Risk-Based Capital Rules Proposed Rule on Risk-Based Capital Standards: Market Risk
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FDIC Financial Institution Letters › Risk-Based Capital Rules Proposed Rule on Risk-Based Capital Standards: Market Risk
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Draft Dated 12/03/2010
DEPARTMENT OF THE TREASURY
Offce of the Comptroller of the Currency
12 CFR Part 3
Docket ID: OCC-2010-0003
RIN 1557-AC99
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
Regulations Hand Y; Docket No. R-(xxxx)
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN (xxxx-xxxx)
Risk-Based Capital Guidelines: Market Risk
AGENCIES: Offic.e of
the Comptroller of
the Currency, Department of
the Treasury;
Board of
Governors of
the Federal Reserve System; and Federal Deposit Insurance
Corporation.
ACTION: Notice of proposed rulemaking with request for public comment.
SUMMARY: The Offce of
the Comptroller of
the Currency (OCC), Board of
Governors of
the Federal Reserve System (Board), and Federal Deposit Insurance
Corporation (FDIC) are requesting comment on a proposal to revise their market risk
capital rules to modify their scope to better capture positions for which the market risk
capital rules are appropriate; reduce procyclicality in market risk capital requirements;
enhance the rules' sensitivity to risks that are not adequately captured under the current
regulatory measurement methodologies; and increase transparency through enhanced
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Draft Dated 12/03/2010
disclosures. The proposal does not include the methodologies adopted by the Basel
Committee on Banking Supervision for calculating the specific risk capital requirements
for debt and securitization positions due to their reliance on credit ratings, which is
impermissible under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The proposal, therefore, retains the current specific risk treatment for these positions until
the agencies develop alternatives standards of creditworthiness as required by the Act.
The proposed rules are substantively the same across the agencies.
DATES: Comments on this notice of
proposed rulemaking must be received by
(INSERT DATE 90 DAYS AFTER PUBLICATION IN THE FEDERAL REGISTER);
201 i.
ADDRESSES: Comments should be directed
to:
ent specific risk treatment for these positions until
the agencies develop alternatives standards of creditworthiness as required by the Act.
The proposed rules are substantively the same across the agencies.
DATES: Comments on this notice of
proposed rulemaking must be received by
(INSERT DATE 90 DAYS AFTER PUBLICATION IN THE FEDERAL REGISTER);
201 i.
ADDRESSES: Comments should be directed
to: .
occ:
Because paper mail in the Washington, DC area and at the Agencies is subject to delay,
commenters are encouraged to submit comments by the Federal eRulemaking Portal or e-
mail, if
possible. Please use the title "Risk-Based Capital Guidelines: Market Risk" to
facilitate the organization and distribution of
the comments. You may submit comments
by any ofthe following methods:
. Federal eRulemaking Portal-"regulations.gov": Go to
http://www.regulations.gov. Select "Document Type" of "Proposed Rules," and
in "Enter Keyword or ID Box," enter Docket ID "OCC-20l0-0003," and click
"Search." On "View By Relevance" tab at bottom of screen, in the "Agency"
column, locate the proposed rule for OCC, in the "Action" column, click on
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Draft Dated 12/03/2010
"Submit a Comment" or "Open Docket Folder" to submit or view public
comments and to view supporting and related materials for this rulemaking action.
. Click on the "Help" tab on the Regulations.gov home page to get information on
using Regulations.gov, including instructions for submitting or viewing public
comments, viewing other supporting and related materials, and viewing the
docket after the close of the comment period.
. E-mail: regs.comments~occ.treas.gov.
. Mail: Office
of
the
Comptroller
of
the
Currency,
250E
Street,
SW.,Mail
Stop 2-
3, Washington, DC 20219.
. Fax: (202) 874-5274.
. Hand Delivery/Courier: 250 EStreet~ SW;, MailStop-2-3, Washington, DC
20219.
Instructions: You must include "OCC" as the agency name and "Docket ID OCC-
2010-0003" in your comment
t after the close of the comment period.
. E-mail: regs.comments~occ.treas.gov.
. Mail: Office
of
the
Comptroller
of
the
Currency,
250E
Street,
SW.,Mail
Stop 2-
3, Washington, DC 20219.
. Fax: (202) 874-5274.
. Hand Delivery/Courier: 250 EStreet~ SW;, MailStop-2-3, Washington, DC
20219.
Instructions: You must include "OCC" as the agency name and "Docket ID OCC-
2010-0003" in your comment. In general, OCC will enter all comments received into the
docket and publish them on the Regulations.gov Web site without change, including any
business or personal information that you provide such as name and address information,
e-mail addresses, or phone numbers. Comments received, including attachments and
other supporting materials, are part of
the public record and subject to public disclosure.
Do not enclose any information in your comment or supporting materials that you
consider confidential or inappropriate for public disclosure.
You may review comments and other related materials that pertain to this
proposed rule by any of the following methods:
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Draft Dated 12/03/2010
. Viewing Comments Electronically: Go to http://www.regulations.gov. Select
"Document Type" of "Public Submissions," in "Enter Keyword or ID Box," enter
Docket ID "OCC-20l0-0003," and click "Search." Comments wiii be listed under
"View By Relevance" tab at bottom of screen. If comments from more than one
agency are listed, the "Agency" column will indicate which comments were
received by the OCC.
· Viewing Comments Personally: You may personally inspect and photocopy
comments at the OCC, 250 E Street, SW, Washington, DC. For security reasons,
the OCC requires that visitors make an appointment to inspect comments. You
may do so by calling (202) 874-4700. Upon arrival, visitors wil be
required to present valid govemment~issued photo identification and to submit to
security screening in order to inspect and photocopy
comments.
y personally inspect and photocopy
comments at the OCC, 250 E Street, SW, Washington, DC. For security reasons,
the OCC requires that visitors make an appointment to inspect comments. You
may do so by calling (202) 874-4700. Upon arrival, visitors wil be
required to present valid govemment~issued photo identification and to submit to
security screening in order to inspect and photocopy
comments.
. Docket: You may also view or request available background documents and
project summaries using the methods described above.
Board: You may submit comments, identified by Docket No. R-(xxxxJ, by any of
the
following methods:
· Agency Web Site: http://w"\vw.fedcralreserve.2:ov. Follow the instructions for
submitting comments at
http://www . federal
reserve. gOY / generalinfo/foia/ProposedRegs.cfm.
· Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions
for submitting comments.
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Draft Dated 12/03/2010
. E-mail: regs.comments(¿iJederalreserve.gov. Include docket number in the subject
line of the message.
. Federal eRulemaking Portal: "Regulations.gov": Go to http://www.regulations.gov
and follow the instructions for submitting comments.
. FAX: (202) 452-3819 or (202) 452-3102.
. Mail: Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve
System, 20th Street and Constitution Avenue, NW, Washington, DC 20551.
All public comments are available from the Board's Web site at
http://www . fedcralrescrve. go"\! generalj nfo/foia/ProposedRegs. cfm as submitted, unless
modified for technical reasons. Accordingly, your comments will not be edited to
remove any identifying or contact information. Public comments may also be viewed
electronically or in paper form in
Room MP-500 of
the
Board's Martin Building (20th and
C Street, NW) between 9:00 a.m. and 5:00 p.m. on weekdays.
FDIC: You may submit comments by any of
the following methods:
. Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions
for submitting comments
emove any identifying or contact information. Public comments may also be viewed
electronically or in paper form in
Room MP-500 of
the
Board's Martin Building (20th and
C Street, NW) between 9:00 a.m. and 5:00 p.m. on weekdays.
FDIC: You may submit comments by any of
the following methods:
. Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions
for submitting comments.
· Agency Web site: http://,vww.FDIC.gov/regulations/laws/fedelal/propose.html
. Mail: Robert E. Feldman, Executive Secretary, Attention: Comments/Legal ESS,
Federal Deposit Insurance Corporation, 550 17th Street, NW, Washington, DC
20429.
. Hand Delivered/Courier: The guard station at the rear of
the 550 17th Street
Building (located on F Street), on business days between 7:00 a.m. and 5:00 p.m.
. E-mail: comments(á)FDJC.c,ov.
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Draft Dated 12/03/2010
Instructions: Comments submitted must include "FDIC" and "RIN (xxxx-xxxxJ."
Comments received will be posted without change to
http://www.FDIC.gov/regulatiol1s/laws/federal/propose.html. including any personal
information provided.
FOR FURTHER INFORMATION CONTACT:
ace: Roger Tufts, Senior Economic Advisor, Capital Policy Division, (202) 874-4925,
or Ron Shimabukuro, Senior Counsel, Carl Kaminski, Senior Attorney, or Hugh Carney,
Attorney, Legislative and Regulatory Activities Division, (202) 874-5090, Office of
the
Comptroller of
the Currency, 250 E Street, SW, Washington, DC 20219.
Board: Ana Lee Hewko, (202) 530-6260, Assistant Director, Capital and Regulatory
Policy, or Connie Horsley, (202) 452-5239, Senior Supervisory Financial Analyst,
Division of
Banking SupervisionandRegulation; or April C. Snyder, Counsel, (202)
452-3099, or Benjamin W.McDonough, Counsel, (202) 452-2036, Legal Division. For
the hearing impaired only, Telecommunication Device for the Deaf (TDD), (202) 263-
4869.
FDIC: Bobby R
) 530-6260, Assistant Director, Capital and Regulatory
Policy, or Connie Horsley, (202) 452-5239, Senior Supervisory Financial Analyst,
Division of
Banking SupervisionandRegulation; or April C. Snyder, Counsel, (202)
452-3099, or Benjamin W.McDonough, Counsel, (202) 452-2036, Legal Division. For
the hearing impaired only, Telecommunication Device for the Deaf (TDD), (202) 263-
4869.
FDIC: Bobby R. Bean, Chief, Policy Section, (202) 898-6705; Karl Reitz, Senior Capital
Markets Specialist, (202) 898-6775; Jim Weinberger, Senior Policy Analyst, (202) 898-
7034, Division of Supervision and Consumer Protection; or Mark Handzlik, Counsel,
(202) 898-3990; or Michael Phillips, Counsel, (202) 898-3581, Supervision Branch,
Legal Division.
SUPPLEMENTARY INFORMATION:
Table of Contents
1. Introduction
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Draft Dated 12/03/20 i 0
A. Background
B. Summary of
the Current Market Risk Capital Rule
1. Covered Positions
2. Capital Requirement for Market Risk
3. Internal Models-Based Capital Requirement
4. Specific Risk
5. Calculation of
the Risk-Based Capital Ratio
II. Proposed Revisions to the Market Risk Capital Rule
A. Objectives of
the Proposed
Revisions
B. Description ofthe,
Proposed Revisions to the
Market Risk Capital Rule
1. Scope
2. Reservation of Authority
3.. Modification of the Definition of Covered Position
4. Requirements for the Identification of
Trading Positions and
Management of Covered Positions
5. General Requirements for Internal Models
Model Approval and Ongoing Use Requirements
Risks Reflected in Models
Control, Oversight, and Validation Mechanisms
Internal Assessment of Capital Adequacy
Documentation
6. Capital Requirement for Market Risk
Determination of
the Multiplication Factor
7
tion
4. Requirements for the Identification of
Trading Positions and
Management of Covered Positions
5. General Requirements for Internal Models
Model Approval and Ongoing Use Requirements
Risks Reflected in Models
Control, Oversight, and Validation Mechanisms
Internal Assessment of Capital Adequacy
Documentation
6. Capital Requirement for Market Risk
Determination of
the Multiplication Factor
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7. VaR-based Capital Requirement
Quantitative Requirements for VaR-based Measure
8. Stressed VaR-based Capital Requirement
Quantitative Requirements for Stressed VaR-based Measure
9. Revised Modeling Standards for Specific Risk
10. Stanr:ardized Specific Risk Capital Requirement
Debt Positions
Equity Positions
Securitization Positions
11. Incremental Risk Capital Requirement
12. Comprehensive Risk Capital Requirement
13. Disclosure,Requirements
i. Introduction
A. Background
The first international
capital framework for banks1 entitled International
Convergence of
Capital Measurement and Capital Standards (1988 Capital Accord) was
developed by the Basel Committee on Banking Supervision (BCBS)2 and endorsed by the
G-IO governors in 1988. The OCC, the Board, and the FDIC (collectively, the agencies)
1 For simplicity, and unless otherwise indicated, the preamble to this notice of proposed rulemaking uses
tlie term "bank" to include banks, savings associations, and bank holding companies (BHCs). The terms
"bank holding company" and "BHC" refer only to bank holding companies regulated by the Board.
2 The BCBS is a commttee of
banking supervisory authorities, which was established by the central bank
governors of
the G-10 countries in 1975
ed, the preamble to this notice of proposed rulemaking uses
tlie term "bank" to include banks, savings associations, and bank holding companies (BHCs). The terms
"bank holding company" and "BHC" refer only to bank holding companies regulated by the Board.
2 The BCBS is a commttee of
banking supervisory authorities, which was established by the central bank
governors of
the G-10 countries in 1975. It consists of
senior representatives of
bank supervisory
authorities and central banks from Argentina, Australia, Belgium, Brazil, Canada, China, France, Geimany,
Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia,
Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the
United States. Documents issued by the BCBS are available through the Bank for International Settlement.s
Web site at http://www.bis.arg.
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Draft Dated 12/0312010
implemented the 1988 Capital Accord in 1989 through the issuance of the general risk-
based capital rules.3 In 1996, the BCBS amended the 1988 Capital Accord to require
banks to measure and hold capital to cover their exposure to market risk associated with
foreign exchange and commodity positions and positions located in the trading account
(the Market Risk Amendment (MRA) or market risk framework).4 The agencies
implemented the MRA with an effective date of January 1, 1997 (market risk capital
rule).5
In June 2004, the BCBS issued a document entitled International Convergence of
Capital
Measurement and Capital Standards: A Revised Framework (New Accord or
Basel II), which was intended for use by individual countries as the basis for national
consultation and implementation. The New Accord
sets forth a "three-pillar" framework
that includes (i) risk-based capital requirements for credit risk, market risk, and ,:
operational risk (Pillar 1); (ii) supervisory review of capital ädequacy (Pillar 2); and (iii)
market discipline through enhanced public disclosures (Pillar 3)
intended for use by individual countries as the basis for national
consultation and implementation. The New Accord
sets forth a "three-pillar" framework
that includes (i) risk-based capital requirements for credit risk, market risk, and ,:
operational risk (Pillar 1); (ii) supervisory review of capital ädequacy (Pillar 2); and (iii)
market discipline through enhanced public disclosures (Pillar 3).
The New Accord retained much of
the MRA; however, after its release, the BCBS
announced that it would develop improvements to the market risk framework, especially
with respect to the treatment of specific risk, which refers to the risk of loss on a position
due to factors other than broad-based movements in market prices. As a result, in July
2005, the BCBS and the International Organization of Securities Commissions (IOSCO)
published The Application of
Basel II to Trading Activities and the Treatment of
Double
3 The agencies' general risk-based capital rules are at 12 CFR part 3, Appendix A (OCC); 12 CFR part 208,
Appendix A and 12 CFR part 225, Appendix A (Board); and 12 CFR part 325, Appendix A (FDIC).
4 In 1997, the BCBS modified the MRA to remove a provision pertaining to the specific risk capital charge
under the internal models approach (see htt::/!www.bis.org/press/p970918a.htm).
561 FR 47358 (September 6, 1996). The agencies' market risk capital rules are at 12 CFR part 3, Appendix
B (OCC), 12 CFR part 208, Appendix E and 12 CFR paii 225, Appendix E (Board), and 12 CFR part 325,
Appendix C (FDIC).
9
the BCBS modified the MRA to remove a provision pertaining to the specific risk capital charge
under the internal models approach (see htt::/!www.bis.org/press/p970918a.htm).
