Risk-Based Capital Rules Proposed Rule on Risk-Based Capital Standards: Market Risk; Alternatives to Credit Ratings for Debt and Securitization Positions
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FDIC Financial Institution Letters › Risk-Based Capital Rules Proposed Rule on Risk-Based Capital Standards: Market Risk; Alternatives to Credit Ratings for Debt and Securitization Positions
Text
Vol. 76
Tuesday
No. 7
January 11, 2011
Part IV
Department of the Treasury
Office of the Comptoller of the Currency
12 CFR Part 3
Federal Reserve System
12 CFR Parts 208 and 225
Federal Deposit Insurance Corporation
12 CFR Part 325
Risk-Based Capital Guidelines: Market Risk; Proposed Rule
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Federal Register / Vol. 76, No. 7 / Tuesday, January 11, 2011 / Proposed Rules
DEPARTMENT OF THE TREASURY
Office 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 H and Y; Docket No. R–1401]
RIN No. 7100–AD61
FEDERAL DEPOSIT INSURANCE
CORPORATION
12 CFR Part 325
RIN 3064–AD70
Risk-Based Capital Guidelines: Market
Risk
AGENCY: Office 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 Office 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 disclosures
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 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 alternative 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 April 11, 2011.
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 of the following methods:
• Federal eRulemaking Portal—
‘‘regulations.gov’’: Go to http://www.
regulations.gov
ct 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 of the 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–2010–0003,’’ 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
‘‘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, 250 E Street, SW., Mail
Stop 2–3, Washington, DC 20219.
• Fax: (202) 874–5274.
• Hand Delivery/Courier: 250 E
Street, SW., Mail Stop 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
CC 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:
• 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–2010–
0003,’’ and click ‘‘Search.’’ Comments
will 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
will be required to present valid
government-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–1401 and
RIN No. 7100–AD61, by any of the
following methods:
• Agency Web Site: http://www.
federalreserve.gov. Follow the
instructions for submitting comments at
http://www.federalreserve.gov/
generalinfo/foia/ProposedRegs.cfm.
• Federal eRulemaking Portal: http://
www.regulations.gov
summaries using
the methods described above.
Board: You may submit comments,
identified by Docket No. R–1401 and
RIN No. 7100–AD61, by any of the
following methods:
• Agency Web Site: http://www.
federalreserve.gov. Follow the
instructions for submitting comments at
http://www.federalreserve.gov/
generalinfo/foia/ProposedRegs.cfm.
• Federal eRulemaking Portal: http://
www.regulations.gov. Follow the
instructions for submitting comments.
• E-mail: regs.comments@
federalreserve.gov. Include docket
number in the subject line of the
message.
• 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.federalreserve.gov/generalinfo/
foia/ProposedRegs.cfm as submitted,
unless modified for technical reasons.
Accordingly, your comments will not be
edited to remove any identifying or
contact information. Public comments
may also be viewed electronically or in
paper form in Room MP–500 of the
Board’s Martin Building (20th and C
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r 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
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Federal Register / Vol. 76, No. 7 / Tuesday, January 11, 2011 / Proposed Rules
1 For simplicity, and unless otherwise indicated,
the preamble to this notice of proposed rulemaking
uses the 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 committee 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, Germany, 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 Settlements Web
site at http://www.bis.org.
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
http://www.bis.org/press/p970918a.htm).
5 61 FR 47358 (September 6, 1996)
sk-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
http://www.bis.org/press/p970918a.htm).
5 61 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 part 225, Appendix E (Board), and 12
CFR part 325, Appendix C (FDIC).
Street, NW.) between 9 a.m. and 5 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://www.FDIC.
gov/regulations/laws/Federal/propose.
html.
• Mail: Robert E. Feldman, Executive
Secretary, Attention: Comments/Legal
ESS, Federal Deposit Insurance
Corporation, 550 17th Street, NW.,
Washington, DC 20429.
• Hand Delivered/Courier: The guard
station at the rear of the 550 17th Street
Building (located on F Street), on
business days between 7 a.m. and 5 p.m.
