accounting principles (GAAP) (with certain

adjustments). The risk-based ratios measure

regulatory capital as a percentage of both on- and

off-balance-sheet credit exposures with some gross

differentiation based on perceived credit risk. The

Agencies’ capital rules may be found at 12 CFR Part

3 (OCC), 12 CFR Parts 208 and 225 (Board), 12 CFR

Part 325 (FDIC), and 12 CFR Part 567 (OTS).

2 The BSC was established in 1974 by the central-

bank governors of the Group of Ten (G–10)

countries. Countries are represented on the BSC by

their central bank and also by authorities with bank

supervisory responsibilities

ceived credit risk. The

Agencies’ capital rules may be found at 12 CFR Part

3 (OCC), 12 CFR Parts 208 and 225 (Board), 12 CFR

Part 325 (FDIC), and 12 CFR Part 567 (OTS).

2 The BSC was established in 1974 by the central-

bank governors of the Group of Ten (G–10)

countries. Countries are represented on the BSC by

their central bank and also by authorities with bank

supervisory responsibilities. Current member

countries are Belgium, Canada, France, Germany,

Italy, Japan, Luxembourg, the Netherlands, Spain,

Sweden, Switzerland, the United Kingdom, and the

United States. The 1988 Accord is described in a

document entitled ‘‘International Convergence of

Capital Measurement and Capital Standards.’’ This

document and other documents issued by the BSC

are available through the Bank for International

Settlements website at www.bis.org.

D. Competitive Considerations

II. Application of the Advanced Approaches

in the United States

A. Threshold Criteria for Mandatory

Advanced Approach Organizations

Application of Advanced Approaches at

Individual Bank/Thrift Levels

U.S. Banking Subsidiaries of Foreign

Banking Organizations

B. Implementation for Advanced Approach

Organizations

C. Other Considerations

General Banks

Majority-Owned or Controlled Subsidiaries

Transitional Arrangements

III. Advanced Internal Ratings-Based

Approach (A–IRB)

A. Conceptual Overview

Expected Losses versus Unexpected Losses

B. A–IRB Capital Calculations

Wholesale Exposures: Definitions and

Inputs

Wholesale Exposures: Formulas

Wholesale Exposures: Other

Considerations

Retail Exposures: Definitions and Inputs

Retail Exposures: Formulas

A–IRB: Other Considerations

Purchased Receivables

Credit Risk Mitigation Techniques

Equity Exposures

C. Supervisory Assessment of A–IRB

Framework

Overview of Supervisory Framework

U.S. Supervisory Review

IV. Securitization

A. General Framework

Operational Criteria

Differences Between the General A–IRB

Framework and the A–IRB Approach for

Securitization Exposures

B

xposures: Formulas

A–IRB: Other Considerations

Purchased Receivables

Credit Risk Mitigation Techniques

Equity Exposures

C. Supervisory Assessment of A–IRB

Framework

Overview of Supervisory Framework

U.S. Supervisory Review

IV. Securitization

A. General Framework

Operational Criteria

Differences Between the General A–IRB

Framework and the A–IRB Approach for

Securitization Exposures

B. Determining Capital Requirements

General Considerations

Capital Calculation Approaches

Other Considerations

V. AMA Framework for Operational Risk

A. AMA Capital Calculation

Overview of the Supervisory Criteria

B. Elements of an AMA Framework

VI. Disclosure

A. Overview

B. Disclosure Requirements

VII. Regulatory Analysis

A. Executive Order 12866

B. Regulatory Flexibility Act

C. Unfunded Mandates Reform Act of 1995

D. Paperwork Reduction Act

List of Acronyms

I. Executive Summary

A. Introduction

In the United States, banks, thrifts,

and bank holding companies (banking

organizations or institutions) are subject

to minimum regulatory capital

requirements. Specifically, U.S. banking

organizations must maintain a

minimum leverage ratio and two

minimum risk-based ratios.1 The

current U.S. risk-based capital

requirements are based on an

internationally agreed framework for

capital measurement that was

developed by the Basel Committee on

Banking Supervision (Basel Supervisors

Committee or BSC) and endorsed by the

G–10 Governors in 1988.2 The

international framework (1988 Accord)

accomplished several important

objectives. It strengthened capital levels

at large, internationally active banks and

fostered international consistency and

coordination. The 1988 Accord also

reduced disincentives for banks to hold

liquid, low-risk assets. Moreover, by

requiring banks to hold capital against

off-balance-sheet exposures, the 1988

Accord represented a significant step

forward for regulatory capital

measurement

ives. It strengthened capital levels

at large, internationally active banks and

fostered international consistency and

coordination. The 1988 Accord also

reduced disincentives for banks to hold

liquid, low-risk assets. Moreover, by

requiring banks to hold capital against

off-balance-sheet exposures, the 1988

Accord represented a significant step

forward for regulatory capital

measurement.

Although the 1988 Accord has been a

stabilizing force for the international

banking system, the world financial

system has become increasingly more

complex over the past fifteen years. The

BSC has been working for several years

to develop a new regulatory capital

framework that recognizes new

developments in financial products,

incorporates advances in risk

measurement and management

practices, and more precisely assesses

capital charges in relation to risk. On

April 29, 2003, the BSC released for

public consultation a document entitled

‘‘The New Basel Capital Accord’’ (New

Accord) that sets forth proposed

revisions to the 1988 Accord. The BSC

will accept industry comment on the

New Accord through July 31, 2003 and

expects to issue a final revised Accord

by the end of 2003. The BSC expects

that the New Accord would have an

effective date for implementation of

December 31, 2006.

Accordingly, the Agencies are

soliciting comment on all aspects of this

ANPR, which is based on certain

proposals in the New Accord.

Comments will assist the Agencies in

reaching a determination on a number

of issues related to how the New Accord

would be proposed to be implemented

in the United States. In addition, in light

of the public comments submitted on

the ANPR, the Agencies will seek

appropriate modifications to the New

Accord.

B. Overview of the New Accord

The New Accord encompasses three

pillars: minimum regulatory capital

requirements, supervisory review, and

market discipline

of issues related to how the New Accord

would be proposed to be implemented

in the United States. In addition, in light

of the public comments submitted on

the ANPR, the Agencies will seek

appropriate modifications to the New

Accord.

B. Overview of the New Accord

The New Accord encompasses three

pillars: minimum regulatory capital

requirements, supervisory review, and

market discipline. Under the first pillar,

a banking organization must calculate

capital requirements for exposure to

both credit risk and operational risk

(and market risk for institutions with

significant trading activity). The New

Accord does not change the definition

of what qualifies as regulatory capital,

the minimum risk-based capital ratio, or

the methodology for determining capital

charges for market risk. The New

Accord provides several methodologies

for determining capital requirements for

both credit and operational risk. For

credit risk there are two general

approaches; the standardized approach

(essentially a package of modifications

to the 1988 Accord) and the internal

ratings-based (IRB) approach (which

uses an institution’s internal estimates

of key risk drivers to derive capital

requirements). Within the IRB approach

there is a foundation methodology, in

which certain risk component inputs are

provided by supervisors and others are

supplied by the institutions, and an

advanced methodology (A–IRB), where

institutions themselves provide more

risk inputs.

The New Accord provides three

methodologies for determining capital

requirements for operational risk; the

basic indicator approach, the

standardized approach, and the

advanced measurement approaches

(AMA). Under the first two

methodologies, capital requirements for

operational risk are fixed percentages of

specified, objective risk measures (for

example, gross income). The AMA

provides the flexibility for an institution

to develop its own individualized

approach for measuring operational risk,

subject to supervisory oversight

ardized approach, and the

advanced measurement approaches

(AMA). Under the first two

methodologies, capital requirements for

operational risk are fixed percentages of

specified, objective risk measures (for

example, gross income). The AMA

provides the flexibility for an institution

to develop its own individualized

approach for measuring operational risk,

subject to supervisory oversight.

The second pillar of the New Accord,

supervisory review, highlights the need

for banking organizations to assess their

capital adequacy positions relative to

overall risk (rather than solely to the

minimum capital requirement), and the

need for supervisors to review and take

appropriate actions in response to those

assessments. The third pillar of the New

Accord imposes public disclosure

requirements on institutions that are

intended to allow market participants to

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Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

3 The Agencies continue to reserve the right to

require higher minimum capital levels for

individual institutions, on a case-by-case basis, if

necessary to address particular circumstances.

4 Thus, for example, to be in the well-capitalized

PCA category a bank must have at least a 10 percent

total risk-based capital ratio, a 6 percent Tier I risk-

based capital ratio, and a 5 percent leverage ratio.

The other PCA categories also would not change.

assess key information about an

institution’s risk profile and its

associated level of capital.

The Agencies do not expect the

implementation of the New Accord to

result in a significant decrease in

aggregate capital requirements for the

U.S. banking system

al ratio, a 6 percent Tier I risk-

based capital ratio, and a 5 percent leverage ratio.

The other PCA categories also would not change.

assess key information about an

institution’s risk profile and its

associated level of capital.

The Agencies do not expect the

implementation of the New Accord to

result in a significant decrease in

aggregate capital requirements for the

U.S. banking system. Individual banking

organizations may, however, face

increases or decreases in their minimum

risk-based capital requirements because

the New Accord is more risk sensitive

than the 1988 Accord and the Agencies’

existing risk-based capital rules (general

risk-based capital rules). The Agencies

will continue to analyze the potential

impact of the New Accord on both

systemic and individual bank capital

levels.

C. Overview of U.S. Implementation

The Agencies believe that the

advanced risk and capital measurement

methodologies of the New Accord are

the most appropriate approaches for

large, internationally active banking

organizations. As a result, large,

internationally active banking

organizations in the United States

would be required to use the A–IRB

approach to credit risk and the AMA to

operational risk. The Agencies are

proposing to identify three types of

banking organizations: institutions

subject to the advanced approaches on

a mandatory basis (core banks);

institutions not subject to the advanced

approaches on a mandatory basis, but

that choose voluntarily to apply those

approaches (opt-in banks); and

institutions that are not mandatorily

subject to and do not apply the

advanced approaches (general banks).

Core banks would be those with total

banking (and thrift) assets of $250

billion or more or total on-balance-sheet

foreign exposure of $10 billion or more

bject to the advanced

approaches on a mandatory basis, but

that choose voluntarily to apply those

approaches (opt-in banks); and

institutions that are not mandatorily

subject to and do not apply the

advanced approaches (general banks).

Core banks would be those with total

banking (and thrift) assets of $250

billion or more or total on-balance-sheet

foreign exposure of $10 billion or more.

Both core banks and opt-in banks

(advanced approach banks) would be

required to meet certain infrastructure

requirements (including complying with

specified supervisory standards for

credit risk and operational risk) and

make specified public disclosures before

being able to use the advanced

approaches for risk-based regulatory

capital calculation purposes.3

General banks would continue to

apply the general risk-based capital

rules. Because the general risk-based

capital rules include a buffer for risks

not easily quantified (for example,

operational risk and concentration risk),

general banks would not be subject to an

additional direct capital charge for

operational risk.

Under this proposal, some U.S.

banking organizations would use the

advanced approaches while others

would apply the general risk-based

capital rules. As a result, the United

States would have a bifurcated

regulatory capital framework. That is,

U.S. capital rules would provide two

distinct methodologies for institutions

to calculate risk-weighted assets (the

denominator of the risk-based capital

ratios). Under the proposed framework,

all U.S. institutions would continue to

calculate regulatory capital, the

numerator of the risk-based capital

ratios, as they do now. Importantly, U.S

urcated

regulatory capital framework. That is,

U.S. capital rules would provide two

distinct methodologies for institutions

to calculate risk-weighted assets (the

denominator of the risk-based capital

ratios). Under the proposed framework,

all U.S. institutions would continue to

calculate regulatory capital, the

numerator of the risk-based capital

ratios, as they do now. Importantly, U.S.

banking organizations would continue

to be subject to a leverage ratio

requirement under existing regulations,

and Prompt Corrective Action (PCA)

legislation and implementing

regulations would remain in effect.4 It is

recognized that in some cases, under the

proposed framework, the leverage ratio

would serve as the most binding

regulatory capital constraint.

Implementing the capital framework

described in this ANPR would raise a

number of significant practical and

conceptual issues about the role of

economic capital calculations relative to

regulatory capital requirements. The

capital formulas described in this

ANPR, as well as the economic capital

models used by banking organizations,

assume the ability to assign precisely

probabilities to future credit and

operational losses that might occur. The

term ‘‘economic capital’’ is often used to

refer to the amount of capital that

should be allocated to an activity

according to the results of such an

exercise. For example, a banking

organization might compute the amount

of income, reserves, and capital that it

would need to cover the 99.9th

percentile of possible credit losses

associated with a given type of lending.

The desired degree of certainty of

covering losses is related to several

factors including, for example, the

banking organization’s target credit

rating. The higher the loss percentile the

institution wishes to provide protection

against, the less likely the capital held

by the institution would be insufficient

to cover losses, and the higher would be

the institution’s credit rating

ing.

The desired degree of certainty of

covering losses is related to several

factors including, for example, the

banking organization’s target credit

rating. The higher the loss percentile the

institution wishes to provide protection

against, the less likely the capital held

by the institution would be insufficient

to cover losses, and the higher would be

the institution’s credit rating.

While the Agencies intend to move to

a framework where regulatory capital is

more closely aligned to economic

capital, the Agencies do not intend to

place sole reliance on the results of

economic capital calculations for

purposes of computing minimum

regulatory capital requirements.

Banking organizations face risks other

than credit and operational risks, and

the assumed loss distributions

underlying banking organizations’

economic capital calculations are

subject to the risk of error.

Consequently, the Agencies continue to

view the leverage ratio tripwires

contained in existing PCA and other

regulations as important components of

the regulatory capital framework.

The A–IRB Approach for Credit Risk

Under the A–IRB approach for credit

risk, an institution’s internal assessment

of key risk drivers for a particular

exposure (or pool of exposures) would

serve as the primary inputs in the

calculation of the institution’s minimum

risk-based capital requirements.

