BHC Supervision Manual

Table of Contents4000 Financial Analysis

Sections Subsections Title

4000.0 Financial Factors—Introduction

4010.0 Parent Only—Debt Servicing Capacity—Cash Flow

4010.0.1 Introduction and Scope of the Analysis4010.0.2 Cash Flow Statement4010.0.3 Supervisory Determination as to Adequacy of Parent

Company Cash Flow4010.0.4 Specific Guidelines for Debt Servicing Capacity4010.0.5 Sources of Funds to Make Up Shortfalls4010.0.6 Reporting the Results4010.0.7 Inspection Objectives4010.0.8 Inspection Procedures

4010.1 Leverage

4010.1.1 Acquisition Debt4010.1.2 Inspection Considerations

4010.2 Liquidity

4010.2.1 Introduction4010.2.2 Supervisory Approach to Analyzing Parent Company

Liquidity4010.2.3 Statement of Parent Company Liquidity Position4010.2.4 Analysis of Underlying Sources to Fund Debt and to

Meet Other Obligations4010.2.4.1 Interest Bearing Deposits with Subsidiary Banks4010.2.5 Advances to Subsidiaries4010.2.6 Liquidity and Liabilities of the Parent4010.2.7 Analyzing Funding Mismatches4010.2.8 Reporting the Results of the Analysis4010.2.9 Inspection Objectives4010.2.10 Inspection Procedures

4020.0 Banks

4020.1 Capital—Banks

4020.2 Asset Quality—Banks

4020.3 Earnings—Banks

4020.4 Liquidity—Banks

4020.4.1 Sound Liquidity-Risk Management4020.4.2 Liquidity-Risk Management Using the Federal Reserve’s

Primary Credit Program4020.4.3 Analysis of Liquidity

4020.5 Summary Analysis—Banks

BHC Supervision Manual January 2007Page 1


4020.6–4020.8

Reserved

4020.9 Supervision Standards for De Novo State MemberBanks of Bank Holding Companies

4020.9.1 Definition and Scope of the De Novo BankSupervision Policy

4020.9.2 Capital Standards for BHCs’ Subsidiary Banks4020.9.3 Cash Flows to a BHC Parent

4030.0 Nonbanks

4030.0.1 Introduction4030.0.2 Analysis of Financial Condition and Risk Assessment

4030.1 Classifications—Nonbanks: Credit Extending

4030.2 Earnings—Nonbanks: Credit Extending

4030.3 Leverage—Nonbanks: Credit Extending

4030.4 Reserves—Nonbanks: Credit Extending

4040.0 Nonbanks: Noncredit Extending

4040.0.1 Earnings4040.0.2 Risk Exposure

4050.0 Nonbanks: Noncredit Extending (Service Charters)

4060.0 Consolidated—Earnings

4060.1 Consolidated—Asset Quality

4060.2 Reserved

4060.3 Consolidated Capital—Examiners’ Guidelinesfor Assessing the Capital Adequacy of BHCs

4060.3.1 Introduction to Examiner Guidelines for Risk-BasedCapital

4060.3.2 Overview of Risk-Based Capital Guidelines4060.3.2.1 Definition of Capital4060.3.2.1.1 Tier 1 Capital4060.3.2.1.2 Tier 2 Capital4060.3.2.1.3 Deductions from Tier 1 and Tier 2 Capital4060.3.2.2 Procedures for Risk-Weighting of On- and

Off-Balance-Sheet Items4060.3.2.2.1 Risk Categories4060.3.2.2.2 Application of the Risk Weights4060.3.3 Implementation

Table of Contents 4000 Financial Analysis



4060.3.4 Documentation4060.3.5 Supervisory Considerations for Calculating

and Evaluating Risk-Based Capital4060.3.5.1 Investments in and Advances to Unconsolidated

Banking and Finance Subsidiaries and OtherSubsidiaries

4060.3.5.1.1 Review and Monitoring of Intangible Assets4060.3.5.1.2 Reciprocal Holdings of Banking Organizations’

Capital Instruments4060.3.5.1.3 Limit on Deferred Tax Assets4060.3.5.1.4 Nonfinancial Equity Investments4060.3.5.1.5 Revaluation Reserves4060.3.5.2 Certain Balance-Sheet-Activity Considerations4060.3.5.2.1 Investment in Shares of a Mutual Fund4060.3.5.2.2 Loans Secured by First Liens on One- to Four-Family

Residential Properties or Multifamily ResidentialProperties

4060.3.5.3 Certain Off-Balance-Sheet-Activity Considerations4060.3.5.3.1 Assets Sold with Recourse4060.3.5.3.2 Definitions4060.3.5.3.3 Recourse Obligations, Direct-Credit Substitutes, Residual

Interests, and Asset- and Mortgage-Backed Securities4060.3.5.3.4 Ratings-Based Approach—Externally Rated Positions4060.3.5.3.5 Residual Interests4060.3.5.3.6 Other Unrated Positions4060.3.5.3.7 Limitations on Risk-Based Capital Requirements4060.3.5.3.8 Risk-Based Capital Treatment of Certain Other Types

of Off-Balance-Sheet Items and Transactions4060.3.5.3.9 Small-Business Loans and Leases on Personal

Property Transferred with Recourse (FAS 140 Sales)4060.3.5.3.10 Securities Lent4060.3.5.3.11 Commitments4060.3.5.3.12 Asset-Backed Commercial Paper Program Assets4060.3.5.3.13 Derivative Contracts (Interest-Rate, Exchange-Rate,

and Commodity- (Including Precious Metals) andEquity-Linked Contracts)

4060.3.5.3.14 Treatment of Commodity and Equity Contracts4060.3.5.3.15 Netting of Swaps and Similar Contracts4060.3.5.3.16 Financial Standby Letters of Credit and Performance

Standby Letters of Credit4060.3.5.3.17 Credit Derivatives4060.3.5.3.18 Credit Derivatives Used to Synthetically

Replicate Collateralized Loan Obligations4060.3.5.3.19 Reservation of Authority4060.3.5.3.20 Board Exceptions (Reservation of Authority) for

Securities Lending4060.3.5.3.21 Board Exception (Reservation of Authority) for Regulation

T Margin Debits—Regulation T Margin Loans4060.3.5.4 Considerations in the Overall Assessment of Capital

Adequacy4060.3.5.4.1 Unrealized Asset Values4060.3.5.4.2 Ineligible Collateral and Guarantees




4060.3.5.4.3 Overall Asset Quality4060.3.5.4.4 Interest-Only Strips and Principal-Only Strips4060.3.5.4.5 Interest-Rate Risk4060.3.5.4.6 Claims on, and Claims Guaranteed by, OECD Central

Governments4060.3.5.4.7 Accounting for Defined Benefit Pension and Other

Postretirement Plans4060.3.6 Difference in Application of the Risk-Based Capital

Guidelines to Banking Organizations4060.3.6.1 Difference in Treatment of Perpetual Preferred Stock4060.3.6.2 Perpetual Preferred Stock4060.3.7 Cash Redemption of Perpetual Preferred Stock4060.3.7.1 Federal Reserve’s Supervisory Position on

Cash Redemption of Tier 1 Preferred Stock4060.3.8 Common Stock Repurchases and Dividend Increases

on Common Stock4060.3.9 Qualifying Mandatory Convertible Debt Securities

and Perpetual Debt4060.3.9.1 Trust Preferred Securities Mandatorily Convertible into

Noncumulative Perpetual Preferred Securities4060.3.10 Inspection Objectives4060.3.11 Inspection Procedures4060.3.11.1 Verification of the Risk-Based Capital Ratio4060.3.11.2 Verification of the Tier 1 Leverage Ratio4060.3.11.3 Overall Assessment of Capital Adequacy4060.3.12 Laws, Regulations, Interpretations, and Orders

4060.4 Consolidated Capital—Tier One Leverage Measure

4060.4.1 Capital Adequacy Guidelines for Bank HoldingCompanies: Tier 1 Leverage Measure

4060.4.1.1 Overview of the Tier 1 Leverage Measure for BankHolding Companies

4060.4.1.2 Tier 1 Leverage Ratio for BHCs

4060.5 Capital Adequacy—Advanced Approaches

4060.5.1 Advanced Measurement Approaches InteragencyGuidance for Operational Risk

4060.5.2 Establishment of a Risk-Based Capital Floor

4060.6−4060.7

Reserved

4060.8 Consolidated Risk-Based Capital—Direct-CreditSubstitutes Extended to ABCP Programs

4060.8.1 Assessment of Internal Rating Systems4060.8.2 Inspection Objectives4060.8.2.1 Internal Risk-Rating System4060.8.2.2 Internal Risk-Rating System for ABCP Securitization

Exposures4060.8.2.3 Internally Rated Exposures




4060.8.2.4 Monitoring of ABCP Programs by Rating Agencies4060.8.2.5 Underwriting Standards and Management Oversight4060.8.2.6 Internal Rating Consistency with Ratings Issued by the

Rating Agencies4060.8.2.7 First-Loss Position for Program-Wide Credit Enhancement4060.8.2.8 Concentrations of Non-Investment-Grade Seller/Servicers4060.8.2.9 Underlying Assets of the ABCP Program Structured to

Investment-Grade Risk4060.8.3 Decision Tree4060.8.4 Inspection Procedures4060.8.4.1 Organizing the Inspection Process4060.8.4.2 Step One—Acceptable Internal Risk-Rating Systems4060.8.4.3 Step Two—Use of an Established Internal Risk-Rating

System Tailored to ABCP Securitization Exposures4060.8.4.4 Step Three—Relevant Internally Rated Exposures4060.8.4.5 Step Four—ABCP Program Monitored by Rating Agencies4060.8.4.6 Step Five—Sufficient Underwriting Standards and

Management Oversight4060.8.4.7 Step Six—Consistency of Internal Ratings of ABCP

Program’s Exposures with Ratings Issued by theRating Agencies

4060.8.4.8 Determine Adequacy of Internal Ratings Systems4060.8.4.9 Step Seven—Determination of Whether the Program-Wide

Credit Enhancements Are in the First-Loss Position4060.8.4.10 Step Eight—Risk Levels Posed by Concentrations of

Non-Investment Grade Seller/Servicers4060.8.4.11 Step Nine—The Portion of Underlying Assets of the ABCP

Program Structured to Investment-Grade Risk4060.8.5 Internal Control Questionnaire4060.8.6 Appendix A—Overview of ABCP Programs4060.8.7 Appendix B—Credit-Approval Memorandum

4060.9 Consolidated Capital Planning Processes—Payment ofDividends, Stock Redemptions, and Stock Repurchasesat Bank Holding Companies

4060.9.1 Review of Capital Adequacy Management4060.9.1.1 Dividends in Cash or Other Value4060.9.1.2 Stock Redemptions and Repurchases4060.9.2 Inspection Objectives4060.9.3 Inspection Procedures4060.9.4 Laws, Regulations, Interpretations, Orders

4061.0 Consolidated Capital (Capital Planning)

4061.0.1 Capital Positions of Bank Holding Companies4061.0.2 Board of Director Responsibilities4061.0.2.1 Annual Capital Planning Requirement4061.0.2.2 Mandatory Elements of a Capital Plan4061.0.2.3 Net Capital Distribution Limitation4061.0.2.4 Data Collection

4062.0 Reserved


BHC Supervision Manual July 2016Page 5


4063.0 Federal Reserve Supervisory Assessment of CapitalPlanning and Positions for LISCC Firms and Largeand Complex Firms

4063.0.1 Federal Reserve Guidance on Supervisory Assessmentof Capital Planning and Positions for LISCC Firms andLarge and Complex Firms

4064.0 Reserved

4065.0 Federal Reserve Supervisory Assessment of CapitalPlanning and Positions for Large and Noncomplex Firms

4065.0.1 Federal Reserve Guidance on Supervisory Assessment ofCapital Planning and Positions for Large andNoncomplex Firms

4066.0 Consolidated—Funding and Liquidity Risk Management

4066.0.1 Appendix A—Interagency Policy Statement on Fundingand Liquidity Risk Management

4066.0.2 Appendix B—Interagency Guidance on Funds TransferPricing Related to Funding and ContingentLiquidity Risks

4069.0 Dodd-Frank Act Company-Run Stress Testing for BankingOrganizations with Total Consolidated Assets of$10–50 Billion

4069.1.1 Dodd-Frank Act Stress Test Timelines4069.1.2 Scenarios for Dodd-Frank Act Stress Tests4069.1.3 Dodd-Frank Act Stress Test Methodologies and Practices4069.1.4 Estimating the Potential Impact on Regulatory Capital

Levels and Capital Ratios4069.1.5 Controls, Oversight, and Documentation4069.1.6 Report to Supervisors4069.1.7 Public Disclosure of Dodd-Frank Act Test Results