• E-mail: comments@FDIC.gov.
Instructions: Comments submitted
must include ‘‘FDIC’’ and ‘‘RIN [3064–
AD70].’’ Comments received will be
posted without change to http://www.
FDIC.gov/regulations/laws/Federal/
propose.html, including any personal
information provided.
FOR FURTHER INFORMATION CONTACT:
OCC: 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: Anna Lee Hewko, (202) 530–
6260, Assistant Director, Capital and
Regulatory Policy, or Connie Horsley,
ital 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: Anna Lee Hewko, (202) 530–
6260, Assistant Director, Capital and
Regulatory Policy, or Connie Horsley,
(202) 452–5239, Senior Supervisory
Financial Analyst, Division of Banking
Supervision and Regulation; 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
I. Introduction
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 of the 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
vation 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. 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. Standardized Specific Risk Capital
Requirement
Debt Positions
Equity Positions
Securitization Positions
11. Incremental Risk Capital Requirement
12. Comprehensive Risk Capital
Requirement
13. Disclosure Requirements
III. Regulatory Flexibility Act Analysis
IV. OCC Unfunded Mandates Reform Act of
1995 Determination
V. Paperwork Reduction Act
VI. Plain Language
I. Introduction
A. Background
The first international capital
framework for banks 1 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–10 governors in 1988. The OCC,
the Board, and the FDIC (collectively,
the agencies) 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 Int
s 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 adequacy
(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
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
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I to Trading
Activities and the Treatment of Double
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
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Federal Register / Vol. 76, No. 7 / Tuesday, January 11, 2011 / Proposed Rules
6 71 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.
7 The June 2010 revisions can be found, in their
entirety, at http://bis.org/press/p100618/annex.pdf.
8 The agencies’ advanced approaches rules are at
12 CFR part 3, Appendix C (OCC); 12 CFR part 208,
Appendix F and 12 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.
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 of loss 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 of loss that could result
from bankruptcy, insolvency, or similar proceeding.
For credit derivatives, default risk means the risk
of loss on a position that could result from the
default of the reference exposure(s)
ult risk is the risk of loss 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 of loss that could result
from bankruptcy, insolvency, or similar proceeding.
For credit derivatives, default risk means the risk
of loss on a position that could result from the
default of the reference exposure(s).
10 The primary Federal supervisor of a bank may
also permit the use of alternative techniques to
measure the market risk of de minimis exposures,
if the techniques adequately measure associated
market risk.
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 a joint notice of proposed
rulemaking (2006 proposal) in which
they proposed amendments 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
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
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 banks’ 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. In June, 2010, the BCBS
published 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. Part I.B.
of this preamble summarizes and
provides background on the current
market risk capital rule
BCBS
published 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. Part I.B.
of this preamble summarizes and
provides background on the current
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.
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) 8 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 or more of total assets, 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
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 or more of total assets, 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
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
ule
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.
A bank’s total 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
VaR-based capital requirement is based
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Federal Register / Vol. 76, No. 7 / Tuesday, January 11, 2011 / Proposed Rules
11 See section 5(c) of the agencies’ market risk
capital rules for a description of this method.
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 futures 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
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 determined under the general
risk-based capital rules.
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
qualitative and quantitative criteria. The
qualitative requirements reflect basic
components of sound market risk
management. 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 10-business-day
movement in rates or prices. Price
changes estimated using shorter time
periods must be adjusted to the 10-
business-day standard
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 10-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.
A bank 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 current market risk capital rule
imposes backtesting requirements that
must be calculated quarterly. A bank
must compare its daily VaR-based
measure for each of the preceding 250
business days to its actual daily 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
g 250
business days to its actual daily 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 I.B.5 of this preamble).
A bank subject 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 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
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 bank does not model specific
risk, it must calculate its specific risk
capital requirement, or ‘‘add-on,’’ using
a standardized method.11 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-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 of the 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
ort positions in an equity, multiplied
by a specific risk-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 of the 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. 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
foreign exchange 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
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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
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Federal Register / Vol. 76, No. 7 / Tuesday, January 11, 2011 / Proposed Rules
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 maturity 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.