Formulas, or risk weight functions,

specified by supervisors would use the

banking organization’s estimated inputs

to derive a specific dollar amount

capital requirement for each exposure

(or pool of exposures). This dollar

capital requirement would be converted

into a risk-weighted assets equivalent by

multiplying the dollar amount of the

capital requirement by 12.5—the

reciprocal of the 8 percent minimum

risk-based capital requirement

upervisors would use the

banking organization’s estimated inputs

to derive a specific dollar amount

capital requirement for each exposure

(or pool of exposures). This dollar

capital requirement would be converted

into a risk-weighted assets equivalent by

multiplying the dollar amount of the

capital requirement by 12.5—the

reciprocal of the 8 percent minimum

risk-based capital requirement.

Generally, banking organizations using

the A–IRB approach would assign assets

and off-balance-sheet exposures into

one of three portfolios: wholesale

(corporate, interbank, and sovereign),

retail (residential mortgage, qualifying

revolving, and other), and equities.

There also would be specific treatments

for securitization exposures and

purchased receivables. Certain assets

that do not constitute a direct credit

exposure (for example, premises,

equipment, or mortgage servicing rights)

would continue to be subject to the

general risk-based capital rules and risk

weighted at 100 percent. A brief

overview of each A–IRB portfolio

follows.

Wholesale (Corporate, Interbank, and

Sovereign) Exposures

Wholesale credit exposures comprise

three types of exposures: corporate,

interbank, and sovereign. Generally, the

meaning of interbank and sovereign

would be consistent with the general

risk-based capital rules. Corporate

exposures are exposures to private-

sector companies; interbank exposures

are primarily exposures to banks and

securities firms; and sovereign

exposures are those to central

governments, central banks, and certain

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consistent with the general

risk-based capital rules. Corporate

exposures are exposures to private-

sector companies; interbank exposures

are primarily exposures to banks and

securities firms; and sovereign

exposures are those to central

governments, central banks, and certain

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Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

5 Asset correlation is a measure of the tendency

for the financial condition of a borrower in a

banking organization’s portfolio to improve or

degrade at the same time as the financial condition

of other borrowers in the portfolio improve or

degrade.

6 When the PD, LGD, and EAD parameters are

assigned separately to individual exposures, it may

be referred to as a ‘‘bottom-up’’ approach. When

those parameters are assigned to predetermined sets

of exposures (pools or segments), it may be referred

to as a ‘‘top-down’’ approach.

7 The market risk capital rules were implemented

by the banking agencies in 1996. The market risk

capital rules apply to any banking organization

whose trading activity (on a consolidated

worldwide basis) equals 10 percent or more of total

assets, or $1 billion or more. The market risk capital

rules are found at 12 CFR Part 3, Appendix B

(OCC), 12 CFR Parts 208 and 225, Appendix E

(Board), and 12 CFR Part 325, Appendix C (FDIC).

The OTS, to date, has not adopted the market risk

capital rules.

other public-sector entities (PSEs).

Within the wholesale exposure category,

in addition to the treatment for general

corporate lending, there would be four

sub-categories of specialized lending

(SL). These are project finance (PF),

object finance (OF), commodities

finance (CF), and commercial real estate

(CRE). CRE is further subdivided into

low-asset-correlation CRE, and high-

volatility CRE (HVCRE)

sector entities (PSEs).

Within the wholesale exposure category,

in addition to the treatment for general

corporate lending, there would be four

sub-categories of specialized lending

(SL). These are project finance (PF),

object finance (OF), commodities

finance (CF), and commercial real estate

(CRE). CRE is further subdivided into

low-asset-correlation CRE, and high-

volatility CRE (HVCRE).

For each wholesale exposure, an

institution would assign four

quantitative risk drivers (inputs): (1)

Probability of default (PD), which

measures the likelihood that the

borrower will default over a given time

horizon; (2) loss given default (LGD),

which measures the proportion of the

exposure that will be lost if a default

occurs; (3) exposure at default (EAD),

which is the estimated amount owed to

the institution at the time of default; and

(4) maturity (M), which measures the

remaining economic maturity of the

exposure. Institutions generally would

be able to take into account credit risk

mitigation techniques (CRM), such as

collateral and guarantees (subject to

certain criteria), by adjusting their

estimates for PD or LGD. The wholesale

A–IRB risk weight function would use

all four risk inputs to produce a specific

capital requirement for each wholesale

exposure. There would be a separate,

more conservative risk weight function

for certain acquisition, development,

and construction loans (ADC) in the

HVCRE category.

Retail Exposures

Within the retail category, three

distinct risk weight functions are

proposed for three product areas that

exhibit different historical loss

experiences and different asset

correlations.5 The three retail sub-

categories would be: (1) Exposures

secured by residential mortgages and

related exposures; (2) qualifying

revolving exposures (QRE); and (3) other

retail exposures

Retail Exposures

Within the retail category, three

distinct risk weight functions are

proposed for three product areas that

exhibit different historical loss

experiences and different asset

correlations.5 The three retail sub-

categories would be: (1) Exposures

secured by residential mortgages and

related exposures; (2) qualifying

revolving exposures (QRE); and (3) other

retail exposures. QRE would include

unsecured revolving credits (such as

credit cards and overdraft lines), and

other retail would include most other

types of exposures to individuals, as

well as certain exposures to small

businesses. The key inputs to the three

retail risk weight functions would be a

banking organization’s estimates of PD,

LGD, and EAD. There would be no

explicit M component to the retail A–

IRB risk weight functions. Unlike

wholesale exposures, for retail

exposures, an institution would assign a

common set of inputs (PD, LGD, and

EAD) to predetermined pools of

exposures, which are typically referred

to as segments, rather than to individual

exposures.6 The inputs would be used

in the risk weight functions to produce

a capital charge for the associated pool

of exposures.

Equity Exposures

Banking organizations would use a

market-based internal model for

determining capital requirements for

equity exposures in the banking book.

The internal model approach would

assess capital based on an estimate of

loss under extreme market conditions.

Some equity exposures, such as

holdings in entities whose debt

obligations qualify for a zero percent

risk weight, would continue to receive

a zero percent risk weight under the A–

IRB approach to equities. Certain other

equity exposures, such as those made

through a small business investment

company (SBIC) under the Small

Business Investment Act or a

community development corporation

(CDC) or a community and economic

development entity (CEDE), generally

would be risk weighted at 100 percent

under the A–IRB approach to equities

zero percent risk weight under the A–

IRB approach to equities. Certain other

equity exposures, such as those made

through a small business investment

company (SBIC) under the Small

Business Investment Act or a

community development corporation

(CDC) or a community and economic

development entity (CEDE), generally

would be risk weighted at 100 percent

under the A–IRB approach to equities.

Banking organizations that are subject to

the Agencies’ market risk capital rules

would continue to apply those rules to

assess capital against equity positions

held in the trading book.7 Banking

organizations that are not subject to the

market risk capital rules would treat

equity positions in the trading account

as if they were in the banking book.

Securitization Exposures

Under the A–IRB treatment for

securitization exposures, a banking

organization that originates a

securitization would first calculate the

A–IRB capital charge that would have

been assessed against the underlying

exposures as if the exposures had not

been securitized. This capital charge

divided by the size of the exposure pool

is referred to as KIRB. If an originating

banking organization retains a position

in a securitization that obligates the

banking organization to absorb losses up

to or less than KIRB, the banking

organization would deduct the retained

position from capital as is currently

required under the general risk-based

capital rules. The general risk-based

capital rules, however, require a dollar-

for-dollar risk-based capital deduction

for certain residual interests retained by

originating banking organizations in

asset securitization transactions

regardless of amount. The A–IRB

framework would no longer require

automatic deduction of such residual

interests. The amount to be deducted

would be capped at KIRB for most

exposures

risk-based

capital rules, however, require a dollar-

for-dollar risk-based capital deduction

for certain residual interests retained by

originating banking organizations in

asset securitization transactions

regardless of amount. The A–IRB

framework would no longer require

automatic deduction of such residual

interests. The amount to be deducted

would be capped at KIRB for most

exposures. For a position in excess of

the KIRB threshold, the originating

banking organization would use an

external-ratings-based approach (if the

position has been rated by an external

rating agency or a rating can be inferred)

or a supervisory formula to determine

the capital charge for the position.

Non-originating banking organizations

that invest in a securitization exposure

generally would use an external-ratings-

based approach (if the exposure has

been rated by an external rating agency

or a rating can be inferred). For unrated

liquidity facilities that banking

organizations provide to securitizations,

capital requirements would be based on

several factors, including the asset

quality of the underlying pool and the

degree to which other credit

enhancements are available. These

factors would be used as inputs to a

supervisory formula. Under the A–IRB

approach to securitization exposures,

banking organizations also would be

required in some cases to hold

regulatory capital against securitizations

of revolving exposures that have early

amortization features.

Purchased Receivables

Purchased receivables, that is, those

that are purchased from another

institution either through a one-off

transaction or as part of an ongoing

program, would be subject to a two-part

capital charge: one part is for the credit

risk arising from the underlying

receivables and the second part is for

dilution risk

lving exposures that have early

amortization features.

Purchased Receivables

Purchased receivables, that is, those

that are purchased from another

institution either through a one-off

transaction or as part of an ongoing

program, would be subject to a two-part

capital charge: one part is for the credit

risk arising from the underlying

receivables and the second part is for

dilution risk. Dilution risk refers to the

possibility that contractual amounts

payable by the underlying obligors on

the receivables may be reduced through

future cash payments or other credits to

the accounts made by the seller of the

receivables. The framework for

determining the capital charge for credit

risk permits a purchasing organization

to use a top-down (pool) approach to

estimating PDs and LGDs when the

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purchasing organization is unable to

assign an internal risk rating to each of

the purchased accounts. The capital

charge for dilution risk would be

calculated using the wholesale risk

weight function with some additional

specified risk inputs.

The AMA for Operational Risk

Under the A–IRB approach, capital

charges for credit risk would be directly

calibrated solely for such risk and, thus,

unlike the 1988 Accord, would not

implicitly include a charge for

operational risk. As a result, the

Agencies are proposing that banking

organizations operating under the A–

IRB approach also would have to hold

regulatory capital for exposure to

operational risk. The Agencies are

proposing to define operational risk as

the risk of losses resulting from

inadequate or failed internal processes,

people, and systems, or external events

include a charge for

operational risk. As a result, the

Agencies are proposing that banking

organizations operating under the A–

IRB approach also would have to hold

regulatory capital for exposure to

operational risk. The Agencies are

proposing to define operational risk as

the risk of losses resulting from

inadequate or failed internal processes,

people, and systems, or external events.

Under the AMA, each banking

organization would be able to use its

own methodology for assessing

exposure to operational risk, provided

the methodology is comprehensive and

results in a capital charge that is

reflective of the operational risk

experience of the organization. The

operational risk exposure would be

multiplied by 12.5 to determine a risk-

weighted assets equivalent, which

would be added to the comparable

amounts for credit and market risk in

the denominator of the risk-based

capital ratios. The Agencies will be

working closely with institutions over

the next few years as operational risk

measurement and management

techniques continue to evolve.

Other Considerations

Boundary Issues

With the introduction of an explicit

regulatory capital charge for operational

risk, an issue arises about the proper

treatment of losses that can be attributed

to more than one risk factor. For

example, where a loan defaults and the

banking organization discovers that the

collateral for the loan was not properly

secured, the banking organization’s

resulting losses would be attributable to

both credit and operational risk. The

Agencies recognize that these types of

boundary issues are important and have

significant implications for how banking

organizations would compile loss data

sets and compute regulatory capital

charges

organization discovers that the

collateral for the loan was not properly

secured, the banking organization’s

resulting losses would be attributable to

both credit and operational risk. The

Agencies recognize that these types of

boundary issues are important and have

significant implications for how banking

organizations would compile loss data

sets and compute regulatory capital

charges.

The Agencies are proposing the

following standard to govern the

boundary between credit and

operational risk: A loss event that has

characteristics of credit risk would be

incorporated into the credit risk

calculations for regulatory capital (and

would not be incorporated into

operational risk capital calculations).

This would include credit-related fraud

losses. Thus, in the above example, the

loss from the loan would be attributed

to credit risk (not operational risk) for

regulatory capital purposes. This

separation between credit and

operational risk is supported by current

U.S. accounting standards for the

treatment of credit risks.

With regard to the boundary between

the trading book and the banking book,

for institutions subject to the market risk

rules, positions currently subject to

those rules include all positions held in

the trading account consistent with

GAAP. The New Accord proposed

additional criteria for positions

includable in the trading book for

purposes of market risk capital

requirements. The Agencies encourage

comment on these additional criteria

and whether the Agencies should

consider adopting such criteria (in

addition to the GAAP criteria) in

defining the trading book under the

Agencies’ market risk capital rules. The

Agencies are seeking comment on the

proposed treatment of the boundaries

between credit, operational, and market

risk

arket risk capital

requirements. The Agencies encourage

comment on these additional criteria

and whether the Agencies should

consider adopting such criteria (in

addition to the GAAP criteria) in

defining the trading book under the

Agencies’ market risk capital rules. The

Agencies are seeking comment on the

proposed treatment of the boundaries

between credit, operational, and market

risk.

Supervisory Considerations

The advanced approaches introduce

greater complexity to the regulatory

capital framework and would require a

high level of sophistication in the

banking organizations that implement

the advanced approaches. As a result,

the Agencies propose to require core

and opt-in banks to meet certain

infrastructure requirements and comply

with specific supervisory standards for

credit risk and for operational risk. In

addition, banking organizations would

have to satisfy a set of public disclosure

requirements as a prerequisite for

approval to using the advanced

approaches. Supervisory guidance for

each credit risk portfolio type, as well

as for operational risk, is being

developed to ensure a sufficient degree

of consistency within the supervisory

framework, while also recognizing that

internal systems will differ between

banking organizations. The goal is to

establish a supervisory framework

within which all institutions must

develop their internal systems, leaving

exact details to each institution. In the

case of operational risk in particular, the

Agencies recognize that measurement

methodologies are still evolving and

flexibility is needed.

It is important to note that supervisors

would not look at compliance with

requirements, or standards alone.

Supervisors also would evaluate

whether the components of an

institution’s advanced approaches are

consistent with the overall objective of

sound risk management and

measurement

, the

Agencies recognize that measurement

methodologies are still evolving and

flexibility is needed.

It is important to note that supervisors

would not look at compliance with

requirements, or standards alone.

Supervisors also would evaluate

whether the components of an

institution’s advanced approaches are

consistent with the overall objective of

sound risk management and

measurement. An institution would

have to use appropriately the advanced

approaches across all material business

lines, portfolios, and geographic regions.