561 FR 47358 (September 6, 1996). The agencies' market risk capital rules are at 12 CFR part 3, Appendix
B (OCC), 12 CFR part 208, Appendix E and 12 CFR paii 225, Appendix E (Board), and 12 CFR part 325,
Appendix C (FDIC).
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Default Effects. The BCBS incorporated the July 2005 changes into the June 2006
comprehensive version of
the New Accord and follow its "three-pillar" structure.
Specifically, the Pillar 1 changes narrow the types of
positions that are subject to the
market risk framework and revise modeling standards and procedures for calculating
minimum regulatory capital requirements; the Pillar 2 changes require banks to conduct
internal assessments of their capital
adequacy with respect to market risk, taking into
account the output of
their internal models, valuation adjustments, and stress tests; and
the Pillar 3 changes require banks to disclose certain quantitative and qualitative
. information, including their valuation techniques for covered positions, the soundness
standard used for modeling purposes, and, their internal capital
adequacy assessment
methodologies.
In September 2006, the agencies .issued ajoint notice of proposed rulemaking
(2006 proposal) in which they proposed amendniepts to their market risk capital rules
that would implement the BCBS's changes to
the market risk framework.6 The BCBS
began work on significant changes to the market risk framework in 2007 due to issues
highlighted by the financial crisis. As a result, the agencies did not finalize the 2006
proposaL. This joint notice of proposed rulemaking (proposed rule) incorporates aspects
of the agencies' 2006 proposal as well as further revisions to the New Accord (and
associated guidance) published by the BCBS in July 2009
began work on significant changes to the market risk framework in 2007 due to issues
highlighted by the financial crisis. As a result, the agencies did not finalize the 2006
proposaL. This joint notice of proposed rulemaking (proposed rule) incorporates aspects
of the agencies' 2006 proposal as well as further revisions to the New Accord (and
associated guidance) published by the BCBS in July 2009. These publications include
Revisions to the Basel II Market Risk Framework, Guidelines for Computing Capital for
67 i FR 55958, (September 25, 2006). The 2006 proposal was issued jointly by the agencies and the Office
of Thrift Supervision (OTS). In the proposal, the OTS, which had not previously adopted the MRA,
proposed adopting a market risk capital rule.
10
Draft Dated 12/03/2010
Incremental Risk in the Trading Book, and Enhancements to the Basel II Framework
(collectively, the 2009 revisions).
The 2009 revisions to the market risk framework place additional prudential
requirements on bans' internal models for measuring market risk and require enhanced
qualitative and quantitative disclosures, particularly with respect to banks' securitization
activities. The revisions also introduce an incremental risk capital requirement to capture
default and credit quality migration risk for non-securitization credit products. With
respect to securitizations, the 2009 revisions require banks to apply the standardized
measurement method for specific risk to these positions, except for "correlation trading"
. positions (described further below), for which banks may choose to model all material
price risks.
The 2009 revisions also add a stressed Value-at-Risk (VaR)-based capital
requirement to banks' VaR-based capital
requirement under the existing framework
009 revisions require banks to apply the standardized
measurement method for specific risk to these positions, except for "correlation trading"
. positions (described further below), for which banks may choose to model all material
price risks.
The 2009 revisions also add a stressed Value-at-Risk (VaR)-based capital
requirement to banks' VaR-based capital
requirement under the existing framework. In
June, 2010,
the BCBSpublished additional revisions to the market risk framework that
included establishing a floor on the risk-based capital requirement for modeled
correlation trading positions.7
These revisions to the market risk framework and other proposed revisions are
discussed more fully
below. Par I.B. of
this
preamble sumarizes and
provides
background on the curent market risk capital rule. Part II describes the proposed
revisions to the market risk capital rule that incorporate aspects of
the BCBS 2005 and
2009 revisions to the market risk framework.
7 The June 2010 revisions can be found, in their entirety, at littp:!/bis.orsdpress/p 10061 8iannex.pdf.
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Draft Dated 12/03/2010
Question 1: The agencies request comment on all aspects of the proposed rule
and specifically on whether and for what reasons certain aspects of
the proposed rule
present particular implementation challenges. Responses should be detailed as to the
nature and impact of such challenges. What, if any, specific approaches (for example,
transitional arrangements) should the agencies consider to address such challenges and
why?
B. Summary of the Current Market Risk Capital Rule
The current market risk capital rule supplements both the agencies' general risk-
based capital rules and the advanced capital adequacy guidelines (advanced approaches
rules) (collectively, the credit risk
capital rules)&by requiring any bank subject to the
market risk capital rule to adjust its risk-based capital ratios to reflect market risk in its
trading activities
nt Market Risk Capital Rule
The current market risk capital rule supplements both the agencies' general risk-
based capital rules and the advanced capital adequacy guidelines (advanced approaches
rules) (collectively, the credit risk
capital rules)&by requiring any bank subject to the
market risk capital rule to adjust its risk-based capital ratios to reflect market risk in its
trading activities. The rule applies to a bank
with worldwide, consolidated trading
activity equal to 10 percent ormore oftotalassets, or $1 billion or more. The primary
federal supervisor of a bank may apply the market risk capital rule to a bank if
the
supervisor deems it necessary or appropriate for safe and sound banking practices. In
addition, the supervisor may exempt a bank that meets the threshold criteria from
application of
the rule if
the supervisor determines the bank meets such criteria as a
consequence of accounting, operational, or similar considerations, and the supervisor
deems such an exemption to be consistent with safe and sound banking practices.
1. Covered Positions
8 The agencies' advanced approaches rules are at 12 CFR part 3, Appendix C (OCC); 12 CFR part 208,
Appendix F and l2 CFR part 225, Appendix G (Board); and 12 CFR part 325, Appendix D (FDIC). For
purposes of this preamble, the term "credit risk capital rules" refers to the general risk-based capital rules
and the advanced approaches rules (that also apply to operational risk), as applicable to the bank using the
proposed rule.
12
hes rules are at 12 CFR part 3, Appendix C (OCC); 12 CFR part 208,
Appendix F and l2 CFR part 225, Appendix G (Board); and 12 CFR part 325, Appendix D (FDIC). For
purposes of this preamble, the term "credit risk capital rules" refers to the general risk-based capital rules
and the advanced approaches rules (that also apply to operational risk), as applicable to the bank using the
proposed rule.
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Draft Dated 12/0312010
The current market risk capital rule requires a bank to maintain regulatory capital
against the market risk of its covered positions. Covered positions are defined as all on-
and off-balance sheet positions in the bank's trading account (as defined in the
instructions to the Consolidated Reports of Condition and Income (Call Report) or to the
FR Y-9C Consolidated Financial Statements for Bank Holding Companies (FR Y-9C)),
and all foreign exchange and commodity positions, whether or not they are in the trading
account. Covered positions exclude all positions in the trading account that, in form or
substance, act as liquidity facilities that provide liquidity support to asset-backed
commercial paper.
2. Capital
Requirement for Market Risk
The current market risk capital rule defines market risk as the risk of loss resulting
from movements in market prices. Market risk consists of general market risk and
specific risk components. General market risk is defined
as changes in the market value
of positions resulting from broad market movements, such as changes in the general level
of interest rates, equity prices, foreign exchange rates, or commodity prices. Specific risk
is defined as changes in the market value of a position due to factors other than broad
market movements and includes event and default risk, as well as idiosyncratic risk.9
A bank that is subject to the market risk capital rule is required to use an internal
model to calculate a VaR-based measure of its exposure to market risk
ity prices, foreign exchange rates, or commodity prices. Specific risk
is defined as changes in the market value of a position due to factors other than broad
market movements and includes event and default risk, as well as idiosyncratic risk.9
A bank that is subject to the market risk capital rule is required to use an internal
model to calculate a VaR-based measure of its exposure to market risk. A bank's total
9 Idiosyncratic risk is the risk of loss in the value of a position that arises from changes in risk factors
unique to that position. Event risk is the risk of loss on a position that could result from sudden and
unexpected large changes in market prices or specific events other than the default of the issuer. Default
risk is the risk ofloss on a position that could result from the failure of an obligor to make timely payments
of principal or interest on its debt obligation, and the risk ofloss that could result from bankptcy,
insolvency, or similar proceeding. For credit derivatives, default risk means the risk ofloss on a position
that could result from the default of the reference exposure( s).
13
Draft Dated 12/03/2010
risk-based capital requirement for covered positions generally consists of a VaR-based
capital requirement plus an add-on for specific risk, if specific risk is not captured in the
bank's internal VaR modeL. 10 The V aR -based capital requirement is based on an estimate
of the amount that the value of one or more positions could decline over a stated time
horizon and at a stated confidence leveL. A bank may determine its capital requirement
for specific risk using a standardized method or, with supervisory approval, may use
internal models to measure its minimum capital requirement for specific risk.
3. Internal Models-Based Capital Requirement
In calculating the capital requirement for market risk, a
bank is required to use an
internal model that meets specified quaJitativeandqual1titative criteria. The quaLitative
requirements reflect basiccomponents of sound marketriskmanagement
with supervisory approval, may use
internal models to measure its minimum capital requirement for specific risk.
3. Internal Models-Based Capital Requirement
In calculating the capital requirement for market risk, a
bank is required to use an
internal model that meets specified quaJitativeandqual1titative criteria. The quaLitative
requirements reflect basiccomponents of sound marketriskmanagement. For example,
the current market risk capital rule
requires an
independent
risk control unit that reports
directly to senior management and an internal risk measurement model that is integrated
into the daily management process. The quantitative criteria include the use of a VaR-
based measure based on a 99.0 percent, one-tailed confidence leveL. The VaR-based
measure must be based on a price shock equivalent to a 1 O-business-day movement in
rates or prices. Price changes estimated using shorter time periods must be adjusted to
the 10-business-day standard. The minimum effective historical observation period for
deriving the rate or price changes is one year and data Sets must be updated at least every
three months or more frequently if market conditions warrant. In all cases, under the
current rule, a bank must have the capability to update its data sets more frequently than
every three months in anticipation of
market conditions that would require such updating.
10 The primary federal supervisor of a bank may also permt the use of alternative techniques to measure the
market risk of de minimis exposures, if
the techniques adequately measure associated market risk.
14
nder the
current rule, a bank must have the capability to update its data sets more frequently than
every three months in anticipation of
market conditions that would require such updating.
10 The primary federal supervisor of a bank may also permt the use of alternative techniques to measure the
market risk of de minimis exposures, if
the techniques adequately measure associated market risk.
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Draft Dated 12/0312010
A ban need not use a single model to calculate its VaR-based measure. A bank's
internal model may use any generally accepted approach, such as variance-covariance
models, historical simulations, or Monte Carlo simulations. However, the level of
sophistication of the bank's internal model must be commensurate with the nature and
size of the positions it covers. The internal model must use risk factors sufficient to
measure the market risk inherent in all covered positions. The risk factors must address
interest rate risk, equity price risk, foreign exchange rate risk, and commodity price risk.
The curent market risk capital rule imposes backtesting requirements that must
be calculated quarterly. A bank must èompare its daily VaR-based measure for each of
the preceding 250
business" days to its actuaLdaily trading profit or loss, which typically
'includes realized and unrealized gains and losses on portfolio positions as well as fee
" income and commissions associated
with trading activities. If the quarterly backtesting
shows that the bank's daily net trading
loss exceeded its corresponding daily VaR-based
measure, a backtesting exception has occurred. If a bank experiences more than four
backtesting exceptions over the preceding 250 business days, it is generally required to
apply a multiplication factor in excess of 3 when it calculates its risk-based capital ratio
(see section 1.B.5 of
this preamble).
A bank subj ect to the market risk capital rule is also required to conduct stress
tests to assess the impact of adverse market events on its positions
experiences more than four
backtesting exceptions over the preceding 250 business days, it is generally required to
apply a multiplication factor in excess of 3 when it calculates its risk-based capital ratio
(see section 1.B.5 of
this preamble).
A bank subj ect to the market risk capital rule is also required to conduct stress
tests to assess the impact of adverse market events on its positions. The market risk
capital rule does not prescribe specific stress-testing methodologies.
4. Specific Risk
Under the current market risk capital rule, a bank may use an internal model to
measure its exposure to specific risk if it has demonstrated to its primary federal
15
Draft Dated 12/03/2010
supervisor that the model measures the specific risk, including event and default risk, as
well as idiosyncratic risk, of its debt and equity positions. A bank that incorporates
specific risk in its internal model but fails to demonstrate that the model adequately
measures all aspects of specific risk is subject to a specific risk add-on. In this case, if the
bank can validly separate its VaR-based measure into a specific risk portion and a general
market risk portion, the add-on is equal to the previous day's specific risk portion. If the
bank cannot separate the VaR-based measure into a specific risk portion and a general
market risk portion, the add-on is equal to the sum of
the previous day's VaR-based
measures for subportfolios of debt and equity positions that contain specific risk.
If the ban does not model specific iisk, it must calculate its specific risk capital
requirement, or "add-on," using a standardized method, 1 i Under this method, the
specific
risk add-on for debt positions is calculated by multiplying the absolute value of
the
current market value of each net long and net short position in a debt instrument by
the appropriate specific risk-weighting factor in the rule
ban does not model specific iisk, it must calculate its specific risk capital
requirement, or "add-on," using a standardized method, 1 i Under this method, the
specific
risk add-on for debt positions is calculated by multiplying the absolute value of
the
current market value of each net long and net short position in a debt instrument by
the appropriate specific risk-weighting factor in the rule. These specific risk-weighting
factors range from zero to 8.0 percent and are based on the identity of
the obligor and, in
the case of some positions, the credit rating and remaining contractual maturity of
the
position. Derivative instruments are risk-weighted according to the market value of
the
effective notional amount of
the underlying position. A bank may net long and short debt
positions (including derivatives) in identical debt issues or indices. A bank may also
offset a "matched" position in a derivative and its corresponding underlying instrument.
Under the standardized method, the specific risk add-on for equity positions is the
sum of
the bank's net long and short positions in an equity, multiplied by a specific risk-
i i See section 5 (c) of the agencies' market risk capital mles for a description of this method.
16
Draft Dated 12/03/2010
weighting factor. A bank may net long and short positions (including derivatives) in
identical equity issues or equity indices in the same market. The specific risk add-on is
8.0 percent ofthe net equity position, unless the bank's portfolio is both liquid and well-
diversified, in which case the specific risk add-on is 4.0 percent. For positions that are
index contracts comprising a well-diversified portfolio of equities, the specific risk add-
on is 2.0 percent of
the net long or net short position in the index.12
5. Calculation of the Risk-Based Capital Ratio
A bank subject to the current market risk capital rule must calculate its adjusted
risk-based capital ratios as follows
case the specific risk add-on is 4.0 percent. For positions that are
index contracts comprising a well-diversified portfolio of equities, the specific risk add-
on is 2.0 percent of
the net long or net short position in the index.12
5. Calculation of the Risk-Based Capital Ratio
A bank subject to the current market risk capital rule must calculate its adjusted
risk-based capital ratios as follows. First, the bank must calculate its adjusted risk-
weighted assets; which equals its risk-weighted assets calculated under the general risk-
based capital rule excluding the risk-weighted' amounts of
covered positions (except
Joreignexchange positions outside the trading. account and over-the-counter derivative
instruments)13 and cash-secured securities borrowing.
receivables that meet the criteria of
the market risk capital rule.