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 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
60
business days 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 bank
must allocate tier 1 and tier 2 capital
equal to 8.0 percent of adjusted risk-
weighted assets, and further allocate
excess tier 1, excess tier 2, and tier 3 14
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 1 capital must equal at least 28.6
percent of the measure for market risk.
The sum of tier 2 (both allocated and
excess) and allocated tier 3 capital may
not exceed 100 percent of tier 1 capital
(both allocated and excess). Term
subordinated debt and intermediate-
term preferred stock and related surplus
included in tier 2 capital (both allocated
and excess) may not exceed 50 percent
of tier 1 capital (both allocated and
excess). 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
iate-
term preferred stock and related surplus
included in tier 2 capital (both allocated
and excess) may not exceed 50 percent
of tier 1 capital (both allocated and
excess). 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 rule;
to enhance modeling requirements in a
manner 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 10-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
ample, 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.
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
bank 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
criteria 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 bank or
to ensure safe and sound banking
practices
eshold 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
criteria 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 bank 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 of 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 bank’s risk-based capital
requirements under the rule are not
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 bank 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
ent 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 bank 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 general risk-
based capital rules or advanced
approaches rules, as appropriate, to
more appropriately reflect the risks of
the positions.
3. Modification 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
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ion 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
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Federal Register / Vol. 76, No. 7 / Tuesday, January 11, 2011 / Proposed Rules
15 See 12 CFR part 3, section 3 (OCC); 12 CFR part
208, Appendix A, section II.B and 12 CFR part 225,
Appendix A, section II.B (Board); and 12 CFR part
325, Appendix A, section II.B.3 (FDIC). The
treatment of guarantees is described in sections 33
and 34 of the advanced approaches rules.
asset or liability as ‘‘trading’’ for
purposes of U.S. Generally Accepted
Accounting Principles (GAAP) 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
trading assets and trading liabilities and
the treatment of those positions under
GAAP. 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
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 (discussed below). The agencies
encourage the sound risk management
of trading positions. Therefore, the
agencies include in the definition of a
covered position any hedges that offset
the risk of trading positions. The
agencies are concerned, 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 bank’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
hat 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 currency,
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
support 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
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. 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 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
peline’’ 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
of risk-weighted assets under the credit
risk capital rules 15 if it is used to hedge
a position that is not a covered position
(for example, a credit derivative hedge
of a loan 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.
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
er 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
government 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 primarily 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
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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
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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-party protection providers. The
credit derivative or guarantee may be collateralized
or uncollateralized.
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 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
(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 of their capital
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. 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 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)
sure 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 securitization
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.
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
ion
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.
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 positions as well as which of its
trading positions are correlation trading
positions. In determining the scope of
trading positions, the bank must
consider (i) the extent 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 of trading 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
d by senior
management. The trading strategy must
articulate the expected holding period
of, and the market risk associated with,
each portfolio of trading 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).
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 (iii) above;
(v) at least annual reassessment by
senior management 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
scenarios
;
(v) at least annual reassessment by
senior management 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
scenarios.
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
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costs, future administrative costs,
liquidity, and model risk. These new
valuation requirements reflect the
agencies’ concerns about deficiencies in
banks’ valuation of less 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 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
roposed 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. 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 part, 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 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
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 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-
art 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 models as appropriate to ensure
that they continue to meet the agencies’
standards for model approval and
employ risk measurement
methodologies that are most appropriate
for the bank’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
will 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 bank’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
s 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 bank’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 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 of model approval, how else
could the agencies address concerns
about outdated models?
Risks Reflected in Models. Under the
proposed rule, a bank must incorporate
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
out outdated models?
Risks Reflected in Models. Under the
proposed rule, a bank must incorporate
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. 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.
Control, Oversight, and Validation
Mechanisms. The proposed rule
maintains the current requirement that
a bank 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
te 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 models.
