Risk-based Capital Rules Final Rule on Risk-Based Capital Standards: Market Risk

Vol. 77

Thursday,

No. 169

August 30, 2012

Part V

Department of the Treasury

Office of the Comptroller of the Currency

12 CFR Part 3

Federal Reserve System

12 CFR Parts 208 and 225

Federal Deposit Insurance Corporation

12 CFR Part 325

Risk-Based Capital Guidelines: Market Risk; Rule

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

1 For simplicity, and unless otherwise indicated,

the preamble to this final rule uses the term ‘‘bank’’

to include banks 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 and 12 CFR part 167

(OCC); 12 CFR parts 208 and 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

requirement under the internal models approach

(see http://www.bis.org/press/p970918a.htm)

is.org.

3 The agencies’ general risk-based capital rules are

at 12 CFR part 3, appendix A and 12 CFR part 167

(OCC); 12 CFR parts 208 and 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

requirement under the internal models approach

(see http://www.bis.org/press/p970918a.htm).

DEPARTMENT OF THE TREASURY

Office of the Comptroller of the

Currency

12 CFR Part 3

[Docket ID: OCC–2012–0002]

RIN 1557–AC99

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R–1401]

RIN 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: Joint final rule.

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

revising their market risk capital rules to

better capture positions for which the

market risk capital rules are appropriate;

reduce procyclicality; enhance the rules’

sensitivity to risks that are not

adequately captured under current

methodologies; and increase

transparency through enhanced

disclosures. The final rule does not

include all of the methodologies

adopted by the Basel Committee on

Banking Supervision for calculating the

standardized 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 of 2010.

Instead, the final rule includes

alternative methodologies for

calculating standardized specific risk

capital requirements for debt and

securitization positions.

DATES: The final rule is effective January

1, 2013

r 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 of 2010.

Instead, the final rule includes

alternative methodologies for

calculating standardized specific risk

capital requirements for debt and

securitization positions.

DATES: The final rule is effective January

1, 2013.

FOR FURTHER INFORMATION CONTACT:

OCC: Roger Tufts, Senior Economic

Advisor, Capital Policy Division, (202)

874–4925, or Ron Shimabukuro, Senior

Counsel, or Carl Kaminski, Senior

Attorney, Legislative and Regulatory

Activities Division, (202) 874–5090,

Office of the Comptroller of the

Currency, 250 E Street SW.,

Washington, DC 20219.

Board: Anna Lee Hewko, Assistant

Director, (202) 530–6260, Connie

Horsley, Manager, (202) 452–5239, Tom

Boemio, Manager, (202) 452–2982,

Dwight Smith, Senior Supervisory

Financial Analyst, (202) 452–2773, or

Jennifer Judge, Supervisory Financial

Analyst, (202) 452–3089, Capital and

Regulatory Policy, Division of Banking

Supervision and Regulation; or

Benjamin W. McDonough, Senior

Counsel, (202) 452–2036, or April C.

Snyder, Senior Counsel, (202) 452–

3099, Legal Division. For the hearing

impaired only, Telecommunication

Device for the Deaf (TDD), (202) 263–

4869.

FDIC: Karl Reitz, Chief, Capital

Markets Strategies Section,

kreitz@fdic.gov; Bobby R. Bean,

Associate Director, bbean@fdic.gov;

Ryan Billingsley, Chief, Capital Policy

Section, rbillingsley@fdic.gov; David

Riley, Senior Policy Analyst,

dariley@fdic.gov, Capital Markets

Branch, Division of Risk Management

Supervision, (202) 898–6888; or Mark

Handzlik, Counsel, mhandzlik@fdic.gov,

Michael Phillips, Counsel,

mphillips@fdic.gov, Greg Feder,

Counsel, gfeder@fdic.gov, or Ryan

Clougherty, Senior Attorney,

rclougherty@fdic.gov; Supervision

Branch, Legal Division, Federal Deposit

Insurance Corporation, 550 17th Street

NW., Washington, DC 20429

Capital Markets

Branch, Division of Risk Management

Supervision, (202) 898–6888; or Mark

Handzlik, Counsel, mhandzlik@fdic.gov,

Michael Phillips, Counsel,

mphillips@fdic.gov, Greg Feder,

Counsel, gfeder@fdic.gov, or Ryan

Clougherty, Senior Attorney,

rclougherty@fdic.gov; Supervision

Branch, Legal Division, Federal Deposit

Insurance Corporation, 550 17th Street

NW., Washington, DC 20429.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

II. Overview of Comments

1. Comments on the January 2011 Proposal

2. Comments on the December 2011

Amendment

III. Description of the Final Market Risk

Capital Rule

1. Scope

2. Reservation of Authority

3. 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. Modeling Standards for Specific Risk

10. Standardized Specific Risk Capital

Requirement

Debt and Securitization Positions

Treatment Under the Standardized

Measurement Method for Specific Risk

for

Modeled Correlation Trading Positions and

Non-modeled Securitization Positions

Equity Positions

Due Diligence Requirements for

Securitization Positions

11. Incremental Risk Capital Requirement

12. Comprehensive Risk Capital

Requirement

13. Disclosure Requirements

IV. Regulatory Flexibility Act Analysis

V. OCC Unfunded Mandates Reform Act of

1995 Determination

VI. Paperwork Reduction Act

VII. Plain Language

I

ng Positions and

Non-modeled Securitization Positions

Equity Positions

Due Diligence Requirements for

Securitization Positions

11. Incremental Risk Capital Requirement

12. Comprehensive Risk Capital

Requirement

13. Disclosure Requirements

IV. Regulatory Flexibility Act Analysis

V. OCC Unfunded Mandates Reform Act of

1995 Determination

VI. Paperwork Reduction Act

VII. Plain Language

I. Introduction

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 central bank 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

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

5 61 FR 47358 (September 6, 1996). In 1996, the

Office of Thrift Supervision did not implement the

market risk framework for savings associations and

savings and loan holding companies. However, also

included in today’s Federal Register, the agencies

are proposing to expand the scope of their market

risk capital rules to apply to Federal and state

savings associations as well as savings and loan

holding companies

6, 1996). In 1996, the

Office of Thrift Supervision did not implement the

market risk framework for savings associations and

savings and loan holding companies. However, also

included in today’s Federal Register, the agencies

are proposing to expand the scope of their market

risk capital rules to apply to Federal and state

savings associations as well as savings and loan

holding companies. Therefore, the market risk rule

would not apply to savings associations or savings

and loan holding companies until such times as the

agencies’ were to finalize their proposal to expand

the scope of their market risk capital rules. The

agencies’ market risk capital rules are at 12 CFR

part 3, appendix B (OCC); 12 CFR parts 208 and

225, appendix E (Board); and 12 CFR part 325,

appendix C (FDIC).

6 The June 2010 revisions can be found in their

entirety at http://bis.org/press/p100618/annex.pdf.

7 In the context of the market risk capital rules,

the specific risk-weighting factor is a scaled

measure that is similar to the ‘‘risk weights’’ used

in the general risk-based capital rules (e.g., the zero,

20 percent, 50 percent, and 100 percent risk

weights) for determining risk-weighted assets. The

measure for market risk is multiplied by 12.5 to

convert it to market risk equivalent assets, which

are then added to the denominator of the risk-based

capital ratios.

8 76 FR 1890 (January 11, 2011).

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 (Basel II), which was

intended for use by individual countries

as the basis for national consultation

and implementation. Basel II sets forth

a ‘‘three-pillar’’ framework that includes

ffective

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 (Basel II), which was

intended for use by individual countries

as the basis for national consultation

and implementation. Basel II sets forth

a ‘‘three-pillar’’ framework that includes

(1) Risk-based capital requirements for

credit risk, market risk, and operational

risk (Pillar 1); (2) supervisory review of

capital adequacy (Pillar 2); and (3)

market discipline through enhanced

public disclosures (Pillar 3).

Basel II 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) jointly published

The Application of Basel II to Trading

Activities and the Treatment of Double

Default Effects (the 2005 revisions). The

BCBS incorporated the 2005 revisions

into the June 2006 comprehensive

version of Basel II and followed its

‘‘three-pillar’’ structure. Specifically, the

Pillar 1 changes narrow the types of

positions that are subject to the market

risk framework and revise modeling

standards and procedures for

calculating minimum regulatory capital

requirements. The Pillar 2 changes

require banks to conduct internal

assessments of their capital adequacy

with respect to market risk, taking into

account the output of their internal

models, valuation adjustments, and

stress tests

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. 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.

The BCBS began work on significant

changes to the market risk framework in

2007 and developed reforms aimed at

addressing issues highlighted by the

financial crisis. These changes were

published in the BCBS’s 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 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 a

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’ existing

general VaR-based capital requirement

the 2009

revisions require banks to apply a

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’ existing

general VaR-based capital requirement.

In June 2010, the BCBS published

additional revisions to the market risk

framework including a floor on the risk-

based capital requirement for modeled

correlation trading positions (2010

revisions).6

Both the 2005 and 2009 revisions

include provisions that reference credit

ratings. The 2005 revisions also

expanded the ‘‘government’’ category of

debt positions to include all sovereign

debt and changed the standardized

specific risk-weighting factor for

sovereign debt from zero percent to a

range of zero to 12.0 percent based on

the credit rating of the obligor and the

remaining contractual maturity of the

debt position.7

The 2009 revisions include changes to

the specific risk-weighting factors for

rated and unrated securitization

positions. For rated securitization

positions, the revisions assign a specific

risk-weighting factor based on the credit

rating of a position, and whether such

rating represents a long-term credit

rating or a short-term credit rating. In

addition, the 2009 revisions provide for

the application of higher specific risk-

weighting factors to rated

resecuritization positions relative to

similarly-rated securitization exposures.

Under the 2009 revisions, unrated

securitization positions were to be

deducted from total capital, except

when the unrated position was held by

a bank that had approval and ability to

use the supervisory formula approach

(SFA) to determine the specific risk add-

on for the unrated position

g factors to rated

resecuritization positions relative to

similarly-rated securitization exposures.

Under the 2009 revisions, unrated

securitization positions were to be

deducted from total capital, except

when the unrated position was held by

a bank that had approval and ability to

use the supervisory formula approach

(SFA) to determine the specific risk add-

on for the unrated position. Finally,

under Basel III: A Global Regulatory

Framework for More Resilient Banks

and Banking Systems (Basel III),

published by the BCBS in December

2010, and revised in June 2011, certain

items, including certain securitization

positions, that had been deducted from

total capital are assigned a risk weight

of 1,250 percent.

On January 11, 2011, the agencies

issued a joint notice of proposed

rulemaking (January 2011 proposal) that

sought public comment on revisions to

the agencies’ market risk capital rules to

implement the 2005, 2009, and 2010

revisions.8 The key objectives of the

proposal were to enhance the rule’s

sensitivity to risks not adequately

captured, including default and credit

migration; enhance modeling

requirements in a manner that is

consistent with advances in risk

management since the agencies’ initial

implementation of the MRA; modify the

definition of ‘‘covered position’’ to

better capture positions for which

treatment under the rule is appropriate;

address shortcomings in the modeling of

certain risks; address procyclicality; and

increase transparency through enhanced

disclosures. The objective of enhancing

the risk sensitivity of the market risk

capital rule is particularly important

because of banks’ increased exposures

to traded credit and other structured

products, such as credit default swaps

(CDSs) and asset-backed securities, and

exposures to less liquid products.