4070.0 BHC Rating System

4070.0.1 The Bank Holding Company RFI/C(D) Rating System4070.0.2 Description of the Rating-System Elements4070.0.2.1 The Composite (C) Rating4070.0.2.2 The Risk-Management (R) Component4070.0.2.2.1 Risk-Management Subcomponents4070.0.2.3 The Financial-Condition (F) Component4070.0.2.3.1 Financial-Condition Subcomponents (CAEL)4070.0.2.4 The Impact (I) Component4070.0.2.4.1 Risk-Management Factors4070.0.2.4.2 Financial Factors4070.0.2.5 The Depository Institutions (D) Component4070.0.3 Implementation of the BHC Rating System by BHC Type4070.0.3.1 Noncomplex BHCs with Assets of $1 Billion or Less

(Shell Holding Companies)4070.0.3.2 Noncomplex BHCs with Assets Greater Than $1 Billion




4070.0.3.2.1 One-Bank Holding Companies4070.0.3.2.2 Multibank Holding Companies4070.0.3.3 Complex BHCs4070.0.3.4 Nontraditional BHCs4070.0.4 Rating Definitions for the RFI/C(D) Rating System4070.0.4.1 Composite Rating4070.0.4.2 Risk-Management Component4070.0.4.2.1 Risk-Management Subcomponents4070.0.4.3 Financial-Condition Component4070.0.4.3.1 The Financial-Condition Subcomponents4070.0.4.4 Impact Component4070.0.4.5 Depository Institutions Component

4070.1 Rating the Adequacy of Risk-Management Processesand Internal Controls of Bank Holding Companies

4070.1.1 Elements of Risk Measurement4070.1.1.1 Active Board and Senior Management Oversight4070.1.1.2 Adequate Policies, Procedures, and Limits4070.1.1.3 Adequate Risk Monitoring and Management

Information Systems4070.1.1.4 Adequate Internal Controls4070.1.2 Rating Definitions4070.1.3 Reporting Conclusions

4070.2 Reserved

4070.3 Revising Supervisory Ratings

4070.4 Reserved

4070.5 Nondisclosure of Supervisory Ratings

4070.5.1 Limited Disclosure of Confidential Composite andComponent Ratings in Inspections and Examinations

4070.5.2 Interagency Advisory on the Confidentiality of theSupervisory Rating and Other NonpublicSupervisory Information

4070.5.3 Confidentiality Provisions in Third-Party Agreements

4071.0 Supervisory Guidance for Assessing Risk Management atSupervised Institutions with Total Consolidated AssetsLess than $50 Billion

4071.0.1 Elements of Risk Management

4071.0.1.1 Board and Senior Management Oversight

4071.0.1.2 Policies, Procedures, and Limits

4071.0.1.3 Risk Monitoring and Management Information Systems

4071.0.1.4 Internal Controls

4070.0.1.5 Conclusions




4080.0 Federal Reserve System BHC Surveillance Program

4080.0.1 Outlier List4080.0.2 Watch List4080.0.3 HC Monitoring Screen4080.0.4 Intercompany Transactions Exception List4080.0.5 The Surveillance Program’s BHC Performance Report4080.0.6 Role in Inspection Process

4080.1 Surveillance Program for Small Holding Companies

4090.0 Country Risk

4090.0.05 Definition, Composition, and Exposures of Country Riskand Evaluating the Adequacy of Country-RiskManagement

4090.0.1 Country Risks and Factors4090.0.1.1 Macroeconomic Factors4090.0.1.2 Social, Political, and Legal Climate4090.0.1.3 Factors Specific to Banking Organizations4090.0.2 Risk-Management Process for Country Risk4090.0.2.1 Oversight by the Board of Directors4090.0.2.2 Policies and Procedures for Managing Country Risk4090.0.2.3 Country-Exposure Reporting System4090.0.2.4 Country-Risk Analysis Process4090.0.2.5 Country-Risk Ratings4090.0.2.6 Country-Exposure Limits4090.0.2.7 Monitoring Country Conditions4090.0.2.8 Stress Testing4090.0.2.9 Internal Controls and Audit4090.0.3 Reporting Requirements4090.0.3.1 Country Exposure Report (FFIEC 009)4090.0.3.2 Country Exposure Information Report (FFIEC 009a)4090.0.3.3 Country Exposure Report for U.S. Branches and Agencies

of Foreign Banks (FFIEC 019)4090.0.4 Inspection Objectives4090.0.5 Inspection Procedures



Financial Factors (Introduction)Section 4000.0

The analysis of financial factors should be con-ducted in four primary parts, namely: (1) parentonly, (2) banking subsidiary(ies), (3) nonbanksubsidiary(ies), and (4) consolidated organiza-tion. In view of the fact that all BHCs are notstructured in the same organizational and finan-cial manner, it is important that examiners beflexible in their approach and be judicious intheir use of ratio analysis and peer group com-parisons. There is no substitute for using soundjudgment and creativity while performing ananalysis, providing all of the pertinent informa-tion is available. The summary and conclusionsshould follow from the information presented inthe analysis.The analysis is intended to determine the

financial strengths and weaknesses of an organi-zation and the impact of conditions at the parentcompany and nonbank subsidiary which couldadversely affect the condition of the bankingsubsidiary. As a regulatory agency, a goal of theFederal Reserve System is to safeguard andprotect the soundness of commercial banks. TheSystem oversees holding company banking and

nonbanking activities to assure the continuedsafety and soundness of individual banks andthe industry as a whole.The analysis of financial factors resulting

from the inspection of a bank holding companyis essentially a finding of facts and an expres-sion of judgment. In conducting an appraisal ofa holding company’s condition, the financialanalysis of the organization, based on a ‘‘build-ing block’’ or ‘‘component’’ approach, shouldprovide the examiner with a solid foundationfrom which to proceed. In order to complete theanalysis it is first necessary to accumulate suffi-cient information concerning the parent com-pany, bank and nonbanking subsidiary(ies) andthe consolidated organization. A final analysisshould not be attempted until these integral partshave been thoroughly reviewed.The completion of the financial analysis will

culminate with the preparation of a rating forthe bank holding company. Manual section4070.0, entitled ‘‘Bank Holding Company Rat-ing System,’’ presents the rating system in itsentirety.

BHC Supervision Manual December 1992Page 1

Parent Only(Debt Servicing Capacity—Cash Flow) Section 4010.0

4010.0.1 INTRODUCTION ANDSCOPE OF THE ANALYSIS

The cash flow analysis isapplicable to all bankholding companies with consolidated assets inexcess of $1 billion, those that have substantivefixed charges or debt outstanding,as well asselect others at the option of the Reserve Bank.Key parts of the analysis involve the use of:1. A standardized ‘‘Cash Flow Statement

(Parent)’’ page (refer to manual sections 5010.23and 5020.13 for the illustrated pages) whichincludes computation of the cash earnings cov-erage ratios and analyses; regarding the results;2. Earnings cash flow coverage ratios to mea-

sure the parent company’s ability:a. To pay its fixed charges, including inter-

est costs, lease expense, income taxes, retire-ment of long-term debt (including sinking fundprovisions), and preferred stock cash dividends,and

b. To pay common stock cash dividends.3. Guidelines for supervisory determination

of parent company debt servicing capacity.The cash flow statement page of the inspec-

tion report presents the cash earnings and thecash expenditures of the parent company. Withinthe statement are the key components to be usedin the ‘‘Fixed Charge Coverage Ratio,’’ whichmeasures the parent company’s ability to meetits fixed obligations, and a ‘‘Common StockCash Dividend Coverage Ratio’’ which mea-sures the ability of the remaining, or residual,earnings to cover common stock dividends.

4010.0.2 CASH FLOW STATEMENT

The cash flow statement is an effective tool usedin understanding how a particular bank holdingcompany operates. Its primary objective is tosummarize the financing and investing activitiesof the holding company, including the extent towhich the entity has generated funds (externallyand internally) during the period. The cash flowstatement is related to both the income state-ment and the balance sheet and provides infor-mation that otherwise can be obtained only par-tially by interpreting each of those statements.An analysis of past cash flow statements can

supply important information regarding the usesof funds, such as internal asset growth or acqui-sitions, as well as data on the sources of fundsused and the financing needs of management. A

projected cash flow statement will focus on theneed for future funds, its applications, andthe sources from which they are likely to beavailable.Specifically, the analysis of the cash flow

statement is necessary for a thorough under-standing of a bank holding company and thenature of its operations to the extent that itprovides information on such areas as:1. Utilizationof fundsprovidedbyoperations;2. Use of funds from a new debt issue or sale

of stock;3. Source of funds used for acquisitions or

additional capital contributions;4. Means of payment of a dividend in the

face of an operating loss;5. Means of debt repayment and stock

redemption.While the cash flow statement provides an

overall perspective of a holding company’s utili-zation of available funds, it does not, by itself,indicate possible or actual difficulties the parentcompany may have in meeting its fixed obliga-tions from internally generated funds. Fixedobligations or fixed charges are those recurringexpenses which must be paid as they fall due,which includes interest expense, lease expense,sinking fund requirements, scheduled debt re-payments and preferred dividends.One ratio that may be used to calculate the

strength of a parent company’s earnings to meetits fixed charges or obligations is theFixedCharge Coverage Ratio(FCCR). The compo-nents of the ratio are included on the ‘‘CashFlowStatement (Parent)’’ page.TheFixedChargeCoverage Ratio (FCCR) measures the parentcompany’s ability to pay forfixed contractualobligations if management is toretain control ofthe organization,thereby satisfying the expecta-tion of creditors and preferred stockholders. Netincomeafter taxesis used in the formula. Inter-est and lease expenses are already deducted toarrive at the net income figure and must beadded back to obtain the earnings available topay such charges. Interest expense is usually thelargest component among all ‘‘fixed charges,’’and the ability to pay this expense from earningscash flow is critical to an assurance of continuedrefunding of the parent company’s debt. It mea-sures not only the extent to which net cashoperating earnings covers the debt servicingrequirements of the parent company, but thecapacity to pay income taxes and preferred stock


cash dividends as well, thereby meeting theexpectations that creditors and preferred share-holders have for the protection of their respec-tive interests. The need forbetter than a 1:1coverage is therefore critical.Another important formula, required to be

calculated is theCommon Stock Cash DividendCoverage Ratio(CSCDCR) which measures theability of the parent company to pay commonstock cash dividends. The CSCDCR will show,in turn, whether the residual cash earnings of theparent company are sufficient to pay the com-mon stock cash dividend and, if not, the amountthat must be provided from other sources ofcash, such as the liquidation of assets or addi-tional borrowings, to cover the shortfall.Significant shortfalls in the CSCDCR are to

be scrutinized in light of the Board’s November1985 Policy Statement on ‘‘Cash Dividends NotFully Covered by Earnings.’’ According to thestatement, a bank holding company should notmaintain its existing rate of cash dividends oncommon stock unless:1. The holding company’s net income avail-

able to common stockholders over the past yearhas been sufficient to fully fund the dividends;and2. The prospective rate of earnings retention

appears consistent with the organization’s capi-tal needs, asset quality, and overall financialcondition.A bank holding company whose cash divi-

dends are inconsistent with the above criteria isto give serious consideration to cutting or elimi-nating its dividends. The need forat least a 1:1coverageis therefore critical.The two ratios1 are calculated as follows:

FCCR =

After tax cash income (1) + interestexpense (2) + lease & rental

expense (3)

interest expense (2) + lease & rentalexpense (3) + contractual long-termdebt retired (4) + preferred stock

dividend payments (5)

CSCDCR =

After tax cash income (1)− [Contractual long-term debt

retired (4) + preferredstock dividendpayments (5)]

Common Stock DividendPayments (6)

Note that the Cash Flow Statement (Parent)page presents only cash items included in theparent’s income and therefore the analyst canuse its income figures without any need toadjust for noncash items.Both the Fixed Charge Coverage and the

Common Stock Cash Dividends Coverage ratiosare considered inadequate at less than 1:1. If aholding company is generating funds which pro-vide at least dollar-for-dollar coverage, no criti-cism need be made. However, the examinershould be aware that these ratios, as well asothers, are merely guidelines and good judg-ment must prevail. A ratio of 1.02:1 may passthe test, but it is only barely adequate. No criti-cismmay necessarily be warranted for the periodcovered by the 1.02:1 ratio, but it may be indic-ative of a deteriorating trend over the past fewyears. Accordingly, an appropriate commentconcerning the trend may be warranted.When reviewing these ratios, it should be

kept in mind that certain components in thenumerator can to some degree be altered at thediscretion of management. For example, byaltering the dividends paid by bank subsidiaries,the amount of funds available to the parent tocoverfixedchargescanbe increasedordecreased.For this reason, the fixed charge and funds flowratios should be analyzed in conjunction with areview of the dividend payout ratios of thesubsidiary banks. Cash flow ratios that other-wise appear adequate may be a cause for con-cern if the banks are paying out dividends thatare too high in relation to capital or overallcondition. Analysts should evaluate the bankdividend payout ratios in light of the bank’scapital and financial condition. Only in this waycan the analyst gain a better understanding ofthe quality of the parent’s cash flow and itspotential effect on bank subsidiaries.Ratios of less than 1:1 coverage show that

internally generated funds are not sufficient tomeet a parent company’s needs. In many cases,the examiner may find low coverage ratios yetall fixed charges were paid as agreed. Had theynot been, the company would have incurredsevere financial difficulties long before the startof the inspection. Therefore, when less thanadequate ratios appear and obligations are paid

1. The numbered ( ) items correspond to the numberedlines on the ‘‘Cash Flow Statement (Parent)’’ page.

Parent Only (Debt Servicing Capacity—Cash Flow) 4010.0


on time, the examiner must determine whatother source of funds was utilized to make upthe shortfall and to permit the timely payment ofobligations.