The bank then must calculate its measure for market risk, which equals the sum of
the VaR-based capital requirement for market risk, the specific risk add-on (if any), and
the capital requirement for de minimis exposures (if any). The VaR-based capital
requirement equals the greater of (i) the previous day's VaR -based measure; or (ii) the
average of
the daily VaR-based measures for each of
the preceding 60 business days
12 In addition, for futures contracts on broadly based indices that are matched by offsetting equity baskets, a
bank may apply a 2.0 percent specific risk requirement to the futues and stock basket positions if
the
basket comprises at least 90 percent of
the capitalization of
the index. The 2.0 percent specific risk
requirement applies to only one side of certain futures-related arbitrage strategies when either: (i) the long
and short positions are in exactly the same index at different dates or in different markets; or (ii) the long
and short positions are in different but similar indices at the same date
basket comprises at least 90 percent of
the capitalization of
the index. The 2.0 percent specific risk
requirement applies to only one side of certain futures-related arbitrage strategies when either: (i) the long
and short positions are in exactly the same index at different dates or in different markets; or (ii) the long
and short positions are in different but similar indices at the same date.
13 Foreign exchange positions outside the trading account and all over-the-counter derivative positions,
regardless of whether they are in the trading account, must be included in a bank's risk-weighted assets as
determned under the general risk-based capital rules.
17
Draft Dated 12/03/2010
multiplied by three, or such higher multiplier as may be required under the backtesting
requirements of
the market risk capital rule. The measure for market risk is multiplied by
12.5 to calculate market-risk-equivalent assets. The market-risk-equivalent assets are
added to adjusted risk-weighted assets to compute the denominator of
the bank's risk..
based capital ratio.
To calculate the numerator, the ban must allocate tier 1 and tier
2 capital equal to
8.0 percent of adjusted risk-weighted assets, and furher allocate excess tier 1, excess
tier 2, and tier 314 capital equal to the measure for market risk. The sum of tier 2 and
tier 3 capital allocated for market risk may not exceed 250 percent of
tier 1 capital. As a
result, tier i capital must equal at least 28.6 percent of
the measure for market risk. rhe
sum of tier 2 (both allocated and excess) and allocated tier 3 capital may not exceed
100 percent oftier 1 capital (both allocated and excess). Term subordinated debt and
intermediate-tenn preferred stock and related surplus included in tier 2 capital (both
allocated and excess) may not exceed 50 percent of tier 1 capital (both allocated and
excess). The sum of
tier 1 and tier 2 capital (both allocated and excess) and allocated
tier 3 capital is the numerator of
the bank's total risk-based capital ratio.
II
(both allocated and excess). Term subordinated debt and
intermediate-tenn preferred stock and related surplus included in tier 2 capital (both
allocated and excess) may not exceed 50 percent of tier 1 capital (both allocated and
excess). The sum of
tier 1 and tier 2 capital (both allocated and excess) and allocated
tier 3 capital is the numerator of
the bank's total risk-based capital ratio.
II. Proposed Revisions to the Market Risk Capital Rule
A. Objectives of the Proposed Revisions
The key objectives of
the proposed revisions to the current market risk capital rule
are to enhance the rule's sensitivity to risks that are not adequately captured by the current
14 Tier 1 and tier 2 capital are defined in the general risk-based capital rules. Tier 3 capital is subordinated
debt that is unsecured, is fully paid up, has an original maturity of at least two years, is not redeemable
before matuity without prior approval by the primary federal supervisor, includes a lock-in clause
precluding payment of either interest or principal (even at maturity) if the payment would cause the issuing
bank's risk-based capital ratio to fall or remain below the minimum required under the credit risk capital
rules, and does not contain and is not covered by any covenants, terms, or restrictions that are inconsistent
with safe and sound banking practices.
18
Draft Dated 12/03/2010
rule; to enhance modeling requirements in a maner that is consistent with advances in
risk management since the initial implementation of the rule; to modify the definition of
covered position to better capture positions for which treatment under the rule is
appropriate; to address shortcomings in the modeling of certain risks; to address certain
procyclicality concerns; and to increase transparency through enhanced disclosures
rements in a maner that is consistent with advances in
risk management since the initial implementation of the rule; to modify the definition of
covered position to better capture positions for which treatment under the rule is
appropriate; to address shortcomings in the modeling of certain risks; to address certain
procyclicality concerns; and to increase transparency through enhanced disclosures. The
objective of enhancing the risk sensitivity of
the rule is particularly important because of
banks' increased exposure to traded credit products, such as credit default swaps (CDSs)
and asset-backed securities, in other structured products, and in less liquid products. The
risks of these products are generally not fully captured in current VaR models, which rely
on a 1 O-business~day, one-tail,
99.0 percent confidence level soundness standard,
For example,
the growth in traded credit products has increased default and credit
migration risks that should be captured in. a regulatory capital requirement for specific
risk but have proved difficult to capture adequately within current specific
risk models.
The agencies did not contemplate risks associated with less liquid credit products when
the market risk capital rule was first adopted. Therefore, the agencies propose to
implement an incremental risk capital requirement that would apply to a bank that models
specific risk for one or more portfolios of debt or, if applicable, equity positions, and to
incorporate explicit measures of liquidity.
In addition, to address the agencies' concerns about the appropriate treatment of
covered positions that have limited price transparency, the agencies propose to require
banks to have a well-defined valuation process for all covered positions. The specific
proposals are discussed below.
19
re portfolios of debt or, if applicable, equity positions, and to
incorporate explicit measures of liquidity.
In addition, to address the agencies' concerns about the appropriate treatment of
covered positions that have limited price transparency, the agencies propose to require
banks to have a well-defined valuation process for all covered positions. The specific
proposals are discussed below.
19
Draft Dated 12/03/20l0
B. Description of the Proposed Revisions to the Market Risk Capital Rule
1. Scope
The proposed market risk capital rule does not change the set of
banks to which
the rule applies. That is, the proposed rule continues to apply to any bank with aggregate
trading assets and trading liabilities equal to 10 percent or more of total assets, or
$1 billion or more. The proposed rule applies to a ban that meets the market risk capital
rule applicability threshold regardless of
whether the bank uses the general risk-based
capital rules or the advanced approaches rules.
The primary federal supervisor of a bank that does not meet the threshold crIteiia
may apply the market risk capital rule to the bank if
the supervisor deems it necessary or
appropriate given the level of
market risk of
the ban or to ensure safe and sound banking
practices. The primary federal supervisor may also exclude a bank that meets the
threshold criteria from application of the rule if the supervisor determines that the
exclusion is appropriate based on the level of
market risk of
the bank and is consistent
with safe and sound banking practices.
Question 2: The agencies seek comment on the appropriateness the proposed
applicability thresholds. What, if any, alternative thresholds should the agencies consider
and why?
2
ets the
threshold criteria from application of the rule if the supervisor determines that the
exclusion is appropriate based on the level of
market risk of
the bank and is consistent
with safe and sound banking practices.
Question 2: The agencies seek comment on the appropriateness the proposed
applicability thresholds. What, if any, alternative thresholds should the agencies consider
and why?
2. Reservation of Authority
The proposed rule contains a reservation of authority that affirms the authority of
a bank's primary federal supervisor to require the bank to hold an overall amount of
capital greater than would otherwise be required under the rule if the supervisor
determines that the ban's risk-based capital requirements under the rule are not
20
Draft Dated 12/03/2010
commensurate with the market risk of the bank's covered positions. In addition, the
agencies anticipate that there may be instances when the proposed rule would generate a
risk-based capital requirement for a specific covered position or portfolio of covered
positions that is not commensurate with the risks of
the covered position or portfolio. In
these cases, a bank's primary federal supervisor may require the ban to assign a different
risk-based capital requirement to the covered position or portfolio of covered positions
that better reflects the risk of the position or portfolio. The proposed rule also provides
authority for a bank's primary federal supervisor to require the bank to calculate capital
requirements for specific positions or portfolios under the market risk capital rule or
under either the generaLrisk-based capital rules or advanced
approaches rules, as
appropriate, to more appropriately reflect the risks of the positions.
3
isk of the position or portfolio. The proposed rule also provides
authority for a bank's primary federal supervisor to require the bank to calculate capital
requirements for specific positions or portfolios under the market risk capital rule or
under either the generaLrisk-based capital rules or advanced
approaches rules, as
appropriate, to more appropriately reflect the risks of the positions.
3. Modifcation of the Definition of Covered Position."
The proposed rule modifies the definition"
of a covered
position to include trading
assets and trading liabilities (as reported on schedule RC-D of
the Call Report or
Schedule HC-D of
the Consolidated Financial Statements for Bank Holding Companies)
that are trading positions. Under the proposal, a trading position is defined as a position
that is held by the bank for the purpose of short-term resale or with the intent of
benefiting from actual or expected short-term price movements, or to lock in arbitrage
profits. Thus, the characterization of an asset or liability as "trading" for purposes of
U.S. Generally Accepted Accounting Principles (GAA) will not necessarily determine
whether the asset or liability is a "trading position" for purposes of
the proposed rule.
Commenters on the 2006 proposal expressed concerns that the proposed covered position
definition would create inconsistencies between the regulatory capital treatment of certain
21
Draft Dated 12/03/2010
trading assets and trading liabilities and the treatment of
those positions under GAA.
The agencies, however, continue to believe that relying on the accounting definition of
trading assets and trading liabilities, without modification, would not be appropriate
because it includes positions that are not held with the intent or ability to trade.
The proposed covered position definition includes trading assets and trading
liabilities that hedge covered positions
e positions under GAA.
The agencies, however, continue to believe that relying on the accounting definition of
trading assets and trading liabilities, without modification, would not be appropriate
because it includes positions that are not held with the intent or ability to trade.
The proposed covered position definition includes trading assets and trading
liabilities that hedge covered positions. In addition, the trading asset or trading liability
must be free of any restrictive covenants on its tradability or the bank must be able to
hedge its material risk elements in a two-way market. A trading asset or trading liability
that hedges a trading position is a covered position only if
the
hedge is within the scope
of
the bank's hedging strategy,(discussedbelow). The agencies
encourage the sound risk
. management of trading positions.' Therefore, theagéncies include in the definition of a
covered position any hedges that offset the riskortradingpositionso The agencies are
c.oncerned, however, that a bank
could
craft its hedging strategies in order to bring non-
trading positions that are more appropriately treated under the credit risk capital rules into
the ban's covered positions. The agencies will review a bank's hedging strategies to
ensure that they are not being manipulated in this manner. For example, mortgage-
backed securities that are not held with the intent to trade, but that are hedged with
interest rate swaps to mitigate interest rate risk, would be subject to the credit risk capital
rules.
Consistent with the current definition of covered position, under the proposed
rule, a covered position also includes any foreign exchange or commodity position,
whether or not it is a trading asset or trading liability. With prior supervisory approval, a
bank may exclude from its covered positions any structural position in a foreign curency,
22
would be subject to the credit risk capital
rules.
Consistent with the current definition of covered position, under the proposed
rule, a covered position also includes any foreign exchange or commodity position,
whether or not it is a trading asset or trading liability. With prior supervisory approval, a
bank may exclude from its covered positions any structural position in a foreign curency,
22
Draft Dated 12/03/2010
which is defined as a position that is not a trading position and that is (i) a subordinated
debt, equity, or minority interest in a consolidated subsidiary that is denominated in a
foreign currency; (ii) capital assigned to foreign branches that is denominated in a foreign
currency; (iii) a position related to an unconsolidated subsidiary or another item that is
denominated in a foreign currency and that is deducted from the bank's tier 1 and tier 2
capital; or (iv) a position designed to hedge a bank's capital ratios or earnings against the
effect of adverse exchange rate movements on (i), (ii), or (iii).
Also consistent with the current rule, the proposed definition of a covered position
explicitly excludes any position that, in form or substance, acts as a liquidity facility that
provides sùpport to asset-backed commercial paper. In addition, the definition of covered
position excludes all intangible assets, including servicing assets. Intangible assets
are
excluded
because
their
risks are
explicitly addressed in the credit risk capital rules, often
through a deduction from capitaL.
The proposed covered position definition excludes any equity position that is not
publicly traded, other than a derivative that references a publicly traded equity; any direct
real estate holding; and any position that a bank holds with the intent to securitize.
Equity positions that are not publicly traded would include private equity investments,
most hedge fund investments, and other such closely-held and non-liquid investments
that are not easily marketable
tion that is not
publicly traded, other than a derivative that references a publicly traded equity; any direct
real estate holding; and any position that a bank holds with the intent to securitize.
Equity positions that are not publicly traded would include private equity investments,
most hedge fund investments, and other such closely-held and non-liquid investments
that are not easily marketable. Direct real estate holdings include real estate for which
the bank holds title, such as "other real estate owned" held from foreclosure activities,
and bank premises used by a bank as part of its ongoing business activities. With such
real estate holdings, marketability and liquidity are uncertain or even impractical as the
assets are an integral part of
the bank's ongoing business. Indirect investments in real
23
Draft Dated 1 2/03/20 1 0
estate, such as through real estate investment trusts or special purpose vehicles, must
meet the definition of a trading position in order to be a covered position. Positions that a
bank holds with the intent to securitize include a "pipeline" or "warehouse" of loans
being held for securitization; the agencies do not view the intent to securitize these
positions as synonymous with the intent to trade them. Consistent with the 2009
revisions, the agencies believe all of
these excluded positions have significant constraints
in terms of a bank's ability to liquidate them readily and value them reliably on a daily
basis.
The proposed covered position definition excludes a credit derivative that the
bank recognizes as a guarantee
for
purposes
of calculating the amount ofrisk-vv'eighted.
assets under the credit risk capitalrules15 if it is
used to hedge a
position that is not a
covered position (for example, acredít derivative hedge,ofa 19an that is not a covered
position). This requires the bank to include the credit derivative in its risk-weighted
assets for credit risk and exclude it from its VaR-based measure for market risk
oses
of calculating the amount ofrisk-vv'eighted.
assets under the credit risk capitalrules15 if it is
used to hedge a
position that is not a
covered position (for example, acredít derivative hedge,ofa 19an that is not a covered
position). This requires the bank to include the credit derivative in its risk-weighted
assets for credit risk and exclude it from its VaR-based measure for market risk. This
proposed treatment of a credit derivative hedge avoids the mismatch that arises when the
hedged position (for example, a loan) is not a covered position and the credit derivative
hedge is a covered position. This mismatch has the potential to overstate the VaR-based
measure of
market risk if only one side of
the transaction were reflected in that measure.
Question 3: The agencies request comment on all aspects of
the proposed
definition of covered position.
15 See 12 CFR part 3, section 3 (OCC); 12 CFR part 208, Appendix A, section ILB and 12 CFR part 225,
Appendix A, section n.B (Board); and 12 CFR part 325, Appendix A, section n.B.3 (FDIC). The
treatment of guarantees is described in sections 33 and 34 of the advanced approaches rules.
24
Draft Dated 12/03/2010
Under the proposed rule, in addition to commodities and foreign exchange
positions, covered positions include debt positions, equity positions and securitization
positions. The proposal defines a debt position as a covered position that is not a
securitization position or a correlation trading position and that has a value that reacts
primarily to changes in interest rates or credit spreads. Examples of debt positions
include corporate and governent bonds, certain nonconvertible preferred stock, certain
convertible bonds, and derivatives (including written and purchased options) for which
the underlying instrument is a debt position.
The proposal defines an equity position as a covered position that is not a
securitization position or a correlation trading position and
that has a value that reacts
primarly to changes in equity prices
vernent bonds, certain nonconvertible preferred stock, certain
convertible bonds, and derivatives (including written and purchased options) for which
the underlying instrument is a debt position.
The proposal defines an equity position as a covered position that is not a
securitization position or a correlation trading position and
that has a value that reacts
primarly to changes in equity prices. Examples of equity positions include voting or
nonvoting common stock, certain convertible bonds, commitments to buy or sell equity
instruments, equity indices, and a derivative for which the underlying instrument is an
equity position.