Exposures in non-significant business

units as well as asset classes that are

immaterial in terms of size and

perceived risk profile may be exempted

from the advanced approaches with

supervisory approval. These immaterial

portfolios would be subject to the

general risk-based capital rules.

Proposed supervisory guidance for

corporate credit exposures and for

operational risk is provided separately

from this ANPR in today’s Federal

Register. The draft supervisory guidance

for corporate credit exposures is entitled

‘‘Supervisory Guidance on Internal-

Ratings-Based Systems for Corporate

Credit.’’ The guidance includes

specified supervisory standards that an

institution’s internal rating system for

corporate exposures would have to

satisfy for the institution to be eligible

to use the A–IRB approach for credit

risk. The draft operational risk guidance

is entitled ‘‘Supervisory Guidance on

Operational Risk Advanced

Measurement Approaches for

Regulatory Capital.’’ The operational

risk guidance includes identified

supervisory standards for an

institution’s AMA framework for

operational risk. The Agencies

encourage commenters to review and

comment on the draft guidance pieces

in conjunction with this ANPR. The

Agencies intend to issue for public

comment supervisory guidance on retail

credit exposures, equity exposures, and

securitization exposures over the next

several months

e includes identified

supervisory standards for an

institution’s AMA framework for

operational risk. The Agencies

encourage commenters to review and

comment on the draft guidance pieces

in conjunction with this ANPR. The

Agencies intend to issue for public

comment supervisory guidance on retail

credit exposures, equity exposures, and

securitization exposures over the next

several months.

Supervisory Review

As mentioned above, the second pillar

of the New Accord focuses on

supervisory review to ensure that an

institution holds sufficient capital given

its overall risk profile. The concepts of

Pillar 2 are not new to U.S. banking

organizations. U.S. institutions already

are required to hold capital sufficient to

meet their risk profiles, and supervisors

may require that an institution hold

more capital if its current levels are

deficient or some element of its business

practices suggest the need for more

capital. The Agencies also have the right

to intervene when capital levels fall to

an unacceptable level. Given these long-

standing elements of the U.S.

supervisory framework, the Agencies

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8 The Agencies note that under the general risk-

based capital rules some institutions currently are

able to hold less capital than others on some types

of assets (for example, through innovative financing

structures or use of credit risk mitigation

techniques). In addition, some institutions may

hold lower amounts of capital because the market

perceives them as highly diversified, while others

hold higher amounts of capital because of

concentrations of credit risk or other factors.

are not proposing to introduce specific

requirements or guidelines to

implement Pillar 2

innovative financing

structures or use of credit risk mitigation

techniques). In addition, some institutions may

hold lower amounts of capital because the market

perceives them as highly diversified, while others

hold higher amounts of capital because of

concentrations of credit risk or other factors.

are not proposing to introduce specific

requirements or guidelines to

implement Pillar 2. Instead, existing

guidance, rules, and regulations would

continue to be enforced and

supplemented as necessary as part of

this proposed new regulatory capital

framework. However, all institutions

operating under the advanced

approaches would be expected by

supervisors to address specific

assumptions embedded in the advanced

approaches (such as diversification in

credit portfolios), and would be

evaluated for their ability to account for

deviations from the underlying

assumptions in their own portfolios.

Disclosure

An integral part of the advanced

approaches is enhanced public

disclosure practices and improved

transparency. Under the Agencies’

proposal, specific disclosure

requirements would be applicable to all

institutions using the advanced

approaches. These disclosure

requirements would encompass capital,

credit risk, equities, credit risk

mitigation, securitization, market risk,

operational risk, and interest rate risk in

the banking book.

D. Competitive Considerations

It is essential that the Agencies gain

a full appreciation of the possible

competitive equity concerns that may be

presented by the establishment of a new

capital framework. The creation of a

bifurcated capital framework in the

United States—one set of capital

standards applicable to large,

internationally active banking

organizations (and those that choose to

apply the advanced approaches), and

another set of standards applicable to all

other institutions—has created concerns

among some parties about the potential

impact on competitive equity between

the two sets of banking organizations

pital framework in the

United States—one set of capital

standards applicable to large,

internationally active banking

organizations (and those that choose to

apply the advanced approaches), and

another set of standards applicable to all

other institutions—has created concerns

among some parties about the potential

impact on competitive equity between

the two sets of banking organizations.

Similarly, differences in supervisory

application of the advanced approaches

(both within the United States and

abroad) among large, internationally

active institutions may pose competitive

equity issues among such institutions.

The New Accord relies upon

compliance with certain minimum

operational and supervisory

requirements to promote consistent

interpretation and uniformity in

application of the advanced approaches.

Nevertheless, independent supervisory

judgment will be applied on a case-by-

case basis. These processes, albeit

subject to detailed and explicit

supervisory guidance, contain an

inherent amount of subjectivity and

must be assessed by supervisors on an

ongoing basis. This supervisory

assessment of the internal processes and

controls leading to an institution’s

internal ratings and other estimates

must maintain the high level of internal

risk measurement and management

processes contemplated in this ANPR.

The BSC’s Accord Implementation

Group (AIG), in which the Agencies

play an active role, will seek to ensure

that all jurisdictions uniformly apply

the same high qualitative and

quantitative standards to internationally

active banking institutions. However, to

the extent that different supervisory

regimes implement these standards

differently, there may be competitive

dislocations. One concern is that the

U.S. supervisory regime will impose

greater scrutiny in its implementation

standards, particularly given the

extensive on-site presence of bank

examiners in the United States

andards to internationally

active banking institutions. However, to

the extent that different supervisory

regimes implement these standards

differently, there may be competitive

dislocations. One concern is that the

U.S. supervisory regime will impose

greater scrutiny in its implementation

standards, particularly given the

extensive on-site presence of bank

examiners in the United States.

Quite distinct from the need for a

level playing field among

internationally active institutions are

the competitive concerns of those

institutions that do not elect to adopt or

may not qualify for the advanced

approaches. Some banking

organizations have expressed concerns

that small or regional banks would

become more likely to be acquired by

larger organizations seeking to lever

capital efficiencies. There also is a

qualitative concern about the impact of

being considered a ‘‘second tier’’

institution (one that does not implement

the advanced approaches) by the

market, rating agencies, or sophisticated

customers such as government or

municipal depositors and borrowers.

Finally, there is the question of what, if

any, competitive distortions might be

introduced by differences in regulatory

capital minimums between the

advanced approaches and the general

risk-based capital rules for loans or

securities with otherwise similar risk

characteristics, and the extent to which

such distortions may be mitigated in an

environment in which well-managed

banking organizations continue to hold

excess capital.8

Because the advanced framework

described in this ANPR is more risk-

sensitive than the 1988 Accord and the

general risk-based capital rules, banking

organizations under the advanced

approaches would face increases in

their minimum risk-based capital

charges on some assets and decreases on

others

an

environment in which well-managed

banking organizations continue to hold

excess capital.8

Because the advanced framework

described in this ANPR is more risk-

sensitive than the 1988 Accord and the

general risk-based capital rules, banking

organizations under the advanced

approaches would face increases in

their minimum risk-based capital

charges on some assets and decreases on

others. The results of a Quantitative

Impact Study (QIS3) the BSC conducted

in late 2002 indicated the potential for

the advanced approaches described in

this document to produce significant

changes in risk-based capital

requirements for specific activities; the

results also varied on an institution-by-

institution basis. The results of QIS3 can

be found at http://www.bis.org and

various results of QIS3 are noted at

pertinent places in this ANPR.

The Agencies do not believe the

results of QIS3 are sufficiently reliable

to form the basis of a competitive

impact analysis, both because the inputs

to the study were provided on a best-

efforts basis and because the proposals

in this ANPR are in some cases different

than those that formed the basis of QIS3.

The Agencies are nevertheless

interested in views on how changes in

regulatory capital (for the total of credit

and operational risk) of the magnitude

described in QIS3, if such changes were

in fact realized, would affect the

competitive landscape for domestic

banking organizations.

The Agencies plan to conduct at least

one more QIS, and potentially other

economic impact analyses, to better

understand the potential impact of the

proposed framework on the capital

requirements for individual U.S.

banking organizations and U.S. banking

organizations as a whole

uch changes were

in fact realized, would affect the

competitive landscape for domestic

banking organizations.

The Agencies plan to conduct at least

one more QIS, and potentially other

economic impact analyses, to better

understand the potential impact of the

proposed framework on the capital

requirements for individual U.S.

banking organizations and U.S. banking

organizations as a whole. This may

affect the Agencies’ further proposals

through recalibrating the A–IRB risk

weight formulas and making other

modifications to the proposed

approaches if the capital requirements

do not seem consistent with the overall

risk profiles of banking organizations or

safe and sound banking practices.

If competitive effects of the New

Accord are determined to be significant,

the Agencies would need to consider

potential ways to address those effects

while continuing to seek to achieve the

objectives of the current proposal.

Alternatives could potentially include

modifications to the proposed

approaches, as well as fundamentally

different approaches. The Agencies

recognize that an optimal capital system

must strike a balance between the

objectives of simplicity and regulatory

consistency across banking

organizations on the one hand, and the

degree of risk sensitivity of the

regulation on the other. There are many

criteria that must be evaluated in

achieving this balance, including the

resulting incentives for improving risk

measurement and management

practices, the ease of supervisory and

regulatory enforcement, the degree to

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sensitivity of the

regulation on the other. There are many

criteria that must be evaluated in

achieving this balance, including the

resulting incentives for improving risk

measurement and management

practices, the ease of supervisory and

regulatory enforcement, the degree to

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9 In this regard, alternative approaches would

take time to develop, but might present fewer

implementation challenges. Additional work would

be necessary to advance the goal of competitive

equity among internationally active banking

organizations. If consensus on alternative

approaches could not be reached at the BSC, a

departure from the Basel framework also could raise

significant international and domestic issues.

10 For banks this means the December

Consolidated Report of Condition and Income (Call

Report). For thrifts this means the December Thrift

Financial Report.

which the overall level of regulatory

capital in the banking system is broadly

preserved, and the effects on domestic

and international competition. The

Agencies are interested in commenters’

views on alternatives to the advanced

approaches that could achieve this

balance, and in particular on

alternatives that could do so without a

bifurcated approach.9

The Agencies are committed to

investigate the full scope of possible

competitive impact and welcome all

comments in this regard. Some

questions are suggested below that may

serve to focus commenters’ general

reactions. More specific questions also

are suggested throughout this ANPR.

These questions should not be viewed

as limiting the Agencies’ areas of

interest or commenters’ submissions on

the proposals. The Agencies encourage

commenters to provide supporting data

and analysis, if available

ments in this regard. Some

questions are suggested below that may

serve to focus commenters’ general

reactions. More specific questions also

are suggested throughout this ANPR.

These questions should not be viewed

as limiting the Agencies’ areas of

interest or commenters’ submissions on

the proposals. The Agencies encourage

commenters to provide supporting data

and analysis, if available.

What are commenters’ views on the

relative pros and cons of a bifurcated

regulatory capital framework versus a single

regulatory capital framework? Would a

bifurcated approach lead to an increase in

industry consolidation? Why or why not?

What are the competitive implications for

community and mid-size regional banks?

Would institutions outside of the core group

be compelled for competitive reasons to opt-

in to the advanced approaches? Under what

circumstances might this occur and what are

the implications? What are the competitive

implications of continuing to operate under

a regulatory capital framework that is not risk

sensitive?

If regulatory minimum capital

requirements declined under the advanced

approaches, would the dollar amount of

capital held by advanced approach banking

organizations also be expected to decline? To

the extent that advanced approach

institutions have lower capital charges on

certain assets, how probable and significant

are concerns that those institutions would

realize competitive benefits in terms of

pricing credit, enhanced returns on equity,

and potentially higher risk-based capital

ratios? To what extent do similar effects

already exist under the current general risk-

based capital rules (for example, through

securitization or other techniques that lower

relative capital charges on particular assets

for only some institutions)? If they do exist

now, what is the evidence of competitive

harm?

Apart from the approaches described in

this ANPR, are there other regulatory capital

approaches that are capable of ameliorating

competitive concerns while at the

-

based capital rules (for example, through

securitization or other techniques that lower

relative capital charges on particular assets

for only some institutions)? If they do exist

now, what is the evidence of competitive

harm?

Apart from the approaches described in

this ANPR, are there other regulatory capital

approaches that are capable of ameliorating

competitive concerns while at the same time

achieving the goal of better matching

regulatory capital to economic risks? Are

there specific modifications to the proposed

approaches or to the general risk-based

capital rules that the Agencies should

consider?

II. Application of the Advanced

Approaches in the United States

By its terms, the 1988 Accord applied

only to internationally active banks.

Under the New Accord, the scope of

application has been broadened also to

encompass bank holding companies that

are parents of internationally active

‘‘banking groups.’’

A. Threshold Criteria for Mandatory

Advanced Approach Organizations

The Agencies believe that for large,

internationally active U.S. institutions

only the advanced approaches are

appropriate. Accordingly, the Agencies

intend to identify three groups of

banking organizations: (1) Large,

internationally active banking

organizations that would be subject to

the A–IRB approach and AMA on a

mandatory basis (core banks); (2)

organizations not subject to the

advanced approaches on a mandatory

basis, but that voluntarily choose to

adopt those approaches (opt-in banks);

and all remaining organizations that are

not mandatorily subject to and do not

apply the advanced approaches (general

banks).

For purposes of identifying core

banks, the Agencies are proposing a set

of objective criteria for industry

consideration. Specifically, the

Agencies are proposing to treat as a core

bank any banking organization that has

o

adopt those approaches (opt-in banks);

and all remaining organizations that are

not mandatorily subject to and do not

apply the advanced approaches (general

banks).

For purposes of identifying core

banks, the Agencies are proposing a set

of objective criteria for industry

consideration. Specifically, the

Agencies are proposing to treat as a core

bank any banking organization that has

(1) total commercial bank (and thrift)

assets of $250 billion or more, as

reported on year-end regulatory reports

(with banking assets of consolidated

groups aggregated at the U.S. bank

holding company level); 10 or (2) total

on-balance-sheet foreign exposure of

$10 billion or more, as reported on the

year-end Country Exposure Report

(FFIEC 009) (with foreign exposure of

consolidated groups aggregated at the

U.S. bank holding company level).

These threshold criteria are

independent; meeting either condition

would mean an institution is a core

bank.