4010.0.3 SUPERVISORYDETERMINATION AS TOADEQUACY OF PARENT COMPANYCASH FLOW

A supervisory determination about the adequacyof parent company cash flow, and its use as ameasure of parent company debt servicingcapacity, requires more information than just theresults of the Fixed Charge Coverage and Com-mon Stock Cash Dividend Coverage Ratios. Thetypical major parent company does not generatean earnings cash flow by conducting bankingoperations itself, although it nevertheless mayincur a heavy external debt on behalf of itsoperating subsidiaries which are the generatorsof the actual earnings cash flow. Therefore, theparent company earnings cash flow may not beindicative of theactual earnings power of theentire banking organization. For example, thecash earnings of the parent company may bekept low by management to avoid State or localincome tax liability and/or to increase leveragedlending volumes at the subsidiary level. Con-versely, cash earnings may be forced to theparent company through imprudent levels ofupstream cash dividend payments which eventu-ally will endanger the operating subsidiaries andthe parent itself.A supervisory determination about the ade-

quacy of parent company cash flow must takeplace attwo levels:(1) by analyzing the resultsof the two coverage ratios using the net earningscash flowrealizedby the parent company,and(2) by analyzing the effect that upstream cashflow to the parent company has had, and can beexpected to have, on the financial condition ofthe bank subsidiaries and the significant non-bank subsidiaries. The latter focus should be onsignificant nonbank subsidiaries whose capitaland dividend policies are subject to separateregulation—such as thrifts—or subsidiaries withsignificant external funding, whose creditorspresumably monitor capital and dividend poli-cies of the subsidiary.

4010.0.4 SPECIFIC GUIDELINES FORDEBT SERVICING CAPACITY

The specific guidelines for debt servicing capac-ity are as follows:1. The adequacy or inadequacy of parent

company cash flow, and thereby the capacity tosustain the parent company’s debt, is deter-mined ultimately from the results of the FixedCharge and Common Stock Cash Dividend Cov-erage Ratios, and the related analysis of theeffects of upstream cash flow on the financialcondition of the key subsidiaries.2. For those parent companies with material

amounts of long-term debt, coverage ratios inexcess of 1:1 will not necessarily be consideredsufficient to sustain the parent company’s lever-ageunless: first,the Tier 1 capital positions ofthe bank subsidiaries are considered adequate;second,that the bank holding company’s con-solidated Tier 1 capital position is consideredadequate; andthird, the parent’s liquidity isjudged adequate. If that is not the case, then acriticalcommenton the ‘‘Examiner’sComments’’page should be made regarding the potentiallyexcessive leverage of the parent, as well as thatof its subsidiaries. A specific period of timeshould be established for the management ofthe bank holding company to submit a capitalimprovement program acceptable to the System.Moreover,where the capital positions, bank andconsolidated, are considered adequate but thedividend payout ratios are excessive, it is indic-ative of a potential future debt servicing prob-lem and should be brought to management’sattention. Since the earnings level may not besustainable, corrective action must be takenwithin a specified period of time.3. For coverage ratios of less than 1:1, there

is a presumption of a critical comment on the‘‘Examiner’s Comments’’ page of the inspectionreportunlessthe shortfall is prudently planned,2

insignificant in amount and/or the trend of earn-ings cash flow and dividend policies clearlypoint toward a return to sufficient parent com-pany earnings cash flow coverage.

a. In circumstances where the Tier 1 capi-tal position ofany bank subsidiaryis consideredinadequate, a written program of correctiveaction should be required, including the stepsnecessary to reestablish positive earnings cashflow coverage at the parent company.

b. In circumstances where the Tier 1con-solidatedcapital position of the holding com-pany is considered inadequate, a written pro-

2. A planned cash flow shortfall might typically occurwhen the parent elects to reduce (or not increase) dividendsfrom subsidiaries because it anticipated an excess cash orliquid asset position from certainexternal sources(i.e., stockor debt issuance, dividend reinvestment plans, or tax refunds)sufficient to cover the deficiency.



gram of corrective action should be required,including the steps necessary to reestablish pos-itive earnings cash flow coverage at the parentcompany.

c. In circumstances where the Tier 1 capi-tal position of each bank subsidiaryand theconsolidated Tier 1 capital position of the bankholding company is considered adequate, butthere is a developed trend of inadequate earn-ings cash flow coverage at the parent companylevel or excessive dividend payouts from thesubsidiaries, a written program of correctiveaction should be required to reestablish andmaintain a positive earnings cash flow at theparent company.

4010.0.5 SOURCES OF FUNDS TOMAKE UP SHORTFALLS

Basically, there are three source categories, otherthan current earnings, that could be used tomake up any deficit: (1) liquidation of assets,(2) proceeds from a stock offering, or (3) bor-rowed funds. These sources must be thoroughlyanalyzed to determine the extent they were andcould still be utilized. It must be kept in mindthat the use of these sources cannot permanentlyeliminate a shortfall in the flow of funds fromcurrent operations. These alternative sourcesonly alleviate temporarily the effects of a short-fall. Nevertheless, a deficit could have beenintentionally allowed to occur because the hold-ing company knew of funds coming from thesealternate sources. For example, the parent knewof an impending stock sale and cut dividendsfrom subsidiaries significantly. In future years,dividends from subsidiaries could be restored tonormal proportions, bringing the ratios up toadequate levels.At this point, it must be determined what, if

any, criticism is necessary when an unplannedshortfall is made up by any of these alternatesources. The necessity of liquidating assets tomeet cash needs may warrant a critical com-ment. The parent’s advances to subsidiaries andits investment in marketable securities are con-sidered temporary investments. That is, the hold-ing company may reasonably expect to sell itssecurities and be repaid on its advances to sub-sidiaries within a reasonably short period oftime. In the case of advances to a problemsubsidiary, repayments may not be forthcoming.Nevertheless, if the parent does receive partialpayments, such funds are available to meet cash

needs. The concern to the examiner is the extentto which such temporary investments can berelied upon before they are fully exhausted. Ifthe continued liquidation of those investmentsto meet cash needs has fully exhausted the assetsor will do so in the near future, then appropriatecritical comments are warranted. Such com-ments should stress that the liquidation of theinvestment portfolio and the advances to subsid-iaries can no longer be considered a reliablesource of funds.Another method which may be used by a

holding company to overcome a flow of fundsdeficiency is the sale of capital stock which is aneffective source for generating permanent fundsfor the parent. However, it must be recognizedthat the primary reason for the stock offeringwas something other than covering the shortfall(i.e., debt repayment, capital contributions tosubsidiaries, acquisitions). Therefore, it cannotbe relied upon as a consistent annual source tosupplement internally generated funds fromoperations. Also, it should be realized that thesale of stock will increase future fundingrequirements as additional dividends will haveto be paid. Consequently, where no significantimprovement in internal operations is contem-plated in future periods, an appropriate com-ment is warranted indicating the potentialproblem.Holding companies also compensate for inad-

equate funds flow with borrowed money.Although not a permanent source of funds, long-term debt is a source similar to the sale of stock.Its main purpose, however, was not to cover theshortfall. Long-term debt cannot be consideredas a reliable, consistent annual source, andmoreover, its existence creates new fundingrequirements.Short-term debt is perhaps the most com-

monly used source to cover a deficit cash flowfrom operations and its use is of serious concernfrom a supervisory viewpoint. Unlike long-termdebt and equity issues, short-term borrowings(i.e., bank loans, commercial paper) are readilyavailable to holding companies which can anddo rely on this source year after year for sup-port. As a consequence, this indebtednessincreases fixed charges and where materialimprovement in earnings does not develop, theshortfall could increase in subsequent periodsthereby necessitating even larger borrowingrequirements. This practice may jeopardize theparent’s liquidity position since short-term lia-bilities rise without a corresponding increase inliquid assets as the borrowed funds are used topay expenses. Here, an appropriate comment iswarranted indicating the problems.



4010.0.6 REPORTING THE RESULTS

If the coverage ratios are less than 1:1, thenappropriate comments are necessary to explainthe external source utilized to make up the short-fall. The supporting details may be shown withinthe comments section of the Cash Flow State-ment. More significant comments should beincluded on the ‘‘Analysis of Financial Factors’’page or the ‘‘Examiner’s Comments’’ page. Theexaminer may include prior years’ results forcomparative purposes.

4010.0.7 INSPECTION OBJECTIVES

1. To determine the ability of the parent tomanage its cash position and operate withindebt service and funding requirements.2. To measure the parent’s ability to meet its

fixed obligations and its dependency on bor-rowed funds to meet its cash needs.3. To determine if the parent company’s div-

idends to stockholders are covered by residualcash earnings.4. To analyze any cash flow transaction which

may adversely affect the financial stability ofthe parent.5. To discuss with parent company manage-

ment:a. Deficit cash flows arising from internal

operations;b. Steps management has taken, or plans

to take, to restore adequate cash earnings cover-age for fixed charges and dividend paymentsand whether such plans should be commensu-rate with the maintenance of adequate loan lossreserves and Tier 1 capital levels in the bank andmajor nonbank subsidiaries.

c. Any parent company borrowings orrestructurings needed to sustain dividend pay-ments to shareholders; and

d. The need to increase cash flow althoughthere may be no deficit in current cash flowcoverage.

4010.0.8 INSPECTION PROCEDURES

1. Prepare the ‘‘Cash Flow Statement(Parent)’’ FR 1225.

a. Analyze each item of the parentcompany’scomparativebalancesheetand incomestatement. Since accrual figures may be used forall accounts except tax and dividend payments,adjustment to the figures may be necessary forthe difference between accrual and cash basisaccounting.

b. Examine the underlying nature of periodincreases or decreases for the balances listed onthe financial statements, particularly any mate-rial transactions that aided in averting coverageratio shortfalls.

c. Note contractual long-term debt retired(net decrease in borrowed funds, including sink-ing fund provisions) as a memo item on thebottom of the page, where indicated.

d. Compute the fixed charge and commonstock cash dividend coverage ratios as illus-trated on the page.The numbered items in theformula correspond with the numbered items onthe ‘‘Cash Flow Statement (Parent)’’ page.

e. Answer the six questions on the ‘‘CashFlow Statement (Parent)’’ page that prompt ananalysis.2. Analyze the Results.a. If there is full coverage, no problem

should be assumed. However,the underlyingassets and transactions that provided for thecoverage should be examined to make certainthat ‘‘no problem’’ does, in fact, exist.

b. If a shortfall exists, provide guidelinesto the parent company’s management for devel-oping a workable contingency plan, using your‘‘good examiner judgement’’, considering theviability of all sources in resolving the shortfall.

• Review thesourcesfor making up short-falls:— Liquidation or sale of assets,giving

full consideration to external marketconcerns and losses that may resultfrom the sales.

— Proceeds from stock offerings.— Increase in borrowed funds, includ-

ing a restructuring of short term debtto long term debt.

— Sale of capital stock.— Payments from subsidiaries on

advances in the form of amortizationor interest.

— Short term debt.

3. Report the Results.a. When an ‘‘engineered’’ (planned) short-

fall exists,indicate that one does exist, the rea-sons therefore, and the degree of severity towhich it should be addressed, either as part ofthe answers to the questions on the ‘‘Cash FlowStatement (Parent)’’, the ‘‘Analysis of FinancialFactors’’ page, or the ‘‘Examiner’s Comments’’page. Provide management’s assessment as to



whether planned short falls will occur in thefuture.

b. When an unplanned shortfall exists,determine the extent of criticism that is to bemade when short falls are lessened or correctedby an imprudent use ofalternative sources.

Based on the severity of the situation, determinewhether the comments will be provided in theinspection report as answers to the questions onthe Cash Flow Statement, or within the contentof the ‘‘Analysis of Financial Factors’’ page, orthe ‘‘Examiner’s Comments’’ page.