Under the proposal, a securitization is a transaction in which: (i) all or a portion of
the credit risk of one or more underlying exposures is transferred to one or more third
parties; (ii) the credit risk associated with the underlying exposures has been separated
into at least two tranches that reflect different levels of seniority; (iii) performance of the
securitization exposures depends upon the performance of
the underlying exposures; (iv)
all or substantially all of
the underlying exposures are financial exposures (such as loans,
commitments, credit derivatives, guarantees, receivables, asset-backed securities,
mortgage-backed securities, other debt securities, or equity securities); (v) for non-
synthetic securitizations, the underlying exposures are not owned by an operating
25
the performance of
the underlying exposures; (iv)
all or substantially all of
the underlying exposures are financial exposures (such as loans,
commitments, credit derivatives, guarantees, receivables, asset-backed securities,
mortgage-backed securities, other debt securities, or equity securities); (v) for non-
synthetic securitizations, the underlying exposures are not owned by an operating
25
Draft Dated 12/03/2010
company; 16 (vi) the underlying exposures are not owned by a small business investment
company described in section 302 of
the Small Business Investment Act of 1958 (15
u.S.C. 682); and (vii) the underlying exposures are not owned by a firm an investment in
which qualifies as a community development investment under 12 U.S.c. 24(Eleventh).
Further, a bank's primary federal supervisor may determine that a transaction in which
the underlying exposures are owned by an investment firm that exercises substantially
unfettered control over the size and composition of its assets, liabilities, and off-balance
sheet exposures is not a securitization based on the transaction's leverage, risk profile, or
economic substance. Generally, the agencies Would consider investment firms that can
easily change the size and composition oftheircapital structure,
as well as the size and.
composition of their assets and off~balance sheet
exposures as eligible for exclusion from
the securitization definition under this provision. Based on a particular transaction's
leverage, risk profile, or economic substance, a
bank's primary federal supervisor may
deem an exposure to a transaction to be a securitization exposure, even if
the exposure
does not meet the criteria in provisions (v), (vi), or (vii) above
sets and off~balance sheet
exposures as eligible for exclusion from
the securitization definition under this provision. Based on a particular transaction's
leverage, risk profile, or economic substance, a
bank's primary federal supervisor may
deem an exposure to a transaction to be a securitization exposure, even if
the exposure
does not meet the criteria in provisions (v), (vi), or (vii) above. A securitization position
is a covered position that is (i) an on-balance sheet or off-balance sheet credit exposure
(including credit-enhancing representations and warranties) that arises from a
securitization (including a resecuritization); or (ii) an exposure that directly or indirectly
references a securitization exposure described in (i) above.
A securitization position includes nth-to-default credit derivatives and
resecuritization positions. The proposal defines an nth-to-default credit derivative as a
16 In a synthetic securitization, a company uses credit derivatives or guarantees to transfer a portion of the
credit risk of one or more underlying exposures to third-part protection providers. The credit derivative or
guarantee may be collateralized or uncollateralized.
26
Draft Dated 12/03/2010
credit derivative that provides credit protection only for the nth-defaulting reference
exposure in a group of reference exposures. In addition, under the proposal, a
resecuritization is a securitization in which one or more of the underlying exposures is a
securitization exposure. A resecuritization position is (i) an on- or off-balance sheet
exposure to a resecuritization; or (ii) an exposure that directly or indirectly references a
resecuritization exposure described in (i)
erence
exposure in a group of reference exposures. In addition, under the proposal, a
resecuritization is a securitization in which one or more of the underlying exposures is a
securitization exposure. A resecuritization position is (i) an on- or off-balance sheet
exposure to a resecuritization; or (ii) an exposure that directly or indirectly references a
resecuritization exposure described in (i).
The proposal defines a correlation trading position as (i) a securtization position
for which all or substantially all of
the value of
the underlying exposures is based on the
credit quality of a single company for which a two-way market exists, or on commonly
traded indices based
on such exposures for which a two-way market exists on the indices;
or (ii) a position that is not
a securitization
position and that hedges a position described
in clause
(i) above. Under the proposed definition,
a correlation trading position does not
include
a resecuritization position, a derivative of a securitization position that does not
provide a pro rata share in the proceeds of a securitization tranche, or a securitization
position for which the underlying assets or reference exposures are retail exposures,
residential mortgage exposures, or commercial mortgage exposures. Correlation trading
positions are typically not rated by external credit rating agencies and may include CDO
index tranches, bespoke CDO tranches, and nth-to-default credit derivatives.
Standardized CDS indices and single-name CDSs are examples of instruments used to
hedge these positions. While banks typically hedge correlation trading positions, hedging
frequently does not reduce a bank's net exposure to a position because the hedges often
do not perfectly match the position.
27
ies and may include CDO
index tranches, bespoke CDO tranches, and nth-to-default credit derivatives.
Standardized CDS indices and single-name CDSs are examples of instruments used to
hedge these positions. While banks typically hedge correlation trading positions, hedging
frequently does not reduce a bank's net exposure to a position because the hedges often
do not perfectly match the position.
27
Draft Dated 12/03/2010
4. Requirements for the Identification of
Trading Positions and Management of
Covered Positions
Section 3 of
the proposal introduces new requirements for the identification of
trading positions and the management of covered positions. The agencies believe that
these new requirements are warranted based on the inclusion of
more credit risk-related,
less liquid, and less actively traded products in banks' covered positions. The risks of
these positions may not be fully reflected in the requirements of
the market risk capital
rule and may be more appropriately captured under credit risk capital rules.
The proposed rule requires a bank to have clearly defined policies and procedures
for determining which of its trading
assets and trading liabilities are trading posilions as
well as which of
its trading positions are corrèlationtrading positions. In determining the
scope oftrading positions, the bank must consider
(i) the extènt to which a position (or a
hedge of its material risks) can be marked-to-market daily by reference to a two-way
market; and (ii) possible impairments to the liquidity of a position or its hedge.
In addition, the bank must have clearly defined trading and hedging strategies.
The bank's trading and hedging strategies for its trading positions must be approved by
senior management. The trading strategy must articulate the expected holding period of,
and the market risk associated with, each portfolio oftrading positions
d (ii) possible impairments to the liquidity of a position or its hedge.
In addition, the bank must have clearly defined trading and hedging strategies.
The bank's trading and hedging strategies for its trading positions must be approved by
senior management. The trading strategy must articulate the expected holding period of,
and the market risk associated with, each portfolio oftrading positions. The hedging
strategy must articulate for each portfolio the level of market risk the bank is willing to
accept and must detail the instruments, techniques, and strategies the bank will use to
hedge the risk of
the portfolio. The hedging strategy should be applied at the level at
which trading positions are risk managed at the bank (for example, trading desk, portfolio
levels).
28
Draft Dated 12/03/2010
The proposed rule requires a bank to have clearly defined policies and procedures
for actively managing all covered positions. In the context of non-traded commodities
and foreign exchange positions, active management includes managing the risks of those
positions within the bank's risk limits. For all covered positions, these policies and
procedures, at a minimum, must require (i) marking positions to market or model on a
daily basis; (ii) assessing on a daily basis the bank's ability to hedge position and
portfolio risks and the extent of market liquidity; (iii) establishment and daily monitoring
of
limits on positions by a risk control unit independent of
the trading business unit; (iv)
daily monitoring by senior management of
the information described in (i) through (iiì)
above; (v)'at least annual reassessment by seniormanagement of established limits on
positions; and (vi)
at least annual assessments by qualified personnel of
the quality
of
market inputs to the valuation process, the
soundness of
key assumptions, the reliability
of parameter estimation in pricing models, and the stability and accuracy of model
calibration under alternative market scenaros
ì)
above; (v)'at least annual reassessment by seniormanagement of established limits on
positions; and (vi)
at least annual assessments by qualified personnel of
the quality
of
market inputs to the valuation process, the
soundness of
key assumptions, the reliability
of parameter estimation in pricing models, and the stability and accuracy of model
calibration under alternative market scenaros.
The proposed rule introduces new requirements for the prudent valuation of
covered positions that include maintaining policies and procedures for valuation, marking
positions to market or to model, independent price verification, and valuation adjustments
or reserves. The valuation process must consider, as appropriate, unearned credit
spreads, close-out costs, early termination costs, investing and funding costs, future
administrative costs, liquidity, and model risk. These new valuation requirements reflect
the agencies' concerns about deficiencies in banks' valuation ofless liquid trading
positions, especially in light of the historical focus of the market risk capital rule on a 10-
business-day time horizon and a one-tail, 99.0 percent confidence level, which has
29
Draft Dated 12/0312010
proved to be inadequate at times to reflect the full extent of
the risks of
less liquid
positions.
5. General Requirements for Internal Models
Model Approval and Ongoing Use Requirements. Under the proposed rule, a
bank must receive the prior written approval of its primary federal supervisor before
using any internal model to calculate its market risk capital requirement. The 2006
proposal included a requirement that a bank receive prior written approval from its
primary federal supervisor before extending the use of an approved model to an
additional business line or product type. Some commenters raised concerns that this
requirement might unduly impede
a new product
launch
pending regulatory approval.
The'agencies have not included this
requirement in the proposed rule
roposal included a requirement that a bank receive prior written approval from its
primary federal supervisor before extending the use of an approved model to an
additional business line or product type. Some commenters raised concerns that this
requirement might unduly impede
a new product
launch
pending regulatory approval.
The'agencies have not included this
requirement in the proposed rule. Instead, the
,proposal requires that a bank promptly notify its primary
federal supervisor when the
bank plans to extend the use of a model
that the primary federal supervisor has approved
to an additional business line or product type.
The proposed rule also requires a bank to notify its primary federal supervisor
promptly if it makes any change to its internal models that would result in a material
change in the bank's amount of risk-weighted assets for a portfolio of covered positions
or when the bank makes any material change to its modeling assumptions. The bank's
primary federal supervisor may rescind its approval, in whole or in par, of
the use of any
internal model, and determine an appropriate regulatory capital requirement for the
covered positions to which the model would apply, if it determines that the model no
longer complies with the market risk capital rule or fails to reflect accurately the risks of
the bank's covered positions. For example, if adverse market events or other
30
Draft Dated i 2/03/20 i 0
developments reveal that a material assumption in a bank's approved model is flawed, the
bank's primary federal supervisor may require the bank to revise its model assumptions
and resubmit the model specifications for review by the supervisor.
Financial markets evolve rapidly, and internal models that were state-of-the-ar at
the time they were approved for use in risk-based capital calculations can become less
relevant as the risks of covered positions evolve and as the industry develops more
sophisticated modeling techniques that better capture material risks
sumptions
and resubmit the model specifications for review by the supervisor.
Financial markets evolve rapidly, and internal models that were state-of-the-ar at
the time they were approved for use in risk-based capital calculations can become less
relevant as the risks of covered positions evolve and as the industry develops more
sophisticated modeling techniques that better capture material risks. The proposed rule
therefore requires a bank to review its internal models periodically, but no less frequently
than annually, in light of developments in financial markets and modeling technologies,
and to
enhance those modelsas appropriate to ensure that they continue to meet the
agencies' standards for model approval and employ risk measurement methodologies that
are
most appropriate for thebank's'covered positions. It
is essential that a bank
continually improve 'its models to ensure
that its market risk capital requirement reflects
the risk of
the bank's covered positions. A bank's primary federal supervisor wil closely
scrutinize the bank's model review practices as a matter of safety and soundness.
To support the model review and enhancement requirement discussed above, the
agencies are considering imposing a capital supplement in circumstances in which a
ban's internal model continues to meet the qualification requirements of
the rule, but
develops specific shortcomings in risk identification, risk aggregation and representation,
or validation. The regulatory capital supplement would reflect the materiality of
these
shortcomings associated with the bank's current model and could result in a risk-
weighted assets surcharge that would apply until such time that the bank enhances its
model to the satisfaction of its primary federal supervisor. For example, the capital
31
k identification, risk aggregation and representation,
or validation. The regulatory capital supplement would reflect the materiality of
these
shortcomings associated with the bank's current model and could result in a risk-
weighted assets surcharge that would apply until such time that the bank enhances its
model to the satisfaction of its primary federal supervisor. For example, the capital
31
Draft Dated 12/03/2010
supplement could take the form of a model risk multiplier similar to the backtesting
multiplier for VaR-type models in section 4 of
the proposed rule. Depending on the
materiality of the shortcomings, the supervisor could increase the multiplier on any
model above three, generally subject to the restriction that the resulting capital
requirement not exceed the capital requirement that would apply under the proposed
rule's standardized measurement method for specific risk.
Question 4: Under what circumstances should the agencies require a model-
specific capital supplement? What criteria could the agencies use to apply capital
supplements consistently across banks? Aside from a capital supplement or withdrawal
. 01 model approval, how else could
the agencies address concerns about outdated models?
Risks Reflected in Models. Under the proposed rule, a bank mustincorporate its
internal models into its risk management process and integrate the internal models used
for
calculating its VaR-based measure into
its daily risk management process. The level
of sophistication of a bank's models must be commensurate with the complexity and
amount of
its covered positions. To measure market risk, a bank's internal models may
use any generally accepted modeling approach, including but not limited to variance-
covariance models, historical simulations, or Monte Carlo simulations. A bank's internal
models must properly measure all material risks in the covered positions to which they
are applied
be commensurate with the complexity and
amount of
its covered positions. To measure market risk, a bank's internal models may
use any generally accepted modeling approach, including but not limited to variance-
covariance models, historical simulations, or Monte Carlo simulations. A bank's internal
models must properly measure all material risks in the covered positions to which they
are applied. The proposed rule requires that risks arising from less liquid positions and
positions with limited price transparency be modeled conservatively under realistic
market scenarios. The proposed
rule also requires a bank to have a rigorous process for
reestimating, reevaluating and updating its models to ensure continued applicability and
relevance.
32
Draft Dated 12/03/2010
Control, Oversight, and Validation Mechanisms. The proposed rule maintains the
current requirement that a ban have a risk control unit that reports directly to senior
management and is independent of its business trading units. In addition, the proposed
rule provides specific model validation standards that are similar to those in the advanced
approaches rules. Specifically, the proposal requires a bank to validate its internal
models initially and on an ongoing basis. The validation process must be independent of
the internal models' development, implementation, and operation, or the validation
process must be subjected to an independent review of its adequacy and effectiveness.
The review personnel do not necessarily have to be external to the bank in order to
achieve the required independence. A bank should ensure that individuals who perform' ..
. the. review are not biased in their assessment due to their involvement in the
development, implementation, or operation of
the mòdels.
. Under the proposed rule, validation must include an evaluation of the conceptual
soundness of
the internal models
necessarily have to be external to the bank in order to
achieve the required independence. A bank should ensure that individuals who perform' ..
. the. review are not biased in their assessment due to their involvement in the
development, implementation, or operation of
the mòdels.
. Under the proposed rule, validation must include an evaluation of the conceptual
soundness of
the internal models. This evaluation should include evaluation of empirical
evidence and documentation supporting the methodologies used; important model
assumptions and their limitations; adequacy and robustness of empirical data used in
parameter estimation and model calibration; and evidence of a model's strengths and
weakesses. Validation also must include an ongoing monitoring process that includes a
review and verification of
processes and the comparson of
the bank's model outputs with
relevant internal and external data sources or estimation techniques. The results of
this
comparson provide a valuable diagnostic tool for identifying potential weaknesses in a
bank's models. As part of
this comparison, the bank should investigate the source of any
33
Draft Dated i 2/03/20 i 0
differences between the model estimates and the relevant internal or external data or
estimation techniques and whether the extent of
the differences is appropriate.
Validation of internal models must include an outcomes analysis process that
includes backtesting. Consistent with the 2009 revisions, the proposed rule requires a
bank's validation process for internal models used to calculate its VaR-based measure to
include an outcomes analysis process that includes a comparson of the changes in the
bank's portfolio value that would have occurred were end-of-day positions to remain
unchanged (therefore, excluding fees, commissions, reserves, net interest income, and
.intraday trading) with VaR-based measures
during a sample period not used in model
. development.