Generally, the risks of these products

have not been fully captured by VaR

models that rely on a 10-business-day,

one-tail, 99.0 percent confidence level

soundness standard

e is particularly important

because of banks’ increased exposures

to traded credit and other structured

products, such as credit default swaps

(CDSs) and asset-backed securities, and

exposures to less liquid products.

Generally, the risks of these products

have not been fully captured by VaR

models that rely on a 10-business-day,

one-tail, 99.0 percent confidence level

soundness standard.

When publishing the January 2011

proposal, the agencies did not propose

to implement those aspects of the 2005

and 2009 revisions that rely on the use

of credit ratings due to certain

provisions of the Dodd-Frank Wall

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

9 Public Law 111–203, 124 Stat. 1376 (July 21,

2010). Section 939A(a) of the Dodd-Frank Act

provides that not later than 1 year after the date of

enactment, each Federal agency shall: (1) Review

any regulation issued by such agency that requires

the use of an assessment of the credit-worthiness of

a security or money market instrument; and (2) any

references to or requirements in such regulations

regarding credit ratings. Section 939A further

provides that each such agency ‘‘shall modify any

such regulations identified by the review under

subsection (a) to remove any reference to or

requirement of reliance on credit ratings and to

substitute in such regulations such standard of

credit-worthiness as each respective agency shall

determine as appropriate for such regulations.’’ See

15 U.S.C. 78o–7 note.

10 The consultative document is available at

http://www.bis.org/publ/bcbs219.htm.

Street Reform and Consumer Protection

Act (the Dodd-Frank Act).9 The January

2011 proposal did not include new

specific risk add-ons but included as an

interim solution the treatment under the

agencies’ current market risk capital

rules

ermine as appropriate for such regulations.’’ See

15 U.S.C. 78o–7 note.

10 The consultative document is available at

http://www.bis.org/publ/bcbs219.htm.

Street Reform and Consumer Protection

Act (the Dodd-Frank Act).9 The January

2011 proposal did not include new

specific risk add-ons but included as an

interim solution the treatment under the

agencies’ current market risk capital

rules. Subsequently, after developing

and considering alternative standards of

creditworthiness, the agencies issued in

December 2011 a joint notice of

proposed rulemaking (NPR) that

amended the January 2011 proposal

(December 2011 amendment) to include

alternative methodologies for

calculating the specific risk capital

requirements for covered debt and

securitization positions under the

market risk capital rules, consistent

with section 939A of the Dodd-Frank

Act. The agencies are now adopting a

final rule, which incorporates comments

received on both the January 2011

proposal and December 2011

amendment and includes aspects of the

BCBS’s 2005, 2009, and 2010 revisions

(collectively, the MRA revisions) to the

market risk framework.

II. Overview of Comments

The agencies received six comment

letters on the January 2011 proposal and

30 comment letters on the December

2011 amendment from banking

organizations, trade associations

representing the banking or financial

services industry, and other interested

parties. This section of the preamble

highlights commenters’ main concerns

and briefly describes how the agencies

have responded to comments received

in the final rule. A more detailed

discussion of comments on specific

provisions of the final rule is provided

in section III of this preamble.

1. Comments on the January 2011

Proposal

While commenters expressed general

support for the proposed revisions to

the agencies’ market risk capital rules,

many noted that the BCBS’s market risk

framework required further

improvement in certain areas

he final rule. A more detailed

discussion of comments on specific

provisions of the final rule is provided

in section III of this preamble.

1. Comments on the January 2011

Proposal

While commenters expressed general

support for the proposed revisions to

the agencies’ market risk capital rules,

many noted that the BCBS’s market risk

framework required further

improvement in certain areas. For

example, some commenters expressed

concern about certain duplications in

the capital requirements, such as the

requirement for both a VaR-based

measure and a stressed VaR-based

measure, because such redundancies

would result in excessive capital

requirements and distortions in risk

management. A different commenter

noted that the use of numerous risk

measures with different time horizons

and conceptual approaches may

encourage excessive risk taking.

Although commenters characterized

the conceptual overlap of certain

provisions of the January 2011 proposal

as resulting in duplicative capital

requirements, the agencies believe that

these provisions provide a prudent level

of conservatism in the market risk

capital rule.

One commenter noted that the rule’s

VaR-based measure has notable

shortcomings because it may encourage

procyclical behavior and regulatory

arbitrage. This commenter also asserted

that because marked-to-market assets

can experience significant price

volatility, the proposal’s required

capital levels may not be sufficient to

address this volatility. The agencies are

concerned about these issues but believe

that the January 2011 proposal

addressed these concerns, for example,

through the addition of a stressed VaR-

based measure

bitrage. This commenter also asserted

that because marked-to-market assets

can experience significant price

volatility, the proposal’s required

capital levels may not be sufficient to

address this volatility. The agencies are

concerned about these issues but believe

that the January 2011 proposal

addressed these concerns, for example,

through the addition of a stressed VaR-

based measure.

Commenters generally encouraged the

agencies to continue work on the

fundamental review of the market risk

framework recently published as a

consultative document through the

BCBS, and one asserted that the

agencies should wait until this work is

completed before revising the agencies’

market risk capital rules.10 While the

agencies are committed to continued

improvement of the market risk

framework, they believe that the

proposed modifications to the market

risk capital rules are necessary to

address current significant shortcomings

in banks’ measurement and

capitalization of market risk.

Commenters also expressed concern

that the January 2011 proposal differs

from the 2005 and 2009 revisions in

some respects, such as excluding from

the definition of covered position a

hedge that is not within the scope of the

bank’s hedging strategy, providing a

more restrictive definition of two-way

market, and establishing a surcharge for

correlation trading position equal to 15

percent of the specific risk capital

requirements for such positions.

Commenters expressed concern that

such differences could place U.S. banks

at a competitive disadvantage to certain

foreign banking organizations. In

response to commenters’ concerns, the

agencies have revised the definition of

two-way market and adjusted the

surcharge as discussed more fully in

sections II.3 and II.12, respectively, of

this preamble.

2

requirements for such positions.

Commenters expressed concern that

such differences could place U.S. banks

at a competitive disadvantage to certain

foreign banking organizations. In

response to commenters’ concerns, the

agencies have revised the definition of

two-way market and adjusted the

surcharge as discussed more fully in

sections II.3 and II.12, respectively, of

this preamble.

2. Comments on the December 2011

Amendment

While many commenters responding

to the December 2011 amendment

commended the agencies’ efforts to

develop viable alternatives to credit

ratings, most commenters indicated that

the amendment did not strike a

reasonable balance between accurate

measurement of risk and

implementation burden. Commenters’

general concerns with the December

2011 amendment include its overall

lack of risk sensitivity and its

complexity. The agencies have

incorporated a number of changes into

the final rule based on feedback

received from commenters, including

modifications to the approaches for

determining capital requirements for

corporate debt positions and

securitization positions proposed in the

December 2011 amendment. These

changes are intended to increase the risk

sensitivity of the approaches as well as

simplify and reduce the difficulty of

implementing the approaches.

A few commenters asserted that the

proposal exceeded the intent of the

Dodd-Frank Act because the Dodd-

Frank Act was limited to the

replacement of credit ratings and did

not include provisions that, in their

estimation, would significantly increase

capital requirements and thus

negatively affect the economy. While

the agencies acknowledge that capital

requirements may generally increase

under the final rule, the agencies also

believe that the approach provides a

prudent level of conservatism to address

factors such as modeling uncertainties

and that changes to the current rules are

necessary to address significant

shortcomings in the measurement and

capitalization of market risk

the economy. While

the agencies acknowledge that capital

requirements may generally increase

under the final rule, the agencies also

believe that the approach provides a

prudent level of conservatism to address

factors such as modeling uncertainties

and that changes to the current rules are

necessary to address significant

shortcomings in the measurement and

capitalization of market risk.

One commenter suggested that the

agencies allow banks a transition period

of at least one year to implement the

market risk capital rule after

incorporation of alternatives to credit

ratings. The agencies believe that a one-

year transition period is not necessary

for banks to implement the credit

ratings alternatives in the final rule. The

agencies have determined based on

comments and discussions with

commenters that the information

required for calculation of capital

requirements under the final rule will

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

11 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

include operational risk capital requirements), as

applicable to the bank using the market risk capital

rule.

be available to banks. Other commenters

indicated that the proposal would be

burdensome for community banks if the

agencies used the proposed approaches

to address the use of credit ratings in the

general risk-based capital rules

rules and the advanced approaches rules (that also

include operational risk capital requirements), as

applicable to the bank using the market risk capital

rule.

be available to banks. Other commenters

indicated that the proposal would be

burdensome for community banks if the

agencies used the proposed approaches

to address the use of credit ratings in the

general risk-based capital rules. The

agencies believe that it is important to

align the methodologies for calculating

specific risk-weighting factors for debt

positions and securitization positions in

the market risk capital rules with

methodologies for assigning risk weights

under the agencies’ other capital rules.

Such alignment reduces the potential

for regulatory arbitrage between rules.

The agencies are proposing similar

credit rating alternatives in the three

notices of proposed rulemaking for the

risk-based capital requirements that are

published elsewhere in today’s Federal

Register.

Several commenters requested

extensions of the comment period citing

the complexity of the December 2011

amendment and resulting difficulty of

assessing its impact in the time period

given as well as the considerable burden

faced by banks in evaluating various

regulations related to the Dodd-Frank

Act within similar time periods. The

agencies considered these requests but

believe that sufficient time was

provided between the agencies’

announcement of the proposed

amendment on December 7, 2011, and

the close of the comment period on

February 3, 2012, to allow for adequate

analysis of the proposal. The agencies

also met with a number of industry

participants during the comment period

and thereafter in order to clarify the

intent of the comments. Accordingly,

the agencies chose not to extend the

comment period on the December 2011

amendment.

III. Description of the Final Market

Risk Capital Rule

1

comment period on

February 3, 2012, to allow for adequate

analysis of the proposal. The agencies

also met with a number of industry

participants during the comment period

and thereafter in order to clarify the

intent of the comments. Accordingly,

the agencies chose not to extend the

comment period on the December 2011

amendment.

III. Description of the Final Market

Risk Capital Rule

1. Scope

The 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) 11 by requiring any bank subject to

the market risk capital rule to adjust its

risk-based capital ratios to reflect the

market risk in its trading activities. The

agencies did not propose to amend the

scope of application of the market risk

capital rule, which applies to any bank

with aggregate trading assets and trading

liabilities equal to 10 percent or more of

total assets or $1 billion or more. One

commenter stated that the $1 billion

threshold for the application of the

market risk capital rule is not a

particularly risk-sensitive means for

determining the applicability of the

rule. This commenter also expressed

concern that the proposed threshold is

too low, and recommended an

adjustment to recognize the relative risk

of exposures, calculated by offsetting

trading assets and liabilities. The

agencies believe that the current scope

of application of the market risk

requirements reasonably identifies

banks with significant levels of trading

activity and therefore have retained the

existing threshold criteria. While the

agencies are concerned about placing

undue burden on banks, the agencies

believe that the thresholds provided in

the final rule are reasonable given the

risk profile of banks identified by the

current scope of application

market risk

requirements reasonably identifies

banks with significant levels of trading

activity and therefore have retained the

existing threshold criteria. While the

agencies are concerned about placing

undue burden on banks, the agencies

believe that the thresholds provided in

the final rule are reasonable given the

risk profile of banks identified by the

current scope of application.