Once an institution becomes a core

bank it would remain subject to the

advanced approaches on a going

forward basis. If, in subsequent years,

such an institution were to drop below

both threshold levels it would continue

to be a core bank unless it could

demonstrate to its primary Federal

supervisor that it has substantially and

permanently downsized and should no

longer be a core bank. The Agencies are

proposing an annual test for assessing

banking organizations in reference to

the threshold levels. However, as a

banking organization approaches either

of the threshold levels the Agencies

would expect to have ongoing dialogue

with that organization to ensure that

appropriate practices are in place or are

actively being developed to prepare the

organization for implementation of the

advanced approaches

nual test for assessing

banking organizations in reference to

the threshold levels. However, as a

banking organization approaches either

of the threshold levels the Agencies

would expect to have ongoing dialogue

with that organization to ensure that

appropriate practices are in place or are

actively being developed to prepare the

organization for implementation of the

advanced approaches.

Institutions that by expansion or

merger meet the threshold levels must

qualify for use of the advanced

approaches and would be subject to the

same implementation plan requirements

and minimum risk-based capital floors

applicable to core and opt-in banks as

described below. Institutions that seek

to become opt-in banks would be

expected to notify their primary Federal

supervisors well in advance of the date

by which they expect to qualify for the

advanced approaches. Based on the

aforementioned threshold levels, the

Agencies anticipate at this time that

approximately ten U.S. institutions

would be core banks.

Application of Advanced Approaches at

Individual Bank/Thrift Levels

The Agencies are aware that some

institutions might, on a consolidated

basis, exceed one of the threshold levels

for mandatory application of the A–IRB

approach and AMA and, yet, might be

comprised of distinct bank and thrift

charters whose respective sizes fall well

below the thresholds. In those cases, the

Agencies believe that all bank and thrift

institutions that are members of a

consolidated group that is itself a core

bank or an opt-in bank should calculate

and report their risk-based capital

requirements under the advanced

approaches

oach and AMA and, yet, might be

comprised of distinct bank and thrift

charters whose respective sizes fall well

below the thresholds. In those cases, the

Agencies believe that all bank and thrift

institutions that are members of a

consolidated group that is itself a core

bank or an opt-in bank should calculate

and report their risk-based capital

requirements under the advanced

approaches. However, recognizing that

separate bank and thrift charters may, to

a large extent, be independently

managed and have different systems and

portfolios, the Agencies are interested in

comment on the efficacy and burden of

a framework that requires the advanced

approaches to be implemented by (or

pushed down to) each of the separate

subsidiary banks and thrifts that make

up the consolidated group.

U.S. Banking Subsidiaries of Foreign

Banking Organizations

Any U.S. bank or thrift that is a

subsidiary of a foreign bank would have

to comply with the prevailing U.S.

regulatory capital requirements applied

to U.S. banks. Thus, if a U.S. bank or

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11 One notable exception exists at the bank level

where there is an investment in a financial

subsidiary as defined in the Gramm-Leach-Bliley

Act of 1999. For such a subsidiary, assets would

continue to be deconsolidated from the bank’s on-

balance-sheet assets, and capital at the subsidiary

level would be deducted from the bank’s capital.

thrift that is owned by a foreign bank

meets the threshold levels for

mandatory application of the advanced

approaches, the U.S. bank or thrift

would be a core bank. If it does not meet

those thresholds, it would have the

choice to opt-in to the advanced

approaches (and be subject to the same

supervisory framework as other U.S.

banking organizations) or to remain a

general bank. A top-tier U.S

that is owned by a foreign bank

meets the threshold levels for

mandatory application of the advanced

approaches, the U.S. bank or thrift

would be a core bank. If it does not meet

those thresholds, it would have the

choice to opt-in to the advanced

approaches (and be subject to the same

supervisory framework as other U.S.

banking organizations) or to remain a

general bank. A top-tier U.S. bank

holding company that is owned by a

foreign bank also would be subject to

the same threshold levels for core bank

determination and would be subject to

the applicable U.S. bank holding

company capital rules. However,

Federal Reserve SR Letter 01–1 (January

5, 2001) would remain in effect. Thus,

subject to the conditions in SR Letter

01–1, a top-tier U.S. bank holding

company that is owned or controlled by

a foreign bank that is a qualifying

financial holding company generally

would not be required to comply with

the Board’s capital adequacy guidelines.

The Agencies are interested in comment on

the extent to which alternative approaches to

regulatory capital that are implemented

across national boundaries might create

burdensome implementation costs for the

U.S. subsidiaries of foreign banks.

B. Implementation for Advanced

Approach Organizations

As noted earlier, U.S. banking

organizations that apply the advanced

approaches would be required to

comply with supervisory standards

prior to use.

The BSC has targeted December 31,

2006 as the effective date for the

international capital rules based on the

New Accord. The Agencies are

proposing an implementation date of

January 1, 2007. The establishment of a

final effective date in the United States,

however, would be contingent on the

issuance for public comment of a Notice

of Proposed Rulemaking, and

subsequent finalization of any changes

in capital regulations that the Agencies

ultimately decide to adopt

onal capital rules based on the

New Accord. The Agencies are

proposing an implementation date of

January 1, 2007. The establishment of a

final effective date in the United States,

however, would be contingent on the

issuance for public comment of a Notice

of Proposed Rulemaking, and

subsequent finalization of any changes

in capital regulations that the Agencies

ultimately decide to adopt.

Because of the need to pre-qualify for

the advanced approaches, banking

organizations would need to take a

number of steps upon the finalization of

any changes to the capital regulations.

These steps would include developing

detailed written implementation plans

for the A–IRB approach and the AMA

and keeping their primary supervisors

advised of these implementation plans

and schedules. Implementation plans

would need to address all supervisory

standards for the A–IRB approach and

the AMA, include objectively

measurable milestones, and demonstrate

that adequate resources would be

realistically budgeted and made

available. An institution’s board of

directors would need to approve its

implementation plans.

The Agencies expect core banks to

make every effort to meet the

supervisory standards as soon as

practicable. In this regard, it is possible

that some core banks would not qualify

to use the advanced approaches in time

to meet the effective date that is

ultimately established. For those

banking organizations, the

implementation plan would need to

identify when the supervisory standards

would be met and when the institution

would be ready for implementation. The

Agencies note that developing an

appropriate infrastructure to support the

advanced approaches for regulatory

capital that fully complies with

supervisory conditions and expectations

and the associated supervisory guidance

will be challenging. The Agencies

believe, however, that institutions

would need to be fully prepared before

moving to the advanced approaches

for implementation. The

Agencies note that developing an

appropriate infrastructure to support the

advanced approaches for regulatory

capital that fully complies with

supervisory conditions and expectations

and the associated supervisory guidance

will be challenging. The Agencies

believe, however, that institutions

would need to be fully prepared before

moving to the advanced approaches.

Use of the advanced approaches

would require the primary Federal

supervisor’s approval. Core banks

unable to qualify for the advanced

approaches in time to meet the effective

date would remain subject to the general

risk-based capital rules existing at that

time. The Agencies would consider the

effort and progress made to meet the

qualifying standards and would

consider whether, under the

circumstances, supervisory action

should be taken against or penalties

imposed on individual core banks that

have not adhered to the schedule

outlined in the implementation plan

they submitted to their primary Federal

supervisor.

Opt-in banks meeting the supervisory

standards could seek to qualify for the

advanced approaches in time to meet

the ultimate final effective date or any

time thereafter. Institutions

contemplating opting-in to the advanced

approaches would need to provide

notice to, and submit an

implementation plan and schedule to be

approved by, their primary Federal

supervisor. As is true of core banks, opt-

in banks would need to allow ample

time for developing and executing

implementation plans.

An institution’s primary Federal

supervisor would have responsibility for

determining the institution’s readiness

for an advanced approach and would be

ultimately responsible, after

consultation with other relevant

supervisors, for determining whether

the institution satisfies the supervisory

expectations for the advanced

approaches. The Agencies recognize

that a consistent and transparent

process to oversee implementation of

the advanced approaches would be

crucial

ning the institution’s readiness

for an advanced approach and would be

ultimately responsible, after

consultation with other relevant

supervisors, for determining whether

the institution satisfies the supervisory

expectations for the advanced

approaches. The Agencies recognize

that a consistent and transparent

process to oversee implementation of

the advanced approaches would be

crucial. The Agencies intend to develop

interagency validation standards and

procedures to help ensure consistency.

The Agencies would consult with each

other on significant issues raised during

the validation process and ongoing

implementation.

C. Other Considerations

General Banks

The Agencies expect that the vast

majority of U.S. institutions would be

neither core banks nor opt-in banks.

Most institutions would remain subject

to the general risk-based capital rules.

However, as has been the case since the

1988 Accord was initially implemented

in the United States, the Agencies will

continue to make necessary

modifications to the general risk-based

capital rules as appropriate. In the event

changes are warranted, the Agencies

could implement revisions through

notice and comment procedures prior to

the proposed effective date of the

advanced approaches in 2007.

The Agencies seek comment on

whether changes should be made to the

existing general risk-based capital rules

to enhance their risk-sensitivity or to

reflect changes in the business lines or

activities of banking organizations

without imposing undue regulatory

burden or complication. In particular,

the Agencies seek comment on whether

any changes to the general risk-based

capital rules are necessary or warranted

to address any competitive equity

concerns associated with the bifurcated

framework.

Majority-Owned or Controlled

Subsidiaries

The New Accord generally applies to

internationally active banking

organizations on a fully consolidated

basis

den or complication. In particular,

the Agencies seek comment on whether

any changes to the general risk-based

capital rules are necessary or warranted

to address any competitive equity

concerns associated with the bifurcated

framework.

Majority-Owned or Controlled

Subsidiaries

The New Accord generally applies to

internationally active banking

organizations on a fully consolidated

basis. Thus, consistent with the

Agencies’ general risk-based capital

rules, subsidiaries that are consolidated

under U.S. generally accepted

accounting principles (GAAP) typically

should be consolidated for regulatory

capital calculation purposes under the

advanced approaches as well.11 With

regard to investments in consolidated

insurance underwriting subsidiaries, the

New Accord notes that deconsolidation

of assets and deduction of capital is an

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Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

12 The agencies note that the text above differs

from the floor text in the New Accord, which is

based on 90 and 80 percent of the minimum capital

requirements under the 1988 Accord, rather than on

risk-weighted assets. The Agencies expect that the

final language of the New Accord would need to be

consistent with this approach. The following

example reflects how the floor in the first year

would be applied by a U.S. banking organizaiton.

If the banking organization’s general risk-based

capital calculation produced risk-weighted assets of

$100 billion in its first year of implementation of

the advanced approaches, then its risk weighted

assets in that year could not be less than $90 billion

tent with this approach. The following

example reflects how the floor in the first year

would be applied by a U.S. banking organizaiton.

If the banking organization’s general risk-based

capital calculation produced risk-weighted assets of

$100 billion in its first year of implementation of

the advanced approaches, then its risk weighted

assets in that year could not be less than $90 billion.

If the advanced approach calculation produced risk-

weighted assets of $75 billion (a decrease of one

quarter compared to the general risk-based capital

rules), the organization would not calculate risk-

based capital ratios on the basis of that $75 billion;

rather, its risk-weighted assets would be $90 billion.

Consequently, its minimum total risk-based capital

charge would be $7.2 billion, and it would need $9

billion to satisfy PCA well-capitalized criteria.

appropriate approach. The Federal

Reserve is actively considering several

approaches to the capital treatment for

investments by bank holding companies

in insurance underwriting subsidiaries.

For example, the Federal Reserve is

currently assessing the merits and

weaknesses of an approach that would

consolidate an insurance underwriting

subsidiary’s assets at the holding

company level and permit excess capital

of the subsidiary to be included in the

consolidated regulatory capital of the

holding company. A deduction would

be required for capital that is not readily

available at the holding company level

for general use throughout the

organization.

The Federal Reserve specifically seeks

comment on the appropriate regulatory

capital treatment for investments by bank

holding companies in insurance

underwriting subsidiaries as well as other

nonbank subsidiaries that are subject to

minimum regulatory capital requirements

d for capital that is not readily

available at the holding company level

for general use throughout the

organization.

The Federal Reserve specifically seeks

comment on the appropriate regulatory

capital treatment for investments by bank

holding companies in insurance

underwriting subsidiaries as well as other

nonbank subsidiaries that are subject to

minimum regulatory capital requirements.

Transitional Arrangements

Core and opt-in banks would be

required to calculate their capital ratios

using the A-IRB and AMA

methodologies, as well as the general

risk-based capital rules, for one year

prior to using the advanced approaches

on a stand-alone basis. In order to begin

this parallel-run year, however, the

institution would have to demonstrate

to its supervisor that it meets the

supervisory standards. Therefore,

banking organizations planning to meet

the January 1, 2007 target effective date

for implementation of the advanced

approaches would have to receive

approval from their primary Federal

supervisor before year-end 2005.

Banking organizations that later adopt

the advanced approaches also would

have a one-year dual calculation period

prior to moving to stand-alone usage of

the advanced approaches.

An institution would be subject to a

minimum risk-based capital floor for

two years following moving to the

advanced approaches on a stand-alone

basis. Specifically, in the first year of

stand-alone usage of the advanced

approaches, an institution’s calculated

risk-weighted assets could not be less

than 90 percent of risk-weighted assets

calculated under the general risk-based

capital rules. In the following year, an

institution’s minimum calculated risk-

weighted assets could not be less than

80 percent of risk-weighted assets

calculated under the general risk-based

capital rules.12

As a consequence, advanced approach

banking organizations would need to

conduct two sets of capital calculations

for at least three years

ts

calculated under the general risk-based

capital rules. In the following year, an

institution’s minimum calculated risk-

weighted assets could not be less than

80 percent of risk-weighted assets

calculated under the general risk-based

capital rules.12

As a consequence, advanced approach

banking organizations would need to

conduct two sets of capital calculations

for at least three years. The pre-

implementation calculation of A-IRB

and AMA capital would not need to be

made public, but the banking

organization would be required to

disclose risk-based capital ratios

calculated under both advanced and

general risk-based approaches during

the two-year post-implementation

period. The Agencies would not

propose to eliminate the floors after the

two-year transition period for any

institution applying the advanced

approaches until the Agencies are fully

satisfied that the institution’s systems

are sound and accurately assess risk and

that resulting capital levels are prudent.