The proposed rule expands uponthe current market risk rule's stress-testing
requirement
includes a comparson of the changes in the
bank's portfolio value that would have occurred were end-of-day positions to remain
unchanged (therefore, excluding fees, commissions, reserves, net interest income, and
.intraday trading) with VaR-based measures
during a sample period not used in model
. development.
The proposed rule expands uponthe current market risk rule's stress-testing
requirement. Specifically, the
proposal requires a bank to stress test the market risk of its
,covered positions at a frequency appropriate
to each portfolio, and in no case less
frequently than quarterly. The stress tests must take into account concentration risk,
illiquidity under stressed market conditions, and other risks arising from the bank's
trading activities that may not be captured adequately in the bank's internal models. For
example, it may be appropriate for a bank to include in its stress testing the gapping of
prices, one-way markets, nonlinear or deep out-of-the-money products, jumps-to-default,
and significant changes in correlation. Relevant types of concentration risk include
concentration by name, industry, sector, country, and market. Market concentration
occurs when a bank holds a position that represents a concentrated share of
the market for
a security, and thus requires a longer than usual
liquidity horizon to liquidate the position
without impacting the market. A bank's primary federal supervisor would evaluate the
34
levant types of concentration risk include
concentration by name, industry, sector, country, and market. Market concentration
occurs when a bank holds a position that represents a concentrated share of
the market for
a security, and thus requires a longer than usual
liquidity horizon to liquidate the position
without impacting the market. A bank's primary federal supervisor would evaluate the
34
Draft Dated 12/03/2010
robustness and appropriateness of a bank's stress tests through the supervisory review
process.
The proposed rule requires a ban to have an internal audit function independent
of
business-line management that at least annually assesses the effectiveness of
the
controls supporting the bank's market risk measurement systems, including the activities
of the business trading units and independent risk control unit, compliance with policies
and procedures, and the calculation of
the bank's measure for market risk. The internal
audit function should review the bank's validation processes, including validation
procedures, responsibilities, results, timeliness, and responsiveness to findings. Further,
the
internal audit function
should evaluate
the depth, scope, and quality of
the risk
management systèm review process and conduct appropriate testing to ensure that the
conclusions of
these reviews are well-founded. At least annually, the internal audit
function
must
report its
findings to the bank's board of
directors (or a committee thereof)~
Internal Assessment of Capital Adequacy. The proposed rule requires that a bank
have a rigorous process for assessing its overall capital adequacy in relation to its market
risk. The assessment must take into account market concentration and liquidity risks
under stressed market conditions, as well as other risks that may not be captured fully in
the VaR-based measure.
Documentation
ttee thereof)~
Internal Assessment of Capital Adequacy. The proposed rule requires that a bank
have a rigorous process for assessing its overall capital adequacy in relation to its market
risk. The assessment must take into account market concentration and liquidity risks
under stressed market conditions, as well as other risks that may not be captured fully in
the VaR-based measure.
Documentation. Under the proposal, a bank must document adequately all
material aspects of its internal models, the management and valuation of covered
positions, its control, oversight, validation and review processes and results, and its
internal assessment of capital adequacy. This documentation would facilitate the
35
Draft Dated i 2/03/20 i 0
supervisory review process as well as the bank's internal audit or other review
procedures.
6. Capital Requirement for Market Risk
As under the current rule, the proposed rule requires a bank to calculate its risk-
based capital ratio denominator as the sum of
its adjusted risk-weighted assets and market
risk equivalent assets. To calculate market risk equivalent assets, a bank must multiply
its measure for market risk by 12.5. Under the proposed rule, a bank's measure for
market risk equals the sum of
its VaR-based capital requirement, its stressed VaR-based
capital requirement, any specific risk add-ons, any incremental risk capital requirement,
any comprehensive risk capital requirement, and any capital requirement for de minimis
exposures, each calculated
according
to the requirements ofthe proposed rule as
discussed further below. No. adjustments are permtted to address potential double
counting among any of
these cOmponents ofa bank's measure for market risk
ment, any specific risk add-ons, any incremental risk capital requirement,
any comprehensive risk capital requirement, and any capital requirement for de minimis
exposures, each calculated
according
to the requirements ofthe proposed rule as
discussed further below. No. adjustments are permtted to address potential double
counting among any of
these cOmponents ofa bank's measure for market risk.
Also, consistent with the current rule, under the proposed rule a bank's VaR-
based capital requirement equals the greater of (i) the previous day's VaR-based measure,
or (ii) the average of
the daily VaR-based measures for each of
the preceding 60 business
days multiplied by three, or such higher multiplication factor required based on
backtesting results determined according to section 4 of the proposed rule and discussed
further below. Similarly, under the proposed rule, a bank's stressed VaR-based capital
requirement equals the greater of (i) the most recent stressed VaR-based measure; or (ii)
the average of
the weekly VaR-based measures for each of
the preceding 12 weeks
multiplied by three, or such higher multiplication factor as required based on backtesting
results determined according to section 4 of
the proposed rule. The multiplication factor
36
Draft Dated 12/03/2010
applicable to the stressed-VaR based measure for purposes of
this calculation is based on
the backtesting results for its VaR-based measure; there is no separate backtesting
requirement for the stressed VaR-based measure for purposes of calculating a bank's
measure for market risk.
The proposed rule requires a bank to include in its measure for market risk any
specific risk add-on as required under section 7(c) of
the proposed rule, determined using
the standardized measurement method described in section 10 of the proposed rule. The
proposed rule also requires a bank to include in its measure for market risk any capital
requirement for de minimis exposures
for market risk.
The proposed rule requires a bank to include in its measure for market risk any
specific risk add-on as required under section 7(c) of
the proposed rule, determined using
the standardized measurement method described in section 10 of the proposed rule. The
proposed rule also requires a bank to include in its measure for market risk any capital
requirement for de minimis exposures. Specifically, a bank must add to its measure for
market risk the absolute value of
the market
value of
those de minimis
exposures that are
not captured.in the bank's V aR ~based measure unless the barik has obtained prior written
approval from its primar
federal supervisor to calculate a capital
requirement for the de
minimis exposures
using alternative techniques that appropriately measure the market
risk associated with those exposures. With regard to a ban's total risk-based capital
numerator, the proposed rule eliminates tier 3 capital and the associated allocation
methodologies.
Determination of
the Multiplication Factor. The proposed rule modifies the
current rule's regulatory backtesting framework for determining the multiplication factor
based on the number of
back
testing exceptions. Under the current market risk capital
rule, a bank must compare its daily VaR-based measure to its actual daily trading profit
or loss, which typically includes realized and uilealized gains and losses on portfolio
positions as well as fee income and commissions associated with trading activities.
Under the proposed rule, each quarter, a bank must compare each of its most recent 250
37
exceptions. Under the current market risk capital
rule, a bank must compare its daily VaR-based measure to its actual daily trading profit
or loss, which typically includes realized and uilealized gains and losses on portfolio
positions as well as fee income and commissions associated with trading activities.
Under the proposed rule, each quarter, a bank must compare each of its most recent 250
37
Draft Dated 12/03/2010
business days' trading losses (excluding fees, commissions, reserves, intra-day trading,
and net interest income) with the corresponding daily V aR -based measure calibrated to a
one-day holding period and at a one-tail, 99.0 percent confidence leveL. The excluded
components of
trading profit and loss are not modeled as part of
the VaR-based measure.
Therefore, excluding them from the regulatory backtesting framework will improve the
accuracy of
the backtesting and provide a better assessment of
the bank's internal modeL.
Some commenters on the 2006 proposal raised concerns with this requirement; however,
the agencies continue to believe that banks' trading and reporting systems are sufficiently
sophisticated to allow this type of
back
testing.
Question 5: The agencies request commenLon any
challenges banks may face in
formulating the measure of trading loss -as proposed, particularly for smaller portfolios,
More specifically, which, if any, of
the items to be excluded
from a bank's measure òf
trading loss (fees, commissions, reserves, intra-davtrading; or net interest income)
present difficulties and what is the nature of such difficulties?
7. VaR-Based Capital Requirement
Consistent with the current rule, section 5 of
the proposed rule requires a bank to
use one or more internal models to calculate a daily VaR-based measure that reflects
general market risk for all covered positions
trading loss (fees, commissions, reserves, intra-davtrading; or net interest income)
present difficulties and what is the nature of such difficulties?
7. VaR-Based Capital Requirement
Consistent with the current rule, section 5 of
the proposed rule requires a bank to
use one or more internal models to calculate a daily VaR-based measure that reflects
general market risk for all covered positions. The daily VaR-based measure also may
reflect the bank's specific risk for one or more portfolios of debt or equity positions and
must reflect the specific risk for any portfolios of correlation trading positions that are
modeled under section 9 of the proposed rule.
The proposal adds credit spread risk to the list of risk categories required to be
captured in a bank's VaR-based measure (that is, in addition to interest rate risk, equity
38
Draft Dated 12/03/2010
price risk, foreign exchange rate risk, and commodity price risk). The VaR-based
measure may incorporate empirical correlations within and across risk categories,
provided the bank validates and justifies the reasonableness of its process for measuring
correlations. If
the VaR-based measure does not incorporate empirical correlations
across risk categories, the bank must add the separate measures from its internal models
used to calculate the VaR-based measure for the appropriate market risk categories to
determine the bank's aggregate VaR-based measure. The proposed rule continues to
require models to include risks arising from the nonlinear price characteristics of option
positions or positions with embedded optionality.
Consistent witht,he2009 revisions;undèr the proposed rule, a bank
must be able
to justifyto the satisfaction ofits primary federal
supervisor the omission of any risk
factors from the calculation of
its VaR-based measure that the bank
includes in its pricing
models
dels to include risks arising from the nonlinear price characteristics of option
positions or positions with embedded optionality.
Consistent witht,he2009 revisions;undèr the proposed rule, a bank
must be able
to justifyto the satisfaction ofits primary federal
supervisor the omission of any risk
factors from the calculation of
its VaR-based measure that the bank
includes in its pricing
models. In addition, a bank must demonstrate to the satisfaction of its primary federal
supervisor the appropriateness of any proxies it uses to capture the risks of
the bank's
actual positions for which such proxies are used.
Quantitative Requirements for VaR-based Measure. The proposed rule includes
the same quantitative requirements for the daily VaR-based measure as the current
market risk capital rule. These include the one-tail, 99.0 percent confidence level, a ten-
business-day holding period, and a historical observation period of at least one year..
To calculate VaR-based measures using a 10-day holding period, the bank may
calculate 10-business-day measures directly, or may convert VaR-based measures using
holding periods other than 10 business days to the equivalent of a 10-business-day
holding period. A ban that converts its VaR-based measure in this manner must be able
39
Draft Dated 12/03/2010
to justify the reasonableness of its approach to the satisfaction of its primary federal
supervisor. For example, a ban that computes its VaR-based measure by multiplying a
daily VaR amount by the square root of 10 (that is, using the square root of time) should
demonstrate that daily changes in portfolio value do not exhibit significant mean
reversion, autocorrelation, or volatility clustering. 17
The proposed rule requires a bank's VaR-based measure to be based on data
relevant to the bank's actual exposures and of sufficient quality to support the calculation
of risk-based capital requirements
root of 10 (that is, using the square root of time) should
demonstrate that daily changes in portfolio value do not exhibit significant mean
reversion, autocorrelation, or volatility clustering. 17
The proposed rule requires a bank's VaR-based measure to be based on data
relevant to the bank's actual exposures and of sufficient quality to support the calculation
of risk-based capital requirements. The ban must update data sets at least monthly, or
more frequently as changes in market conditions or portfolio composition warrant. For
banks that use a weighting scheme or
other method for identifying the historical
observation period, the bank must either: (i) use an effective observation period of at least
one year in which the average time lag of the observations is at least six months; or (ii)
demonstrate to its primary federal supervisor that the method used is more effective than
that described in (i) at representing the volatility of
the bank's trading portfolio over a full
business cycle. In the latter case, a bank must update its data more frequently than
monthly and in a manner appropriate for the type of weighting scheme. In general, a
bank using a weighting scheme should update its data daily. Because the most recent
observations typically are the most heavily weighted it is important to include these
observations in the bank's VaR-based measure.
The proposed rule requires a bank to retain and make available to its primary
federal supervisor model performance information on significant subportfolios. Taking
17 Using the square root of time assumes that daily portfolio returns are independent and identically
distributed (IID). When the IID assumption is violated, the square root of
time approximation is not
appropriate.
40
R-based measure.
The proposed rule requires a bank to retain and make available to its primary
federal supervisor model performance information on significant subportfolios. Taking
17 Using the square root of time assumes that daily portfolio returns are independent and identically
distributed (IID). When the IID assumption is violated, the square root of
time approximation is not
appropriate.
40
Draft Dated 12/03/2010
into account the value and composition of a ban's covered positions, the subportfolios
must be sufficiently granular to inform a bank and its supervisor about the ability of
the
bank's VaR model to reflect risk factors appropriately. A ban's primary federal
supervisor must approve the number of subportfolios it uses for subportfolio backtesting.
While the proposed rule does not prescribe the basis for determining significant
subportfolios, the primary federal supervisor may consider the bank's evaluation of
certain factors such as trading volume, product types and number of distinct traded
products, business lines, and number of
traders or trading desks.
The proposed rule requires a ban to retain and make available to its primary
fêderal supervisor,
with no less than a 60 day lag, information for each subportfolio tòr
each business day over the previous two years (500 business days) that includes (i) a.
daily VaR-based measure for the subportfolio calibrated
to a one-tail, 99.0 percent
confidence level; (ii) the daily profit or loss for the subportfolio (that is, the net change in
price of
the positions held in the portfolio at the end of
the previous business day); and
information for each subportfolio tòr
each business day over the previous two years (500 business days) that includes (i) a.
daily VaR-based measure for the subportfolio calibrated
to a one-tail, 99.0 percent
confidence level; (ii) the daily profit or loss for the subportfolio (that is, the net change in
price of
the positions held in the portfolio at the end of
the previous business day); and
(iii) the p-value of
the profit or loss on each day (that is, the probability of observing a
loss greater than reported in (ii) above, based on the model used to calculate the VaR-
based measure described in (i) above).
Daily information on the probability of observing a loss greater than that which
occurred on any day is a useful metric for bans and supervisors to assess the quality of a
bank's VaR modeL. For example, if a bank that used a historical simulation VaR model
using the most recent 500 business days experienced a loss equal to the second worst day
of
the 500, it would assign a probability of
0.004 (2/500) to that loss based on its VaR
modeL. Applying this process over a given period provides information about the
41
Draft Dated 12/03/2010
adequacy of
the VaR model's ability to characterize the whole distribution oflosses,
including information on the size and number of
back
testing exceptions. The
requirement to create and retain this information at the subportfolio level may help
identify particular products or business lines for which the model is not adequately
measuring risk.
Question 6: The agencies request comment on what, if any, challenges exist wit4
the proposed subportfolio backtesting requirements described above
nformation on the size and number of
back
testing exceptions. The
requirement to create and retain this information at the subportfolio level may help
identify particular products or business lines for which the model is not adequately
measuring risk.