Consistent with the January 2011

proposal, under the final rule, the

primary federal supervisor of a bank

that does not meet the threshold criteria

would be still be able to apply the

market risk capital rule to a bank.

Conversely, the primary federal

supervisor may exclude a bank from

application of the rule if the supervisor

were to deem it necessary or appropriate

given the level of market risk of the

bank or to ensure safe and sound

banking practices.

2. Reservation of Authority

The January 2011 proposal contained

a reservation of authority that affirmed

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 that supervisor determined that

the bank’s capital requirement for

market risk under the rule was not

commensurate with the market risk of

the bank’s covered positions. In

addition, the agencies anticipated that

there may be instances when the

January 2011 proposal 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

circumstances, a bank’s primary federal

supervisor could require the bank to

assign a different risk-based capital

requirement to the covered position or

portfolio of covered positions that more

accurately reflects the risk of the

position or portfolio

covered position or portfolio of

covered positions that is not

commensurate with the risks of the

covered position or portfolio. In these

circumstances, a bank’s primary federal

supervisor could require the bank to

assign a different risk-based capital

requirement to the covered position or

portfolio of covered positions that more

accurately reflects the risk of the

position or portfolio. The January 2011

proposal also provided authority for a

bank’s primary federal supervisor to

require the bank to calculate capital

requirements for specific positions or

portfolios using either the market risk

capital rule or the credit risk capital

rules, depending on which outcome

more appropriately reflected the risks of

the positions. The agencies did not

receive any comment on the proposed

reservation of authority and have

adopted it without change in the final

rule.

3. Definition of Covered Position

The January 2011 proposal modified

the definition of a covered position to

include trading assets or 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.

The January 2011 proposal defined a

trading position 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. Therefore, the

characterization of an asset or liability

as ‘‘trading’’ for purposes of U.S.

Generally Accepted Accounting

Principles (U.S. GAAP) would not on its

own determine whether the asset or

liability is a ‘‘trading position’’ for

purposes of the January 2011 proposal.

That is, being reported as a trading asset

or trading liability on the regulatory

reporting schedules is a necessary, but

not sufficient, condition for meeting this

aspect of the covered position definition

under the January 2011 proposal

rinciples (U.S. GAAP) would not on its

own determine whether the asset or

liability is a ‘‘trading position’’ for

purposes of the January 2011 proposal.

That is, being reported as a trading asset

or trading liability on the regulatory

reporting schedules is a necessary, but

not sufficient, condition for meeting this

aspect of the covered position definition

under the January 2011 proposal. Such

a position would also need to be either

a trading position or hedge another

covered position. 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 the material risk elements of the

position in a two-way market.

One commenter was concerned that

this and other references to a two-way

market in the January 2011 proposal

could be construed to require that there

be a two-way market for every covered

position. The January 2011 proposal did

not require that there be a two-way

market for every covered position but

did use that standard for defining some

covered positions, such as certain

correlation trading positions. Rather, in

identifying its trading positions, a

bank’s policies and procedures must

take into account 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.

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ions. Rather, in

identifying its trading positions, a

bank’s policies and procedures must

take into account 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.

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

12 See Financial Accounting Standards Board

Statement 157. This statement defines fair value,

establishes a framework for measuring fair value in

U.S. GAAP and expands disclosures about fair

value measurement. The fair value hierarchy gives

the highest priority to quoted prices (unadjusted) in

active markets for identical assets or liabilities

(Level 1) and the lowest priority to unobservable

inputs (Level 3). Level 3 securities are those for

which inputs are unobservable in the market.

The January 2011 proposal defined a

two-way market as a market where there

are independent bona fide offers to buy

and sell so that a price reasonably

related to the last sales price or current

bona fide competitive bid and offer

quotations can be determined within

one day and settled at that price within

five business days. Commenters

expressed concern about the proposed

definition of a two-way market

including a requirement for settlement

within five business days because it

would automatically exclude a number

of markets where settlement periods are

longer than this time frame. In light of

commenters’ concerns, the agencies

have modified this aspect of the

definition in the final rule to require

settlement within a ‘‘relatively short

time frame conforming to trade

custom.’’

Another commenter requested

clarification regarding whether

securities held as available for sale

under U.S. GAAP may be treated as

covered positions under the rule

er than this time frame. In light of

commenters’ concerns, the agencies

have modified this aspect of the

definition in the final rule to require

settlement within a ‘‘relatively short

time frame conforming to trade

custom.’’

Another commenter requested

clarification regarding whether

securities held as available for sale

under U.S. GAAP may be treated as

covered positions under the rule. This

commenter also indicated that a narrow

reading of the definitions of trading

position and covered position could be

interpreted to require banks to move

positions between treatment under the

market risk and the credit risk capital

rules during periods of market stress. In

particular, the commenter expressed

concern about changes in capital

treatment due to changes in a bank’s

short-term trading intent or the lack of

a two-way market during periods of

market stress that might be temporary.

The commenter suggested that a bank

should be able to continue to treat a

position as a covered position if it met

the definitional requirements when the

position was established,

notwithstanding changes in markets that

led to a longer than expected time

horizon for sale or hedging.

The agencies note that under section

3 of the final rule, as under the

proposed rule, a bank must have clearly

defined policies and procedures that

determine which of its positions are

trading positions. With respect to the

frequency of movement of positions,

consistent with the requirements under

U.S. GAAP, the agencies generally

would expect re-designations of

positions as trading or non-trading to be

rare. Thus, in general, the agencies

would not expect temporary market

movements as described by the

commenter to result in re-designations.

In those limited circumstances where a

bank re-designates a covered position,

the bank should document the reasons

for such action.

Commenters suggested allowing a

bank to treat as a covered position any

hedge that is outside of the bank’s

hedging strategy

us, in general, the agencies

would not expect temporary market

movements as described by the

commenter to result in re-designations.

In those limited circumstances where a

bank re-designates a covered position,

the bank should document the reasons

for such action.

Commenters suggested allowing a

bank to treat as a covered position any

hedge that is outside of the bank’s

hedging strategy. The proposed

definition of covered position included

hedges that offset the risk of trading

positions. The agencies are concerned

that a bank could craft its hedging

strategies to recognize as covered

positions certain non-trading positions

that are more appropriately treated

under the credit risk capital rules. For

example, mortgage-backed securities

that are not held with the intent to

trade, but are hedged with interest rate

swaps, would not be covered positions.

The agencies will review a bank’s

hedging strategies to ensure that they

are not being manipulated in an

inappropriate manner. Consistent with

the concerns raised above, the agencies

continue to believe that a position that

hedges a trading position must be

within the scope of a bank’s hedging

strategy as described in the rule. Thus,

the final rule retains the treatment that

hedges outside of a bank’s hedging

strategy as described in the final rule are

not covered positions.

Other commenters sought clarification

as to whether an internal hedge

(between a banking unit and a trading

unit of the same bank) could be treated

as a covered position if it materially or

completely offset the risk of a non-

covered position or set of positions,

provided the hedge meets the definition

of a covered position. The agencies note

that internal hedges are not recognized

for regulatory capital purposes because

they are eliminated in consolidation

between a banking unit and a trading

unit of the same bank) could be treated

as a covered position if it materially or

completely offset the risk of a non-

covered position or set of positions,

provided the hedge meets the definition

of a covered position. The agencies note

that internal hedges are not recognized

for regulatory capital purposes because

they are eliminated in consolidation.

Commenters inquired as to whether

the phrase ‘‘restrictive covenants on its

tradability,’’ in the covered position

definition, applies to securities

transferable only to qualified

institutional buyers as required under

Rule 144A of the Securities Act of 1933.

The agencies do not believe an

instrument’s designation as a 144A

security in and of itself would preclude

the instrument from meeting the

definition of covered position. Another

commenter asked whether level 3

securities could be treated as covered

positions.12 The agencies note that there

is no explicit exclusion of level 3

securities from being designated as

covered positions, as long as they meet

the requirements of the covered position

definition.

One commenter requested

clarification as to whether the rule

would permit a bank to determine at the

portfolio level whether a set of positions

satisfies the definition of covered

position, provided the bank is able to

demonstrate a sufficiently robust

process for making this determination.

Another commenter found it confusing

and operationally challenging that the

definition of covered position had

requirements both at the position level,

for example, specific exclusions, and at

the portfolio level, in regard to hedging

strategies. The commenter felt that

many of the definitional requirements

are better suited to assessment at a

portfolio level based on robust policies

and procedures. The agencies require

that the covered position determination

be made at the individual position level

quirements both at the position level,

for example, specific exclusions, and at

the portfolio level, in regard to hedging

strategies. The commenter felt that

many of the definitional requirements

are better suited to assessment at a

portfolio level based on robust policies

and procedures. The agencies require

that the covered position determination

be made at the individual position level.

The requirements for policies and

procedures for identifying trading

positions, defining hedging strategies,

and management of covered positions

are requirements for application of the

market risk capital rule broadly.

The January 2011 proposal included

within the definition of a covered

position any foreign exchange or

commodity position, regardless of

whether it is a trading asset or trading

liability. With prior supervisory

approval, a bank could exclude from its

covered positions any structural

position in a foreign currency, which

was defined as a position that is not a

trading position and that is (1)

Subordinated debt, equity, or minority

interest in a consolidated subsidiary

that is denominated in a foreign

currency; (2) capital assigned to a

foreign branch that is denominated in a

foreign currency; (3) 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 (4) a position designed to hedge a

bank’s capital ratios or earnings against

the effect of adverse exchange rate

movements on (1), (2), or (3).

Also, the proposed definition of

covered position had several explicit

exclusions. It explicitly excluded any

position that, in form or substance, acts

as a liquidity facility that provides

support to asset-backed commercial

paper, as well as all intangible assets,

including servicing assets. Intangible

assets were excluded because their risks

are explicitly addressed in the credit

risk capital rules, often through a

deduction from capital

several explicit

exclusions. It explicitly excluded any

position that, in form or substance, acts

as a liquidity facility that provides

support to asset-backed commercial

paper, as well as all intangible assets,

including servicing assets. Intangible

assets were excluded because their risks

are explicitly addressed in the credit

risk capital rules, often through a

deduction from capital. The agencies

received no comment on these

exclusions and have incorporated them

into the final rule.

The definition of covered positions

also excluded any hedge of a trading

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

13 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.

position that the bank’s primary federal

supervisor determines is outside the

scope of a bank’s hedging strategy. One

commenter objected to that exclusion;

however, the agencies believe that

sound risk management should be

guided by explicit strategies subject to

appropriate oversight by bank

management and, therefore, have

retained this provision in the final rule.