These transitional arrangements and

the floors established above relate only

to risk-based capital ratios and do not

affect the continued applicability to all

advanced banking organizations of the

leverage ratio and associated PCA

regulations for banks and thrifts.

Importantly, the minimum capital

requirements and the PCA thresholds

would not be changed. Furthermore,

during the implementation period and

before removal of the floors the

Agencies intend to closely monitor the

effect that the advanced approaches

would have on capital levels at

individual institutions and industry-

wide capital levels. Once the results of

this monitoring process are assessed, the

Agencies may consider modifications to

the advanced approaches to ensure that

capital levels remain prudent

lementation period and

before removal of the floors the

Agencies intend to closely monitor the

effect that the advanced approaches

would have on capital levels at

individual institutions and industry-

wide capital levels. Once the results of

this monitoring process are assessed, the

Agencies may consider modifications to

the advanced approaches to ensure that

capital levels remain prudent.

Given the general principle that the

advanced approaches are expected to be

implemented at the same time across all

material portfolios, business lines, and

geographic regions, to what degree should

the Agencies be concerned that, for example,

data may not be available for key portfolios,

business lines, or regions? Is there a need for

further transitional arrangements? Please be

specific, including suggested durations for

such transitions.

Do the projected dates provide an adequate

timeframe for core banks to be ready to

implement the advanced approaches? What

other options should the Agencies consider?

The Agencies seek comment on

appropriate thresholds for determining

whether a portfolio, business line, or

geographic exposure would be material.

Considerations should include relative asset

size, percentages of capital, and associated

levels of risk for a given portfolio, business

line, or geographic region.

III. Advanced Internal Ratings-Based

(A–IRB) Approach

This section describes the proposed

A–IRB framework for the measurement

of capital requirements for credit risk.

Under this framework, banking

organizations that meet the A–IRB

infrastructure requirements and

supervisory standards would

incorporate internal estimates of risk

inputs into supervisor-provided capital

formulas for the various debt and equity

portfolios to calculate the capital

requirements for each portfolio

A–IRB framework for the measurement

of capital requirements for credit risk.

Under this framework, banking

organizations that meet the A–IRB

infrastructure requirements and

supervisory standards would

incorporate internal estimates of risk

inputs into supervisor-provided capital

formulas for the various debt and equity

portfolios to calculate the capital

requirements for each portfolio. The

discussion below provides background

on the conceptual basis of the A–IRB

approach and then describes the

specific details of the capital formulas

for two of the main exposure categories,

wholesale and retail. Separate sections

follow that describe the A–IRB

treatments of loan loss reserves and

partial charge-offs, the A–IRB treatment

of purchased receivables, the A–IRB

treatment of equity exposures, and the

A–IRB treatment of securitization

exposures. The A–IRB supervisory

requirements and the A–IRB approach

to credit risk mitigation techniques also

are discussed in separate sections.

A. Conceptual Overview

The A–IRB framework has as its

conceptual foundation the belief that

any range of possible losses on a

portfolio of credit exposures can be

represented by a probability density

function (PDF) of possible losses over a

one-year time horizon. If known, the

parameters of a PDF can be used to

specify a particular level of capital that

will lower the probability of the

institution’s insolvency due to adverse

credit risk outcomes to a stated

confidence level. With a known or

estimated PDF, the probability of

insolvency can be measured or

estimated directly, based on the level of

reserves and capital available to an

institution.

The A–IRB framework builds off this

concept and reflects an effort to develop

a common set of risk-sensitive formulas

for the calculation of required capital for

credit risk

risk outcomes to a stated

confidence level. With a known or

estimated PDF, the probability of

insolvency can be measured or

estimated directly, based on the level of

reserves and capital available to an

institution.

The A–IRB framework builds off this

concept and reflects an effort to develop

a common set of risk-sensitive formulas

for the calculation of required capital for

credit risk. To a large extent, this

framework resembles more systematic

quantitative approaches to the

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Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

13 The theoretical underpinnings for obtaining

portfolio-invariant capital charges within credit

VaR models are provided in the paper ‘‘A Risk-

Factor Model Foundation for Ratings-Based Bank

Capital Rules,’’ by Michael Gordy, forthcoming in

the Journal of Financial Intermediation. The A–IRB

formulas are derived as an application of these

results to a single-factor CreditMetrics-style mode.

For mathematical details of this model, see M.

Gordy, ‘‘A comparative Anatomy of Credit Risk

Models.’’ Journal of Banking and Finance, January

2000, or H.R. Koyluogu and A. Hickman,

‘‘Reconcilable Differences.’’ Risk, October 1998.

measurement of credit risk that many

banking organizations have been

developing. These approaches being

developed by banking organizations

generally rely on a statistical or

probability-based assessment of credit

risk and use inputs broadly similar to

those required under the A–IRB

approach. Like the value-at-risk (VaR)

model that forms the basis for the

market risk capital rules, the output of

these statistical approaches to credit risk

is typically an estimate of loss threshold

on a credit exposure or pool of credit

exposures that is highly unlikely to be

exceeded by actual credit-related losses

on the exposure or pool

ly similar to

those required under the A–IRB

approach. Like the value-at-risk (VaR)

model that forms the basis for the

market risk capital rules, the output of

these statistical approaches to credit risk

is typically an estimate of loss threshold

on a credit exposure or pool of credit

exposures that is highly unlikely to be

exceeded by actual credit-related losses

on the exposure or pool.

Many banking organizations now use

such a credit VaR amount as the basis

for an internal assessment of the

economic capital necessary to cover

credit risk. In this context, it is common

for banking organizations’ internal

credit risk models to consider a one-year

loss horizon, and to focus on a high loss

threshold confidence level (that is, a

loss threshold that has a small

probability of being exceeded), such as

the 99.95th percentile. This is because

banking organizations typically seek to

hold an amount of economic capital for

credit risk whose probability of being

exceeded is broadly consistent with the

institution’s external credit rating and

its associated default probability. For

example, the one-year historical

probability of default for AA-rated firms

is less than 5 basis points (0.05 percent).

There is a great deal of variation

across banking organizations in the

specifics of their credit risk

measurement approaches. It is

important to recognize that the A–IRB

approach is not intended to allow

banking organizations to use all aspects

of their own models to estimate

regulatory capital for credit risk. The A–

IRB approach has been developed as a

single, common methodology that all

advanced approach banking

organizations would use, and consists of

a set of formulas (or functions) and a

single set of assumptions regarding

critical parameters for the formulas

s not intended to allow

banking organizations to use all aspects

of their own models to estimate

regulatory capital for credit risk. The A–

IRB approach has been developed as a

single, common methodology that all

advanced approach banking

organizations would use, and consists of

a set of formulas (or functions) and a

single set of assumptions regarding

critical parameters for the formulas. The

A–IRB approach draws on the same

conceptual underpinnings as the credit

VaR approaches that banking

organizations have developed

individually, but likely differs in many

specifics from the approach used by any

individual institution.

The specific A–IRB formulas require

the banking organization first to

estimate certain risk inputs, which the

organization may do using a variety of

techniques. The formulas themselves,

into which the estimated risk inputs are

inserted, are broadly consistent with the

most common statistical approaches for

measuring credit risk, but also are more

straightforward to calculate than those

typically employed by banking

organizations (which often require

computer simulations). In particular, an

important property of the A–IRB

formulas is portfolio invariance. That is,

the A–IRB capital requirement for a

particular exposure generally does not

depend on the other exposures held by

the banking organization; as with the

general risk-based capital rules, the total

credit risk capital requirement for a

banking organization is simply the sum

of the credit risk capital requirements

on individual exposures or pools of

exposures.13

As with the existing credit VaR

models, the output of the A–IRB

formulas is an estimate of the amount of

credit losses over a one-year period that

would only be exceeded a small

percentage of the time. In the case of the

A–IRB formulas, this nominal

confidence level is set to 99.9 percent

ply the sum

of the credit risk capital requirements

on individual exposures or pools of

exposures.13

As with the existing credit VaR

models, the output of the A–IRB

formulas is an estimate of the amount of

credit losses over a one-year period that

would only be exceeded a small

percentage of the time. In the case of the

A–IRB formulas, this nominal

confidence level is set to 99.9 percent.

This means that within the context of

the A–IRB modeling assumptions a

banking organization’s overall credit

portfolio capital requirement can be

thought of as an estimate of the 99.9th

percentile of potential losses on that

portfolio over a one-year period. In

practice, however, this 99.9 percent

nominal target likely overstates the

actual level of confidence because the

A–IRB framework does not explicitly

address portfolio concentration issues or

the possibility of errors in estimating

PDs, LGDs, or EADs. The choice of the

99.9th percentile reflects a desire on the

part of the Agencies to align the

regulatory capital standard with the

default probabilities typically associated

with maintaining low investment grade

ratings (that is, BBB) even in periods of

economic adversity and to ensure

neither a substantial increase or

decrease in overall required capital

levels among A–IRB banking

organizations compared with the capital

levels that would be required under the

general risk-based capital rules. It also

recognizes that the risk-based capital

rules count a broader range of

instruments as eligible capital (for

example, certain subordinated debt)

than do internal economic capital

methodologies.

Expected Losses Versus Unexpected

Losses

The diagram below shows a

hypothetical loss distribution for a

portfolio of credit exposures over a one-

year horizon. The loss distribution is

represented by the curve, and is drawn

in such a way that it depicts a higher

proportion of losses falling below the

mean value than falling above the mean

than do internal economic capital

methodologies.

Expected Losses Versus Unexpected

Losses

The diagram below shows a

hypothetical loss distribution for a

portfolio of credit exposures over a one-

year horizon. The loss distribution is

represented by the curve, and is drawn

in such a way that it depicts a higher

proportion of losses falling below the

mean value than falling above the mean.

The average value of credit losses is

referred to as expected loss (EL). The

losses that exceed the expected level are

labeled unexpected loss (UL). An

overarching policy question concerns

whether the proposed design of the A–

IRB capital requirements should reflect

an expectation that institutions would

allocate capital to cover both EL and a

substantial portion of the range of

possible UL outcomes, or only the UL

portion of the range of possible losses

(that is, from the EL point out to the

99.9th percentile).

The Agencies recognize that some

institutions, in their comment letters on

earlier BSC proposals and in discussion

with supervisory staffs, have

highlighted the view that regulatory

capital should not be allocated for EL.

They emphasize that EL is normally

incorporated into the interest rate and

spreads charged on specific products,

such that EL is covered by net interest

margin and provisioning. The

implication is that supervisors would

review provisioning policies and the

adequacy of reserves as part of a

supervisory review, much as they do

today, and would require additional

reserves and/or regulatory capital for EL

in cases where reserves were deemed

insufficient. However, the Agencies are

concerned that the accounting

definition of general reserves differs

significantly across countries, and that

banking practices with respect to the

recognition of impairment also are very

different. Thus, the Agencies are

proposing to include EL in the

calibration of the risk weight functions

atory capital for EL

in cases where reserves were deemed

insufficient. However, the Agencies are

concerned that the accounting

definition of general reserves differs

significantly across countries, and that

banking practices with respect to the

recognition of impairment also are very

different. Thus, the Agencies are

proposing to include EL in the

calibration of the risk weight functions.

The Agencies also note that the

current regulatory definition of capital

includes a portion of general reserves.

That is, general reserves up to 1.25

percent of risk-weighted assets are

included in the Tier 2 portion of total

capital. If the risk weight functions were

calibrated solely to UL, it could be

argued that the definition of capital

would also need to be revisited. In the

United States, such a discussion would

require a review of the provisioning

practices of institutions under GAAP

and of the distinctions drawn between

specific and general provisions.

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14 See forthcoming paper by M. Gordy referenced

in footnot number 12 above.

The framework described in this

ANPR calibrates the risk-based capital

requirements to the sum of EL plus UL,

which raises significant calibration

issues. Those calibration issues would

be treated differently if the calibration

were based only on the estimate of UL.

That is, decisions with respect to

significant policy variables that are

described below hinge crucially on the

initial decision to base the calibration

on EL plus UL, rather than UL only.

These issues include, for example, the

appropriate mechanism for

incorporating any future margin income

(FMI) that is associated with particular

business lines, as well as the

appropriate method for incorporating

general and specific reserves into the

risk-based capital ratios

cribed below hinge crucially on the

initial decision to base the calibration

on EL plus UL, rather than UL only.

These issues include, for example, the

appropriate mechanism for

incorporating any future margin income

(FMI) that is associated with particular

business lines, as well as the

appropriate method for incorporating

general and specific reserves into the

risk-based capital ratios.

A final overarching assumption of the

A–IRB framework is the role of asset

correlations. Within the A–IRB capital

formulas (as in the credit VaR models of

many banking organizations), asset

correlation parameters provide a

measure of the extent to which changes

in the economic value of separate

exposures are presumed to move

together. A higher asset correlation

between a particular asset and other

assets in the same portfolio implies a

greater likelihood that the asset will

decline in value at the same time as the

portfolio as a whole declines in value.

Because this means a greater chance that

the asset will be a contributor to high

loss scenarios, its capital requirement

under the A–IRB framework also is

higher.

Specifically, the A–IRB capital

formulas described in detail below are

based on the assumption that

correlation in defaults across borrowers

is attributable to their common

dependence on one or more systematic

risk factors. The basis for this

assumption is the observation that a

banking organization’s borrowers are

generally susceptible to adverse changes

in the global economy. These systematic

factors are distinct from the borrower-

specific, or idiosyncratic, risk factors

that determine the probability that a

specific loan will be repaid. Like other

risk-factor models, the A–IRB

framework assumes that these borrower-

specific factors represent idiosyncratic

sources of risk, and thus (unlike the

systematic risk-factors) are diversified in

a large lending portfolio

ese systematic

factors are distinct from the borrower-

specific, or idiosyncratic, risk factors

that determine the probability that a

specific loan will be repaid. Like other

risk-factor models, the A–IRB

framework assumes that these borrower-

specific factors represent idiosyncratic

sources of risk, and thus (unlike the

systematic risk-factors) are diversified in

a large lending portfolio.

The A–IRB approach allows for much

improved sensitivity to many of the

loan-level determinants of economic

capital (such as PD and LGD), but does

not explicitly address how an

exposure’s economic capital might vary

with the degree of concentration in the

overall portfolio to specific industries or

regions, or even to specific borrowers.