Question 6: The agencies request comment on what, if any, challenges exist wit4
the proposed subportfolio backtesting requirements described above. How might banks
determine significant subportfolios of covered positions that would be subject to these
requirements? What basis could be used to determine an aPQopriate number of
.:ubportfolios? Isthe.Q-vah!~ë: useful
statistic for evaluating the efficac--a ball's Va~
model in gauging market risk? What, if any, other statistics should the agencies consider '
.and whiZ
The current market risk capital rule requires a bank to include in its VaR-based
measure only covered positions. In contrast, the proposed rule allows a bank to include
term repo-style transactions in its VaR-based measure even though these positions may
not meet the definition of a covered position, provided the bank includes all such term
repo-style transactions consistently over time. Under the proposed rule, a term repo-style
transaction is a repurchase or reverse repurchase transaction, or a securities borrowing or
securities lending transaction, including a transaction in which the bank acts as agent for
a customer and indemnifies the customer against loss, that has an original maturity in
excess of one business day, provided that it meets certain requirements, including being
based solely on liquid and readily marketable securities or cash and subject to daily
42
e transaction, or a securities borrowing or
securities lending transaction, including a transaction in which the bank acts as agent for
a customer and indemnifies the customer against loss, that has an original maturity in
excess of one business day, provided that it meets certain requirements, including being
based solely on liquid and readily marketable securities or cash and subject to daily
42
Draft Dated 12/03/2010
marking-to-market and daily margin maintenance requirements.18 While repo-style
transactions typically are close adjuncts to trading activities, GAA traditionally has not
permitted companies to report them as trading assets or trading liabilities. Repo-style
transactions included in the VaR-based measure will continue to be subject to the
requirements of
the credit risk capital rules for calculating capital for counterpary credit
risk.
8. Stressed VaR-based Capital Requirement
Under section 6 of
the proposed rule, a bank must calculate at least weekly a
stressed VaR-based measure using the same internal model(s) used to calculate its VaR-
based measure. The stressed VaR-based measure supplements the VaR-based measure,
which,
due
to inherentlirnitations,provedinadequatè in producing capital requirements
. appropriate to the levelof losses incurred
at 'many banks during the financial market
crisis that began inmid-2007. The stressed VaR~based measure mitigates the
procyclicality of the minimum capital requirements for market risk and contributes to a
more appropriate measure of
the risks of a bank's covered positions.
Quantitative Requirements for Stressed VaR-based Measure. To determine the
stressed VaR-based measure, a bank must use the same model(s) used to calculate its
VaR-based measure, but with model inputs calibrated to reflect historical data from a
continuous l2-month period that reflects a period of significant financial stress
appropriate to the bank's current portfolio
f a bank's covered positions.
Quantitative Requirements for Stressed VaR-based Measure. To determine the
stressed VaR-based measure, a bank must use the same model(s) used to calculate its
VaR-based measure, but with model inputs calibrated to reflect historical data from a
continuous l2-month period that reflects a period of significant financial stress
appropriate to the bank's current portfolio. The stressed VaR-based measure must be
calculated at least weekly and be no less than the bank's VaR-based measure. The
18 See Section 2, "Definitions," of the proposed rule for a full definition of a term repo-style transaction.
43
Draft Dated 12/0312010
agencies generally expect that a bank's stressed VaR-based measure wil be substantially
greater than its VaR-based measure.
The proposed rule requires a bank to have policies and procedures that describe
how it determines the period of significant financial stress used to calculate the bank's
stressed VaR-based measure, and to be able to provide empirical support for the period
used. These policies and procedures must address (i) how the bank links the period of
significant financial stress used to calculate the stressed VaR-based measure to the
composition and directional bias of
the bank's current portfolio; and (ii) the bank's
process for selecting, reviewing, and updatìng the period of significant financial stress
. used to
calculate the stressed VaR-based measure and for monitoring the appropriateness
of
the l2-month period in light of
the bank's current portfolio. The bank: must obtain the
prior appi;oval of
its primary federal
supervisor for, and notify its primary federal
supervisor if
the bank makes anymaterial changes to,
these policies and procedures. A
bank's primary federal supervisor may require it to use a different period of significant
financial stress in the calculation of
the bank's stressed VaR-based measure.
9
e bank's current portfolio. The bank: must obtain the
prior appi;oval of
its primary federal
supervisor for, and notify its primary federal
supervisor if
the bank makes anymaterial changes to,
these policies and procedures. A
bank's primary federal supervisor may require it to use a different period of significant
financial stress in the calculation of
the bank's stressed VaR-based measure.
9. Revised Modeling Standards for Specific Risk
The proposed rule more clearly specifies the modeling standards for specific risk
and eliminates the current option for a bank to model some but not all material aspects of
specific risk for an individual portfolio of debt or equity positions. As under the current
market risk capital rule, a bank may use one or more internal models to measure the
specific risk of a portfolio of debt or equity positions with specific risk. A bank must also
use one or more internal models to measure the specific risk of a portfolio of correlation
trading positions with specific risk that are modeled under section 9 of
the proposed rule.
44
Draft Dated 12/03/2010
A ban may not, however, model the specific risk of securitization positions that are not
modeled under section 9 of the proposed rule. This treatment addresses regulatory
arbitrage opportunities as well as deficiencies in the modeling of securitization positions
that became more evident during the course of the financial market crisis that began in
mid-2007.
Under the proposed rule, the internal models must explain the historical price
variation in the portfolio, be responsive to changes in market conditions, be robust to an
adverse environment, and capture all material aspects of specific risk for the debt and
equity positions. Specifically, the proposed
revisions require that a bank's internal
models capture event risk and idiosyncratic risk; capture and demonstrate sensitivity to
material differences between positions that are
similar but not
identical; and capture and
nges in market conditions, be robust to an
adverse environment, and capture all material aspects of specific risk for the debt and
equity positions. Specifically, the proposed
revisions require that a bank's internal
models capture event risk and idiosyncratic risk; capture and demonstrate sensitivity to
material differences between positions that are
similar but not
identical; and capture and
. demonstrate
sensitivity
to changes in portfolio composition and concentrations. If a
bank
calculates an incremental risk measure for a portfolio of debt or equity positions under
section 8 of the proposed rule, the bank is not required to capture default and credit
migration risks in its internal models used to measure the specific risk of
those portfolios.
Under the current market risk capital rule, if a bank incorporates specific risk in
its internal model but fails to demonstrate to its primary federal supervisor that its internal
model adequately measures all aspects of specific risk for a portfolio of debt and equity
positions, the bank is subject to an internal models-based specific risk add-on for that
portfolio. In contrast, the proposed rule requires a bank that does not have an approved
internal model that captures all material aspects of specific risk for a particular portfolio
of debt, equity, or correlation trading positions to use the standardized measurement
method (described in section 10 of
the proposed rule) to calculate a specific risk add-on
45
s-based specific risk add-on for that
portfolio. In contrast, the proposed rule requires a bank that does not have an approved
internal model that captures all material aspects of specific risk for a particular portfolio
of debt, equity, or correlation trading positions to use the standardized measurement
method (described in section 10 of
the proposed rule) to calculate a specific risk add-on
45
Draft Dated 12/03/2010
for that portfolio. This proposed change reflects the agencies' interest in creating
incentives for more robust specific risk modeling. Due to concerns about the ability of a
bank to model the specific risk of certain securitization positions, the proposed rule
requires a bank to calculate a specific risk add-on under the standardized measurement
method for all of its securitization positions that are not correlation trading positions
modeled under section 9 of
the proposed'rule. The agencies note that not all debt, equity,
or securitization positions have specific risk (for example, certain interest rate swaps).
Under the proposed rule, there is no specific risk capital requirement for positions
without specific risk. A bank should have clear policies and procedures for determining
whethetaposition has specifìc risk:
While the proposed rule continues to
provide for flexibility and a combination of
approaches to measure market risk, including the use
of different models to measure the
general market risk and the specifìcrisk of one or more portfolios of debt and equity
positions, the agencies strongly encourage banks to develop and implement models that
integrate the measurement ofVaR for general market risk and specific risk. A bank's use
of a combination of approaches would be subject to supervisory review to ensure that the
overall capital requirement for market risk is commensurate with the risks of
the bank's
covered positions.
10
folios of debt and equity
positions, the agencies strongly encourage banks to develop and implement models that
integrate the measurement ofVaR for general market risk and specific risk. A bank's use
of a combination of approaches would be subject to supervisory review to ensure that the
overall capital requirement for market risk is commensurate with the risks of
the bank's
covered positions.
10. Standardized Specific Risk Capital Requirement
The proposed rule requires a bank to calculate a total specific risk add-on for each
portfolio of debt and equity positions for which the bank's VaR-based measure does not
capture all material aspects of specific risk and for each of its securitization positions that
is not modeled under section 9 of the proposed rule. A ban must calculate each specific
46
Draft Dated 12/03/2010
risk add-on in accordance with the requirements of
the proposed rule. The ban must add
the total specific risk add-on for each portfolio of
positions to the ban's measure for
market risk. The specific risk add-on for an individual debt or securitization position that
represents purchased credit protection is capped at the market value of
the protection.
For debt, equity, and securitization positions that are derivatives with linear
payoffs (for example, futures, equity swaps), a bank must apply a risk weighting factor to
the market value of
the effective notional amount of
the underlying instrument or index
portfolio. For debt, equity, and securitization positions that are derivatives with nonlinear
payoffs (for example, options, interest rate caps, tranched positions), a bank must apply a
risk weighting factor to the market value of the effective notional amount of the
. underlying instrument or portfolio multiplied by the derivative's delta (that is, the change
of
the derivative's value relative to changes in the price of
the reference exposure). For a
standard interest rate derivative, the effective notional amount refers to the apparent or
stated notional principal amount
ly a
risk weighting factor to the market value of the effective notional amount of the
. underlying instrument or portfolio multiplied by the derivative's delta (that is, the change
of
the derivative's value relative to changes in the price of
the reference exposure). For a
standard interest rate derivative, the effective notional amount refers to the apparent or
stated notional principal amount. If the contract contains a multiplier or other leverage
enhancement, the apparent or stated notional principal amount must be adjusted to reflect
the effect of
the multiplier or leverage enhancement in order to determine the effective
notional amount. A swap must be included as an effective notional position in the
underlying debt, equity, or securitization instrument or portfolio, with the receiving side
treated as a long position and the paying side treated as a short position. Consistent with
the current rules, a ban may net long and short positions (including derivatives) in
identical issues or identical indices. A bank may also net positions in depositary receipts
against an opposite position in an identical equity in different markets, provided that the
bank includes the costs of conversion.
47
Draft Dated 12/03/2010
The proposed rule also expands the recognition of hedging effects for debt and
securitization positions. A set of
transactions consisting of either a debt position and its
credit derivative hedge or a securitization position and its credit derivative hedge has a
specific risk add-on of zero if the debt or securitization position is fully hedged by a total
return swap (or similar instrument where there is a matching of payments and changes in
market value of
the position) and there is an exact match between the reference
obligation, the maturity, and the currency of
the swap and the debt or securitization
position
on and its credit derivative hedge has a
specific risk add-on of zero if the debt or securitization position is fully hedged by a total
return swap (or similar instrument where there is a matching of payments and changes in
market value of
the position) and there is an exact match between the reference
obligation, the maturity, and the currency of
the swap and the debt or securitization
position.
If a set of
transactions consisting,of either a debt
position and its credit derivative
hedge
or a securitization position and its credit derivative hedge does not meet the criteria
for no specific risk add-on, the specific risk add-on for the set oftraiisactions is equal to
20.0 percent of
the specific risk add-on for the side of
the transaction with the higher
specific risk add-on, provided that the credit risk of
the position is fully hedged by a
credit default swap (or similar instrument), and there is an exact match between the
reference obligation of
the credit derivative hedge and the
debt or securitization position,
the maturity of
the credit derivative hedge and the debt or securitization position, and the
currency of
the credit derivative hedge and the debt or securitization position. For a set of
transactions that consists of either a debt position and its credit derivative hedge or a
securitization position and its credit derivative hedge that does not meet the criteria for
full offset or the 80.0 percent offset described above (for example, there is mismatch in
the maturity of
the credit derivative hedge and that of
the debt or securitization position),
but in which all or substantially all of
the price risk has been hedged, the specific risk
48
redit derivative hedge or a
securitization position and its credit derivative hedge that does not meet the criteria for
full offset or the 80.0 percent offset described above (for example, there is mismatch in
the maturity of
the credit derivative hedge and that of
the debt or securitization position),
but in which all or substantially all of
the price risk has been hedged, the specific risk
48
Draft Dated 12/03/2010
add-on is equal to the specific risk add-on for the side of the transaction with the larger
specific risk add-on.
Debt and Securitization Positions. While most securitization positions are
considered debt positions under the current market risk capital rule, the agencies
distinguish between securitization positions and debt positions in the proposed rule
because of new proposed requirements that are uniquely applicable to securitization
positions. Under the proposed rule, the total specific risk add-on for a portfolio of debt or
securitization positions is the sum of
the specific risk add-ons for individual debt or
securitization positions, which are determined by multiplying the absolute value of
the
current marketvalue of each net long or net
short debt or securitization position by an
appropriate risk-weighting factor for the position.
The 2005 revisions to the màrket risk
framework incorporated changes to the
standardized measurement method used for calculating the specific risk add-ons for debt
positions. For example, the "governent" category was expanded to include all
sovereign debt, and the specific risk-weighting factor for sovereign debt was changed
from zero percent to a range from zero to 12.0 percent based on the external rating of
the
obligor and the remaining contractual maturity of the debt position. Table 1 below
provides an illustrative representation of
the specific risk-weighting factors applicable to
debt positions in the "governent," "qualifying," and "other" categories under the market
risk framework.
49
ereign debt was changed
from zero percent to a range from zero to 12.0 percent based on the external rating of
the
obligor and the remaining contractual maturity of the debt position. Table 1 below
provides an illustrative representation of
the specific risk-weighting factors applicable to
debt positions in the "governent," "qualifying," and "other" categories under the market
risk framework.
49
Draft Dated 12/03/2010
Table 1 - Specific Risk-Weighting Factors for Debt Positions
Category
Ilustrative External Rating
Description
Remaining Contractual
Maturity
Specific
Risk
Weight
Factor
--------- ------
i
I
i I
-+----------~
i 12.00% I
Highest investment grade to
second highest investment grade
(for example, AA to AA-).
Government
Residual term to final
maturity 6 months or less.
Residual term to final
maturity greater than 6 and
up to and including 24
months.
Residual term to final I
maturity exceeding 24 .
i months. i
One category bel~Ç~i~~;~rri~nt~~~-~~_--~~----l
grade to two categories below I
I investment grade (for examplt: 'I,
,,~ ' , ' BB+ to B-). , , '. ' _~I~--_,
i More than two categories below
investment
grade.
Third highest investment grade to
lowest investment grade (for
example, A+ to BBB-).
0.00%
0.25%
1.00%
I
1.60%
8.00%
Umated.
8.00%
Qualifying
Not applicable.
Residual term to final
maturity 6 months or less.
Residual term to final
maturity greater than 6 and
up to and including 24
months.
Residual term to final
maturity exceeding 24
months.
0.25%
1.00%
1.60%
Other
One category below investment
grade to two categories below
investment grade (for example,
BB+ to B-).
More than two categories below
investment grade, or equivalent
based on a bank's internal ratings.
Umated.
8.00%
12.00%
8.00%
50
or less.
Residual term to final
maturity greater than 6 and
up to and including 24
months.
Residual term to final
maturity exceeding 24
months.
0.25%
1.00%
1.60%
Other
One category below investment
grade to two categories below
investment grade (for example,
BB+ to B-).
More than two categories below
investment grade, or equivalent
based on a bank's internal ratings.
Umated.
8.00%
12.00%
8.00%
50
Draft Dated 12/03/2010
The 2009 revisions to the market risk framework also incorporated changes to the
specific risk-weighting factors under the standardized measurement method for rated
securitization and re-securitization positions as well as other treatments for unrated
securitization and re-securitization positions. For rated positions, the revisions apply risk
weights according to whether the positions' external rating represents a long-term credit
rating or a short-term credit rating and generally apply higher risk weights to rated re-
securitization positions than to other rated securitization positions. Tables 2 and 3 below
provide illustrative representations of
the specific risk-weighting factors applicable to
rated securitization and re-securitization position under the market risk framework. This
tteatment,was designed to. addres~ regulatory arbitrageopportllnities as well as
deficiencies in the modeling
of seciiritization positions that became more evident during
tht: course of the financialllarket crisis that began in mid-2007. This revised treatment
also assigns a more risk-sensitive capital requirement to securitization positions than
applied previously
the market risk framework. This
tteatment,was designed to. addres~ regulatory arbitrageopportllnities as well as
deficiencies in the modeling
of seciiritization positions that became more evident during
tht: course of the financialllarket crisis that began in mid-2007. This revised treatment
also assigns a more risk-sensitive capital requirement to securitization positions than
applied previously.