Under the final rule and as proposed,

the 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 include

private equity investments, most hedge

fund investments, and other such

closely-held and non-liquid investments

that are not easily marketable

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 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

respect to such real estate holdings, the

determination of marketability and

liquidity can be difficult or even

impractical because 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 to be a covered

position. One commenter sought

clarification that indirect real estate

holdings (such as an exposure to a real

estate investment trust) could qualify as

a covered position. The agencies note

that such an indirect investment may

qualify, provided the position otherwise

meets the definition of a covered

position.

Commenters requested clarification

regarding whether hedge fund

exposures that hedge a covered position

are within the scope of a bank’s hedging

strategy qualify for inclusion in the

definition of a covered position.

Generally, hedge fund exposures are not

covered positions because they typically

are equity positions (as defined under

the final rule) that are not publicly

traded. The fact that a bank has a

hedging strategy for excluded equity

positions would not alone qualify such

positions to be treated as covered

positions under the rule.

Positions that a bank holds with the

intent to securitize include a ‘‘pipeline’’

or ‘‘warehouse’’ of loans being held for

securitization

lly

are equity positions (as defined under

the final rule) that are not publicly

traded. The fact that a bank has a

hedging strategy for excluded equity

positions would not alone qualify such

positions to be treated as covered

positions under the rule.

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 the

positions excluded from the covered

position definition have significant

constraints in terms of a bank’s ability

to liquidate them readily and value

them reliably on a daily basis.

The covered position definition also

excludes a credit derivative that a bank

recognizes as a guarantee for purposes

of calculating its risk-weighted assets

under the agencies’ credit risk capital

rules if the credit derivative 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 treatment

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

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 because only one

side of the transaction would be

reflected in that measure. Accordingly,

the final rule adopts this aspect of the

proposed definition of covered position

without change.

Under the January 2011 proposal, in

addition to commodities and foreign

exchange positions, a covered position

includes debt positions, equity

positions, and securitization positions

asure of market risk because only one

side of the transaction would be

reflected in that measure. Accordingly,

the final rule adopts this aspect of the

proposed definition of covered position

without change.

Under the January 2011 proposal, in

addition to commodities and foreign

exchange positions, a covered position

includes debt positions, equity

positions, and securitization positions.

Consistent with the January 2011

proposal, the final rule 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 final rule 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 final rule as under the

January 2011 proposal, a securitization

is defined as a transaction in which (1)

All or a portion of the credit risk of one

or more underlying exposures is

transferred to one or more third parties;

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 final rule as under the

January 2011 proposal, a securitization

is defined as a transaction in which (1)

All or a portion of the credit risk of one

or more underlying exposures is

transferred to one or more third parties;

(2) the credit risk associated with the

underlying exposures has been

separated into at least two tranches that

reflect different levels of seniority; (3)

performance of the securitization

exposures depends upon the

performance of the underlying

exposures; (4) all or substantially all of

the underlying exposures are financial

exposures (such as loans, commitments,

credit derivatives, guarantees,

receivables, asset-backed securities,

mortgage-backed securities, other debt

securities, or equity securities); (5) for

non-synthetic securitizations, the

underlying exposures are not owned by

an operating company; 13 (6) 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 (7) 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).

Under the final rule, 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

nder the final rule, 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.

Based on a particular transaction’s

leverage, risk profile, or economic

substance, a bank’s primary federal

supervisor may also deem an exposure

to a transaction to be a securitization

exposure, even if the exposure does not

meet the criteria in provisions (5), (6),

or (7) above. A securitization position is

a covered position that is (1) 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 (2) an exposure that

directly or indirectly references a

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-

balance sheet or off-balance sheet credit

exposure (including credit-enhancing

representations and warranties) that

arises from a securitization (including a

resecuritization) or (2) an exposure that

directly or indirectly references a

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

securitization exposure described in (1)

above.

Under the final rule as under the

January 2011 proposal, a securitization

position includes nth-to-default credit

derivatives and resecuritization

positions. The rule 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, a

resecuritization is defined as a

securitization in which one or more of

the underlying exposures is a

securitization exposure. A

resecuritization position is (1) an on- or

off-balance sheet exposure to a

resecuritization or (2) an exposure that

directly or indirectly references a

resecuritization exposure described in

(1).

Some commenters expressed the

desire to align the proposed definition

of securitization in the market risk

capital rule with the Basel II definition.

For instance, one commenter suggested

excluding from the definition of a

securitization exposures that do not

resemble what is customarily thought of

as a securitization. The agencies note

that the proposed definition is

consistent with the definition contained

in the agencies’ advanced approaches

rules and believe that remaining

consistent is important in order to

reduce regulatory capital arbitrage

opportunities across the rules

ing from the definition of a

securitization exposures that do not

resemble what is customarily thought of

as a securitization. The agencies note

that the proposed definition is

consistent with the definition contained

in the agencies’ advanced approaches

rules and believe that remaining

consistent is important in order to

reduce regulatory capital arbitrage

opportunities across the rules.

The January 2011 proposal and the

final rule define a correlation trading

position as (1) 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

(2) a position that is not a securitization

position and that hedges a position

described in (1) above. Under this

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 may

include collateralized debt obligation

(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. The agencies are adopting the

definition of a debt, equity,

securitization, and correlation trading

position in the final rule as proposed

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. The agencies are adopting the

definition of a debt, equity,

securitization, and correlation trading

position in the final rule as proposed.

The agencies note that certain aspects

of the final rule, including the definition

of ‘‘covered position,’’ are substantially

similar to the definitions of similar

terms used in the agencies’ proposed

rule that would implement section 619

of the Dodd-Frank Act, familiarly

referred to as the ‘‘Volcker rule.’’ The

agencies intend to promote consistency

across regulations employing similar

concepts to increase regulatory

effectiveness and reduce unnecessary

burden.

Section 619 of the Dodd-Frank Act

contains certain prohibitions and

restrictions on the ability of a bank (or

nonbank financial company supervised

by the Board under Title I of the Dodd-

Frank Act) to engage in proprietary

trading and have certain interests in, or

relationships with, a covered fund as

defined under section 619 of the Dodd-

Frank Act and applicable regulations or

private equity fund. Section 619 defines

proprietary trading to mean engaging as

a principal for the trading account, as

defined under section 619(h)(6), of a

bank (or relevant nonbank) in the

purchase or sale of securities and other

financial instruments.

In November 2011, the agencies,

together with the SEC sought comment

on an NPR that would implement

section 619 of the Dodd-Frank Act (the

Volcker NPR)

. Section 619 defines

proprietary trading to mean engaging as

a principal for the trading account, as

defined under section 619(h)(6), of a

bank (or relevant nonbank) in the

purchase or sale of securities and other

financial instruments.

In November 2011, the agencies,

together with the SEC sought comment

on an NPR that would implement

section 619 of the Dodd-Frank Act (the

Volcker NPR). The Volcker NPR

includes in the definition of ‘‘trading

account’’ all exposures of a bank subject

to the market risk capital rule that fall

within the definition of ‘‘covered

position,’’ except for certain foreign

exchange and commodity positions,

unless they otherwise are in an account

that meets the other prongs of the

Volcker NPR ‘‘trading account’’

definition. Those prongs focus on

determining whether a banking entity

subject to section 619 of the Dodd-Frank

Act is acquiring or taking a position in

securities or other covered instruments

principally for the purpose of short-term

trading. Specifically, the definition of

‘‘trading account’’ under the Volcker

NPR would include any account that is

used by a bank to acquire or take one

or more covered financial positions for

the purpose of (1) Short-term resale, (2)

benefitting from actual or expected

short-term price movements, (3)

realizing short-term arbitrage profits, or

(4) hedging one or more such positions.

These standards correspond with the

definition of ‘‘trading position’’ under

the final market risk capital rule and are

generally the type of positions to which

the proprietary trading restrictions of

section 13 of the BHC Act, which

implements section 619 of the Dodd-

Frank Act, were intended to apply

(3)

realizing short-term arbitrage profits, or

(4) hedging one or more such positions.

These standards correspond with the

definition of ‘‘trading position’’ under

the final market risk capital rule and are

generally the type of positions to which

the proprietary trading restrictions of

section 13 of the BHC Act, which

implements section 619 of the Dodd-

Frank Act, were intended to apply.

Thus, the Volcker NPR would cover all

positions of a bank that receive trading

position treatment under the final

market risk capital rule because they

meet a nearly identical standard

regarding short-term trading intent,

thereby eliminating the potential for

inconsistency or regulatory arbitrage in

which a bank might characterize a

position as ‘‘trading’’ for regulatory

capital purposes but not for purposes of

the Volcker NPR.

Covered positions generally would be

subject to the Volcker NPR unless they

are foreign exchange or commodity

positions that would not otherwise fall

into the definition of ‘‘trading account’’

under the Volcker NPR or would

otherwise be eligible for one of the

exemptions to the prohibitions under

the Volcker NPR and section 619 of the

Dodd-Frank Act.

4. Requirements for the Identification of

Trading Positions and Management of

Covered Positions

Section 3 of the January 2011

proposal introduced new requirements

for the identification of trading

positions and the management of

covered positions. These new

requirements would enhance prudent

capital management to address the

issues that arise when banks include

more credit risk-related, less liquid, and

less actively traded products in their

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

new

requirements would enhance prudent

capital management to address the

issues that arise when banks include

more credit risk-related, less liquid, and

less actively traded products in their

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.

Consistent with the January 2011

proposal, the final 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 (1) 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 (2)

possible impairments to the liquidity of

a position or its hedge.

In addition, a bank must have clearly

defined trading and hedging strategies.

The bank’s trading and hedging

strategies for its trading positions must

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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. 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)

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).

Also consistent with the January 2011

proposal, the final 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 (1) Marking positions to market

or model on a daily basis; (2) assessing

on a daily basis the bank’s ability to

hedge position and portfolio risks and

the extent of market liquidity; (3)

establishment and daily monitoring of

limits on positions by a risk control unit

independent of the trading business

unit; (4) daily monitoring by senior

management of the information

described in (1) through (3) above; (5) at

least annual reassessment by senior

management of established limits on

positions; and (6) 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 January 2011 proposal introduced

new requirements for the prudent

valuation of covered positions,

including maintaining policies and

procedures for valuation, marking

positions to market or to model,

independent price verification, and

valuation adjustments or reserves

timation in pricing models, and the

stability and accuracy of model

calibration under alternative market

scenarios.

The January 2011 proposal introduced

new requirements for the prudent

valuation of covered positions,

including maintaining policies and

procedures for valuation, marking

positions to market or to model,

independent price verification, and

valuation adjustments or reserves.

Under the proposal, a bank’s valuation

of covered positions would be required

to consider, as appropriate, unearned

credit spreads, close-out costs, early

termination costs, investing and funding

costs, future administrative costs,

liquidity, and model risk. These

valuation requirements reflect the

agencies’ concerns about deficiencies in

banks’ valuation of less liquid trading

positions, especially in light of the prior

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 proven at times to be

inadequate in reflecting the full extent

of the market risk of less liquid

positions.

Several commenters expressed

concern about including consideration

of future administrative costs in the

valuation process because they believe

calculation of this estimate would be

difficult and arbitrary and would result

in only a minor increase in total costs.