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 weaknesses.
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Validation also must include an ongoing
monitoring process that includes a
review and verification of processes and
the comparison of the bank’s model
outputs with relevant internal and
external data sources or estimation
techniques. The results of this
comparison 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 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
identifying potential
weaknesses in a bank’s models. As part
of this comparison, the bank should
investigate the source of any 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 comparison 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 upon the
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
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 robustness and
appropriateness of a bank’s stress tests
through the supervisory review process.
The proposed rule requires a bank 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 system 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
).
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 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 of the proposed rule as
discussed further below. No
adjustments are permitted to address
potential double counting among any of
these components of a bank’s measure
for market risk
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 of the proposed rule as
discussed further below. No
adjustments are permitted to address
potential double counting among any of
these components of a 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 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
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 VaR-based
measure unless the bank has obtained
prior written approval from its primary
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 bank’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 backtesting 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 unrealized gains and losses
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the
number of backtesting 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 unrealized gains and losses
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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.
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 business days’ trading losses
(excluding fees, commissions, reserves,
intra-day trading, and net interest
income) with the corresponding daily
VaR-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
backtesting.
Question 5: The agencies request
comment on any challenges banks may
face in formulating the measure of
trading loss as proposed, particularly
for smaller portfolios
me 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
backtesting.
Question 5: The agencies request
comment on 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 of
trading loss (fees, commissions,
reserves, intra-day trading, 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 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
d 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 with the 2009 revisions,
under the proposed rule, a bank must be
able to justify to the satisfaction of its
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
bank that converts its VaR-based
measure in this manner must be able to
justify the reasonableness of its
approach to the satisfaction of its
primary Federal supervisor
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
bank that converts its VaR-based
measure in this manner must be able to
justify the reasonableness of its
approach to the satisfaction of its
primary Federal supervisor. For
example, a bank 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. The bank 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
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 into account the value and
composition of a bank’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 bank’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 bank to
retain and make available to its primary
Federal supervisor, with no less than a
60 day lag, information for each
subportfolio for 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)
l; (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 banks 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
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18 See Section 2, ‘‘Definitions,’’ of the proposed
rule for a full definition of a term repo-style
transaction.
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 adequacy of the
VaR model’s ability to characterize the
whole distribution of losses, including
information on the size and number of
backtesting 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 with the proposed subportfolio
backtesting requirements described
above
on on the size and number of
backtesting 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 with 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 appropriate number of
subportfolios? Is the p-value a useful
statistic for evaluating the efficacy of a
bank’s VaR model in gauging market
risk? What, if any, other statistics should
the agencies consider and why?
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
marking-to-market and daily margin
maintenance requirements.18 While
repo-style transactions typically are
close adjuncts to trading activities,
GAAP traditionally has not permitted
companies to report them as trading
assets or trading liabilities
ided that it meets certain
requirements, including being based
solely on liquid and readily marketable
securities or cash and subject to daily
marking-to-market and daily margin
maintenance requirements.18 While
repo-style transactions typically are
close adjuncts to trading activities,
GAAP 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
counterparty 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
inherent limitations, proved inadequate
in producing capital requirements
appropriate to the level of losses
incurred at many banks during the
financial market crisis that began in
mid-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 12-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 agencies
generally expect that a bank’s stressed
VaR-based measure will be substantially
greater than its VaR-based measure
torical data from
a continuous 12-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 agencies
generally expect that a bank’s stressed
VaR-based measure will 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 updating the
period of significant financial stress
used to calculate the stressed VaR-based
measure and for monitoring the
appropriateness of the 12-month period
in light of the bank’s current portfolio.