Table 2 - Long-term Credit Rating Specific Risk-Weighting Factors for Securitization
and Re-securitization Positions
Securitization
exposure
Resecuritization
Ilustrative External Rating
(that is not a
exposure
Example
resecuritization
Description
exposure)
Risk-weighting
Risk-weighting
factor
factor
Highest investment grade rating
AA
1.60%
3.20%
Second-highest investment grade rating
AA
l.60%
3.20%
Third-highest investment grade rating
A
4.00%
8.00%
Lowest investment grade rating
BBB
8.00%
18.00%
One category below investment grade
BB
28.00%
52.00%
51
Draft Dated 12/03/2010
Two categories below investment grade
B
100.00%
100.00%
Three categories or more below
investment grade
CCC
lOO.OO%
100.00%
Table 3 - Short-term Credit Rating Specific Risk-Weighting Factors for Securitization
and Re-securitization Positions
Securitization
exposure
Resecuritization
Ilustrative External Rating
(that is not a
exposure
Description
Example
resecuritization
Risk-weighting
exposure)
factor
Risk-weighting
factor
Highest investment grade rating
A-1/P-1
1.60%
3.20%
Second-highest investment grade rating
A-2/P-2
4.00%
8.00%
Third-highest investment grade rating
A-3/P-3
8.00% ~18.00%
.
' -
100.00%--1
All other ~'atings
N/A
100.00%
--
._--__________~
As a result ofthe recent
enactment in the United States of
the Dodd-Frank Wall
Street Reform and Consumer Protection Act19 (the Act), the agencies may not reference
or require reliance on credit ratings in the assessment of
the creditworthiness of a security
or money market instrument
nvestment grade rating
A-3/P-3
8.00% ~18.00%
.
' -
100.00%--1
All other ~'atings
N/A
100.00%
--
._--__________~
As a result ofthe recent
enactment in the United States of
the Dodd-Frank Wall
Street Reform and Consumer Protection Act19 (the Act), the agencies may not reference
or require reliance on credit ratings in the assessment of
the creditworthiness of a security
or money market instrument. The Act provides that each federal agency, after a required
review of its regulations, must remove from each of its regulations any reference to or
requirement of reliance on credit ratings and substitute a standard of creditworthiness the
agency determines is appropriate for the regulation.2o
The 2005 and 2009 BCBS revisions include provisions that rely on credit ratings
for determining the specific risk-weighting factors for debt, securitization, and re-
securitization positions. These provisions would need to be revised when implemented in
the U.S. in order to conform to the Act. The agencies acknowledge that the specific risk
19 See Public Law 111-203 (July 21, 2010).
20 See section 939A ofthe Act.
52
Draft Dated 12/03/2010
treatment for debt, securitization and re-securitization positions outlined in Tables 1
through 3 would provide a more risk-sensitive treatment for these positions than exists
under the current rule; however, pending the agencies' development of appropriate
standards of creditworthiness to replace use of credit ratings as required by the Act, the
proposed rule retains as a placeholder the current rule's method for determining specific
risk add-oil applicable to debt and securitization positions. More specifically, the
"governent," "qualifying," and "other" categories as described in the current market
risk capital rule and associated risk-weighting factors would continue to apply to a ban's
debt and securitization positions until the agencies develop a substitute standard of
creditworthiness to:replace reliance
on credit ratings. For completeness and to ensure
. t-"
ritization positions. More specifically, the
"governent," "qualifying," and "other" categories as described in the current market
risk capital rule and associated risk-weighting factors would continue to apply to a ban's
debt and securitization positions until the agencies develop a substitute standard of
creditworthiness to:replace reliance
on credit ratings. For completeness and to ensure
. t-".
uniformity of
regulatory text across the agencies' rules, the proposed rule includes in. i
section 10(b) the current standardized measurement method for these positions. The..
agencies
acknowledge the shortcomings of the current treatment and recognize that it
will
have to be amended in accordance with the requirements ofthe Act. To the extent
possible, the amended treatment would seek to establish comparable capital requirements
for the affected positions in order to ensure international consistency and competitive
equity. At the same time, the agencies believe it is important to move forward with the
revisions to the market risk rules contained in this proposal.21
When the agencies determine a substitute standard of creditworthiness for
external ratings as required by the Act, they intend to incorporate the new standard into
their capital rules, including the market risk rule. The agencies are currently reviewing
21 The agencies also note that certain other provisions of
the Act may affect the market risk capital rules.
For example, the credit risk retention requirements of
the Act may affect whether a securitization position
retained by a bank pursuant to the requirements meets the definition of a trading position or a covered
position.
53
uding the market risk rule. The agencies are currently reviewing
21 The agencies also note that certain other provisions of
the Act may affect the market risk capital rules.
For example, the credit risk retention requirements of
the Act may affect whether a securitization position
retained by a bank pursuant to the requirements meets the definition of a trading position or a covered
position.
53
Draft Dated 12/03/2010
alternative approaches to the use of credit ratings across all of the agencies' regulations
and requirements with the goal of establishing a uniform alternative credit-worthiness
standard. The agencies have asked for public input on this process through an advance
notice of
proposed rulemaking (ANPR).22 The agencies noted in the ANR that in
evaluating any standard of creditworthiness for purpose of determining risk-based capital
requirements, the agencies will, to the extent practicable and consistent with the other
objectives, consider whether the standard would:
. appropriately distinguish the credit risk associated with a particular exposure
within an asset class;
. be suffciently transparent, unbiased, replicable, änd defined to allow banking
organizations of varying size ànd complexity to arrve at the same assessment of
creditworthiness for similar expòsùres and to allow for appropriate supervisory
review;
. provide for the timely and accurate measurement of
negative and positive changes
in creditworthiness;
. minimize opportunities for regulatory capital arbitrage;
. be reasonably simple to implement and not add undue burden on banking
organizations; and
. foster prudent risk management.
22 75 FR 52283 (August 25, 20l0).
54
ess for similar expòsùres and to allow for appropriate supervisory
review;
. provide for the timely and accurate measurement of
negative and positive changes
in creditworthiness;
. minimize opportunities for regulatory capital arbitrage;
. be reasonably simple to implement and not add undue burden on banking
organizations; and
. foster prudent risk management.
22 75 FR 52283 (August 25, 20l0).
54
Draft Dated 12/03/2010
Question 7: What specific standards of creditworthiness that meet the agencies'
suggested criteria for a creditworthiness standard outlined above should the agencies
consider for these positions?
Under the proposed rule, the total specific risk add-on for a portfolio of nth -to-
default credit derivatives is the sum of the specific risk add-oil for individual nth -to-
default credit derivatives, as computed therein. A bank must calculate a specific risk add-
on for each nth -to-default credit derivative position regardless of
whether the bank is a net
protection buyer or net protection seller.
For first-to-default credit derivatives, the specific risk add-on is the lesser of (i)
the
sum of
the specific risk add~ons for the individual reference credit exposures'
in the
group
of
reference exposures; and (ii)the maximum possible
credit
event payment under
the credit derivative contract: Where a bank has a riskposition in one oftherefereiice
. credit exposures underlying a first-to-default credit derivative and this credit derivative
hedges the bank's risk position, the bank is allowed to reduce both the specific risk add-
on for the reference credit exposure and that part of the specific risk add-on for the credit
derivative that relates to this particular reference credit exposure such that its specific risk
add-on for the pair reflects the ban's net position in the reference credit exposure
vative and this credit derivative
hedges the bank's risk position, the bank is allowed to reduce both the specific risk add-
on for the reference credit exposure and that part of the specific risk add-on for the credit
derivative that relates to this particular reference credit exposure such that its specific risk
add-on for the pair reflects the ban's net position in the reference credit exposure.
Where a ban has multiple risk positions in reference credit exposures underlying a first-
to-default credit derivative, this offset is allowed only for the underlying reference credit
exposure having the lowest specific risk add-on.
For second-or-subsequent-to-default credit derivatives, the specific risk add-on is
the lesser of: (i) the sum of
the specific risk add-ons for the individual reference credit
exposures in the group of reference exposures, but disregarding the (n-l) obligations with
55
Draft Dated 12/03/2010
the lowest specific risk add-ons; or (ii) the maximum possible credit event payment under
the credit derivative contract. For second-or-subsequent-to-default credit derivatives, no
offset of
the specific risk add-on with an underlying reference credit exposure is allowed
under the proposed rule.
Equity Positions. Under the proposed rule, the total specific risk add-on for a
portfolio of equity positions is the sum of
the specific risk add-ons of
the individual
equity positions, which are determined by multiplying the absolute value of
the current
market value of each net long or short equity position by an appropriate risk-weighting
factor.
The proposed ruÌe retains
the specific risk add-oils applicable to equity positions
under.the current market risk capital rule,
with one exception. Consistent
with the 2009
revisions, the proposed rule eliminates the provision.that allows a bank to apply a specific
risk-weighting factor of 4.0 to an equity position held in a portfolio that is both liquid and
well-diversified
k-weighting
factor.
The proposed ruÌe retains
the specific risk add-oils applicable to equity positions
under.the current market risk capital rule,
with one exception. Consistent
with the 2009
revisions, the proposed rule eliminates the provision.that allows a bank to apply a specific
risk-weighting factor of 4.0 to an equity position held in a portfolio that is both liquid and
well-diversified. Instead, a bank must multiply the absolute value of
the current market
value of each net long or short equity position by a risk-weighting factor of 8.0 percent.
For equity positions that are index contracts comprising a well-diversified portfolio of
equity instruments, the absolute value of
the current market value of each net long or
short position is multiplied by a risk-weighting factor of2.0 percent. A portfolio is well-
diversified if it contains a large number of individual equity positions, with no single
position representing a substantial portion of
the portfolio's total market value.
The proposed rule retains the specific risk treatment in the current market risk
capital rule for equity positions arising from futures-related arbitrage strategies where
long and short positions are in exactly the same index at different dates or in different
56
Draft Dated 12/03/2010
market centers, or where long and short positions are in index contracts at the same date
in different but similar indices. The proposed rule also retains the current treatment for
futures contracts on main indices that are matched by offsetting positions in a basket of
stocks comprising the index.
Due Diligence Requirements for Securitization Positions. The proposed rule
incorporates requirements from the 2009 revisions that banks perform due diligence on
securitization positions
date
in different but similar indices. The proposed rule also retains the current treatment for
futures contracts on main indices that are matched by offsetting positions in a basket of
stocks comprising the index.
Due Diligence Requirements for Securitization Positions. The proposed rule
incorporates requirements from the 2009 revisions that banks perform due diligence on
securitization positions. The due diligence requirements apply to all securitization
positions and emphasize the need for banks to conduct their own due diligence of
bOlTower creditworthiness, in addition to any use of
third-party assessments, and not
place undue reliance on external credit ratìngs.
In order to meet the proposed due diligence requirements, a bank must be able to i'
demonstrate, to the satisfaction
of its primary federal supervisor, a comprehensive ' , ,
understanding of the features of a securitization position that would materially affect the 'i .
performance of
the bank's securitization position. The bank's analysis must be
commensurate with the complexity of
the securitization position and the materiality of
the position in relation to capitaL.
To support the demonstration of its comprehensive understanding, for each
securitization position, the bank must conduct and document an analysis of
the risk
characteristics of a securitization position prior to acquiring the position, considering: (i)
structural features of
the securitization that would materially impact the performance of
the position, for example, the contractual cash flow waterfall, waterfall-related triggers,
credit enhancements, liquidity enhancements, market value triggers, the performance of
organizations that service the position, and deal-specific definitions of default; (ii)
57
cquiring the position, considering: (i)
structural features of
the securitization that would materially impact the performance of
the position, for example, the contractual cash flow waterfall, waterfall-related triggers,
credit enhancements, liquidity enhancements, market value triggers, the performance of
organizations that service the position, and deal-specific definitions of default; (ii)
57
Draft Dated 12/03/2010
relevant information regarding the performance of
the underlying credit exposure(s), for
example, the percentage of loans 30, 60, and 90 days past due; default rates; prepayment
rates; loans in foreclosure; property types; occupancy; average credit score or other
measures of creditworthiness; average LTV ratio; and industry and geographic
diversification data on the underlying exposure(s); (iii) relevant market data of
the
securitization, for example, bid-ask spreads, most recent sales price and historical price
volatility, trading volume, implied market rating, and size, depth and concentration level
of the market for the securitization; and (iii) for resecuritization positions, performance
information on the underlying securitization exposures, for example, the issuer name and
credit quality, and Tnecharacteristics and perforrnance:of the exposures underlying the
. securitization exposures. On an on-goingbasis,butnokssfrequently than quarterly, the
bank must also evaluate, review;andupdate:as approprate theai1alysis required above
for each securitization position
itions, performance
information on the underlying securitization exposures, for example, the issuer name and
credit quality, and Tnecharacteristics and perforrnance:of the exposures underlying the
. securitization exposures. On an on-goingbasis,butnokssfrequently than quarterly, the
bank must also evaluate, review;andupdate:as approprate theai1alysis required above
for each securitization position.
Question 8: What, if any, specific challenges are involved with meeting the
proposed due diligence requirements and for what types of securitization positions? How
might the agencies address these challenges while still ensuring that a ban conducts an
appropriate level of due diligence commensurate with
the risks of its covered positions?
For example, would it be appropriate to scale the requirements according to a position's
expected holding period? How would such scaling affect a bank's ability to demonstrate
a comprehensive understanding of
the risk characteristics of a securitization position?
What are the benefits and drawbacks of
requiring public disclosures regarding a bank's
processes for performing due diligence on its securitization positions?
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Draft Dated 12/03/2010
The agencies are considering alternative methodologies to the standardized
measurement method for determining the specific risk capital requirement for
securtization positions to better recognize the risk reduction benefits of hedging.
Conceptually, such a methodology could recognize some degree of offsetting between
positions that reference the same pool of assets but have different levels of seniority, or
between positions that reference similar but not identical assets. For example, it could
use a formulaic approach to determine a degree of offset between securitization positions
that are similar to an index. Inputs to the formula could include factors such as the
attachment and detachment points of an individual securitization position, the aggregate
ts but have different levels of seniority, or
between positions that reference similar but not identical assets. For example, it could
use a formulaic approach to determine a degree of offset between securitization positions
that are similar to an index. Inputs to the formula could include factors such as the
attachment and detachment points of an individual securitization position, the aggregate
. capital requirement of
its underlying exposures, and the percentage ofunâerlying
obligors
common to the securitization exposure and the index.
Question
9: What alternative non-inodels-based methodologies could the agencies
. use to determine the specific risk
add-ons for securitization positions? . Please provide
specific details on the mechanics of and rationale for any suggested methodology. Please
also describe how the methodology conservatively recognizes some degree of
hedging
benefits, yet captures the basis risk between non-identical positions. To what types of
securitization positions would such a methodology apply and why?
11. Incremental Risk Capital Requirement
Under section 8 of the proposed rule, a bank that measures the specific risk of a
portfolio of debt positions using internal models must calculate an incremental risk
measure for that portfolio using an internal model (incremental risk model). Incremental
risk consists of the default risk of a position (that is, the risk of loss on the position upon
an event of default (for example, the failure of
the obligor to make timely payments of
59
k that measures the specific risk of a
portfolio of debt positions using internal models must calculate an incremental risk
measure for that portfolio using an internal model (incremental risk model). Incremental
risk consists of the default risk of a position (that is, the risk of loss on the position upon
an event of default (for example, the failure of
the obligor to make timely payments of
59
Draft Dated 12/03/2010
principal or interest), including bankptcy, insolvency, or similar proceeding) and the
credit migration risk of a position (that is, price risk that arises from significant changes
in the underlying credit quality of the position).