In response to commenters’ concern, the

agencies removed this requirement from

the final rule. In all other respects, the

agencies are adopting the proposed

requirements for the valuation of

covered positions.

5. General Requirements for Internal

Models

Model Approval and Ongoing Use

Requirements. The January 2011

proposal would have required a bank to

receive the prior written approval of its

primary federal supervisor before using

any internal model to calculate its

market risk capital requirement

, the

agencies are adopting the proposed

requirements for the valuation of

covered positions.

5. General Requirements for Internal

Models

Model Approval and Ongoing Use

Requirements. The January 2011

proposal would have required a bank to

receive the prior written approval of its

primary federal supervisor before using

any internal model to calculate its

market risk capital requirement. Also, a

bank would be required to 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 agencies consider these

requirements to be appropriate and are

adopting them in the final rule.

One commenter on the January 2011

proposal inquired as to whether models

used by the bank, but developed by

parties outside of the bank (commonly

referred to as vendor models), are

permissible for calculating market risk

capital requirements given approval

from the bank’s primary federal

supervisor. The agencies believe that a

vendor model may be acceptable for

purposes of calculating a bank’s risk-

based capital requirements if it

otherwise meets the requirements of the

rule and is properly understood and

implemented by the bank.

The final rule, consistent with the

January 2011 proposal, requires a bank

to notify its primary federal supervisor

promptly if it makes any change to an

internal model that would result in a

material change in the amount of risk-

weighted assets for a portfolio of

covered positions or when the bank

makes any material change to its

modeling assumptions

stood and

implemented by the bank.

The final rule, consistent with the

January 2011 proposal, requires a bank

to notify its primary federal supervisor

promptly if it makes any change to an

internal model that would result in a

material change in the 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 an 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. In the final rule, the agencies

made minor modifications to this

provision in section 3(c)(3) to improve

clarity and correct a cross-reference.

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 effective as the risks of

covered positions evolve and as the

industry develops more sophisticated

modeling techniques that better capture

material risks

ection 3(c)(3) to improve

clarity and correct a cross-reference.

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 effective as the risks of

covered positions evolve and as the

industry develops more sophisticated

modeling techniques that better capture

material risks. Therefore, under the final

rule, as under the January 2011

proposal, a bank must 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, in the bank’s

judgment, most appropriate for the

bank’s covered positions. It is essential

that a bank continually review, and as

appropriate, make adjustments to its

models to help ensure that its market

risk capital requirement reflects the risk

of the bank’s covered positions. A

bank’s primary federal supervisor will

closely review the bank’s model review

practices as a matter of safety and

soundness. The agencies are adopting

these requirements in the final rule.

Risks Reflected in Models. The final

rule requires a bank to 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 its 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

rate with the complexity

and amount of its covered positions. To

measure its 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. Consistent

with the January 2011 proposal, the

final rule requires that risks arising from

less liquid positions and positions with

limited price transparency be modeled

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

14 See Supervisory Guidance on Model Risk

Management, issued by the OCC and Federal

Reserve (April 4, 2011).

conservatively under realistic market

scenarios. The January 2011 proposal

also would require a bank to have a

rigorous process for re-estimating, re-

evaluating, and updating its models to

ensure continued applicability and

relevance. The final rule retains these

proposed requirements for internal

models.

Control, Oversight, and Validation

Mechanisms. The final rule, consistent

with the January 2011 proposal, requires

a bank to have a risk control unit that

reports directly to senior management

and that is independent of its business

trading units. In addition, the final rule

provides specific model validation

standards similar to those in the

advanced approaches rules.

Specifically, the final rule 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

on

standards similar to those in the

advanced approaches rules.

Specifically, the final rule requires a

bank to validate its internal models

initially and on an ongoing basis. The

validation process must be independent

of the internal models’ development,

implementation, and operation, or the

validation process must be subjected to

an independent review of its adequacy

and effectiveness. The review personnel

do not necessarily have to be external to

the bank in order to achieve the

required independence. A bank should

ensure that individuals who perform the

review are not biased in their

assessment due to their involvement in

the development, implementation, or

operation of the models.

Also consistent with the January 2011

proposal, the final rule requires

validation to include an evaluation of

the conceptual soundness of the internal

models. This should include an

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.

Validation also must include an

ongoing monitoring process that

includes a review of all model processes

and verification that these processes are

functioning as intended 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

dentifying

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 January

2011 proposal required 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 final rule, consistent with the

January 2011 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 large price movements,

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 adversely affecting the

market

nd 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 adversely affecting the

market. A bank’s primary federal

supervisor will evaluate the robustness

and appropriateness of any bank stress

tests required under the final rule

through the supervisory review process.

One commenter advocated an

exemption from the proposed

backtesting requirements for vendor

models, and stated that banks using the

same vendor model would be

duplicating their efforts. The agencies

believe that each bank must be

responsible for ensuring that its market

risk capital requirement reflects the

risks of its covered positions. Each bank

generally customizes some aspects of a

vendor model and has a unique trading

profile. Therefore, effective backtesting

of either a vendor-provided or

internally-developed model requires

reference to a bank’s experience with its

own positions, which is consistent with

guidance issued by the OCC and the

Board with respect to the use of internal

and third-party models.14

Consistent with the January 2011

proposal, the final 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

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). The final rule

adopts the January 2011 proposal’s

requirements pertaining to control,

oversight, and validation mechanisms.

Internal Assessment of Capital

Adequacy. The final rule, consistent

with the January 2011 proposal, requires

a bank to have a rigorous process for

assessing its overall capital adequacy in

relation to its market risk. This

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. The final rule also

adopts as proposed the requirement that

a bank 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

will facilitate the supervisory review

process as well as the bank’s internal

audit or other review procedures.

6. Capital Requirement for Market Risk

Consistent with the January 2011

proposal, the final 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

adequacy. This documentation

will facilitate the supervisory review

process as well as the bank’s internal

audit or other review procedures.

6. Capital Requirement for Market Risk

Consistent with the January 2011

proposal, the final 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. However, the agencies

are making changes to this calculation

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15 76 FR 37620 (June 28, 2011).

16 Section 171 of the Dodd-Frank Act (12 U.S.C.

5371) requires the agencies to establish

consolidated minimum risk-based capital

requirements for depository institutions, bank

holding companies, savings and loan holding

companies, and nonbank financial companies

supervised by the Board that are not less than the

capital requirements the agencies establish under

section 38 of the Federal Deposit Insurance Act to

apply to insured depository institutions, regardless

of total asset size or foreign financial exposure

(generally applicable risk-based capital

requirements). Currently, the general risk-based

capital rules (supplemented by the market risk

capital rule) are the generally applicable risk-based

capital rules for purposes of section 171 of the

Dodd-Frank Act. 12 U.S.C. 5371.

in the final rule for banks subject to the

advanced approaches rules (as amended

in June 2011 to implement certain

provisions in section 171 of the Dodd-

Frank Act).15 Under the advanced

approaches rules, a bank is required to

calculate its risk-based capital

requirements under the general risk-

based capital rules and the advanced

approaches rules for purposes of

determining compliance with minimum

regulatory capital requirements

dvanced approaches rules (as amended

in June 2011 to implement certain

provisions in section 171 of the Dodd-

Frank Act).15 Under the advanced

approaches rules, a bank is required to

calculate its risk-based capital

requirements under the general risk-

based capital rules and the advanced

approaches rules for purposes of

determining compliance with minimum

regulatory capital requirements. Thus, a

bank subject to the advanced

approaches rules is required to calculate

both a general risk-based capital ratio

denominator based on the general risk-

based capital rules and an advanced

risk-based capital ratio denominator

based on the advanced approaches

rules, each supplemented by the market

risk capital rules as appropriate.16

Consequently, a bank subject to the

advanced approaches rules and the

market risk capital rules is also required

to calculate both general adjusted risk-

weighted assets and advanced adjusted

risk-weighted assets under the market

risk capital rules as the starting point to

determine its risk-based capital ratio

denominators. The agencies have

revised the mechanics of section 4 of the

final rule to be consistent with the risk-

based capital ratio calculation

requirements under the advanced

approaches rules.

To calculate general market risk

equivalent assets, a bank must multiply

its general measure for market risk by

12.5. A bank subject to the advanced

approaches rules also must calculate its

advanced market risk equivalent assets

by multiplying its advanced measure for

market risk by 12.5. The final rule

requires a bank’s general and advanced

measures for market risk to equal the

sum of its VaR-based capital

requirement, its stressed VaR-based

capital requirement, specific risk add-

ons, incremental risk capital

requirement, comprehensive risk capital

requirement, and capital requirement

for de minimis exposures, each

calculated according to defined

applicable requirements

he final rule

requires a bank’s general and advanced

measures for market risk to equal the

sum of its VaR-based capital

requirement, its stressed VaR-based

capital requirement, specific risk add-

ons, incremental risk capital

requirement, comprehensive risk capital

requirement, and capital requirement

for de minimis exposures, each

calculated according to defined

applicable requirements. The

components of the two measures for

market risk described above are the

same except for a potential difference

stemming from the specific risk add-ons

component. This difference arises

because a bank may not use the SFA

(discussed further below) to calculate its

general measure for market risk for

securitization positions while it must

use the SFA, provided the bank has

sufficient information, to calculate its

advanced measure for market risk for

the same positions. Consistent with the

proposal, under the final rule, no

adjustments are permitted to address

potential double counting among any of

the components of a bank’s measure(s)

for market risk.

The final rule requires a bank to

include in its measure for market risk

any specific risk add-on as required

under section 7 of the rule, determined

using the standardized measurement

methods described in section 10 of the

rule. For a bank subject to the advanced

approaches rules, these standardized

measurement methods may include the

SFA for securitization positions as

discussed further below, where both the

securitization position and the bank

would meet the requirements to use the

SFA. Such a bank must use the SFA in

all instances where possible to calculate

specific risk add-ons for its

securitization positions. The agencies

expect banks to use the SFA rather than

the simplified supervisory formula

approach (SSFA) in all instances where

the data to calculate the SFA is

available. The agencies expect a bank to

apply the SFA on a consistent basis for

a given position

A. Such a bank must use the SFA in

all instances where possible to calculate

specific risk add-ons for its

securitization positions. The agencies

expect banks to use the SFA rather than

the simplified supervisory formula

approach (SSFA) in all instances where

the data to calculate the SFA is

available. The agencies expect a bank to

apply the SFA on a consistent basis for

a given position. For instance, if a bank

is able to calculate a specific risk add-

on for a securitization position using the

SFA, the agencies would expect the

bank to continue to have access to the

information needed to perform this

calculation on an ongoing basis for that

position. If the bank were to change the

methodology it used for calculating the

specific risk add-on for such a

securitization position, it should be able

to explain and justify the change in

approach (e.g., based on data

availability) to its primary federal

supervisor.

As described above, a bank subject to

the advanced approaches rules must

calculate two market risk equivalent

asset amounts: a general measure for

market risk and an advanced measure

for market risk. A bank subject to the

advanced approaches rules may not use

the SFA to calculate its general measure

for market risk, because this

methodology is not available under the

general risk-based capital rules.