The bank must obtain the prior approval
of its primary Federal supervisor for,
and notify its primary Federal
supervisor if the bank makes any
material 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
ecifies 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. A
bank 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
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
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
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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 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)
ion 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 whether a
position has specific 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 specific risk of one
or more portfolios of debt and equity
positions, the agencies strongly
encourage banks to develop and
implement models that integrate the
measurement of VaR 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 bank must calculate
each specific risk add-on in accordance
with the requirements of the proposed
rule. The bank must add the total
specific risk add-on for each portfolio of
positions to the bank’s measure for
market risk
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 bank must calculate
each specific risk add-on in accordance
with the requirements of the proposed
rule. The bank must add the total
specific risk add-on for each portfolio of
positions to the bank’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. 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
otional 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 bank 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.
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.
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 of transactions 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 credi
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 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 market value of each net long or
net short debt or securitization position
by an appropriate risk-weighting factor
for the position
e 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 market value 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 market risk
framework incorporated changes to the
standardized measurement method used
for calculating the specific risk add-ons
for debt positions. For example, the
‘‘government’’ 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 ‘‘government,’’
‘‘qualifying,’’ and ‘‘other’’ categories
under the market risk framework.
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TABLE 1—SPECIFIC RISK-WEIGHTING FACTORS FOR DEBT POSITIONS
Category
Illustrative external rating description
Remaining contractual maturity
Specific risk
(%) weight
factor
Government ...................
Highest investment grade to second highest in-
vestment grade (for example, AAA to AA¥).
.................................................................................
0 .00
Third highest investment grade to lowest invest-
ment grade (for example, A+ to BBB¥).
Residual term to final maturity 6 months or less ...
0 .25
Residual term to final maturity greater than 6 and
up to and including 24 months
t investment grade to second highest in-
vestment grade (for example, AAA to AA¥).
.................................................................................
0 .00
Third highest investment grade to lowest invest-
ment grade (for example, A+ to BBB¥).
Residual term to final maturity 6 months or less ...
0 .25
Residual term to final maturity greater than 6 and
up to and including 24 months.
1 .00
Residual term to final maturity exceeding 24
months.
1 .60
One category below investment grade to two cat-
egories below investment grade (for example,
BB+ to B¥).
.................................................................................
8 .00
More than two categories below investment grade
.................................................................................
12 .00
Unrated ...................................................................
.................................................................................
8 .00
Qualifying .......................
Not applicable ........................................................
Residual term to final maturity 6 months or less ...
0 .25
Residual term to final maturity greater than 6 and
up to and including 24 months.
1 .00
Residual term to final maturity exceeding 24
months.
1 .60
Other ..............................
One category below investment grade to two cat-
egories below investment grade (for example,
BB+ to B¥).
.................................................................................
8 .00
More than two categories below investment
grade, or equivalent based on a bank’s internal
ratings.
.................................................................................
12 .00
Unrated ...................................................................
................................................................................
.............................................
8 .00
More than two categories below investment
grade, or equivalent based on a bank’s internal
ratings.
.................................................................................
12 .00
Unrated ...................................................................
.................................................................................
8 .00
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 treatment was designed
to address 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. 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
Illustrative external rating description
Example
Securitization expo-
sure (that is not a
resecuritization
exposure) risk-
weighting factor
(%)
Resecuritization
exposure risk-
weighting factor
(%)
Highest investment grade rating ............................................................................
ECIFIC RISK-WEIGHTING FACTORS FOR SECURITIZATION AND RE-
SECURITIZATION POSITIONS
Illustrative external rating description
Example
Securitization expo-
sure (that is not a
resecuritization
exposure) risk-
weighting factor
(%)
Resecuritization
exposure risk-
weighting factor
(%)
Highest investment grade rating .............................................................................
AAA ....................
1.60
3.20
Second-highest investment grade rating ................................................................
AA ......................
1.60
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
Two categories below investment grade ................................................................
B .........................
100.00
100.00
Three categories or more below investment grade ................................................
CCC ...................
100.00
100.00
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B .........................
100.00
100.00
Three categories or more below investment grade ................................................
CCC ...................
100.00
100.00
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Federal Register / Vol. 76, No. 7 / Tuesday, January 11, 2011 / Proposed Rules
19 See Public Law 111–203 (July 21, 2010).
20 See section 939A of the Act.
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.