Parent Only(Leverage) Section 4010.1

BHC financial leverageis the use of debt tosupplement the equity in a company’s capitalstructure. It is anticipated that funds generatedthrough borrowings will be invested and earn arate of return above their cost so that the netinterest margin generated will improve the com-pany’s net income, providing a higher rate ofreturn on stockholders’ equity which has other-wise remained constant. Since no creditor orlender would be willing to extend credit withoutthe cushion and safety provided by the stock-holders’ equity, this borrowing process is alsoreferred to as ‘‘trading on equity.’’ That is,utilizing the existence of a given amount ofequity capital as a borrowing base. Stockholdersand management often view leveraging as afavorable financial alternative because if ownershave provided only a small portion of totalfinancing, much of the financial risk will beborne by the lenders, alleviating the need of thestockholders to assume the total risk. In addi-tion, by raising funds through long-term debt,the owners gain the benefits of maintaining con-trol of the firm with a limited investment ratherthan diluting existing ownership via the sale ofadditional capital stock.There are, however, some unfavorable aspects

in this type of financing. As a holding companysubstitutes debt for equity, keeping its asset sizeconstant, its leverage ratio will increase. Theincrease in leverage increases the probabilitythat a company may go into default since alarger portion of the income stream generatedby earning assets must then be used to meetincreased fixed charges (interest expense). (Thisassumes that increases in future earnings are notanticipated. While earnings may be sufficient tomeet fixed interest expenses at the time the debtis issued, it is possible that future earnings willnot be sufficient to meet the increased expens-es.) In addition, utilization of leverage reducesmanagement flexibility in making future deci-sions because lenders impose restrictive cove-nants that may limit future debt issues, limitdividend payments, or impose constraints onspecific operating ratios. However, not all of theeffects of increased leverage are unfavorable.Additional long-term debt may have the favor-able effect of extending maturities on obliga-tions and may improve liquidity.Leverage ratios measure the contribution of

owners compared with the financing providedby lenders. Companies with low leverage ratiosgenerally have less exposure to loss when theeconomy is in a recession, but they may alsohave lower expected returns when the economy

booms. Firms with high leverage ratios run therisk of large losses but also have a chance ofearning high rates of return on equity and assets.Thus, if a company earns more on the borrowedfunds than it pays in interest, the return to theowners is increased. For example, if the com-pany earns 10 percent on assets and debt costs8 percent, there is a 2 percent differential accru-ing to the stockholders. However, if the returnon assets falls to 7 percent, the differentialbetween that figure and the cost of debt must bemade up from total profits.A bank holding company is composed of at

least two tiers, parent and subsidiary, and eachtier may issue long-term debt in its own name.Several different types of long-term debt instru-ments are utilized by holding companies. Corpo-rations make use of instruments such as deben-tures, convertible debentures, term loans, capitalnotes and mortgage notes. (See Manual section2080.0—‘‘Funding’’). While most issues aregenerally sold to the public, in some cases,issues of subsidiaries have been placed directlywith another subsidiary, the parent company, orperhaps with an unaffiliated banking institution.Alternatively, issues presently held on the booksof the parent may have been originally issued byone of the subsidiaries and later transferred tothe parent. These transfers have often occurredat the time of the formation of the holdingcompany when debt of the subsidiaries wasassumed by the parent.The proceeds of parent company long-term

debt may be advanced to banking subsidiariesas debt or invested in banking subsidiaries asequity. When parent debt is issued, and theproceeds are advanced to subsidiaries as debt, acondition of ‘‘simple leverage’’ exists. Whensuch proceeds are invested in subsidiaries asequity, a condition of ‘‘double leverage’’ is saidto exist since the increase in the subsidiarybank’s capital base will allow the bank toincrease its own borrowings.1 In effect, the

1. Parent company ‘‘total leverage’’ may be defined as therelationship between equity at the parent level and the totalassets of the parent company. Such assets typically consist ofinvestments in bank and nonbank subsidiaries, advances toaffiliates, deposits with bank affiliates and securities. A usefulrelated measure of parent company leverage is ‘‘investmentleverage’’ which may be defined as the relationship betweenparent equity and its equity investments in subsidiaries. Sincethe equity which has been invested in subsidiaries can, andoften is, further leveraged by external borrowings of suchsubsidiaries, this type of parent company investment leveragecan lead to what is referred to as ‘‘double leverage.’’


parent’s capital injection which was funded bydebt, provides the bank with greater debt capac-ity, thereby allowing the bank to borrow addi-tional funds on its own. Therefore, the originalborrowing by the parent has, in effect, beencompounded when the bank borrows based onits newly injected equity.If the parent debt is reinvested as equity in a

bank, the servicing of interest and principal isusually provided by dividends paid to the parentby the bank subsidiaries. The bank dividends,however, may become restricted based on thebank’s earning power which may not providefor sufficient retention of earnings to support itsasset growth. Problems may be less severe whenparent debt is downstreamed as debt to the banksubsidiary. When the terms and maturities of theindentures match, the obligation of a bank tomeet its interest and principal payments to theparent are contractual and represent fixed charges(interest is tax deductible) which will continueup to the maturity of the note. When funds aredownstreamed as equity and the bank typicallyissues dividends to its parent, it is easier torestrict the flow of funds from the bank than ifthe funds were downstreamed as debt whichresults in bank payments of interest expense.Bank dividend declarations are subject to limita-tions imposed by sections 5199(b) (12 U.S.C.60) and 5204 (12 U.S.C. 56) of the UnitedStates Revised Statutes, while interest paymentsare not subject to such restrictions.

4010.1.1 ACQUISITION DEBT

Some holding companies use debt for the acqui-sition of subsidiary banks. The Board believesthat a high level of acquisition debt can impair

the holding company’s ability to act as a sourceof strength to its bank subsidiaries, and thusdoes not favor the use of a substantial amount ofacquisition debt in bank holding company for-mations. However, the Board recognizes thatthe use of acquisition debt in the formation ofcertain holding companies may be necessary,particularly when transferring the ownership ofsmall community banks (approximately $150million or less), and the maintenance of localownership in those banks. To this end, and inthe interest of maintaining a safe and soundbanking system, the Board has adopted a policyfor assessing financial factors in the formationof small one-bank holding companies. (see Man-ual section 2090.2)

4010.1.2 INSPECTIONCONSIDERATIONS

Generally, it is not the examiner’s responsibilityto criticize the method of term financing used bya bank holding company. The examiner, how-ever, should be familiar with the various typesof leveraging and the possible ramifications thatthey may have on a holding company structure.While the use of ratios may show an excessiveleverage position, indicating vulnerability, it isprimarily the corporation’s earning power thatdictates the acceptable level of debt. Accord-ingly, the examiner should compute a holdingcompany’s ability to meet its fixed charges (asdetailed in the preceding section) to determinethe appropriateness of the leverage position. Ifthecompany’searningsdonotsupport thepresentfixed charge requirements, or if a declining trendis noted, appropriate comments are warranted.

Parent Only (Leverage) 4010.1


Parent Only(Liquidity) Section 4010.2

WHAT’S NEW IN THIS REVISEDSECTION

This section has been revised to incorporate areference to the ‘‘Liquidity Risk’’ sections (3005.1to 3005.5) of the Federal Reserve System’sTrading and Capital-Markets Activities Manual.These sections provide additional guidance onevaluating a banking organization’s liquiditymanagement.

4010.2.1 INTRODUCTION

Liquidity is generally defined as the ability of acompany to meet its short-term obligations, toconvert assets into cash or to obtain cash, or toroll over or issue new short-term debt. ‘‘Short-term’’ is generally viewed as a time span of upto a year. Since a bank holding company doesnot have the full range of asset and liabilitymanagement options available to it that a bankdoes in managing its liquidity position, a BHCneeds to have a sufficient cushion of liquidassets to support maturing liabilities. Certainassets that would not normally be consideredcurrent may be readily sold to avert a liquiditysqueeze. For example, a holding company maybe participating in long-term loans originated bya small business investment company (SBIC)subsidiary. If these loans are of good quality, theparent’s share may be sold at little or no dis-count to that SBIC subsidiary, another sub-sidiary, or an unaffiliated company to obtain theneeded cash. Consequently, the breakdown ofassets segregating those that are current wouldnot necessarily be indicative of liquid assets,given the nature of bank holding company invest-ments. Therefore, liquid assets are defined asthose assets that are readily available as cash orthat can be converted into cash on an arm’s-length basis without considerable loss.

Liquidity problems are usually a matter of thedegree of severity. A less serious liquidity prob-lem may mean that the company is unable totake advantage of profitable business opportuni-ties. A more serious lack of liquidity may meanthat a company is unable to pay its short-termobligations and is in default—this can lead tothe forced sale of long-term investments andassets and, in its most severe form, to insol-vency and bankruptcy. (See SR-86-17 and SR-85-37.) See also the ‘‘Liquidity Risk’’ sections(3005.1 to 3005.5) of the Federal Reserve Sys-tem’s Trading and Capital-Markets ActivitiesManual. These sections provide additional guid-

ance on evaluating a banking organization’sliquidity management.

4010.2.2 SUPERVISORY APPROACHTO ANALYZING PARENT COMPANYLIQUIDITY

For bank holding companies with consolidatedassets in excess of $1 billion or material amountsof debt outstanding, or others, at the option ofthe Reserve Bank, the analytical approach toparent company liquidity will include the fol-lowing key elements:

1. Evaluate parent company liquidity by analyz-ing the contractual maturity structure of as-sets and liabilities, extending this analysis toconsider the underlying liquidity of the par-ent’s intercompany advances and deposits.Any judgment of adequate parent companyliquidity must be keyed to a finding that theparent has adequate liquid assets, on an un-derlying basis, to meet its short-term debtobligations.

2. Estimate the underlying liquidity of parentliabilities and assets, giving particular atten-tion to interest-bearing deposits in and ad-vances to subsidiaries. Emphasis should beplaced on asset quality and the liquidity pro-file of the bank and key nonbank subsidiar-ies. The estimates are to be reflected in astatement of ‘‘Parent Company Liquidity Po-sition’’ as restated data, with appropriateexplanations as to the basis for the restate-ment.

3. Use the five contractual and estimated under-lying maturity categories on the statement of‘‘Parent Company Liquidity Position’’ to slotin data. The data categories are—a. up to 30 days,b. up to 90 days,c. up to one year,d. one to two years, ande. beyond two years.

The schedule provides for the use of effec-tive remaining maturity categories for theparent company’s short-term assets andliabilities, highlighting funding surpluses ordeficits at key specified periods of time.Examiners have the option of including thestatement in the inspection report in order tosubstantiate or clarify particular judgments.


4. Use the conclusions drawn from the state-ment of ‘‘Parent Company Liquidity Posi-tion’’ as a basis for discussions with manage-ment. Examiners should also comment ontheir findings in detail on the ‘‘Analysis ofFinancial Factors’’ page in the inspectionreport.

5. Ascertaining whether an organization withsignificant funding activities has in place—a. internal parent liquidity management poli-

cies that address and limit the use of short-term funding sources to support varioussubsidiaries, and

b. an internal contingency plan for maintain-ing parent liquidity under adversesituations.

4010.2.3 STATEMENT OF PARENTCOMPANY LIQUIDITY POSITION

The purpose of the statement of ‘‘Parent Com-pany Liquidity Position’’ is to provide a consis-tent method for analyzing parent liquidity. Theschedule is not intended to address the issue ofinterest sensitivity. While only conclusions drawnfrom the schedule of estimated effective maturi-ties are to appear in the inspection report, exam-iners should also collect data on contractual(remaining life) maturities of parent assets andliabilities. Examiners will treat all externallyfunded nonbank entities of the parent companyin a similar fashion.

The maturity categories appearing on theschedule are a basic analytical framework forlooking at funding mismatches and are not nec-essarily appropriate for all organizations. Assuch, categories can be adjusted to fit particularcircumstances. On a conceptual basis, the 30-day period corresponds to a period during whichmarkets might be in temporary disarray due toan external shock. For the largest companieswith substantial overnight and very short-termfunding operations, an additional 1- to 7-daycategory may be needed. The 31- to 90-dayperiod allows for gauging the parent’s ability towithstand internal adversity and demonstrate areturn to ‘‘normal’’ business operations. The91-day to one-year period is a reasonable plan-ning horizon over which an organization mightbe able to readjust its internal funding policiessubstantially. In addition, the up-to-one-year cat-egories, as a group, complement the cash-flowanalysis of debt-servicing capacity by specifi-cally addressing maturing debt that must be

either paid or rolled over at prevailing rates. Theone- to two-year category provides an earlyindication of any funding imbalances that man-agement would have to address in the reason-ably near term. As a practical matter, the over-two-year category has limited analytical valuein most cases and is included principally tomake certain that all deposits and advances areaccounted for.

Using these categories, funding surpluses ordeficits can be identified for specific maturityintervals. For examiners evaluating gaps basedon estimated ‘‘underlying’’ maturities, guide-lines on acceptable practices for funding sur-pluses and shortfalls are set. Examiners wouldbe expected to place particular emphasis on theup-to-30-day period, in which a net liquiditysurplus would be expected to provide at leastthat much time for a parent to ride out a shock.Similarly, the up-to-90-day period would beviewed as the relevant time to demonstrate tothe market that problems are being addressedappropriately and are being brought under con-trol. Imbalances in the 91-day to one-year cat-egories would generally have less significancedue to greater uncertainty regarding the assump-tions that would go into any adjustments.

A logical point for assessing parent liquidityis an assessment of the contractual maturitystructure of the holding company’s balance sheet.Contractual maturities of assets and normal run-off of liabilities are to be slotted into the fivematurity categories depicted. Once completed,the examiner is provided with an initial indica-tion of whether the parent has an adequate cush-ion of short-term liquid assets within the 0- to30-day and the 0- to 90-day categories to covershort-term liabilities or whether a pattern ofsignificant short-term funding gaps exists. Cer-tainly, the identification of such gaps gives guid-ance on obvious areas for further analysis. How-ever, the absence of short-term funding shortfallson a strictly contractual basis gives only limitedcomfort, as the parent’s underlying liquidity stillmust be analyzed more deeply.