The final rule requires a bank to

include in both its general measure for

market risk and its advanced measure

for market risk its capital requirement

for de minimis exposures. Specifically,

a bank must add to its general and

advanced measures 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

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.

The agencies have made conforming

changes to the proposed requirements

for a bank to calculate its risk-based

capital ratio denominator under the

final rule. With regard to a bank’s total

risk-based capital numerator, the final

rule, like the January 2011 proposal,

eliminates tier 3 capital and the

associated allocation methodologies.

As proposed, the final rule requires a

bank’s VaR-based capital requirement to

equal the greater of (1) the previous

day’s VaR-based measure, or (2) 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 rule and as

discussed further below. Similarly, the

final rule requires a bank’s stressed VaR-

based capital requirement to equal the

greater of (1) the most recent stressed

VaR-based measure; or (2) the average of

the weekly stressed 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 rule. The

multiplication factor applicable to the

stressed-VaR based measure for

purposes of this calculation is based on

the backtesting results for the bank’s

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.

Determination of the Multiplication

Factor

ding to section 4 of the rule. The

multiplication factor applicable to the

stressed-VaR based measure for

purposes of this calculation is based on

the backtesting results for the bank’s

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.

Determination of the Multiplication

Factor. Consistent with the January

2011 proposal, the final rule requires a

bank, each quarter, to compare each of

its most recent 250 business days of

trading losses (excluding fees,

commissions, reserves, net interest

income, and intraday trading) 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

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17 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 name or exposure(s). Idiosyncratic

risk is the risk of loss in the value of a position that

arises from changes in risk factors unique to that

position.

18 See section 2 of the final rule for a complete

definition of a term repo-style transaction.

are usually 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

t

arises from changes in risk factors unique to that

position.

18 See section 2 of the final rule for a complete

definition of a term repo-style transaction.

are usually 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.

The agencies sought comment on any

challenges banks may face in

formulating the proposed measure of

trading loss, particularly whether any

excluded components described above

would present difficulties and the

nature of those difficulties. Commenters

expressed concern about challenges in

calculating trading loss net of the above

excluded components, noting that many

banks only have trading gain and loss

data which includes these components.

According to commenters, because

historical data are not always available

for the components excluded from

trading losses, it would be difficult to

immediately create historical trading

gains and losses that exclude these

components. Commenters also indicated

that banks will need to make changes to

their systems to support this

requirement. Because of these concerns,

commenters requested additional time

to come into compliance with the new

requirement.

The agencies acknowledge these

implementation concerns and recognize

that banks may not be able to

immediately implement the new

backtesting requirements. Therefore, the

agencies have specified in the final rule

that banks will be allowed up to one

year after the later of either January 1,

2013, or the date on which a bank

becomes subject to the rule, to begin

backtesting as required under the final

rule. In the interim, consistent with

safety and soundness principles, a bank

subject to the rule as of January 1, 2013,

should continue to follow their current

regulatory backtesting procedures, in

accordance with its primary federal

supervisor’s expectations

either January 1,

2013, or the date on which a bank

becomes subject to the rule, to begin

backtesting as required under the final

rule. In the interim, consistent with

safety and soundness principles, a bank

subject to the rule as of January 1, 2013,

should continue to follow their current

regulatory backtesting procedures, in

accordance with its primary federal

supervisor’s expectations.

One commenter expressed concern

with the proposed backtesting

requirements. In particular, the

commenter described the frequency of

calculations required for determining

the number of exceptions as

burdensome and unnecessary. The

agencies believe that the comparison of

daily trading loss to the corresponding

daily VaR-based measure is a critical

part of a bank’s ongoing risk

management. Such comparisons

improve a bank’s ability to make prompt

adjustment to its market risk

management to address factors such as

changing market conditions and model

deficiencies. A high number of

exceptions could indicate modeling

issues and warrants an increase in

capital requirements by a higher

multiplication factor. Accordingly, the

agencies believe the multiplication

factor and associated backtesting

requirements provide appropriate

incentives for banks to regularly update

their VaR-based models and have

adopted the proposed approach for

determining the number of daily

backtesting exceptions. With the

exception of the timing consideration

discussed above for calculating daily

trading losses, the final rule retains the

proposed backtesting requirements.

7. VaR-Based Capital Requirement

Consistent with the January 2011

proposal, section 5 of the final 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

iming consideration

discussed above for calculating daily

trading losses, the final rule retains the

proposed backtesting requirements.

7. VaR-Based Capital Requirement

Consistent with the January 2011

proposal, section 5 of the final 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 rule. The rule

defines general market risk as the risk of

loss that could result from broad market

movements, such as changes in the

general level of interest rates, credit

spreads, equity prices, foreign exchange

rates, or commodity prices. Specific risk

is the risk of loss on a position that

could result from factors other than

broad market movements and includes

event and default risk as well as

idiosyncratic risk.17 Like the January

2011 proposal, the final rule also 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 final rule, a term repo-style

transaction is defined as 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 tradi

ustomer 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, U.S. 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 under the credit risk

capital rules for calculating capital

requirements for counterparty credit

risk.

As in the January 2011 proposal, the

final rule adds credit spread risk to the

list of risk categories 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 its models and justifies the

reasonableness of its process for

measuring correlations. If the VaR-based

measure does not incorporate empirical

correlations across market risk

categories, the bank must add the

separate measures from its internal

models used to calculate the VaR-based

measure to determine the bank’s

aggregate VaR-based measure. The final

rule, as proposed, requires models to

include risks arising from the nonlinear

price characteristics of option positions

or positions with embedded optionality.

Consistent with the 2009 revisions

and the proposed rule, the final rule

requires a bank to 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

from the nonlinear

price characteristics of option positions

or positions with embedded optionality.

Consistent with the 2009 revisions

and the proposed rule, the final rule

requires a bank to 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 used to

capture the risks of the actual positions

for which such proxies are used.

Quantitative Requirements for VaR-

based Measure. Like the January 2011

proposal, the final rule does not change

the existing quantitative requirements

for the daily VaR-based measure. These

include a 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

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19 Using the square root of time assumes that

daily portfolio returns are independent and

identically distributed. When this assumption is

violated, the square root of time approximation is

not appropriate.

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

distributed. When this assumption is

violated, the square root of time approximation is

not appropriate.

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.19

Consistent with the January 2011

proposal, the final 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 its risk-based capital

requirements. The bank must update its

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 to identify the

appropriate historical observation

period, the bank must either (1) 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 (2) demonstrate to its primary federal

supervisor that the method used is more

effective than that described in (1) 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 for a bank to include

these observations in its VaR-based

measure

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 for a bank to include

these observations in its VaR-based

measure.

Also consistent with the January 2011

proposal, the final 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-based model to

reflect risk factors appropriately. A

bank’s primary federal supervisor must

approve the number of significant

subportfolios the bank uses for

subportfolio backtesting. While the final

rule does not prescribe the basis for

determining significant subportfolios,

the primary federal supervisor may

consider the bank’s evaluation of factors

such as trading volume, product types

and number of distinct traded products,

business lines, and number of traders or

trading desks.

The final rule, consistent with the

January 2011 proposal, requires a bank

to retain and make available to its

primary federal supervisor, with no

more than a 60-day lag, information for

each subportfolio for each business day

over the previous two years (500

business days) that includes (1) A daily

VaR-based measure for the subportfolio

calibrated to a one-tail, 99.0 percent

confidence level; (2) 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 (3) the p-value of the

profit or loss on each day (that is, the

probability of observing a profit less

than or a loss greater than reported in

for the subportfolio

calibrated to a one-tail, 99.0 percent

confidence level; (2) 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 (3) the p-value of the

profit or loss on each day (that is, the

probability of observing a profit less

than or a loss greater than reported in

(2) above, based on the model used to

calculate the VaR-based measure

described in (1) above).

Daily information on the probability

of observing a loss greater than that

which occurred on any given 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

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 many times over a long interval

provides information about the

adequacy of the VaR model’s ability to

characterize the entire 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 does

not adequately measure risk.

The agencies solicited comment on

whether the proposed subportfolio

backtesting requirements would present

any challenges and, if so, the specific

nature of such challenges. In addition,

the agencies sought comment on how to

determine an appropriate number of

subportfolios for purposes of these

requirements. The agencies also

requested comment on whether the p-

value is a useful statistic for evaluating

the efficacy of the VaR model in gauging

market risk, as well as whether the

agencies should consider other statistics

and, if so, why

re of such challenges. In addition,

the agencies sought comment on how to

determine an appropriate number of

subportfolios for purposes of these

requirements. The agencies also

requested comment on whether the p-

value is a useful statistic for evaluating

the efficacy of the VaR model in gauging

market risk, as well as whether the

agencies should consider other statistics

and, if so, why.

Several commenters urged the

agencies to provide discretion and

flexibility in identifying significant

subportfolios. In particular, the

commenters asked the agencies to allow

banks to identify subportfolios based on

the internal management structure of

the bank. Notwithstanding these

comments, the agencies believe the final

rule, like the January 2011 proposal,

provides an appropriate level of

flexibility, as it does not prescribe a

specific basis or parameters for

determining significant subportfolios.

Some commenters urged the agencies to

be sensitive to the operational

challenges associated with meeting

subportfolio backtesting requirements

that would be caused by organizational

changes and model enhancements. The

agencies recognize the operational

challenges involved in meeting these

requirements and will consider them as

part of the ongoing evaluation of a

bank’s compliance with the backtesting

requirements. Some commenters stated

that the p-value statistic does not add

sufficient explanatory power to warrant

the calculation effort, and instead

recommended the use of ‘‘band breaks’’

to detect VaR model deficiencies.

The agencies believe that the p-value

statistic adds significant explanatory

power and will facilitate a more

appropriate evaluation of the VaR

models by both banks and supervisors.

The agencies believe that the so-called

band-break methodology generally fails

to recognize modeling deficiencies

comprehensively and view the p-value

as an improvement over this

methodology

el deficiencies.

The agencies believe that the p-value

statistic adds significant explanatory

power and will facilitate a more

appropriate evaluation of the VaR

models by both banks and supervisors.

The agencies believe that the so-called

band-break methodology generally fails

to recognize modeling deficiencies

comprehensively and view the p-value

as an improvement over this

methodology. VaR models and the

break-band methodology evaluate only

one statistic at the tail of the profit and

loss distribution while the p-values

provide information to banks and

supervisors regarding the

appropriateness of the entire profit and

loss distribution. The agencies have

thus decided to adopt the proposed

subportfolio backtesting requirements in

the final rule as proposed.

8. Stressed VaR-Based Capital

Requirement

Like the January 2011 proposal,

section 6 of the final rule requires a

bank to 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

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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

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

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, the final rule, consistent with

the January 2011 proposal, requires a

bank to 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.

One commenter pointed out that one

interpretation of the January 2011

proposal could be inconsistent with a

BCBS interpretation, which appears to

indicate that a weighting scheme should

not be used for the stressed VaR-based

measure. The final rule requires a bank

to use the same internal model for its

VaR-based measure and its stressed

VaR-based measure. In general, if a bank

chooses to use a weighting scheme for

its VaR-based measure, the agencies

expect this weighting scheme to also be

used for its stressed VaR-based measure

to

indicate that a weighting scheme should

not be used for the stressed VaR-based

measure. The final rule requires a bank

to use the same internal model for its

VaR-based measure and its stressed

VaR-based measure. In general, if a bank

chooses to use a weighting scheme for

its VaR-based measure, the agencies

expect this weighting scheme to also be

used for its stressed VaR-based measure.