22 75 FR 52283 (August 25, 2010).
TABLE 3—SHORT-TERM CREDIT RATING SPECIFIC RISK-WEIGHTING FACTORS FOR SECURITIZATION AND RE-
SECURITIZATION POSITIONS
Illustrative external rating description
Example
Securitization expo-
sure (that is not a
resecuritization
xposure) risk-
weighting factor
(%)
Resecuritization
exposure 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
All other ratings .....................................................................................................................
N/A ......
ade rating ..............................................................................
A–2/P–2
4.00
8.00
Third-highest investment grade rating ..................................................................................
A–3/P–3
8.00
18.00
All other ratings .....................................................................................................................
N/A .......
100.00
100.00
As a result of the recent enactment in
the United States of the Dodd-Frank
Wall Street Reform and Consumer
Protection Act 19 (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.20
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 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-ons
applicable to debt and securitization
positions
e 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-ons
applicable to debt and securitization
positions. More specifically, the
‘‘government,’’ ‘‘qualifying,’’ and ‘‘other’’
categories as described in the current
market risk capital rule and associated
risk-weighting factors would continue to
apply to a bank’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 uniformity
of regulatory text across the agencies’
rules, the proposed rule includes in
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 of the 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
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
f 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
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
ANPR 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 sufficiently transparent,
unbiased, replicable, and defined to
allow banking organizations of varying
size and complexity to arrive at the
same assessment of creditworthiness for
similar exposures 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.
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-ons for
individual nth-to-default credit
derivatives, as computed therein
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-ons 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 risk position in one of the
reference 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 bank’s net position in the reference
credit exposure. Where a bank has
multiple risk positions in reference
credit exposures underlying a first-to-
default credit derivative, this offset is
allowed only for the underlying
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e pair reflects
the bank’s net position in the reference
credit exposure. Where a bank has
multiple risk positions in reference
credit exposures underlying a first-to-
default credit derivative, this offset is
allowed only for the underlying
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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–1) obligations with 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 rule retains the specific
risk add-ons 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
hting factor.
The proposed rule retains the specific
risk add-ons 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 of
2.0 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 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
fferent
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
borrower creditworthiness, in addition
to any use of third-party assessments,
and not place undue reliance on
external credit ratings.
In order to meet the proposed due
diligence requirements, a bank must be
able to demonstrate, to the satisfaction
of its primary Federal supervisor, a
comprehensive understanding of the
features of a securitization position that
would materially affect the 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) 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 o
s,
market value triggers, the performance
of organizations that service the
position, and deal-specific definitions of
default; (ii) 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 the characteristics and
performance of the exposures
underlying the securitization exposures.
On an on-going basis, but no less
frequently than quarterly, the bank must
also evaluate, review, and update as
appropriate the analysis 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 bank 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?
The a
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?
The agencies are considering
alternative methodologies to the
standardized measurement method for
determining the specific risk capital
requirement for securitization 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
capital requirement of its underlying
exposures, and the percentage of
underlying obligors common to the
securitization exposure and the index.
Question 9: What alternative non-
models-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
c
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
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(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 principal or
interest), including bankruptcy,
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 bank 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
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 a 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. The
liquidity horizon for a position may not
be less than the lower of three months
or the contractual maturity of the
position.
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 if held
in a dynamic portfolio in which hedging
can occur in response to observable
changes in credit quality
ult 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 if held
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 rapidly and with less cost
in the event of a change in credit
quality, which leads to a different
exposure to default risk over a 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 manner 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 bank must promptly notify 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
s 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 model 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 of correlation between the
default and credit migration events
across different issuers. The degree of
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 model 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 of long 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
st 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 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.
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 sufficiently liquid 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
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 bank’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
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least weekly. 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 bank 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
rial 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
portfolio 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. 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. Similarly, the
bank’s treatment of liquidity horizons
must be consistent between the bank’s
comprehensive risk model and its
incremental risk model
hat 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. Similarly, the
bank’s treatment of liquid
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