4010.2.4 ANALYSIS OFUNDERLYING SOURCES TO FUNDDEBT AND MEET OTHEROBLIGATIONS

Adjustments to the schedule that better reflectthe parent’s liquidity position will be made asthe next step in the analysis. These adjustmentsrequire the examiner’s judgment on the underly-ing liquidity of the parent’s assets and liabili-ties; particular emphasis placed on interest-

Parent Only (Liquidity) 4010.2


bearing deposits with bank subsidiaries andadvances to both bank and nonbank subsidiaries.

4010.2.4.1 Interest-Bearing Deposits withSubsidiary Banks

The parent’s interest-bearing deposits 1 with thesubsidiary bank(s) may represent either the tem-porary placement of idle funds or a more perma-nent source of bank funding. Temporary depos-its typically are structured to mature in 90 daysor less, are generally not substantial in relationto the overall size of the bank, are usuallysupported by substantial holdings of highly liq-uid bank assets, and could be repaid withouttriggering marketplace concerns regarding theorganization’s overall funding needs. Therefore,if this pattern exists, the temporary depositsmay be considered highly liquid and slotted inthe 0- to 30-day (or 0- to 7-day) period on theschedule, regardless of their contractual matu-rity dates.

Interest-bearing deposits with the subsidiarybank(s) that serve as a permanent source ofbank funds are typically substantial in relationto the size of the bank and are usually placed tofund bank expansion without additional bankborrowings. Here, judgments regarding underly-ing liquidity should be keyed to the CAMELSratings on the bank’s liquidity and asset quality,as well as reasoned judgments on the bank’sability to liquidate assets or replace the funds inthe marketplace through additional borrowings.Asset quality is critical, as it is a leading indica-tor of bad news that will ultimately pull downearnings and undermine market confidence. Asa general principle, the liquidity of the parent’sdeposits in bank(s) should be no better than theliquidity of the bank(s) and should be subject todowngrading if bank asset quality is suspect. Ifbank asset quality is worse than fair, the liquid-ity of these funds should be downgraded. Forbanks with asset quality rated fair, the parent’sdeposits might still be considered liquid, but acloser analysis of the particular situation wouldbe warranted.

Under the assumption that the bank’s assetquality and liquidity positions do not negativelyimpact the bank’s ability to liquidate or replacethese funds, such deposits may be slotted in the0- to 30-day (or 0- to 7-day for large institu-

tions) period on the schedule, regardless of thecontractual maturity. However, if these depositsare substantial, their replacement may triggermarket concerns. At this point, the examiner’sjudgment is necessary to determine an accept-able level at which a portion of the depositscould be replaced in the marketplace withouttriggering such concerns. A starting point forthe examiner should be to evaluate the fundinggaps appearing on the contractual maturity sched-ule with particular attention paid to the 0- to90-day period (0 to 30 days for large institu-tions). While it may be impossible for the bank(s)to replace all the parent’s deposits without trig-gering concerns, the bank(s) may be able toreplace only the portion necessary to eliminatethe negative cumulative funding gap in thegiven time period. If even this amount is deemedto be substantial, the examiner may have noother alternative but to treat the deposits inaccordance with the contractual maturity. Forclarification, the following example is provided.

The contractual maturity schedule of alarge holding company reflects a negative cumu-lative gap of $400 million in the 0- to 30-daytime frame.Thecompany’sbalancesheet includes$2.5 billion in interest-bearing deposits at thesubsidiary bank(s), with $1 billion maturing in30 days and $1.5 billion in 31 to 90 days.

In the examiner’s judgment, the entire$1.5 billion due in over 30 days qualifies to beslotted in the under-30-day category,2 but thebank would face liquidity pressures to replacethis amount prior to its original maturity. How-ever, $400 million, the amount needed to elimi-nate the negative cumulative gap position, couldbe replaced by the bank without undue marketconcern. Therefore, $400 million from the 31-to 90-day period should be re-slotted in theappropriate under 30-day-period.

4010.2.5 ADVANCES TOSUBSIDIARIES

Given the typical composition of bank holdingcompany assets, the examiner is likely to havedifficulty determining the degree of liquidityinherent in advances to subsidiaries.

For those subsidiaries with satisfactory assetquality, the examiner can usually assume thesubsidiary could sell qualifying assets to affili-

1. In concept, the parent could also have advances to banksubsidiaries. Such advances are either booked as deposits(typically off-shore time deposits to avoid reserve require-ments) or as instruments qualifying as tier 1 or tier 2 capital.To the extent that advances to banks are encountered, theanalysis follows the same approach used with deposits.

2. Subject to early withdrawal penalties, which will beeliminated in consolidation.



ate bank(s) up to the quantitative limitations ofsection 23A, as long as the affiliated bank(s) arejudged to have adequate liquidity. The examinercan also assume that a subsidiary that has anestablished program of secondary-market assetsales could at least continue or even modestlyexpand the scope of the program. For subsidiar-ies without a program of asset sales, but whoseassets are of the type that are readily marketablein the secondary market, a limited asset-saleprogram could be considered to provide someasset liquidity. However, caution should be usedin estimating the magnitude of such sales, par-ticularly because large transactions could not beaccomplished quickly without risking marketvisibility and without broadcasting concernsabout the corporation’s funding.

When nonbank advances are substantial, theparent has little or no practical access to thefunds advanced. While an arm’s-length sale ofsuch a subsidiary or a large portion of its assetsto a bank affiliate may not generate a loss, thefunding requirements for a large transaction atthe bank level would probably initiate market-place concerns.3 Similarly, asset sales to anunaffiliated party that are significantly abovenormal would not only trigger market concernsbut would probably also result in a significantdiscount. Furthermore, although it is possiblethat another nonbank subsidiary may act as thefunding vehicle, the subsidiary’s ability to gen-erate the required funds may be restricted atbest. Such restrictions may include marketplaceconcerns, as well as limitations on the maxi-mum leverage positions or on the creation ofsenior debt embedded in debt covenants.

Advances to a subsidiary may be either shortterm or long term and are made for a variety ofreasons, including providing a temporary sourceof income for the parent, enhancing a subsid-iary’s liquidity position, and supporting a sub-sidiary’s operations. Therefore, the purpose ofthe loan, its maturity, and the degree to whichhigh-quality assets of a subsidiary cover theamount due to the parent should also be consid-ered in order to properly categorize advances.

4010.2.6. LIQUIDITY ANDLIABILITIES OF THE PARENT

For liabilities of the parent, the policy presump-

tion should be that their contractual maturityreflects the underlying availability of funds.Exceptions will reflect special circumstances,such as funding from foreign ownershipinterests or partners in joint ventures who haveequity interests and an ongoing businessrelationship. The presence of backup lines ofcredit for commercial paper, while especiallydesirable in the case of regional companies,should not, by itself, cause an examiner to as-sume that the underlying maturity of a parent’sshort-term debt is materially longer than itscontractual term or that these lines will alwaysbe readily available. In fact, organizationsexperiencing considerable problems,particularly asset-quality and liquidityproblems, may find that these facilities are nolonger available.

The examiner should thus review backuplines on a case-by-case basis and be aware ofany escape clauses in interbank agreements.Specifically, for companies with a composite 3or worse bank holding company RFI/C(D) rat-ing or lead banks whose asset quality is a declin-ing 3 or worse or whose asset quality and liquid-ity are rated 3 or worse, it is recommended thatbackup lines with ‘‘material adverse change’’ orsimilar escape clauses not be regarded as satis-factory support to an imbalanced parent com-pany funding position.

Furthermore, certain holding companies’liabilities may often include unamortizing debtinstruments. The company’s ability to retire orreplace such issues at maturity should be evalu-ated as part of the organization’s overall liquid-ity analysis. If management intends to roll overthe maturing issues, the evaluation should bebased on the company’s ability to do so. Whendebt retirement is the route chosen by manage-ment, the examiner’s evaluation and judgmentshould focus on the company’s ability to gener-ate the necessary funds, either through assetliquidation or the issuance of equityinstruments.

The unamortizing portion of debt issues is tobe slotted in the appropriate maturity column oflong-term debt. If the maturity of such issuesfalls due within the 0- to 90-day time frame, theexaminer should comment on the organization’sability to replace the maturing issues or retirethem by the deployment of funds from othersources in a footnote on the schedule. If thematurity of such debt is longer, the replacementor retirement should be addressed in the corpo-ration’s funding plan.

3. Underlying liquidity estimates should follow the approachpreviously stated for deposits.



4010.2.7 ANALYZING FUNDINGMISMATCHES

After adjustments for the underlying liquidity ofthe parent’s interest-bearing deposits andadvances to subsidiaries and the underlyingmaturity of its liabilities, the resulting scheduleshould provide the examiner with the frame-work for looking at funding mismatches as atool for assessing the parent’s overall liquidityposition. The position may be evaluated by theanalysis of the underlying liquidity gaps (appear-ing on the bottom of the schedule). In the 0- to30-day time frame, a net positive gap is ex-pected and reflects the parent’s ability to rideout a temporary market disarray. Although anegative gap in the 8- to 30-day period may beevident in larger organizations, the overall 30-day interval is expected to be positive. Simi-larly, for most organizations, the 0- to 90-dayperiod is expected to reflect a positive position,regardless of a shortfall in the 31- to 90-dayperiod. Failure to meet these conditions requiresappropriate examiner comments on the ‘‘Exam-iner’s Comments’’ page of the report.

The 91-day to one-year time frame (as well asthe 31- to 90-day period for certain larger orga-nizations) is less critical, and negative cumula-tive funding positions of modest size may betolerated if the organization has demonstratedan ability to tap the funding markets, has readilyavailable backup lines of credit, has a reason-able earnings-retention policy, has adequatefunds-flow coverage, and has other fund-generating programs (such as a dividend rein-vestment plan). Judgments on the reasonable-ness of any imbalances in these longer-termcategories should be weighed against the exam-iners’ estimates of the adequacy of these sources.In addition, the examiner should view theselonger periods as a reasonable planning horizonover which the organization should be able toreadjust its funding policies. These longer peri-ods also provide an early indication of howmanagement may address funding imbalancesthat may develop.

A significant shortfall in the 91-day to one-year period is expected to be covered by acontingency funding plan. While no single for-mula for such plans is recommended or pos-sible, each organization needs to address itsparticular situation and the options it faces. At aminimum, the organization needs to addresspossible market shocks, whether they are causedby its own actions or by external events. Fund-ing markets should be addressed individuallyand as a group, both as to their likely resiliencyand the particular organization’s position within

each market. The viability of contingency sourcesshould be tested periodically. The examinershould review the reasonableness of assump-tions and the adequacy of alternative courses aspart of the company’s liquidity analysis. If noplan exists, a plan acceptable to the corpora-tion’s directors should be required. Even if thereare no specific concerns, the existence or lack ofa plan should be taken into account when assess-ing management.

In analyzing liquidity, the examiner willencounter the least difficulty when liquid assetsequal or exceed short-term liabilities. In thoseinstances, the liquidity position is consideredadequate. If the examiner notes a declining trendin the liquidity position, an appropriate com-ment may be warranted, even though sufficientliquidity exists at that time.

Conversely, the examiner will encounter themost difficulty in analyzing liquidity when liq-uid assets are not sufficient to cover short-termobligations. When this situation exists, it is notnecessarily indicative of an inadequate liquidityposition. At that point, the examiner must con-sider other readily available sources of cash thatare not shown on the balance sheet (for example,unused bank lines, dividends from subsidiaries).

Footnotes to financial statements may alsoplay an important role in liquidity analysis. Onesuch footnote may describe indenture restric-tions on long-term debt. While a company maytemporarily alleviate a liquidity bind by payingoff its commercial paper with short-term bankloans, it may be faced with the problem ofpaying off the bank debt if it is precluded fromissuing additional long-term debt.

4010.2.8 REPORTING THE RESULTSOF THE ANALYSIS

In the normal course of the inspection, theexaminer should present his conclusions con-cerning liquidity to management. When there isan indication of some vulnerability, the exam-iner should solicit management’s opinion andany corrective action plans being considered. Ifit appears that management has not addresseditself to the vulnerable or inadequate situation,an appropriate comment should be made. Theresults of this analysis should be discussed inthe parent company section on the ‘‘Analysis ofFinancial Factors’’ page in the inspection report.In addition, the examiner has the option ofincorporating the liquidity schedule in the report



in order to substantiate or clarify particular judg-ments. Criticism with respect to a liquidityshortfall anywhere within the 0- to 90-day timeframe or, in most cases, the absence of a contin-gency plan to cover shortfalls in the under-one-year time frame, should be carried forward tothe ‘‘Examiner’s Comments’’ page and the trans-mittal letter. These concerns should also be dis-cussed with management.


1. To analyze the contractual maturity structureof assets and liabilities, and then extend theanalysis to the underlying liquidity of inter-company advances and deposits—considering whether the underlying liquidityis short term or long term.