Where there is not consistent use of

weighting schemes across both

measures, the bank should document

and be able to explain its approach to

its primary federal supervisor.

The final rule also 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 (1) 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 (2) 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

these policies and procedures and must

notify its primary federal supervisor if

the bank makes any material changes to

them. 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. The final

rule retains the proposed quantitative

requirements for the stressed VaR-based

measure.

9

policies and procedures and must

notify its primary federal supervisor if

the bank makes any material changes to

them. 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. The final

rule retains the proposed quantitative

requirements for the stressed VaR-based

measure.

9. Modeling Standards for Specific Risk

Consistent with the January 2011

proposal, the final rule allows a bank to

use one or more internal models to

measure the specific risk of a portfolio

of debt or equity positions with specific

risk. A bank is required to 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 final

rule. However, a bank is not permitted

to model the specific risk of

securitization positions that are not

modeled under section 9 of the rule.

This treatment addresses regulatory

arbitrage concerns 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 final rule and consistent

with the January 2011 proposal, the

internal models for specific risk are

required to 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 debt and equity positions.

Specifically, the final rule requires 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 to changes

in portfolio composition and

concentrations

o an adverse environment, and

capture all material aspects of specific

risk for debt and equity positions.

Specifically, the final rule requires 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 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.

Commenters asked for guidance or

examples regarding the types of events

captured by the definition of ‘‘event

risk.’’ In response, the agencies have

clarified the definition of event risk in

the final rule as the risk of loss on equity

or hybrid equity positions as a result of

a financial event, such as the

announcement or occurrence of a

company merger, acquisition, spin-off or

dissolution.

The January 2011 proposal required a

bank that does not have an approved

internal model that captures all material

aspects of specific risk for a particular

portfolio of debt, equity, or correlation

trading positions to use the

standardized measurement method to

calculate a specific risk add-on for that

portfolio. This requirement was

intended to provide banks with

incentive to model specific risk more

robustly. However, due to concerns

about the ability of a bank to model the

specific risk of certain securitization

positions, the January 2011 proposal

required a bank to calculate a specific

risk add-on using 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 (for

example, certain interest rate swaps)

have specific risk

tions, the January 2011 proposal

required a bank to calculate a specific

risk add-on using 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 (for

example, certain interest rate swaps)

have specific risk. Therefore, there

would be 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 January 2011 proposal

continued 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 VaR-based models for both

general market risk and specific risk. A

bank’s use of a combination of

approaches is 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. Except for the

revision to the definition of event risk

described above, the final rule retains

the proposed requirements pertaining to

modeling standards for specific risk.

10. Standardized Specific Risk Capital

Requirement

The final rule, like the January 2011

proposal, 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 all of its

securitization positions that is not

modeled under section 9 of the rule

10. Standardized Specific Risk Capital

Requirement

The final rule, like the January 2011

proposal, 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 all of its

securitization positions that is not

modeled under section 9 of the rule.

The final rule requires a bank to

calculate each specific risk add-on in

accordance with the requirements of the

final rule and add the total specific risk

add-on for each portfolio to the

applicable measure(s) for market risk.

Some commenters asserted that the

capital requirement for a given covered

position should not exceed the

maximum loss a bank could incur on

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

that position and requested that the

agencies revise the rule accordingly to

clarify this limitation. The agencies

agree with the principle of limiting a

bank’s capital requirement for a covered

position to its maximum possible loss.

For long positions, this amount is the

loss of all remaining value of the

instrument, assuming no recovery. For

short debt and securitization positions,

this amount is the loss associated with

the position becoming risk free. In some

contexts (for example, equity positions),

the maximum loss may be unbounded

and not constrain the amount of capital

to be held

to its maximum possible loss.

For long positions, this amount is the

loss of all remaining value of the

instrument, assuming no recovery. For

short debt and securitization positions,

this amount is the loss associated with

the position becoming risk free. In some

contexts (for example, equity positions),

the maximum loss may be unbounded

and not constrain the amount of capital

to be held. The agencies have clarified

in the final rule that the specific risk

add-on for an individual debt or

securitization position that represents

purchased credit protection is capped at

the current market value of the

transaction, plus the absolute value of

the present value of all remaining

payments to the protection seller under

the transaction where the sum is equal

to the value of the protection leg of the

transaction. The agencies have also

clarified in the final rule that the

specific risk add-on for an individual

debt or securitization position that

represents sold credit protection is

capped at the effective notional amount

of the credit derivative contract.

For debt, equity, and securitization

positions that are derivatives with linear

payoffs (for example, futures and equity

swaps), the final rule, consistent with

the January 2011 proposal, requires a

bank to apply a specific risk-weighting

factor that is included in the calculation

of a specific risk add-on to the market

value of the effective notional amount of

the underlying instrument or index

portfolio (except where a bank would

instead directly calculate a specific risk

add-on for the position using the SFA)

), the final rule, consistent with

the January 2011 proposal, requires a

bank to apply a specific risk-weighting

factor that is included in the calculation

of a specific risk add-on to the market

value of the effective notional amount of

the underlying instrument or index

portfolio (except where a bank would

instead directly calculate a specific risk

add-on for the position using the SFA).

For debt, equity, and securitization

positions that are derivatives with

nonlinear payoffs (for example, options,

interest rate caps, tranched positions), a

bank must risk-weight the market value

of the effective notional amount of the

underlying instrument or instruments

multiplied by the derivative’s delta (that

is, the change of the derivative’s value

relative to changes in the price of the

underlying instrument or instruments).

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. A bank may net long

and short positions (including

derivatives) in identical issues or

identical indices. A bank may also net

positions in depository receipts against

an opposite position in an identical

equity in different markets, provided

that the bank includes the costs of

conversion.

Like the January 2011 proposal, the

final rule expands the recognition of

credit derivative hedging effects for debt

and securitization positions

ding

derivatives) in identical issues or

identical indices. A bank may also net

positions in depository receipts against

an opposite position in an identical

equity in different markets, provided

that the bank includes the costs of

conversion.

Like the January 2011 proposal, the

final rule expands the recognition of

credit derivative 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 swap 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.

The agencies are clarifying in the final

rule that in cases where a total return

swap references a portfolio of positions

with different maturity dates, the total

return swap maturity date must match

the maturity date of the underlying asset

in that portfolio that has the latest

maturity date.

The January 2011 proposal also

specified that 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

described above, 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: (1) The credit risk of the position

is fully hedged by a credit default swap

(or similar instrument); (2) there is an

exact match between the reference

obligation and currency of the credit

derivative hedge and the debt or

securitization position; and (3) there is

an exact match between the maturity

date of the credit d

the transaction with the

higher specific risk add-on, provided

that: (1) The credit risk of the position

is fully hedged by a credit default swap

(or similar instrument); (2) there is an

exact match between the reference

obligation and currency of the credit

derivative hedge and the debt or

securitization position; and (3) there is

an exact match between the maturity

date of the credit derivative hedge and

the maturity date of the debt or

securitization position.

A commenter noted that credit

derivatives are traded on market

conventions based on standard maturity

dates, whereas debt or securitization

instruments may not have standard

maturity dates. In response, in the final

rule the agencies provide clarification

regarding the circumstances under

which a bank could consider a credit

derivative hedge with a standard

maturity date and the debt or

securitization position that the credit

derivative hedges to have matched

maturity dates. In particular, the

maturity date of the credit derivative

hedge must be within 30 business days

of the maturity date of the debt or

securitization position in the case of

sold credit protection. In the case of

purchased credit protection, the

maturity date of the credit derivative

hedge must be later than the maturity

date of the debt or securitization

position, but no later than the standard

maturity date for that instrument that

immediately follows the maturity date

of the debt or securitization position. In

this case, the maturity date of the credit

derivative hedge may not exceed the

maturity date of the debt or

securitization position by more than 90

calendar days.

Some commenters asked for

clarification regarding whether the 20.0

percent add-on treatment described

above would apply to a credit derivative

that fully hedges the credit risk of a debt

or securitization position, provided

there is an exact match as to the obligor

or issuer but not necessarily an exact

match as to the specific security or

obligation

ition by more than 90

calendar days.

Some commenters asked for

clarification regarding whether the 20.0

percent add-on treatment described

above would apply to a credit derivative

that fully hedges the credit risk of a debt

or securitization position, provided

there is an exact match as to the obligor

or issuer but not necessarily an exact

match as to the specific security or

obligation. The agencies note that a

credit derivative may allow delivery of

more than one reference obligation in

the event of default of an obligor. In that

case, for purposes of determining the

specific risk add-on, the criteria of an

exact match in reference obligation is

satisfied if the debt or securitization

position is included among the

deliverable obligations provided in the

credit derivative documentation.

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 a

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 higher

specific risk add-on.

With respect to calculating the

specific risk add-on for securitization

products under the standardized

measurement method of section 10 of

the January 2011 proposal, commenters

indicated that a bank should be

permitted to de-construct the

components of tranched securitization

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risk add-on for securitization

products under the standardized

measurement method of section 10 of

the January 2011 proposal, commenters

indicated that a bank should be

permitted to de-construct the

components of tranched securitization

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Federal Register / Vol. 77, No. 169 / Thursday, August 30, 2012 / Rules and Regulations

products in an index in order to give

effect to the netting of long and short

positions and hedges. Such an approach

would mean, for example, that the

exposure of various tranches that have

some common issuers in otherwise

different underlying portfolios would be

calculated on an issuer basis and net

exposure would be evaluated by

aggregating across tranches at the issuer

level. The agencies note that netting is

allowed under the final rule, consistent

with the proposal, for long and short

securitization positions in identical

issues or indices but not across

positions in different issues or indices.

Different tranches on the same

underlying issue or index also do not

qualify for netting. With regard to

offsetting treatment, the agencies note

that hedging offsets are available under

certain conditions as discussed above.

For instance, the hedge must have the

identical underlying issue or index as

the risk position and meet other criteria.

A hedge with similar but different

underlying issues or indices would not

be a sufficient match for offsetting

treatment. It is extremely unlikely that

a hedge that is a different tranche from

the securitization position would match

changes in market value, fully hedge the

credit risk, or even hedge substantially

all the market risk of the securitization

position

and meet other criteria.

A hedge with similar but different

underlying issues or indices would not

be a sufficient match for offsetting

treatment. It is extremely unlikely that

a hedge that is a different tranche from

the securitization position would match

changes in market value, fully hedge the

credit risk, or even hedge substantially

all the market risk of the securitization

position. Therefore this matching of

positions would not meet the definition

of a hedge in the final rule, which

requires a position or positions to offset

all, or substantially all, of one or more

material risk factors of another position.

A commenter indicated that the

agencies should permit banks to use a

look-through approach for untranched

indices that would allow netting at the

individual issuer level of index

positions against individual issuer

credit derivative exposures. The

agencies believe such treatment is

appropriate in this case as netting of

exposures between the individual issuer

level and the index is possible, as

changes in the market value of certain

components of an index can be matched

with individual issuer exposures.