That is, it neither rewards nor penalizes

differences across banking organizations

in diversification or concentration

across industry, geography, and names.

To introduce such rewards and

penalties in an appropriate manner

would necessarily entail far greater

operational complexity for both

regulatory and financial institutions.

In contrast, the portfolio models of

credit risk employed by many banking

organizations are quite sensitive to all

forms of diversification. That is, the

economic capital charge assigned to a

loan within such a model will depend

on the portfolio as a whole. In order to

apply a portfolio model to the

calibration of A–IRB capital charges, it

would be necessary to identify the

assumptions needed so that a portfolio

model would yield economic capital

charges that do not depend on portfolio

characteristics. Recent advances in the

finance literature demonstrate that

economic capital charges are portfolio-

invariant if (and only if) two

assumptions are imposed.14 First, the

portfolio must be infinitely fine-grained.

Second, there must be only a single

systematic risk factor.

Infinite granularity, while never

literally attained, is satisfied in an

approximate sense by the portfolios of

large, internationally active banks

ance literature demonstrate that

economic capital charges are portfolio-

invariant if (and only if) two

assumptions are imposed.14 First, the

portfolio must be infinitely fine-grained.

Second, there must be only a single

systematic risk factor.

Infinite granularity, while never

literally attained, is satisfied in an

approximate sense by the portfolios of

large, internationally active banks.

Analysis of data provided by such

institutions shows that taking account of

single-name concentrations in such

portfolios would lead to only trivial

changes in the total capital requirement.

The single risk-factor assumption would

appear, at first glance, more

troublesome. As an empirical matter,

there undoubtedly are distinct cyclical

factors for different industries and

different geographic regions. From a

substantive perspective, however, the

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relevant question is whether portfolios

at large financial institutions are

diversified across the various sub-

sectors of the economy in a reasonably

similar manner. If so, then the portfolio

can be modeled as if there were only a

single factor, namely, the credit cycle as

a whole.

The Agencies seek comment on the

conceptual basis of the A–IRB approach,

including all of the aspects just described

question is whether portfolios

at large financial institutions are

diversified across the various sub-

sectors of the economy in a reasonably

similar manner. If so, then the portfolio

can be modeled as if there were only a

single factor, namely, the credit cycle as

a whole.

The Agencies seek comment on the

conceptual basis of the A–IRB approach,

including all of the aspects just described.

What are the advantages and disadvantages

of the A–IRB approach relative to

alternatives, including those that would

allow greater flexibility to use internal

models and those that would be more

cautious in incorporating statistical

techniques (such as greater use of credit

ratings by external rating agencies)? The

Agencies also encourage comment on the

extent to which the necessary conditions of

the conceptual justification for the A–IRB

approach are reasonably met, and if not, what

adjustments or alternative approach would

be warranted.

Should the A–IRB capital regime be based

on a framework that allocates capital to EL

plus UL, or to UL only? Which approach

would more closely align the regulatory

framework to the internal capital allocation

techniques currently used by large

institutions? If the framework were

recalibrated solely to UL, modifications to

the rest of the A–IRB framework would be

required. The Agencies seek commenters’

views on issues that would arise as a result

of such recalibration.

B. A–IRB Capital Calculations

A common characteristic of the A–IRB

capital formulas is that they calculate

the actual dollar value of the minimum

capital requirement associated with an

exposure (or, in the case of retail

exposures, a pool of exposures). This

capital requirement must be converted

to an equivalent amount of risk-

weighted assets in order to be inserted

into the denominator of a banking

organization’s risk-based capital ratios

of the A–IRB

capital formulas is that they calculate

the actual dollar value of the minimum

capital requirement associated with an

exposure (or, in the case of retail

exposures, a pool of exposures). This

capital requirement must be converted

to an equivalent amount of risk-

weighted assets in order to be inserted

into the denominator of a banking

organization’s risk-based capital ratios.

Because the minimum risk-based capital

ratio in the United States is 8 percent,

the minimum capital requirement on

any asset would be equal to 8 percent

of the risk-weighted asset amount

associated with that asset. Therefore, in

order to determine the amount of risk-

weighted assets to associate with a given

minimum capital requirement, it would

be necessary to multiply the dollar

capital requirement generated by the A–

IRB formulas by the reciprocal of 8

percent, or 12.5.

The following subsections of the

ANPR detail the specific features of the

A–IRB capital formulas for two

principal categories of credit exposure:

wholesale and retail. Both of these

subsections include a proposed

definition of the exposure category, a

description of the banking organization-

estimated inputs required to complete

the capital calculations, a description of

the specific calculations required to

determine the A–IRB capital

requirement, and tables depicting a

range of representative results.

Wholesale Exposures: Definitions and

Inputs

The Agencies propose that a single

credit exposure category—wholesale

exposures—would encompass most

non-retail credit exposures in the A–IRB

framework. The wholesale category

would include the sub-categories of

corporate, sovereign, and interbank

exposures as well as all types of

specialized lending exposures.

Wholesale exposures would include

debt obligations of corporations,

partnerships, limited liability

companies, proprietorships, and

special-purpose entities (including

those created specifically to finance

and/or operate physical assets)

esale category

would include the sub-categories of

corporate, sovereign, and interbank

exposures as well as all types of

specialized lending exposures.

Wholesale exposures would include

debt obligations of corporations,

partnerships, limited liability

companies, proprietorships, and

special-purpose entities (including

those created specifically to finance

and/or operate physical assets).

Wholesale exposures also would

include debt obligations of banks and

securities firms (interbank exposures),

and debt obligations of central

governments, central banks, and certain

public-sector entities (sovereign

exposures). The wholesale exposure

category would not include

securitization exposures, or certain

small-business exposures that are

eligible to be treated as retail exposures.

The Agencies propose that advanced

approach banking organizations would

use the same A–IRB capital formula to

compute capital requirements on all

wholesale exposures with two

exceptions. First, wholesale exposures

to small- and medium-sized enterprises

(SMEs) would use a downward

adjustment to the wholesale A–IRB

capital formula typically based on

borrower size. Second, the A–IRB

capital formula for HVCRE loans

(generally encompassing certain

speculative ADC loans) would use a

higher asset correlation assumption than

other wholesale exposures.

The proposed A–IRB capital

framework for wholesale exposures

would require banking organizations to

assign four key risk inputs for each

individual wholesale exposure: (1)

Probability of default (PD); (2) loss given

default (LGD); (3) exposure at default

(EAD); and (4) effective remaining

maturity (M). In addition, to use the

proposed downward adjustment for

wholesale SMEs described in more

detail below, banking organizations

would be required to provide an

additional input for borrower size (S).

Probability of Default

The first principal input to the

wholesale A–IRB calculation is the

measure of PD

efault (LGD); (3) exposure at default

(EAD); and (4) effective remaining

maturity (M). In addition, to use the

proposed downward adjustment for

wholesale SMEs described in more

detail below, banking organizations

would be required to provide an

additional input for borrower size (S).

Probability of Default

The first principal input to the

wholesale A–IRB calculation is the

measure of PD. Under the A–IRB

approach, a banking organization would

assign an internal rating to each of its

wholesale obligors (or in other words,

assign each wholesale exposure to an

internal rating grade applicable to the

obligor). The internal rating would have

to be produced by a rating system that

meets the A–IRB infrastructure

requirements and supervisory standards

for wholesale exposures, which are

intended to ensure (among other things)

that the rating system results in a

meaningful differentiation of risk among

exposures. For each internal rating, the

banking organization must associate a

specific one-year PD value. Various

approaches may be used to develop

estimates of PDs; however, regardless of

the specific approach, banking

organizations would be expected to

satisfy the supervisory standards. The

minimum PD that may be assigned to

most wholesale exposures is 3 basis

points (0.03 percent). Certain wholesale

exposures are exempt from this floor,

including exposures to sovereign

governments, their central banks, the

BIS, IMF, European Central Bank, and

high quality multilateral development

banks (MDBs) with strong shareholder

support.

The Agencies intend to apply

standards to the PD quantification

process that are consistent with the

broad guidance outlined in the New

Accord. More detailed discussion of

those points is provided in the draft

supervisory guidance on IRB

approaches for corporate exposures

published elsewhere in today’s Federal

Register.

Loss Given Default

The second principal input to the A–

IRB capital formula for wholesale

exposures is LGD

to the PD quantification

process that are consistent with the

broad guidance outlined in the New

Accord. More detailed discussion of

those points is provided in the draft

supervisory guidance on IRB

approaches for corporate exposures

published elsewhere in today’s Federal

Register.

Loss Given Default

The second principal input to the A–

IRB capital formula for wholesale

exposures is LGD. Under the A–IRB

approach, banking organizations would

estimate an LGD for each wholesale

exposure. An LGD estimate for a

wholesale exposure should provide an

assessment of the expected loss in the

event of default of the obligor, expressed

as a percentage of the institution’s

estimated total exposure at default. The

LGD for a defaulted exposure would be

estimated as the expected economic loss

rate on that exposure taking into

account, where appropriate, recoveries,

workout costs, and the time value of

money. Banking organizations would

estimate LGDs as the loss severities

expected to prevail when default rates

are high, unless they have information

indicating that recoveries on a particular

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15 Under the add-on approach, an institution

would determine its EAD for an OTC derivative

contract by adding the current value of the contract

(zero if the current value is negative) and an

estimate of potential future exposure (PFE) on the

contract. The estimated PFE would be equal to the

notional amount of the derivative multiplied by a

supervisor-provided add-on factor that takes into

account the type of instrument and its maturity.

16 Repo-style transactions include reverse

repurchase agreements and repurchase agreements

and securities lending and borrowing

egative) and an

estimate of potential future exposure (PFE) on the

contract. The estimated PFE would be equal to the

notional amount of the derivative multiplied by a

supervisor-provided add-on factor that takes into

account the type of instrument and its maturity.

16 Repo-style transactions include reverse

repurchase agreements and repurchase agreements

and securities lending and borrowing.

17 See Jose Lopez, ‘‘The Empirical Relationship

between Average Asset Correlation, Firm

Probability of Default, and Asset Size.’’ Federal

Reserve Bank of San Francisco Working Paper 02–

05 (June 2002).

class of exposure are unlikely to be

affected to an appreciable extent by

cyclical factors. As with estimates of

other A–IRB inputs, banking

organizations would be expected to be

conservative in assigning LGDs.

Although estimated LGDs should be

grounded in historical recovery rates,

the A–IRB approach is structured to

allow banking organizations to assess

the differential impact of various

factors, including, for example, the

presence of collateral or differences in

loan terms and covenants. The Agencies

expect to impose limitations on the use

of guarantees and credit derivatives in a

banking organization’s LGD estimates.

These limitations are discussed in the

separate section of this ANPR on the A–

IRB treatment of credit risk mitigation

techniques.

Exposure at Default

The third principal input to the

wholesale A–IRB capital formula is

EAD. The Agencies are proposing that

banking organizations would provide

their own estimate of EAD for each

exposure. The EAD for an exposure

would be defined as the amount legally

owed to the banking organization (net of

any charge-offs) in the event that the

borrower defaults on the exposure. For

on-balance-sheet items, banking

organizations would estimate EAD as no

less than the current drawn amount

es are proposing that

banking organizations would provide

their own estimate of EAD for each

exposure. The EAD for an exposure

would be defined as the amount legally

owed to the banking organization (net of

any charge-offs) in the event that the

borrower defaults on the exposure. For

on-balance-sheet items, banking

organizations would estimate EAD as no

less than the current drawn amount. For

off-balance-sheet items, except over-the-

counter (OTC) derivative transactions,

banking organizations would assign an

EAD equal to an estimate of the long-run

default-weighted average EAD for

similar facilities and borrowers or, if

EADs are highly cyclical, the EAD

expected to prevail when default rates

are high. The EAD associated with OTC

derivative transactions would continue

to be estimated using the ‘‘add-on’’

approach contained in the general risk-

based capital rules.15 In addition, there

would be a specific EAD calculation for

the recognition of collateral in the

context of repo-style transactions

subject to a master netting agreement,

the features of which are outlined below

in the section on the A–IRB treatment of

credit risk mitigation techniques.16

Definition of Default and Loss

A banking organization would

estimate inputs relative to the following

definition of default and loss. A default

is considered to have occurred with

respect to a particular borrower when

either or both of the following two

events has taken place: (1) The banking

organization determines that the

borrower is unlikely to pay its

obligations to the organization in full,

without recourse to actions by the

organization such as the realization of

collateral; or (2) the borrower is more

than 90 days past due on principal or

interest on any material obligation to the

organization. The Agencies believe that

the use of the concept of ‘‘unlikely to

pay’’ is largely consistent with the

practice of U.S. banking organizations in

assessing whether a loan is on non-

accrual status

se to actions by the

organization such as the realization of

collateral; or (2) the borrower is more

than 90 days past due on principal or

interest on any material obligation to the

organization. The Agencies believe that

the use of the concept of ‘‘unlikely to

pay’’ is largely consistent with the

practice of U.S. banking organizations in

assessing whether a loan is on non-

accrual status.

Maturity

The fourth principal input to the A–

IRB capital formula is effective

remaining maturity (M), measured in

years. If a wholesale exposure is subject

to a determinable cash flow schedule,

the banking organization would

calculate M as the weighted-average

remaining maturity of the expected cash

flows, using the amounts of the cash

flows as the relevant weights. The

banking organization also would be able

to use the nominal remaining maturity

of the exposure if the weighted-average

remaining maturity of the exposure

cannot be calculated. For OTC

derivatives and repo-style transactions

subject to master netting agreements, the

institution would set M equal to the

weighted-average remaining maturity of

the individual transactions, using the

notional amounts of the individual

transactions as the relevant weights.

In all cases, M would be set no greater

than five years and, with few

exceptions, M would be set no lower

than one year. The exceptions apply to

certain transactions that are not part of

a banking organization’s ongoing

financing of a borrower. For wholesale

exposures that have an original maturity

of less than three months—including

repo-style transactions, money market

transactions, trade finance-related

transactions, and exposures arising from

payment and settlement processes—M

may be set as low as one day. For OTC

derivatives and repo-style transactions

subject to a master netting agreement, M

would be set at no less than five days

esale

exposures that have an original maturity

of less than three months—including

repo-style transactions, money market

transactions, trade finance-related

transactions, and exposures arising from

payment and settlement processes—M

may be set as low as one day. For OTC

derivatives and repo-style transactions

subject to a master netting agreement, M

would be set at no less than five days.