2. To estimate the underlying liquidity of parentliabilities and assets, paying particular atten-tion to interest-bearing deposits in and ad-vances tosubsidiaries.Giveparticularattentionto—a. asset quality, andb. the liquidity profile of the bank and key

nonbank subsidiaries.3. To restate, on the ‘‘Parent Company Liquid-

ity Position’’ report page (see section 5030.0,pages 33–34), the estimates, using the sug-gested five broad contractual and underlyingmaturity categories.

4. To judge the adequacy of parent companyliquidity, keying it to a finding as to whetherthe parent has adequate liquid assets, on anunderlying-liquidity basis, to meet its short-term debt obligations.

5. For BHCs that have significant fundingactivities at the parent level, to determine ifthe parent company has in place—

a. internal parent liquidity management poli-cies that address and limit the use of short-term funding sources to support subsidiar-ies, and

b. an internal contingency plan for maintain-ing parent liquidity in the face of adversity.

6. To draw conclusions from the estimatedremaining effective maturities that appear inthe report.


1. Assess the contractual maturities of the par-ent company’s balance sheet.

2. Slot the contractual maturities of assets andthe normal runoff of liabilities into the fivecategories on the ‘‘Parent Company Liquid-ity Position’’ report page.

3. On the schedule, make adjustments as to theunderlying maturity of the parent company’sassets and liabilities.

4. Review funding mismatches.5. Review the reasonableness of the contin-

gency plan’s assumptions and the adequacyof alternative sources.a. If no plan exists, a plan acceptable to the

corporation’s directors should be required.b. Even if there are no specific concerns, the

existence or lack of a plan should be takeninto account when assessing management.

6. Discuss the results in the parent companysection of the ‘‘Analysis of Financial Fac-tors’’ page in the inspection report.

7. Include in the ‘‘Examiner’s Comments,’’ page1, criticism of liquidity shortfalls within the0- to 90-day period or the absence of acontingency plan to cover shortfalls in theunder-one-year time frame that were dis-cussed with management.



BanksSection 4020.0


Effective January 2011, this section was revisedto provide an introduction to the principal areasof concern when examining a bank, such as theCAMELS components.

In making the determination as to the conditionof the holding company under inspection, anexaminer must, as part of the inspection proce-dures, analyze the financial condition of thebank(s) owned by the holding company. Suchan appraisal is obviously of paramount impor-tance when one considers that the bulk of theconsolidated assets and earnings of a holdingcompany are represented by the bank(s). Theexaminer must incorporate in the analysis, resultsof the most recent commercial examination ofthe subsidiary bank(s).

Therefore, for meaningful results, the analy-sis of the subsidiary bank(s) should commenceafter the results of the latest examination of thebank(s) have been obtained. The primary areasof concern are (1) the quality and adequacy ofthe bank’s capital (C); (2) the quality of thebank’s assets (A); (3) the capability of the boardof directors and management (M) to identify,measure, monitor, and control the risks of thebank’s activities and to ensure that the bank hasa safe, sound, and efficient operation that is incompliance with applicable laws and regula-

tions; (4) the quantity, sustainability, and trendof the bank’s earnings (E); (5) the adequacy ofthe bank’s liquidity (L) position; and (6) thebank’s sensitivity (S) to market risk—the degreeto which changes in interest rates, foreign-exchange rates, commodity prices, or equityprices can adversely affect the bank’s earnings,capital, and liabilities that are subject to marketrisk. See SR-96-38, ‘‘Uniform Financial Institu-tions Rating System,’’ and section A.5020.1 inthe Commercial Bank Examination Manual. Theexaminer’s analysis of the bank must considerand determine whether certain key facets of abank’soperations meet minimum standards and con-form, where required, to bank regulatory restric-tions. The examiner should be especially alert toany exceptions or violations of applicable stat-utes or regulations that could have a materiallyadverse effect upon the financial condition ofthe organization. In addition, the examiner shouldalso consider the conclusions drawn as to theextent of compliance and the adequacy of inter-nal bank policies that contribute to the overallanalysis of the bank’s condition.

Inspection personnel should use the examina-tion ratings of the other federal agencies (whereappropriate) when completing the inspectionreport. However, if substantive differences ofopinion exist as to the bank’s composite rating,adjustments to the rating may be made andfootnoted to indicate the change.


Banks(Capital) Section 4020.1

One area of vital importance in the evaluation ofa bank’s condition is capital adequacy. Consid-eration should be given by the examiner whetherthe bank has sufficient capital to provide anadequate base for growth and a cushion toabsorb possible losses, thereby providing pro-tection to depositors. In that regard, the Board,

has adopted capital adequacy guidelines, thatinclude risk-based and leverage measures whichapply to state member banks. The examinershould refer to section 3020.1 of the Commer-cial Bank Examination Manual for guidance onevaluating the capital adequacy of state memberbanks.


Banks(Asset Quality) Section 4020.2


Effective January 2011, this section was revisedto more clearly explain the components in calcu-lating the total classification ratio and theweighted classification ratio, which are used indetermining the asset quality of subsidiary banks.This section was also revised to include refer-ences to SR-93-30 and SR-96-38.

The quality of a bank’s assets is another area ofmajor supervisory concern. Supervisors con-sider the appraisal and evaluation of a bank’sassets to be one of the most important examina-tion procedures. It will be established by thebank examiner during the examination of a sub-sidiary bank to what degree its funds have beeninvested in assets of good quality that affordreasonable assurance of ultimate collectabilityand regularity of income. The examiner shouldhave further determined that a subsidiary bank’sasset composition is compatible with the natureof the business conducted by the bank, the typeof customer served, and the locality. The hold-ing company examiner is expected to commentupon the total classifications determined by thebank examiner in relation to the bank’s capital.1Consideration should also be given to the sever-ity of the classifications. If the classified assetsare considered not to possess a significant losspotential, favorable consideration should beaccorded this factor.

Past due ratios should also be evaluated. Inthis respect, it is essential that trends be observed.Although a particular lending department’sdelinquent outstandings or an institution’s over-all past due percentage is presently consideredreasonable, a noticeable upward trend may beworthy of comment to management. Excessivearrearages in any area warrant an examiner’scomment in the inspection report. Managementshould take appropriate action to improve anyundesirable past due levels.

In determining an organization’s asset qual-ity, the total classification ratio is an important

indicator to review. The total classification ratiois calculated by adding the total dollar value ofclassified assets divided by the sum of tier 1risk-based capital plus the allowance for loansand lease losses (ALLL). Another yardstickemployed by examiners is the weighted classifi-cation ratio, which takes into consideration theseverity of a bank’s classified assets. In ratingasset quality, the weighted classification ratio isdesigned to distinguish the degree of risk inher-ent in classified assets by ascribing weights toeach category of classification thereby provid-ing another measure of the impact of risk onbank capital.

The following weights are to be used:

Classification Weights

Substandard 20%Doubtful 50%Loss 100%

The weighted classification ratio is calculatedby taking the aggregate of 20 percent of assetsclassified substandard and value impaired (netof allocated transfer risk reserve), 50 percent ofdoubtful, and 100 percent of loss divided by thesum of tier 1 risk-based capital plus the ALLL.In addition to the total and weighted classifica-tions ratios, examiners should also evaluate theadequacy of loan loss valuation reserves as com-pared to weighted classifications. Loss potentialinherent in weighted classified assets must beoffset by valuation reserves and equity capital orappropriate comments should be made.

Another tool that should be considered inevaluating asset quality is the bank’s internalclassification list, if the bank’s lending proce-dures and management are adequate. Additionalinformation on rating a bank’s asset quality isavailable in the Uniform Interagency Bank Rat-ing System. See SR 96-38, ‘‘Uniform FinancialInstitutionsRatingSystem,’’ andsectionA.5020.1in the Commercial Bank Examination Manual.

1. See SR-93-30, specifically the attachment entitled,‘‘Interagency Statement on the Supervisory Definition of Spe-cial Mention Assets.’’ See also SR-04-9 on the attached‘‘Revised Uniform Agreement on the Classification of Assetsand Appraisal of Securities Held by Banks and Thrifts,’’which defines classified assets.


Banks(Earnings) Section 4020.3


Effective January 2016, this section was revisedto include footnote 1.

Comparison of earnings trends with other banksof similar size, along with an analysis of thequality of those earnings, is an effective initialapproach in determining whether or not a bank’searnings are satisfactory. Comprehensive sur-veys of bank earnings by peer group size aretabulated by the Board and many of the ReserveBanks. The results are sufficiently detailed topermit various methods of comparison of theearnings of a specific bank with those in its peergroup.

One ratio used as a means of measuring thequality of a bank’s earnings is its return onaverage assets (net income after taxes dividedby average total assets). If the ratio is low ordeclining rapidly, it could signal, among otherthings, that the bank’s net interest income ormargin is declining or that the bank is experi-encing increased loan losses.

A bank’s current earnings should be sufficientto allow for ample provisions to offset antici-pated losses. Various factors to be considered inthe determination of such losses include a bank’shistoric loss experience, the adequacy of thevaluation reserve, the quality and strength of itsexisting loans and investments and the sound-ness of the loan and administrative policies ofmanagement.

In assessing a bank’s earnings performancecapabilities and the quality of those earnings, anexaminer should give consideration to any spe-cial factors that may affect a particular bank’searnings. For example, a bank located in anurban area of a large city may find it difficult toearn as much as a bank of similar size located ina rural community or a small city. The urbanbank is usually subjected to a higher level ofoperating expenses, particularly in salaries andlocal taxes. Moreover, its proximity to the largecity and the competition afforded by biggerbanks may necessitate lower rates of interest onloans as well as higher rates of interest ondeposits. Consideration should also be given tothe adequacy of the loan loss provisions asreferred to above, the inclusion of any capital-ized accrued interest into interest income, or thenature of any large nonoperating gains when

analyzing earnings. Further consideration shouldbe given to the general nature of a bank’s busi-ness or management’s mode of operation. Abank’s deposit structure and its resulting aver-age interest paid per dollar of deposits maydiffer widely from that of other banks of asimilar size and consequently, its earnings maybe substantially below average as a direct resultof the difference. For example, the maintenanceof a high volume of interest bearing time accountsin relation to total deposits is a major expenseand is quite often the cause for certain banksfalling below the average earnings of compara-bly sized banks.

A bank’s earnings should also be more thansufficiently adequate in relation to its currentdividend rate. It is particularly important that abank’s dividend rate is prudent relative to itsfinancial position and not be based on overlyoptimistic earnings scenarios. See SR-09-4,‘‘Applying Supervisory Guidance and Regula-tions on the Payment of Dividends, StockRedemptions, and Stock Repurchases at BankHolding Companies.”1 Also see section 2020.5and its discussion of the Board’s ‘‘Policy State-ment on the Payment of Cash Dividends byState Member Banks and Bank HoldingCompanies.’’

The percentage that should be retained in thecapital accounts is not clearly established. Onething is certain, the need for retained earnings toaugment capital will depend on the adequacy ofthe existing capital structure as well as thebank’s asset growth rate. Dividend payout ratesmay be regarded as exceeding prudent bankingpractices if capital growth does not keep pacewith asset growth. Prudent management dictatesthat a curtailment of the dividend rate be consid-ered if capital inadequacy is obvious and greaterearnings retention is required. Apparently exces-sive dividend payouts or a record of recentoperating losses should lead the bank or BHCexaminer to refer to sections 5199(b) and 5204of the United States Revised Statutes and

1. SR-09-4 is superseded for a U. S bank holding companyor an intermediate holding company of a foreign bankingorganization with $50 billion or more in total consolidatedassets as stated in SR-15-18, “Federal Reserve SupervisoryAssessment of Capital Planning and Positions for LISCCFirms and Large and Complex Firms,” and SR-15-19, “Fed-eral Reserve Supervisory Assessment of Capital Planning andPositions for Large and Noncomplex Firms.”


section 208.19 of Regulation H which restrictstate member bank dividends.

Analysis of net interest margins is of growingimportance. A comparison should be made of abank’s ability to generate interest income onearning assets relative to the interest expensesassociated with the funds used to finance theearning assets.

Additional information on rating bank earn-ings is available in the Uniform InteragencyBank Rating System. See SR-96-38 ‘‘UniformFinancial Institutions Rating System,’’ and sec-tion A.5020.1 in the Commercial Bank Exami-nation Manual.

Banks (Earnings) 4020.3


Banks(Liquidity) Section 4020.4


This section has been revised to incorporate areference to the ‘‘Liquidity Risk’’ sections (4020.1to 4020.4) of the Federal Reserve System’sCommercial Bank Examination Manual. Thissection has also been revised to include a refer-ence to the March 2010, ‘‘Interagency PolicyStatement on Funding and Liquidity-RiskManagement.’’

Liquidity is generally defined as the ability tomeet short-term obligations, to convert assetsinto cash or obtain cash, or to roll over or issuenew short-term debt. Various techniques areemployed to measure a bank’s (depository insti-tution) liquidity position. The bank examinerconsiders the bank’s location and the nature ofits operations. For example, a small rural bankhas far different needs than a multibillion dollarmoney market institution.