However, matching of positions at the

individual issuer level with tranched

index positions is difficult, as it is

unlikely that changes in market value of

the tranched index would reasonably

match market value changes in tranched

index positions. Therefore, the matching

of such positions would also not meet

the definition of a hedge under the final

rule.

Another commenter suggested

specific treatments for various

permutations of cash, synthetic,

tranched, and untranched positions

with different offsetting considerations.

The agencies decided not to modify the

final rule to accommodate these

variations and believe the netting

benefits and treatment of credit

derivative hedges of debt and

securitization positions as provided for

in the final rule are consistent with the

MRA

treatments for various

permutations of cash, synthetic,

tranched, and untranched positions

with different offsetting considerations.

The agencies decided not to modify the

final rule to accommodate these

variations and believe the netting

benefits and treatment of credit

derivative hedges of debt and

securitization positions as provided for

in the final rule are consistent with the

MRA.

One commenter noted that a pay-as-

you-go CDS should receive the same full

hedge recognition as a total return swap

for purposes of determining the specific

risk add-on under the January 2011

proposal’s standardized measurement

method. While pay-as-you-go CDSs

share several characteristics with total

return swaps, the agencies do not

believe the swap payments are

sufficiently aligned with the changes in

the market value of associated debt or

securitization positions to warrant full

offsetting treatment. If a credit

derivative hedge does not have

payments that match changes in the

market value of the debt or

securitization position, then it does not

meet the criteria for no specific risk add-

on. However, this hedge still may meet

the criteria for a partial offset if it fully

hedges the credit risk of the debt or

securitization position.

Another commenter suggested

permitting banks to measure the specific

risk of non-securitization positions that

hedge securitization positions by using

internal models rather than requiring

use of the standardized measurement

method for specific risk for these hedge

positions. The commenter also

requested that the agencies clarify

whether securitization positions and

their hedges or correlation trading

positions and their hedges should be

evaluated collectively or separately with

regard to specific risk treatment under

the January 2011 proposal

models rather than requiring

use of the standardized measurement

method for specific risk for these hedge

positions. The commenter also

requested that the agencies clarify

whether securitization positions and

their hedges or correlation trading

positions and their hedges should be

evaluated collectively or separately with

regard to specific risk treatment under

the January 2011 proposal.

In the case of a non-securitization

position that hedges a securitization

position that is not a correlation trading

position, a bank is permitted to measure

the specific risk of the hedge using

either an approved internal model or the

standardized measurement method. For

the securitization position itself, a bank

is required to use the standardized

measurement method to calculate the

specific risk add-on. Thus, in this case,

the securitization position and its hedge

are not necessarily treated collectively

for purposes of measuring specific risk.

In the case of a non-securitization

position that hedges a correlation

trading position, this same treatment

applies to the extent the bank is not

using a comprehensive risk model to

measure the price risk of these

positions. However, if a bank is using a

comprehensive risk model for a

portfolio of correlation trading

positions, then the bank must use

models to measure the specific risk of

positions in that portfolio, inclusive of

any hedges. That is, the portfolio is

treated collectively when a bank is

using a comprehensive risk model. The

bank must also determine the total

specific risk add-on for all positions in

the portfolio using the standardized

measurement method for purposes of

determining the comprehensive risk

measure

use

models to measure the specific risk of

positions in that portfolio, inclusive of

any hedges. That is, the portfolio is

treated collectively when a bank is

using a comprehensive risk model. The

bank must also determine the total

specific risk add-on for all positions in

the portfolio using the standardized

measurement method for purposes of

determining the comprehensive risk

measure. The final rule clarifies that a

position that is a correlation trading

position under paragraph (2) of that

definition and that otherwise meets the

definition of a debt position or an equity

position shall be considered a debt

position or an equity position,

respectively, for purposes of section 10

of the final rule.

Another commenter suggested

permitting a bank the option of not

using a derivative’s delta to determine

the effective notional amount of a

derivative with a nonlinear payoff. The

agencies expect an institution engaged

in such derivatives activity to be able to

calculate a delta and therefore have

retained the delta calculation

requirement in the final rule. The

agencies believe this requirement

provides the appropriate factor to

convert the reference notional amount

into an effective notional amount. While

the final rule does not require

supervisory approval to use the

standardized measurement method, the

model used to generate the delta value

is subject to the model validation

requirements under the final rule.

Debt and Securitization Positions. In

the December 2011 amendment, the

agencies proposed alternative

creditworthiness standards for certain

positions, consistent with section 939A

of the Dodd-Frank Act, as described

above. In developing these alternative

standards, the agencies strove to

establish capital requirements

comparable to those published in the

2005 and 2009 revisions to ensure

international consistency and

competitive equity

2011 amendment, the

agencies proposed alternative

creditworthiness standards for certain

positions, consistent with section 939A

of the Dodd-Frank Act, as described

above. In developing these alternative

standards, the agencies strove to

establish capital requirements

comparable to those published in the

2005 and 2009 revisions to ensure

international consistency and

competitive equity. At the same time,

the agencies sought to develop

alternatives that incorporated relevant

policy considerations, including risk

sensitivity, transparency, consistency in

application, and reduced opportunity

for regulatory capital arbitrage.

The proposed alternative standards

would set specific risk-weighting factors

for various covered positions, including

positions that are exposures to sovereign

entities, depository institutions, public

sector entities (PSEs), financial and non-

financial companies, and securitization

transactions. Each proposed standard

(including alternatives to the proposed

standards that the agencies requested

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20 For more information on the OECD country risk

classification methodology, see http://www.oecd.

org/document/49/0,3343,en_2649_34169_1901105_

1_1_1_1,00.html.

21 See ‘‘Basel II,’’ paragraph 55.

comment on in the December 2011

amendment) and the final rule

provisions with respect to each

standard, are discussed in detail in this

section.

Sovereign Debt Positions. Under the

December 2011 amendment, a sovereign

debt position was defined as a direct

exposure to a sovereign entity. The

proposal defined a sovereign entity as a

central government or an agency,

department, ministry, or central bank of

a central government

ent) and the final rule

provisions with respect to each

standard, are discussed in detail in this

section.

Sovereign Debt Positions. Under the

December 2011 amendment, a sovereign

debt position was defined as a direct

exposure to a sovereign entity. The

proposal defined a sovereign entity as a

central government or an agency,

department, ministry, or central bank of

a central government. A sovereign entity

would not include commercial

enterprises owned by the central

government engaged in activities

involving trade, commerce, or profit,

which are generally conducted or

performed in the private sector. The

agencies have retained these definitions

in the final rule.

Under the December 2011

amendment, a bank would determine

specific risk-weighting factors for

sovereign debt positions based on the

Organization for Economic Co-operation

and Development (OECD) Country Risk

Classifications (CRCs).20 The OECD’s

CRCs are used for transactions covered

by the OECD arrangement on export

credits in order to provide a basis under

the arrangement for participating

countries to calculate the premium

interest rate to be charged to cover the

risk of non-repayment of export credits.

The CRC methodology was

established in 1999 and classifies

countries into categories based on the

application of two basic components (1)

the country risk assessment model

(CRAM), which is an econometric

model that produces a quantitative

assessment of country credit risk; and

ries to calculate the premium

interest rate to be charged to cover the

risk of non-repayment of export credits.

The CRC methodology was

established in 1999 and classifies

countries into categories based on the

application of two basic components (1)

the country risk assessment model

(CRAM), which is an econometric

model that produces a quantitative

assessment of country credit risk; and

(2) the qualitative assessment of the

CRAM results, which integrates political

risk and other risk factors not fully

captured by the CRAM. The two

components of the CRC methodology

are combined and result in countries

being classified into one of eight risk

categories (0–7), with countries assigned

to the 0 category having the lowest

possible risk assessment and countries

assigned to the 7 category having the

highest. The OECD regularly updates

CRCs for over 150 countries. Also, CRCs

are recognized by the BCBS as an

alternative to credit ratings.21

In the December 2011 amendment,

the agencies proposed to assign specific

risk-weighting factors to CRCs in a

manner consistent with the assignment

of risk weights to CRCs under the Basel

II standardized framework, as set forth

in table 1.

TABLE 1—MAPPING OF CRC TO RISK

WEIGHTS UNDER THE BASEL ACCORD

CRC classification

Risk weight

(in percent)

0–1 ........................................

0

2 ............................................

20

3 ............................................

50

4 to 6 ....................................

100

7 ............................................

150

No classification assigned ....

100

Similar to the 2005 revisions, the

proposed specific risk-weighting factors

for sovereign debt positions would

range from zero percent for those

assigned a CRC of 0 or 1 to 12.0 percent

for sovereign debt positions assigned a

CRC of 7. Sovereign debt positions that

are backed by the full faith and credit

of the United States are to be treated as

having a CRC of zero

ion assigned ....

100

Similar to the 2005 revisions, the

proposed specific risk-weighting factors

for sovereign debt positions would

range from zero percent for those

assigned a CRC of 0 or 1 to 12.0 percent

for sovereign debt positions assigned a

CRC of 7. Sovereign debt positions that

are backed by the full faith and credit

of the United States are to be treated as

having a CRC of zero. Also similar to the

2005 revisions, the specific risk-

weighting factor for certain sovereigns

that are deemed to be of low credit risk

based on their CRC would vary

depending on the remaining contractual

maturity of the position. The specific

risk-weighting factors for sovereign debt

positions are shown in table 2.

TABLE 2—SPECIFIC RISK-WEIGHTING FACTORS FOR SOVEREIGN DEBT POSITIONS

Specific risk-weighting factor

Percent

0–1

0 .0

Remaining contractual maturity of 6 months or less ....

0 .25

CRC of Sovereign .........................................................

2–3

Remaining contractual maturity of greater than 6 and

up to and including 24 months.

1 .0

Remaining contractual maturity exceeds 24 months ....

1 .6

4–6

8 .0

7

12 .0

No CRC .................................................................................................

8 .0

Default by the Sovereign Entity .............................................................

12 .0

Consistent with the general risk-based

capital rules, in the December 2011

amendment the agencies proposed to

permit banks to assign a sovereign debt

position a specific risk-weighting factor

that is lower than the applicable specific

risk-weighting factor in table 2 if the

position is denominated in the

sovereign entity’s currency, the bank

has at least an equivalent amount of

liabilities in that currency and the

sovereign entity allows banks under its

jurisdiction to assign the lower specific

risk-weighting factor to the same

exposure to the sovereign entity. The

agencies have included these provisions

in the final rule

-weighting factor in table 2 if the

position is denominated in the

sovereign entity’s currency, the bank

has at least an equivalent amount of

liabilities in that currency and the

sovereign entity allows banks under its

jurisdiction to assign the lower specific

risk-weighting factor to the same

exposure to the sovereign entity. The

agencies have included these provisions

in the final rule. As a supplement to the

CRC methodology, to ensure that

current sovereign defaults and sovereign

defaults in the recent past are treated

appropriately under the market risk

capital rule, the agencies proposed

applying a 12.0 percent specific risk-

weighting factor to sovere

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