As with the assignment of PD

estimates, the Agencies propose to

apply supervisory standards for the

estimation of LGD, EAD, and M that are

consistent with the broad guidance

contained in the New Accord. More

detailed discussion of these issues is

provided in the draft supervisory

guidance on IRB approaches for

corporate exposures published

elsewhere in today’s Federal Register.

The Agencies seek comment on the

proposed definition of wholesale exposures

and on the proposed inputs to the wholesale

A–IRB capital formulas. What are views on

the proposed definitions of default, PD, LGD,

EAD, and M? Are there specific issues with

the standards for the quantification of PD,

LGD, EAD, or M on which the Agencies

should focus?

Wholesale Exposures: Formulas

The calculation of the A–IRB capital

requirement for a particular wholesale

exposure would be accomplished in three

steps:

(1) Calculation of the relevant asset

correlation parameter, which would be a

function of PD (as well as borrower size (S)

for SMEs);

(2) Calculation of a preliminary capital

requirement assuming a maturity of one year,

which would be a function of PD, LGD, EAD,

and the asset correlation parameter

calculated in the first step; and

holesale

exposure would be accomplished in three

steps:

(1) Calculation of the relevant asset

correlation parameter, which would be a

function of PD (as well as borrower size (S)

for SMEs);

(2) Calculation of a preliminary capital

requirement assuming a maturity of one year,

which would be a function of PD, LGD, EAD,

and the asset correlation parameter

calculated in the first step; and

(3) Application of a maturity adjustment

for differences between the actual effective

remaining maturity of the exposure and the

one-year maturity assumption in the second

step, where the adjustment would be a

function of both PD and M.

These calculations result in the A–IRB

capital requirement, expressed in dollars, for

a particular wholesale exposure. As noted

earlier, this amount would be converted to a

risk-weighted assets equivalent by

multiplying the amount by 12.5, and the risk-

weighted assets equivalent would be

included in the denominator of the risk-

based capital ratios.

Asset Correlation

The first step in the calculation of the A–

IRB capital requirement for a wholesale

exposure is the calculation of the asset

correlation parameter, which is denoted by

the letter ‘‘R’’ in the formulas below. This

asset correlation parameter is not a fixed

amount; rather, the parameter varies as an

inverse function of PD. For all wholesale

exposures except HVCRE exposures, the asset

correlation parameter approaches an upper

bound value of 24 percent for very low PD

values and approaches a lower bound value

of 12 percent for very high PD values. This

reflects the Agencies’ view that borrowers

with lower credit quality (that is, higher PDs)

are likely to be more idiosyncratic in the

factors affecting their likelihood of default

than borrowers with higher credit quality

(lower PDs)

parameter approaches an upper

bound value of 24 percent for very low PD

values and approaches a lower bound value

of 12 percent for very high PD values. This

reflects the Agencies’ view that borrowers

with lower credit quality (that is, higher PDs)

are likely to be more idiosyncratic in the

factors affecting their likelihood of default

than borrowers with higher credit quality

(lower PDs). Therefore, the higher PD

borrowers are proportionately less influenced

by systematic (sector-wide or economy-wide)

factors common to all borrowers.17

An important practical impact of having

asset correlation decline with increases in PD

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18 The N(x) and G(x) functions are widely used in

statistics and are commonly available in computer

spreadsheet programs. A description of these

functions may be found in the Help function of

most spreadsheet programs or in basic statistical

textbooks.

is to reduce the speed with which capital

requirements increase as PDs increase, and to

increase the speed with which EL dominates

the total capital charge, thereby tending to

reduce procyclicality in the application of

the wholesale A–IRB capital formulas. The

specific formula for determining the asset

correlation parameter for all wholesale

exposures except HVCRE exposures is as

follows:

R = 0.12 * (1¥EXP(¥50 * PD)) + 0.24 *

[1¥(1¥EXP(¥50 * PD))]

Where:

R denotes asset correlation;

EXP(x) denotes the natural exponential

function; and

PD denotes probability of default.

Capital Requirement With Assumed One-

Year Maturity Adjustment

The second step in the calculation of the

A–IRB capital requirement for a particular

wholesale exposure is the calculation of the

capital requirement that would apply to the

exposure assuming a one-year effective

remaining maturity

lation;

EXP(x) denotes the natural exponential

function; and

PD denotes probability of default.

Capital Requirement With Assumed One-

Year Maturity Adjustment

The second step in the calculation of the

A–IRB capital requirement for a particular

wholesale exposure is the calculation of the

capital requirement that would apply to the

exposure assuming a one-year effective

remaining maturity. The specific formula to

calculate this one-year-maturity capital

requirement is as follows:

K1 = EAD * LGD * N[(1¥R)∧¥0.5 * G(PD)

+ (R/(1¥ R))∧0.5 * G(0.999)]

Where:

K1 denotes the one-year-maturity capital

requirement;

EAD denotes exposure at default;

LGD denotes loss given default;

N(x) denotes the standard normal cumulative

distribution function;

R denotes asset correlation;

G(x) denotes the inverse of the standard

normal cumulative distribution function;

and 18

PD denotes probability of default.

There are several important aspects of this

formula. First, it rises in a straight-line

fashion with increases in EAD, meaning that

a doubling of the exposure amount would

result in a doubling of the capital

requirement. It also rises in a straight-line

fashion with increases in LGD, which

similarly implies that a loan with an LGD

estimate twice that of an otherwise identical

loan would have twice the capital

requirement of the other loan. This also

implies that as LGD or EAD estimates

approach zero, the capital requirement would

likewise approach zero. The remainder of the

formula is a function of PD, asset correlation

(R), which is itself a function of PD, and the

target loss percentile amount of 99.9 percent

discussed earlier.

Maturity Adjustment

The third stage in the calculation of the A–

IRB capital requirement for a particular

wholesale exposure is the application of a

maturity adjustment to reflect the exposure’s

actual effective remaining maturity (M)

ormula is a function of PD, asset correlation

(R), which is itself a function of PD, and the

target loss percentile amount of 99.9 percent

discussed earlier.

Maturity Adjustment

The third stage in the calculation of the A–

IRB capital requirement for a particular

wholesale exposure is the application of a

maturity adjustment to reflect the exposure’s

actual effective remaining maturity (M). The

A–IRB maturity adjustment multiplies the

one-year-maturity capital requirement (K1) by

a factor that depends on both M and PD. The

fact that the A–IRB maturity adjustment

depends on PD reflects the Agencies’ view

that there is a greater proportional need for

maturity adjustments for high-quality

exposures (those with low PDs) because there

is a greater potential for such exposures to

deteriorate in credit quality than for

exposures whose credit quality is lower. The

specific formula for applying the maturity

adjustment and generating the A–IRB capital

requirement is as follows:

K = K1 * [1 + (M¥2.5) * b]/[(1¥1.5 * b)],

where b = (0.08451¥0.05898 * LN(PD))2

and:

K denotes the A–IRB capital requirement;

K1 denotes the one-year-maturity capital

requirement;

M denotes effective remaining maturity;

LN(x) denotes the natural logarithm; and

PD denotes probability of default.

In this formula, the value ‘‘b’’ effectively

determines the slope of the maturity

adjustment and is itself a function of PD.

Note that if M is set equal to one, the

maturity adjustment also equals one and K

will therefore equal K1.

To provide a more concrete sense of the

range of capital requirements under the

wholesale A–IRB framework, the following

table presents the A–IRB capital

requirements (K) for a range of values of both

PD and M. In this table LGD is assumed to

equal 45 percent. For comparison purposes,

the general risk-based capital rules assign a

capital requirement of 8 percent for most

commercial loans

To provide a more concrete sense of the

range of capital requirements under the

wholesale A–IRB framework, the following

table presents the A–IRB capital

requirements (K) for a range of values of both

PD and M. In this table LGD is assumed to

equal 45 percent. For comparison purposes,

the general risk-based capital rules assign a

capital requirement of 8 percent for most

commercial loans.

CAPITAL REQUIREMENTS

[In percentage points]

PD

Effective remaining maturity (M)

1 month

1 year

3 years

5 years

0.05 percent .....................................................................................................

0.50

0.92

1.83

2.74

0.10 percent .....................................................................................................

1.00

1.54

2.71

3.88

0.25 percent .....................................................................................................

2.17

2.89

4.44

5.99

0.50 percent .....................................................................................................

3.57

4.40

6.21

8.03

1.00 percent .....................................................................................................

5.41

6.31

8.29

10.27

2.00 percent .....................................................................................................

7.65

8.56

10.56

12.56

5.00 percent .....................................................................................................

11.91

12.80

14.75

16.69

10.00 percent ...................................................................................................

17.67

18.56

20.50

22.45

20.00 percent ...................................................................................................

26.01

26.84

28.65

30.47

The impact of the A–IRB capital

formulas on minimum risk-based capital

requirements for wholesale exposures

would, of course, depend on the actual

values of PD, LGD, EAD, and M that

banking organizations would use as

inputs to the wholesale formulas

5

20.00 percent ...................................................................................................

26.01

26.84

28.65

30.47

The impact of the A–IRB capital

formulas on minimum risk-based capital

requirements for wholesale exposures

would, of course, depend on the actual

values of PD, LGD, EAD, and M that

banking organizations would use as

inputs to the wholesale formulas.

Subject to the caveats noted earlier,

evidence from QIS3 suggested an

average reduction in credit risk capital

requirements for corporate exposures of

about 26 percent for twenty large U.S.

banking organizations.

SME Adjustment

For loans to SMEs not eligible for

retail A–IRB treatment, the proposed

calculation of the A–IRB capital

requirement has one additional

element—a downward adjustment based

on borrower size (S). This adjustment

would effectively lower the A–IRB

capital requirement on wholesale

exposures to SMEs with annual sales (or

total assets) of less than $50 million.

The Agencies believe the measure of

borrower size should be based on

annual sales (rather than total assets),

unless the banking organization can

demonstrate that it would be more

appropriate for the banking organization

to use the total assets of the borrower as

its measure of borrower size. The

borrower size adjustment would be

made to the asset correlation parameter

(R), as shown in the following formula:

RSME = R¥0.04 * [1¥(S¥ 5)/45]

Where

RSME denotes the size-adjusted asset

correlation;

R denotes asset correlation; and

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borrower as

its measure of borrower size. The

borrower size adjustment would be

made to the asset correlation parameter

(R), as shown in the following formula:

RSME = R¥0.04 * [1¥(S¥ 5)/45]

Where

RSME denotes the size-adjusted asset

correlation;

R denotes asset correlation; and

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19 CRE exposures are typically non-recourse

exposures, often to special purpose vehicles, and

are distinguishable from corporate exposures that

are collateralized by real estate for which the

prospects for repayment and recovery depend

primarily on the financial performance of the

broader commercial enterprise that is the obligor.

20 To describe a loan portfolio as having a

relatively high asset correlation means that any

defaults that occur in that portfolio are relatively

likely to occur at the same time, and for this reason

the portfolio is likely to exhibit greater variability

in aggregate default rates. For two portfolios with

the same EL, the portfolio with more highly variable

aggregate default rates warrants higher capital to

cover UL (‘‘bad-tail events’’) with the same level of

confidence. Describing a portfolio as having a

relatively high asset correlation does not imply that

loans in that portfolio have relatively high PD, LGD,

or EL. In particular, loans in high asset correlation

portfolios may well have very low PDs and LGDs

and therefore ELs); conversely, loans in low asset

correlation portfolios may have very high PDs and

LGDs (and ELs). For any two loans from a portfolio

with a given asset correlation (or from two different

portfolios with the same asset correlation), the loan

with the lower EL should be assigned a lower risk

weight

ns in high asset correlation

portfolios may well have very low PDs and LGDs

and therefore ELs); conversely, loans in low asset

correlation portfolios may have very high PDs and

LGDs (and ELs). For any two loans from a portfolio

with a given asset correlation (or from two different

portfolios with the same asset correlation), the loan

with the lower EL should be assigned a lower risk

weight. For any two loans with the same EL, the

loan from the portfolio with the lower asset

correlation should incur a lower capital charge,

because bad-tail events are less likely to occur in

that portfolio.

S denotes borrower size (expressed in

millions of dollars).

The maximum reduction in the asset

correlation parameter based on this

formula is 4 percent, and is achieved

when borrower size is $5 million. For

all borrower sizes below $5 million,

borrower size would be set equal to $5

million. The adjustment shrinks to zero

as borrower size approaches $50

million. The broad rationale for this

adjustment is the view that the credit

condition of SMEs will be influenced

relatively more by idiosyncratic factors

than is the case for larger firms, and,

thus, SMEs would be less likely to

deteriorate simultaneously with other

exposures. This greater susceptibility to

idiosyncratic factors would imply lower

asset correlation. The evidence in favor

of this view is mixed, particularly after

considering that the A–IRB framework

already incorporates a negative

relationship between asset correlation

and PD. The following table illustrates

the practical effect of the SME

adjustment by depicting the capital

requirements (K) across a range of PDs

and borrower sizes. As in the previous

table, LGD is assumed to equal 45

percent. For this table, M is assumed to

be equal to three years. Note that the last

column is identical to the three-year

maturity column in the preceding table

because the SME adjustment is phased

out for borrowers of $50 million or more

in size

tment by depicting the capital

requirements (K) across a range of PDs

and borrower sizes. As in the previous

table, LGD is assumed to equal 45

percent. For this table, M is assumed to

be equal to three years. Note that the last

column is identical to the three-year

maturity column in the preceding table

because the SME adjustment is phased

out for borrowers of $50 million or more

in size.

CAPITAL REQUIREMENTS

[In percentage points]

PD

Borrower size (S)

$5 million

$20 million

$35 million

≥ $50 million

0.05 percent ...................................................................................................

1.44

1.57

1.70

1.83

0.10 percent ...................................................................................................

2.14

2.33

2.51

2.71

0.25 percent ...................................................................................................

3.54

3.83

4.13

4.44

0.50 percent ...................................................................................................

4.97

5.37

5.79

6.21

1.00 percent ...................................................................................................

6.63

7.17

7.72

8.29

2.00 percent ...................................................................................................

8.40

9.11

9.83

10.56

5.00 percent ...................................................................................................

11.70

12.73

13.74

14.75

10.00 percent .................................................................................................

16.76

18.05

19.30

20.50

20.00 percent .................................................................................................