In addition to cash assets, a bank will hold forliquidity purposes a portion of its investmentportfolio of securities that are readily convert-ible into cash. Loan and investment maturitiesare generally matched to certain deposit or otherliability maturities. However, the individualresponsible for a bank’s money managementmust be extremely flexible and have alternatemeans to meet unanticipated changes in liquid-ity needs. To offset these needs, other means ofincreasing liquidity may be needed, which mightinclude increasing temporary short-term bor-rowings, selling longer-term assets, or a combi-nation of both. Factors that the ‘‘money manage-ment’’officerwill consider include theavailabilityof funds, the market value of the saleable assets,prevailing interest rates and the susceptibility tointerest-rate risk, and the bank’s earnings posi-tion and related tax considerations. Althoughmost small banks may not have a ‘‘money man-ager,’’ they too must monitor their liquiditycarefully.

One of the most common methods used bylarge banks to increase liquidity is to use addi-tional borrowings. Some of the other basic meansof improving liquidity include the use of directshort-term credit available through the discountwindow from Reserve Banks, the use of Federalfunds purchases, and the use of loans fromcorrespondent banks.

4020.4.1 SOUND LIQUIDITY-RISKMANAGEMENT

All banks are affected by changes in the eco-nomic climate, and the monitoring of economicand money market trends is crucial to liquidityplanning. Sound financial management can mini-mize the negative effects of these trends whileaccentuating the positive ones. Sound liquidity-risk management requires the followingelements:1

• Effective corporate governance consisting ofoversight by the board of directors and activeinvolvement by management in an institu-tion’s control of liquidity risk.

• Appropriate strategies, policies, procedures,and limits used to manage and mitigate liquid-ity risk.

• Comprehensive liquidity-riskmeasurementandmonitoring systems (including assessments ofthe current and prospective cash flows orsources and uses of funds) that are commensu-rate with the complexity and business activi-ties of the institution.

• Active management of intraday liquidity andcollateral.

• An appropriately diverse mix of existing andpotential future funding sources.

• Adequate levels of highly liquid marketablesecurities free of legal, regulatory, or opera-tional impediments that can be used to meetliquidity needs in stressful situations.

• Comprehensive contingency funding plans(CFPs) that sufficiently address potentialadverse liquidity events and emergency cashflow requirements.

• Internal controls and internal audit processessufficient to determine the adequacy of theinstitution’s liquidity-riskmanagementprocess.

Information that a bank’s management shouldconsider in liquidity planning includes—

1. internal costs of funds,2. maturity and repricing mismatches in the bal-

ance sheet,

1. See the March 10, 2010, ‘‘Interagency Policy Statementon Funding and Liquidity-Risk Management.’’ (See section4066.0, appendix A.) See also the guidance published by theBasel Committee on Banking Supervision, Bank for Interna-tional Settlements, ‘‘Principles for Sound Liquidity-Risk Man-agement and Supervision.’’


3. anticipated funding needs, and4. economic and market forecasts.

In addition, bank management must have aneffective CFP that identifies minimum and maxi-mum liquidity needs and weighs alternativecourses of action designed to meet those needs.Some factors that may affect a bank’s liquidityinclude—

1. a decline in earnings,2. an increase in nonperforming assets,3. deposit concentrations,4. a downgrade by a rating agency,5. expanded business opportunities,6. acquisitions,7. new tax initiatives, and8. assured accessibility to diversified funding

sources, including liquid assets such as high-grade investment securities and a diversifiedmix of wholesale and retail borrowings.

Adequate liquidity contingency planning iscritical to the ongoing maintenance of the safetyand soundness of any depository institution.Contingency planning starts with an assessmentof the possible liquidity events that an institu-tion might encounter. The types of potentialliquidity events considered should range fromhigh-probability/low-impact events that can occurin day-to-day operations to low-probability/high-impact events that can arise through institution-specific or systemic market or operational cir-cumstances. Responses to these events shouldbe assessed in the context of their implicationsfor an institution’s short-term, intermediate-term, and long-term liquidity profile. A funda-mental principle in designing a CFP that addresseseach of these liquidity tenors is to ensure adequatediversification in the potential sources of fundsthat could be used to provide liquidity under avariety of circumstances. Such diversificationshould focus not only on the number of poten-tial funds providers but also on the underlyingstability, availability, and flexibility of fundssources in the context of the type of liquidityevent these sources are expected to address.

See also the ‘‘Liquidity Risk’’ sections (4020.1to 4020.4) of the Board of Governors of theFederal Reserve System’s Commercial BankExamination Manual. These sections provideadditional guidance on evaluating a bankingorganization’s liquidity management.

4020.4.2 LIQUIDITY-RISKMANAGEMENT USING THEFEDERAL RESERVE’S PRIMARYCREDIT PROGRAM

The Federal Reserve’s primary credit program(a type of discount window lending) offers gen-erally sound depository institutions an addi-tional source of available funds, although suchfunds are lent for managing short-term liquidityrisks (at a rate above the target federal fundsrate).2 Management should fully assess thepotential role that the Federal Reserve’s primarycredit program might play in managing the insti-tution’s liquidity. The primary credit programcan be a viable source of very short-term backupfunds. Management may find it appropriate toincorporate the availability of the primary creditprogram into their institution’s diversifiedliquidity-management policies, procedures, andCFPs. The primary credit program has the fol-lowing attributes that make it a viable source ofbackup or contingency funding for short-termpurposes:

1. Primary credit is extended, with minimaladministrative burden, to eligible discountwindow participants.

2. Primary credit is available only to financiallysound depository institutions, as determinedby the lending Federal Reserve Bank.

3. Primary credit can enhance diversification inshort-term CFPs.

4. Borrowings can be secured with an array ofcollateral that is acceptable to the lendingFederal Reserve Bank, including consumerand commercial loans.

5. Requests for primary credit advances can bemade anytime during the day.3

6. There are generally no restrictions on the useof short-term primary credit.

If an institution incorporates primary creditinto its CFP, the institution should ensure that ithas in place with the appropriate Reserve Bankthe necessary borrowing documentation and col-lateral arrangements. This is particularly impor-

2. The Federal Reserve’s secondary credit program pro-vides loans to qualifying depository institutions (for example,those depository institutions that are not eligible for the pri-mary credit program) at an interest rate that is above theprimary credit program’s interest rate. See section 3010.1 ofthe Commercial Bank Examination Manual and SR-03-15,‘‘Interagency Advisory on the Use of the Federal Reserve’sPrimary Credit Program in Effective Liquidity Management,’’for a further discussion of the Federal Reserve’s credit pro-grams.

3. Advances generally are booked at the end of the busi-ness day.

Banks (Liquidity) 4020.4


tant when the intended collateral consists ofloans or other assets that may involve signifi-cant processing or lead time for pledging to theReserve Bank.

It is a long-established sound practice forinstitutions to periodically test all sources ofcontingency funding. Accordingly, if an institu-tion includes the Federal Reserve’s primary andother credit programs, along with borrowingfrom other lenders, in its contingency plans,management should occasionally test the institu-tion’s ability to borrow from all the fundingsources covered by the plan. The goal of suchtesting is to ensure that there are no unexpectedimpediments or complications in the case thatsuch contingency lines need to be used.

Institutions should ensure that any planneduse of primary credit is consistent with thestated purposes and objectives of the program.Under the primary credit program, the FederalReserve generally expects to extend funds on avery short-term basis, usually overnight. There-fore, as with any other type of short-term contin-gency funding, institutions should ensure thatany use of primary credit facilities for short-term liquidity contingencies is accompanied byviable take-out or exit strategies to replace thisfunding expeditiously with other sources offunding. Institutions should factor into theirCFPs an analysis of their eligibility for primarycredit under various scenarios, recognizing thatif their financial condition were to deteriorate,primary credit may not be available. Underthose scenarios, secondary credit may beavailable.

Secondary credit is available at a rate abovethat of primary credit. Secondary credit is avail-able to meet short-term needs (when the borrow-ing is constant and there is a prompt return tomarket funding sources) or to resolve financialdifficulties. The preparations made by a bank toaccess primary credit (the documentation andcollateral requirements) will also support theborrowing of secondary credit.

Another critical element of liquidity manage-ment is an appropriate assessment of the costsand benefits of various sources of potentialliquidity. This assessment is particularly impor-tant in managing short-term and day-to-daysources and uses of funds. Given the above-market rates charged on primary credit, institu-tions should ensure that they adequately assessthe higher costs of this form of credit relative toother available sources. Extended use of anytype of relatively expensive source of funds cangive rise to significant earnings implicationsthat, in turn, may lead to supervisory concerns.

It is also important to note that the Federal

Reserve’s primary credit facility is only one ofmany tools institutions may use in managingtheir liquidity-risk profiles. An institution’s man-agement should ensure that the institution main-tains adequate access to a diversified array ofreadily available and confirmed funding sources,including liquid assets such as high-grade invest-ment securities and a diversified mix of whole-sale and retail borrowings. (See SR-03-15.)

4020.4.2.1 Supervisory and ExaminerConsiderations

Because primary credit can serve as a viablesource of backup, short-term funds, supervisorsand examiners should view the occasional useof primary credit as appropriate and unexcep-tional. At the same time, however, supervisorsand examiners should be cognizant of the impli-cations that too-frequent use of this source ofrelatively expensive funds may have for theearnings, financial condition, and overall safetyand soundness of the institution. Overrelianceon primary credit borrowings, or any othersingle source of short-term contingency funds,regardless of the relative costs, may be symp-tomatic of deeper operational or financial diffi-culties. The use of primary credit, as with theuse of any potential sources of contingencyfunding, is an important management decisionthat must be made in the context of safe andsound banking practices.

4020.4.3 ANALYSIS OF LIQUIDITY

A bank’s liquidity must be evaluated on thebasis of the bank’s capacity to satisfy promptlyits financial obligations and its ability to fulfillthe reasonable borrowing needs of the commu-nities it serves. An examiner’s assessment of abank’s liquidity management should not berestricted to its liquidity position on any particu-lar date. Indeed, the examiner should also focushis or her efforts toward determining the bank’sliquidity position over a specific time period.The examiner’s evaluation should also encom-pass the overall effectiveness of the institution’sasset-liability management and liquidity risk-management strategies. Factors such as the nature,volume, and anticipated takedown of a bank’scredit commitments should also be consideredin arriving at an overall rating for liquidity.

If the bank examiner has commented on a



liquidity deficiency at a subsidiary bank, thebank holding company examiner should con-sider these findings in the overall analysis offinancial factors. Additional information on rat-ing a bank’s liquidity is available in the Uni-

form Interagency Bank Rating System. See SR-96-38, ‘‘Uniform Financial Institutions RatingSystem,’’ and section A.5020.1 in the Commer-cial Bank Examination Manual.



Banks(Summary Analysis) Section 4020.5

The condition of a bank provides importantinsight regarding the quality of bank manage-ment. An appraisal of management’s perfor-mance should be measured in terms of long-term profitability, risk exposure, liquidity, andsolvency; all geared toward assuring the bank’scontinued profitability and overall sound finan-cial condition. Management must meet the bank’schallenges and position in the market placeamong its competitors. It must make plans whichwill achieve the objectives established by thebank’s directors. Management must be con-stantly alert to the need for continued upgradingand expanding of services and facilities toadvance, support, and encourage the bank’sgrowth.

Just as sound management decision makingwill generally produce banks that are free fromserious problems, ineffective management hasinvariably been a prominent factor in almostevery serious problem bank situation. An exam-iner must consider the degree and severity ofproblems that exist in the bank under exam-ination and attempt to establish the respon-sibility for such. The examiner should seek todetermine to what degree the bank’s problemsare attributable to questionable managementjudgment as opposed to outside factors, such asunfavorable economic conditions.

The major portion of a bank holding com-pany’s consolidated assets are held in the banksubsidiaries. Furthermore, at the parent level,

the major asset is generally the investment insubsidiaries, the principal portion of which isthe investment in the bank(s). Therefore, withfew exceptions, it is the overall condition of thebank subsidiaries that reflects the condition ofthe parent company. As the bank holding com-pany examiner reviews the examination re-port(s) for each bank subsidiary, a decision mustbe made with respect to the general condition ofeach bank. When all the bank subsidiaries havebeen reviewed, the examiner must put thesefindings within their proper perspective. Forexample, if four of five bank subsidiaries com-prise less than 10 percent of the combined bank-ing assets, it is the condition of the fifth banksubsidiary that will weigh heavily in the analy-sis. In other words, if the fifth bank comprises90 percent of the combined banking assets, theparent’s investment in that bank also comprisesmost of the holding company’s assets. Thus, thequality of the parent’s assets would be reflectedin the general condition of that bank and appro-priate comments are warranted. It should benoted, however, that regardless of relative size,a bank experiencing problems should be com-mented upon in the summary analysis. SeeSR-04-18, ‘‘Bank Holding Company Rating Sys-tem,’’ to determine how to rate a holding com-pany’s subsidiary depository institution(s) in thebank holding company supervisory framework.See also section 4070.0.