With the prior approval of its primary federal supervisor, a ban may also include
portfolios of equity positions in its incremental risk model, provided that it consistently
includes such equity positions in a manner that is consistent with how the bank internally
measures and manages the incremental risk for such positions at the portfolio leveL.
Default is deemed to occur with respect to any equity position that is included in the
bank's incremental risk model upon the default of any debt of the issuer of the equity
position. A bank may not include correlation
trading positions or securitization positions
in its incremental risk modeL.
Under the proposed rule, a bank's model to measure the
incremental risk of 3
portfolio of debt positions (and equity positions, if applicable) must meet certain
requirements and be approved by the bank's primary federal supervisor before the bank
may use it to calculate its risk-based capital requirement. The model must measure
incremental risk over a one-year time horizon and at a one-tail, 99.9 percent confidence
level, either under the assumption of a constant level of risk, or under the assumption of
constant positions.
The liquidity horizon of a position is the time that would be required for a bank to
reduce its exposure to, or hedge all of
the material risks of, the position(s) in a stressed
market
l must measure
incremental risk over a one-year time horizon and at a one-tail, 99.9 percent confidence
level, either under the assumption of a constant level of risk, or under the assumption of
constant positions.
The liquidity horizon of a position is the time that would be required for a bank to
reduce its exposure to, or hedge all of
the material risks of, the position(s) in a stressed
market. The liquidity horizon for a position may not be less than the lower of
three
months or the contractual maturity of the position.
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Draft Dated 12/03/2010
A position's liquidity horizon is a key risk attribute for purposes of calculating the
incremental risk measure because it puts a bank's overall risk exposure to an actively
managed portfolio into context. Positions with longer (that is, less liquid) liquidity
horizons are more difficult to hedge and result in more exposure to both default and
credit migration risk over any fixed time horizon. In particular, two positions with
differing liquidity horizons but exactly the same amount of default risk if held in a static
portfolio over a one-year horizon may exhibit significantly different amounts of default
risk ifheld in a dynamic portfolio in which hedging can occur in response to observable
changes in credit quality. The position with the shorter liquidity horizon can be hedged
more rapidíy and with less cost in
the event of a change in credit quality, which leads toa
different exposure to default risk overa one-year horizon than the position with the
longer liquidity-horizon.
A constant level of risk assumption assumes that the bank rebalances, or rolls
over, its trading positions at the beginning of each liquidity horizon over a one-year
horizon in a manner that maintains the bank's initial risk leveL. The bank must determine
the frequency
of
rebalancing in a maner consistent with the liquidity horizons of
the
positions in the portfolio. A constant position assumption assumes that a bank maintains
the same set of positions throughout the one-year horizon
ading positions at the beginning of each liquidity horizon over a one-year
horizon in a manner that maintains the bank's initial risk leveL. The bank must determine
the frequency
of
rebalancing in a maner consistent with the liquidity horizons of
the
positions in the portfolio. A constant position assumption assumes that a bank maintains
the same set of positions throughout the one-year horizon. If a bank uses this
assumption, it must do so consistently across all portfolios for which it models
incremental risk. A bank has flexibility in whether it chooses to use a constant risk or
constant position assumption in its incremental risk model; however, the agencies expect
that the assumption will remain fairly constant once selected. As with any material
change to modeling assumptions, the proposed rule requires a ban must promptly notify
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Draft Dated 12/03/2010
its primary federal supervisor if the bank changes from a constant risk to a constant
position assumption or vice versa. Further, to the extent a bank estimates a
comprehensive risk measure under section 9 of
the proposed rule, the bank's selection of
a constant position or a constant risk assumption must be consistent between the bank's
incremental risk model and comprehensive risk modeL. Similarly, the bank's treatment of
liquidity horizons must be consistent between a bank's incremental risk model and
comprehensive risk modeL.
The proposed rule requires a bank's incremental risk mo~el to meet the conditions
described below. The model must recognize the impact of correlations between default
and credit migration events among obligors.! In particular, the existence of an aggregate,
economy':wide credit cycle implies some degree o.f correlation between the default and
credit migration events across different issuers ..Thedegreeof correlation
between
default
and credit migration events of
different issuers may
also
depend on other issuer
attributes such as industry sector or region of domicile
migration events among obligors.! In particular, the existence of an aggregate,
economy':wide credit cycle implies some degree o.f correlation between the default and
credit migration events across different issuers ..Thedegreeof correlation
between
default
and credit migration events of
different issuers may
also
depend on other issuer
attributes such as industry sector or region of domicile. The mòdel must also reflect the
effect of issuer and market concentrations, as well as concentrations that can arise within
and across product classes during stressed conditions.
The bank's incremental risk model must reflect netting only oflong and short
positions that reference the same financial instrument and must also reflect any material
mismatch between a position and its hedge. Examples of such mismatches include
maturity mismatches as well as mismatches between an underlying position and its
hedge, (for example, the use of an index position to hedge
a single name security).
The bank's incremental risk model must also recognize the effect that liquidity
horizons have on hedging strategies. When a bank's hedging strategy requires continual
62
Draft Dated 12/03/2010
rebalancing of
the hedge position, the constraints on rebalancing imposed by the liquidity
horizon of
the hedge must be recognized. As an example, if a position is being hedged
with an instrument with a liquidity horizon of
three months, no rebalancing of
the hedge
can occur within a three month period. Accordingly, any divergence in the value of
the
position and its hedge that occurs because the hedge cannot be rebalanced within the
three month liquidity horizon must be recognized
horizon of
the hedge must be recognized. As an example, if a position is being hedged
with an instrument with a liquidity horizon of
three months, no rebalancing of
the hedge
can occur within a three month period. Accordingly, any divergence in the value of
the
position and its hedge that occurs because the hedge cannot be rebalanced within the
three month liquidity horizon must be recognized. Moreover, in order to reflect the effect
of hedging in the incremental risk measure, the bank must (i) choose to model the
rebalancing of
the hedge consistently over the relevant set of
trading positions; (ii)
demonstrate that the inclusion of rebalancing results in a more appropriate risk
measurement; (iii) demonstrate that the market for
the hedge is suffciently Equid to
permit rebalancing during
periods
of stress; and (iv) capture in the incremental risk model
any residual risks arising from such hedging strategies.
The
incremental risk model must reflect the nonlinear impact of options and other
positions with material nonlinear behavior with respect to default and credit migration
changes. In light of
the one-year horizon of
the incremental risk measure and the
extremely high confidence level required, it is important that nonlinearities be explicitly
recognized. Price changes resulting from defaults or credit migrations can be large and
the resulting nonlinear behavior of
the position can be materiaL. The ban's incremental
risk model must also maintain consistency with the bank's internal risk management
methodologies for identifying, measuring, and managing risk.
A bank that calculates an incremental risk measure under section 8 of the
proposed rule must calculate its incremental risk capital requirement at least weekly.
63
and
the resulting nonlinear behavior of
the position can be materiaL. The ban's incremental
risk model must also maintain consistency with the bank's internal risk management
methodologies for identifying, measuring, and managing risk.
A bank that calculates an incremental risk measure under section 8 of the
proposed rule must calculate its incremental risk capital requirement at least weekly.
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Draft Dated 12/03/2010
This capital requirement is the greater of: (i) the average of
the incremental risk measures
over the previous 12 weeks; or (ii) the most recent incremental risk measure.
12. Comprehensive Risk Capital Requirement
Under section 9 of
the proposed rule, with its primary federal supervisor's prior
approval, a ban may measure all material price risks of one or more portfolios of
correlation trading positions (comprehensive risk measure) using a model
(comprehensive risk model). If the bank uses a comprehensive risk model for a portfolio
of correlation trading positions, the bank must also measure the specific risk of
that
portfolio using internal models that meet the requirements in section 7(b) of
the proposed
rule. If the bank does not use a comprehensive risk model to calculate the price risk of a .
portfolio of correlation trading
positions,
it must calculate a specific risk add-on for the
p.ortfolio under section 7(c) of
the proposed rule, determined
using the standardized
measurement method for specific risk described in section 10 of the proposed rule.
A bank's comprehensive risk model must meet several requirements under the
proposed rule. The model must measure comprehensive risk (that is, all price risk)
consistent with a one-year time horizon and at a one-tail, 99.9 percent confidence level,
under the assumption of either a constant level of risk or constant positions
ent method for specific risk described in section 10 of the proposed rule.
A bank's comprehensive risk model must meet several requirements under the
proposed rule. The model must measure comprehensive risk (that is, all price risk)
consistent with a one-year time horizon and at a one-tail, 99.9 percent confidence level,
under the assumption of either a constant level of risk or constant positions. As
mentioned under the incremental risk measure discussion, while a bank has flexibility in
whether it chooses to use a constant risk or constant position assumption, the agencies
expect that the assumption will remain fairly constant once selected. The bank's
selection of a constant position assumption or a constant risk assumption must be
consistent between the bank's comprehensive risk model and its incremental risk modeL.
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Draft Dated i 2/03/20 i 0
65
Draft Dated i 2/03/20 i 0
model is an appropriate representation of comprehensive risk in light of
the historical
price variation of its correlation trading positions. The agencies win scrutinize the
positions a bank identifies as correlation trading positions and will also review whether
the correlation trading positions have sufficient market data available to support reliable
modeling of
material risks. If
there is insufficient market data to support reliable
modeling for certain positions (such as new products), the agencies may require the bank
to exclude these positions from the comprehensive risk model and, instead, require the
bank to calculate specific risk add-ons for these positions under the standardized
measurement method for specific risk. Again, the proposed rule requires a bank to
proIIptlynotify its primary federal supervisor if
the bank plans.
to extend the use of a
model that has been approved by the supervisor to an additional business line or product
type
comprehensive risk model and, instead, require the
bank to calculate specific risk add-ons for these positions under the standardized
measurement method for specific risk. Again, the proposed rule requires a bank to
proIIptlynotify its primary federal supervisor if
the bank plans.
to extend the use of a
model that has been approved by the supervisor to an additional business line or product
type.
In addition to these requirements, a bank must at least weekly apply to its
portfolio of correlation trading positions a set of specific, supervisory stress scenarios that
capture changes in default rates, recovery rates, and credit spreads; correlations of
underlying exposures; and correlations of a correlation trading position and its hedge. A
bank must retain and make available to its primary supervisor the results of
the
supervisory stress testing, including comparisons with the capital requirements generated
by the bank's comprehensive risk modeL. A bank also must promptly report to its
primary federal supervisor any instances where the stress tests indicate any material
deficiencies in the comprehensive risk modeL.
The agencies are evaluating the appropriate bases for supervisory stress scenarios
to be applied to a bank's portfolio of correlation trading positions. There are inherent
66
Draft Dated 12/03/2010
difficulties in prescribing stress scenarios that would be universally applicable and
relevant across all banks and across all products contained in banks' correlation trading
portfolios. The agencies believe a level of comparability is important for assessing the
sufficiency and appropriateness of
banks' comprehensive risk models, but also recognize
that specific scenaros may not be relevant for certain products or for certain modeling
approaches
uld be universally applicable and
relevant across all banks and across all products contained in banks' correlation trading
portfolios. The agencies believe a level of comparability is important for assessing the
sufficiency and appropriateness of
banks' comprehensive risk models, but also recognize
that specific scenaros may not be relevant for certain products or for certain modeling
approaches. The agencies are considering various options for stress scenarios, including
an approach that would involve specifying stress scenarios based on credit spread shocks
to certain
correlation trading positions (for example, single-name CDSs, CDS indexes,
index tranches), which may replicate historically observed spreads. Another approach
~wouldreqiiIrea bank
to
calibrate
its existing
valuation model to certain specified stress
, periods by ¡adjusting credit-related risk factors to reflect a given stress period. The credit~ ,
related riskfactors, as adjusted,
would then be
used to revalue the bank's correlation
trading portfolio under one or more stress scenarios.
Question 10: What are the benefits and drawbacks of
the supervisory stress
scenario requirements described above and what other specific stress scenario approaches
for the correlation trading portfolio should the agencies consider? For which products
and model types are widely applicable stress scenarios most appropriate, and for which
product and model types is a more tailored stress scenaro most appropriate? What other
stress scenario approaches could consistently reflect the risks of
the entire portfolio of
correlation trading positions?
The agencies have identified prudential challenges associated with relying solely
on banks' comprehensive risk models for determining risk-based capital requirements for
correlation trading positions. For example, a bank's ability to perform robust validation
67
te? What other
stress scenario approaches could consistently reflect the risks of
the entire portfolio of
correlation trading positions?
The agencies have identified prudential challenges associated with relying solely
on banks' comprehensive risk models for determining risk-based capital requirements for
correlation trading positions. For example, a bank's ability to perform robust validation
67
Draft Dated 12/03/2010
of its comprehensive risk model using standard backtesting methods is limited in light of
the proposed requirements for the model to measure potential
losses on correlation
trading positions due to all price risk at a one-year time horizon and high-percentile
confidence leveL. As a result, banks will need to use indirect model validation methods,
such as stress tests, scenario analysis or other methods to assess their models. The
agencies anticipate that banks' comprehensive risk model validation approaches will
evolve over time; however, to address near-term modeling challenges while still giving
consideration to sound risk management practices, the agencies are proposing à floor on
the modeled correlation trading position capital requirements in the form of a capital
surcharge as described below.
A bank approved to measure comprehensive.riskfor one or more portfolios of
correlation trading positions must calculate at least weekly a comprehensive risk
measüre. The comprehensive risk measure equals
the sum
of the output from the bank's
approved comprehensive risk model plus a surcharge on the bank's modeled correlation
trading positions. The agencies propose setting the surcharge equal to 15.0 percent of
the
total specific risk add-on that would apply to the bank's modeled correlation trading
positions under the standardized measurement method for specific risk in section 10 of
the proposed rule
m
of the output from the bank's
approved comprehensive risk model plus a surcharge on the bank's modeled correlation
trading positions. The agencies propose setting the surcharge equal to 15.0 percent of
the
total specific risk add-on that would apply to the bank's modeled correlation trading
positions under the standardized measurement method for specific risk in section 10 of
the proposed rule.
The agencies propose that banks initially be required to calculate the
comprehensive risk measure under the surcharge approach while banks and supervisors
gain experience with the bans' comprehensive risk models. Over time, with approval
from its primary federal supervisor, a bank may be permitted to use a floor approach to
calculate its comprehensive risk measure as the greater of: (1) the output from the bank's
68
Draft Dated 12/03/2010
approved comprehensive risk model; or (2) 8.0 percent of
the total specific risk add-on
that would apply to the bank's modeled correlation trading positions under the
standardized measurement method for specific risk, provided the bank has met the
comprehensive risk modeling requirements in the proposed rule for a period of at least
one year and can demonstrate the effectiveness of its comprehensive risk model through
the results of ongoing validation efforts, including robust benchmarking. Such results
may incorporate a comparison of
the banks' internal model results to those from an
alternative model for certain portfolios and other relevant data. The agencies may also
consider a benchmarking approach that uses banks' internal models to determine capital
requirements for a portfolio specified by the supervisors to allow for a relative
assessment of models across bans. A bank's primary federal superlIsor will monitor the
appropriateness of
the floor approach on an ongoing basis and may rescind its approval of.
this approach ifit detem1ines that the bank's comprehensive risk model may not
suffciently reflect the risks of
the bank's modeled correlation trading positions
tfolio specified by the supervisors to allow for a r
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