24.67

26.08

27.40

28.65

Subject to the caveats mentioned

above, evidence from QIS3 suggested an

average reduction in credit risk-based

capital requirements for corporate SME

exposures of about 39 percent for

twenty large U.S. banking organizations

...

16.76

18.05

19.30

20.50

20.00 percent .................................................................................................

24.67

26.08

27.40

28.65

Subject to the caveats mentioned

above, evidence from QIS3 suggested an

average reduction in credit risk-based

capital requirements for corporate SME

exposures of about 39 percent for

twenty large U.S. banking organizations.

If the Agencies include a SME adjustment,

are the $50 million threshold and the

proposed approach to measurement of

borrower size appropriate? What standards

should be applied to the borrower size

measurement (for example, frequency of

measurement, use of size buckets rather than

precise measurements)?

Does the proposed borrower size

adjustment add a meaningful element of risk

sensitivity sufficient to balance the costs

associated with its computation? The

Agencies are interested in comments on

whether it is necessary to include an SME

adjustment in the A–IRB approach. Data

supporting views is encouraged.

Wholesale Exposures: Other Considerations

Specialized Lending

The specialized lending (SL) asset class

encompasses exposures for which the

primary source of repayment is the income

generated by the specific asset(s) being

financed, rather than the financial capacity of

a broader commercial enterprise. The SL

category encompasses four broad exposure

types:

• Project finance (PF) exposures finance

large, complex, expensive installations that

produce goods or services for sale, such as

power plants, chemical processing plants,

mines, or transportation infrastructure, where

the source of repayment is primarily the

revenues generated by sale of the goods or

services by the installations.

• Object finance (OF) exposures

finance the acquisition of (typically

moveable) physical assets, such as ships

or aircraft, where the source of

repayment is primarily the revenues

generated by the assets being financed,

often through rental or lease contracts

with third parties

e source of repayment is primarily the

revenues generated by sale of the goods or

services by the installations.

• Object finance (OF) exposures

finance the acquisition of (typically

moveable) physical assets, such as ships

or aircraft, where the source of

repayment is primarily the revenues

generated by the assets being financed,

often through rental or lease contracts

with third parties.

• Commodities finance (CF)

exposures are structured short-term

financings of reserves, inventories, or

receivables of exchange-traded

commodities, such as crude oil, metals,

or agricultural commodities, where the

source of repayment is the proceeds of

the sale of the commodity.

• Commercial real estate (CRE)

exposures finance the construction or

acquisition of real estate (including land

as well as improvements) where the

prospects for repayment and recovery

depend primarily on the cash flows

generated by the lease, rental, or sale of

the real estate.19 The broad CRE

category is further divided into two

groups: low-asset-correlation CRE and

HVCRE.20

Most of the issues raised below for

comment are described in substantially

greater detail, in the context of CRE

exposures, in a white paper entitled

‘‘Loss Characteristics of CRE Loan

Portfolios,’’ released by the Federal

Reserve Board on June 10, 2003.

Commenters are encouraged to read the

white paper in conjunction with this

section.

A defining characteristic of SL

exposures (including CRE) is that the

risk factors influencing actual default

rates are likely to influence LGDs as

well. This is because both the

borrower’s ability to repay an exposure

and the banking organization’s recovery

on an exposure in the event of default

are likely to depend on the same

underlying factors, such as the net cash

flows of the property being financed.

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luence LGDs as

well. This is because both the

borrower’s ability to repay an exposure

and the banking organization’s recovery

on an exposure in the event of default

are likely to depend on the same

underlying factors, such as the net cash

flows of the property being financed.

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Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

This suggests a positive correlation

between observed default frequencies

and observed loss rates on defaulted

loans, with both declining during

periods of favorable economic

conditions and both increasing during

unfavorable economic periods. While

cyclicality in LGDs may be significant

for a number of lending activities, the

Agencies believe that cyclicality is

likely to be the norm for SL portfolios,

and that a banking organization’s

procedures for estimating LGD inputs

for SL exposures should assess and

quantify this cyclicality in a

comprehensive and systematic fashion.

The Agencies invite comment on ways to

deal with cyclicality in LGDs. How can risk

sensitivity be achieved without creating

undue burden?

For core and opt-in banks that may

not be able to provide sufficiently

reliable estimates of PD, LGD, and M for

each SL exposure, the New Accord

offers a Supervisory Slotting Criteria

(SSC) approach. Under this approach,

rather than estimating the loan-level risk

parameters, banking organizations

would use slotting criteria to map their

internal risk rating grades to one of five

supervisory rating grades: Strong, Good,

Satisfactory, Weak, and Default. In

addition, supervisory risk weights

would be assigned to each of these

supervisory rating grades. To assist

banking organizations in implementing

these supervisory rating grades, for

reference purposes the New Accord

associates each with an explicit range of

external rating grades

isk rating grades to one of five

supervisory rating grades: Strong, Good,

Satisfactory, Weak, and Default. In

addition, supervisory risk weights

would be assigned to each of these

supervisory rating grades. To assist

banking organizations in implementing

these supervisory rating grades, for

reference purposes the New Accord

associates each with an explicit range of

external rating grades. If the SSC

approach were allowed in the United

States, the Agencies would have to

develop slotting criteria that would take

into account factors such as market

conditions; financial ratios such as debt

service coverage or loan-to-value ratios;

cash flow predictability; strength of

sponsor or developer; and other factors

likely to affect the PD and/or LGD of

each loan.

The Agencies invite comment on the

merits of the SSC approach in the United

States. The Agencies also invite comment on

the specific slotting criteria and associated

risk weights that should be used by

organizations to map their internal rating

grades to supervisory rating grades if the SSC

approach were to be adopted in the United

States.

Under the A–IRB approach, a banking

organization would estimate the risk

inputs for each SL exposure and then

calculate the A–IRB capital charge for

the exposure by substituting the

estimated PD, LGD, EAD, and M into

one of two risk weight functions. The

first risk weight function is the

wholesale risk weight function and

applies to all PF, OF, and CF exposures,

as well as to all low-asset-correlation

CRE exposures (including in-place

commercial properties). The second risk

weight function applies to all HVCRE

exposures. It also is the same as the

wholesale risk weight function, except

that it incorporates a higher asset

correlation parameter. The asset

correlation equation for HVCRE is as

follows:

R = 0.12 × (1¥EXP (¥50 × PD)) + 0.30

× [EXP (¥50 × PD)]

Where

R denotes asset correlation;

EXP denotes the natural exponential

function; and

PD denotes probability of default

on applies to all HVCRE

exposures. It also is the same as the

wholesale risk weight function, except

that it incorporates a higher asset

correlation parameter. The asset

correlation equation for HVCRE is as

follows:

R = 0.12 × (1¥EXP (¥50 × PD)) + 0.30

× [EXP (¥50 × PD)]

Where

R denotes asset correlation;

EXP denotes the natural exponential

function; and

PD denotes probability of default.

The following table presents the A–

IRB capital requirement (K) for a range

of values of both PD and M. In this

table, LGD is assumed to equal 45

percent. This LGD is used for

consistency with the similar table above

for wholesale exposures and should not

be construed as an indication that 45

percent is a typical LGD for HVCRE

exposures.

HVCRE CAPITAL REQUIREMENTS

[In percentage points]

PD

Effective remaining maturity

1 year

3 years

5 years

0.05 percent .................................................................................................................................

1.24

2.46

3.68

0.10 percent .................................................................................................................................

2.05

3.61

5.16

0.25 percent .................................................................................................................................

3.74

5.76

7.77

0.50 percent .................................................................................................................................

5.52

7.79

10.07

1.00 percent .................................................................................................................................

7.53

9.89

12.25

2.00 percent .................................................................................................................................

9.55

11.79

14.02

5.00 percent ................................................................................................................................

............................................................................

7.53

9.89

12.25

2.00 percent .................................................................................................................................

9.55

11.79

14.02

5.00 percent .................................................................................................................................

13.12

15.12

17.11

10.00 percent ...............................................................................................................................

18.59

20.54

22.49

20.00 percent ...............................................................................................................................

26.84

28.65

30.47

All ADC loans would be treated as

HVCRE exposures, unless the borrower

has ‘‘substantial equity’’ at risk or the

property is pre-sold or sufficiently pre-

leased. In part, this reflects some

empirical evidence suggesting that most

ADC loans have relatively high asset

correlations. It also, however, reflects a

longstanding supervisory concern that

CRE lending to finance speculative

construction and development is

vulnerable to, and may worsen,

speculative swings in CRE markets,

especially when there is little borrower

equity at risk. Such lending was a major

factor causing the stress experienced by

many banks in the early 1990s, not only

in the United States but in other

countries as well.

Under the New Accord, SL loans

financing the construction of one- to

four-family residential properties (single

or in subdivisions) are included with

other ADC loans in the high asset

correlation category. However, loans

financing the construction of pre-sold

one- to four-family residential

properties would be eligible to be

treated as low-asset-correlation CRE

exposures. In some cases the loans may

finance the construction of subdivisions

or other groups of houses, some of

which are pre-sold while others are not

ns) are included with

other ADC loans in the high asset

correlation category. However, loans

financing the construction of pre-sold

one- to four-family residential

properties would be eligible to be

treated as low-asset-correlation CRE

exposures. In some cases the loans may

finance the construction of subdivisions

or other groups of houses, some of

which are pre-sold while others are not.

Under the New Accord, each national

supervisory authority is directed to

recognize and incorporate into its

implementation of the New Accord the

high asset correlation determinations of

other national supervisory authorities

for loans made in their respective

jurisdictions. Thus, when the Agencies

designate certain CRE properties as

HVCRE, foreign banking organizations

making extensions of credit to those

properties also would be expected to

treat them as HVCRE. Similarly, when

non-U.S. supervisory authorities

designate certain CRE as HVCRE, U.S.

banking organizations that extend credit

to those properties would be expected to

treat them as HVCRE.

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The Agencies invite the submission of

empirical evidence regarding the (relative or

absolute) asset correlations characterizing

portfolios of ADC loans, as well as comments

regarding the circumstances under which

such loans would appropriately be

categorized as HVCRE.

The Agencies also invite comment on the

appropriateness of exempting from the high-

asset-correlation category ADC loans with

substantial equity or that are pre-sold or

sufficiently pre-leased. The Agencies invite

comment on what standard should be used

in determining whether a property is

sufficiently pre-leased when prevailing

occupancy rates are unusually low

y be

categorized as HVCRE.

The Agencies also invite comment on the

appropriateness of exempting from the high-

asset-correlation category ADC loans with

substantial equity or that are pre-sold or

sufficiently pre-leased. The Agencies invite

comment on what standard should be used

in determining whether a property is

sufficiently pre-leased when prevailing

occupancy rates are unusually low.

The Agencies invite comment on whether

high-asset-correlation treatment for one- to

four-family residential construction loans is

appropriate, or whether they should be

included in the low-asset-correlation

category. In cases where loans finance the

construction of a subdivision or other group

of houses, some of which are pre-sold while

others are not, the Agencies invite comment

regarding how the ‘‘pre-sold’’ exception

should be interpreted.

The Agencies invite comment on the

competitive impact of treating defined

classes of CRE differently. What are

commenters’ views on an alternative

approach where there is only one risk weight

function for all CRE? If a single risk weight

function for all CRE is considered, what

would be the appropriate asset correlation to

employ?

Lease Financings

Under the wholesale A–IRB

framework, some lease financings

require special consideration. A

distinction is made for leases that

expose the lessor to residual value risk,

namely the risk of the fair value of the

assets declining below the banking

organization’s estimate of residual risk

at lease inception. If a banking

organization has exposure to residual

value risk, it would assign a 100 percent

risk weight to the residual value amount

and determine a risk-weighted asset

equivalent for the lease’s remaining net

investment (net of residual value

amount) using the same methodology as

for any other wholesale exposure. The

sum of these components would be the

risk-weighted asset amount for a

particular lease

nization has exposure to residual

value risk, it would assign a 100 percent

risk weight to the residual value amount

and determine a risk-weighted asset

equivalent for the lease’s remaining net

investment (net of residual value

amount) using the same methodology as

for any other wholesale exposure. The

sum of these components would be the

risk-weighted asset amount for a

particular lease. Where a banking

organization does not have exposure to

residual value risk, the lease’s net

investment would be subject to a capital

charge using the same methodology

applied to any other wholesale

exposure.

This approach would be used

regardless of accounting classification as

a direct finance, operating or leveraged

lease. For leveraged leases, when the

banking organization is the equity

participant it would net the balance of

the non-recourse debt against the

discounted lease payment stream prior

to applying the risk weight. If the

banking organization is the debt

participant, the exposure would be

treated as any other wholesale exposure.

The Agencies are seeking comment on the

wholesale A–IRB capital formulas and the

resulting capital requirements. Would this

approach provide a meaningful and

appropriate increase in risk sensitivity in the

sense that the results are consistent with

alternative assessments of the credit risks

associated with such exposures or the capital

needed to support them? If not, where are

there material inconsistencies?

Does the proposed A–IRB maturity

adjustment appropriately address the risk

differences between loans with differing

maturities?

Retail Exposures: Definitions and Inputs

The second major exposure category

in the A–IRB framework is the retail

exposure category. This category

encompasses the vast majority of credit

exposures to individual consumers. The

Agencies also are considering whether

certain SME exposures should be

eligible for retail A–IRB treatment

e risk

differences between loans with differing

maturities?

Retail Exposures: Definitions and Inputs

The second major exposure category

in the A–IRB framework is the retail

exposure category. This category

encompasses the vast majority of credit

exposures to individual consumers. The

Agencies also are considering whether

certain SME exposures should be

eligible for retail A–IRB treatment. The

retail exposure category has three

distinct sub-categories: (1) Residential

mortgages (and related exposures); (2)

qualifying revolving exposures (QREs);

and (3) other retail exposures. There are

separate A–IRB capital formulas for

each of these three sub-categories to

reflect different levels of associated risk.

The Agencies propose that the

residential mortgage exposure sub-

category be defined to include loans

secured by first or subsequent liens on

one-to four-family residential

properties, including term loans and

revolving lines of credit secured by

home equity. There would be no upper

limit on the size of the exposure that

could be included in the residential

mortgage exposure sub-category, but the

borrower would have to be an

individual and the banking organization

should generally manage the exposure

as part of a pool of similar exposures.

Resid

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