Supervision Standards for De Novo StateMember Banks of Bank Holding Companies Section 4020.9

4020.9.1 DEFINITION AND SCOPE OFTHE DE NOVO BANK SUPERVISIONPOLICY

The term ‘‘de novo bank’’ refers to a statemember bank that has been in operation for fiveyears or less. The application and supervisionstandards for de novo state member banks arefound in SR-91-17. De novo state member banksubsidiaries of bank holding companies are sub-ject to those policies. The standards discussed inthis section are limited to a de novo subsidi-ary bank’s financial performance.

The de novo policy also extends to commer-cial banks that have been in existence for lessthan five years and subsequently convert tomembership. Because thrifts, Edge Act compa-nies, and industrial banks that are converting tomembership (‘‘converted banks’’) have not dem-onstrated operating stability as commercialbanks, they also are subject to the de novopolicy, regardless of how long they existedbefore the conversion.

The policy applies to de novo banks throughthe fifth year of operations. Experience hasshown that pronounced problems often surfaceduring a new bank’s fourth and fifth years ofoperation, frequently as a result of inexperi-enced management, management and directorchanges, dissension among directors, directors’lack of involvement, and poor lending practicesduring the early years.

4020.9.2 CAPITAL STANDARDS FORSUBSIDIARY BANKS OF BHCs

De novo subsidiary banks of bank holding com-panies are expected to maintain capital in con-formance with the de novo policy guidelines ofSR-91-17. Initial capital in a de novo state mem-ber bank should be reasonable in relation tostate law, the bank’s location and business plan,and the competitive environment. At a mini-

mum, a de novo bank must maintain a tangibleTier 1 leverage ratio of 9 percent for the firstthree years of operation.1 The applicant’s (thatis, the proposed state member bank’s or thebank holding company’s) initial projections ofasset growth and earnings performances shouldbe reasonably in line with the bank’s ability tomaintain this ratio without relying on additionalcapital injections. The de novo policy also appliesto newly converted commercial banks throughthe third year of existence and to other types ofinstitutions that become Federal Reserve mem-bers for a three-year period beginning from thedate following consummation. Any exceptionsto this policy that are being considered for con-verted banks should be discussed with Boardstaff. Although a 9 percent tangible leverageratio is not required after year three, de novobanks are expected to maintain capital ratioscommensurate with safety-and-soundness con-cerns and, generally, well in excess of regula-tory minimums.

4020.9.3 CASH FLOWS TO A BHCPARENT

Under the current policy on small one-bankholding companies (see section 2090.2.3), denovo banks may not provide funds for servicingthe parent’s debt until the bank receives twoconsecutive CAMELS ratings of 1 or 2 based onfull-scope examinations and, in the judgment ofthe Reserve Bank, can be expected to continueoperating soundly. An exception to this prohibi-tion is the tax payments that are made in accor-dance with the Board’s policy under Regula-tion Y (see section 2070.0 andFRRS4–870).

1. Although this policy applies to a bank holding compa-ny’s acquisition of a de novo state member bank, the FederalReserve also encourages bank holding companies’ nonmem-ber bank subsidiaries to adhere to the same standards.

BHC Supervision Manual June 1997Page 1

NonbanksSection 4030.0

4030.0.1 INTRODUCTION

Generally, a subsidiary of a bank holding com-pany is not liable for debts of any other sub-sidiary of the holding company unless it iscontractually obligated through guarantees,endorsements, or other similar instruments. Thisapparent legal separation may induce false con-fidence that banks are insulated from problemsthat may befall other subsidiaries of the holdingcompany. If a nonbank subsidiary of a bankholding company finds itself in serious financialtrouble, several results are possible. The holdingcompany may work as it was intended, in thatdebts of the failing subsidiary are isolated andnot transferred to other subsidiaries so that atworst, the subsidiary and the parent (the holdingcompany) fail. In this instance, other sub-sidiaries, including bank subsidiaries, areunharmed, and after a change in management orownership, they continue in operation. There isno loss of confidence in the bank by its deposi-tors. However, this is not necessarily the result.Failure of a nonbank subsidiary may lead to a

lack of confidence in the affiliated bank’s abilityto continue in business, which might precipitatea run on the bank’s deposits. The failure of amajor nonbank subsidiary then may place itsaffiliated bank in serious financial trouble. Theexaminer should assess the impact that the fail-ure or the potential failure of a nonbank subsidi-ary may have on an affiliated bank with a simi-lar name.Usually, a financially distressed nonbank sub-

sidiary is aided by the holding company, whichwill do everything in its power to rescue it fromfailure. At a minimum, refusal to do so wouldundermine confidence in the strength of theholding company. Refusal to aid its nonbanksubsidiary might even result in a rise in theinterest cost of the holding company’s futuredebt in the capital markets and, more than likely,preclude issuance of commercial paper.A holding company has considerable discre-

tion in choosing how to assist one of its troubledsubsidiaries. Because the bank is usually thelargest subsidiary, the holding company mayattempt to draw upon the resources of the bankto aid the nonbank subsidiary. The bank cantransfer a substantial portion of its capital throughdividends to the parent company, which maypass these funds on to the troubled nonbanksubsidiary. Also, the nonbank may attempt tosell part of its portfolio to the bank subsidiary toimprove liquidity. The Board’s Interpretation 12C.F.R. 250.250 (at FRRS 3–1133) limits the sale

of nonbank subsidiary loans to the bank affiliateunless the bank had an opportunity to appraisethe credit at the inception of the loan. Therefore,the examiner should closely analyze the off-balance-sheet activity of the nonbank subsidi-ary, particularly activity relating to the sale ofloans shortly after they are made. Referenceshould also be made to section 2020.7, regard-ing the transfer of low-quality loans or otherassets to avoid classification.

4030.0.2 ANALYSIS OF FINANCIALCONDITION AND RISK ASSESSMENT

Because of the potentially damaging effect onthe parent company or its bank subsidiary, theexaminer should conduct a detailed analysisof the financial condition and perform a riskassessment of the nonbank subsidiaries. Theloss to the holding company may not be con-fined to the equity in and advances to the subsid-iary. The contingent liabilities arising from thenonbank subsidiary’s external borrowings arequite often a large multiple of the parent’sinvestment. Particular attention should bedirected to holding companies that have mademassive capital injections in order to rescue afailing subsidiary or to satisfy the external debtobligations of the subsidiary.For each bank holding company with non-

bank activities, examiners should prepare awritten risk assessment of each active nonbanksubsidiary, addressing the financial and manage-rial concerns outlined below.1 This assessmentshould be performed with the same frequencyrequired for full-scope inspections. The purposeof this assessment is to identify subsidiarieswith a risk profile that warrants an on-site pres-ence, even if the subsidiary does not meetthe minimum criteria set forth in section5000.0.4.4.1, ‘‘On-site Reviews of NonbankSubsidiaries.’’ In formulating this assessment,theexaminershouldconsiderall availablesourcesof information including, but not limited to—

• findings, scope, and recency of previousinspections;

1. The assessment of nonbank activities in large, complexorganizations may be focused on an intermediate-tier com-pany with oversight responsibility for multiple nonbanksubsidiaries.


• ongoing monitoring efforts of surveillance andfinancial analysis units;

• information received through first-day lettersor other pre-inspection communications;

• regulatory reports and published financialinformation; and,

• reports of internal and external auditors.

The risk assessment should address each non-bank subsidiary’s funding risk, earnings expo-sure, operational risks, asset quality, capitaladequacy, contingent liabilities and other off-balance-sheet exposures, management informa-tion systems and controls, transactions with

affiliates, growth in assets, and the quality ofoversight provided by the management of thebank holding company and nonbank subsidiary.The examiner should give particular attention toappraising the quality of a nonbank subsidiary’sassets because asset problems therein may leadto other financial problems in the nonbank sub-sidiary and the parent company or bank affili-ates. Examiners are expected to document in theinspection workpapers their assessment of theoverall risk posed by each nonbank subsidiaryand to summarize their assessment of nonbankactivities in the bank holding company inspec-tion report.

Nonbanks 4030.0


Nonbanks: Credit Extending(Classifications) Section 4030.1

The examiner has four alternatives with respectto asset classifications.An appraisal of the degreeof risk involved in a given asset leads to aselection. The examiner can either ‘‘pass’’ theasset or adversely classify the asset ‘‘sub-standard,’’ ‘‘doubtful’’ or ‘‘loss,’’ depending onthe severity of deterioration noted.Since the preponderance of all loans are sub-

ject to some degree of risk, the following ques-tion arises: To what point, or degree, must agiven credit deteriorate to warrant a scheduledcriticism in the report of inspection? Generally,a passed credit has those characteristics whichare recognized as being part of a normal riskasset; the degree of risk is not unreasonable, theloan is being properly serviced, and is eitheradequately secured or repayment is reasonablyassured from a specific source.Classification units are designated as

‘‘substandard,’’ ‘‘doubtful,’’ and ‘‘loss.’’ A sub-standard asset is inadequately protected by thecurrent sound worth and paying capacity of theobligor or of the collateral pledged, if any.Assets so classified must have a well-definedweakness or weaknesses that jeopardize the liq-uidation of the debt. They are characterized bythe distinct possibility that the nonbank subsidi-ary will sustain some loss if the deficiencies are

not corrected. An asset classified doubtful hasall the weaknesses inherent in one classifiedsubstandard with the added characteristic thatthe weaknesses make collection or liquidation infull, on the basis of currently existing facts,conditions, and values, highly questionable andimprobable. Assets classified loss are consid-ered uncollectible and of such little value thattheir continuance as recordable assets is notwarranted. This classification does not meanthat the asset has absolutely no recovery orsalvage value, but rather it is not practical ordesirable to defer reserving against this basi-cally worthless asset even though partial recov-ery may be effected in the future.Although the System does not apply bank

standards when classifying nonbank assets, theclassification categories are the same. Examin-ers of BHC nonbank subsidiaries must appraisethe assets in light of industry standards andconditions inherent in the market.For information on classifying a parent’s

investment in and advances to a noncredit-extending subsidiary, see Manual section4070.0, BHC Rating System.For information on the sufficiency of non-

bank valuation reserves, see Manual section4030.4.


Nonbanks: Credit Extending(Earnings) Section 4030.2

When analyzing the earnings of a nonbank sub-sidiary, the examiner should address two pri-mary questions: (1) Is the return on assets com-mensurate with the risk associated with theassets? (2) What is the impact of earnings andtrends on the parent company and affiliate banks?While a nonbank subsidiary operating at a lossmay be in less than satisfactory condition, thelossmay not necessarily result in amajor adverseimpact on the consolidated earnings. The non-bank subsidiary’s total assets may be insignifi-cant in relation to the consolidated assets of theBHC, but operating losses may result in a sig-nificant reduction in its consolidated earningsposition.In some cases, industry statistics will be avail-

able for comparative purposes. However, afavorable comparison should not necessarily betaken as depicting a satisfactory earnings condi-tion. Actions by the parent company could influ-ence the earnings of its subsidiaries. For exam-ple, management and/or service fees can beadjusted in order to alter the subsidiary’s earn-ings to desired levels. Also, if the parent com-pany is funding the subsidiary, the cost of fundsto the subsidiary can be adjusted above or belowthe parent’s cost of funds thus affecting netincome. In addition, an undercapitalized subsid-iary with only a marginal return on assets couldshow a better return on equity than the ade-quately capitalized independent counterpartexperiencing a good return on its assets. Asimportant as return on equity is as a measureof performance, for nonbank subsidiaries, par-ticularly those that are thinly capitalized, abso-lute level of earnings or return on assets providea more meaningful measure of earningsperformance.The cash return to the parent from its invest-

ment in and advances to a subsidiary less itscosts to carry the assets and related expensesshould exceed the cash return available from aninvestment of a similar amount in securities inorder to justify retaining the subsidiary. If itseems that an alternative employment of fundswould be more rational, the examiner shouldinquire as to management’s plans to improvesubsidiary earnings.

Questions to be answered in analyzing theearnings of credit-extending nonbank subsidi-aries include:1. What is the impact on the parent company

and affiliate banks of a nonbank subsidiary oper-ating at a loss?2. Is the return on assets commensurate with

the risk inherent in the asset portfolios for thosenonbank subsidiaries operating profitably?3. Are intercompanymanagement/service fees

appropriate? From a supervisory perspective,management and service fees should have adirect relationship to and be based solely uponthe fair value of goods and services received.4. Is the subsidiary required to reimburse the

parent for the parent’s interest expense on bor-rowed funds, the proceeds of which have beentreated as ‘‘advances to subsidiaries?’’5. Is the quality of the subsidiary’s earnings

sound? For example, is the company understat-ing the provision for loan losses, relying uponnonoperating gains or capitalization of accruedinterest?Special attention should be directed by the

examiner to the computation of the company’snet interest margin (interest income–interestexpense, divided by average earning assets). Astudy of company yields on investments shouldprovide a measure of the company’s ability toinvest its funds in earning assets that provide arate of return above the company’s cost offunds. As net interest margins narrow, the com-pany may find it more difficult to generate suffi-cient income to meet operating expenses.When discussing growth in earnings, the

examiner should clearly differentiate betweenincreases due to increased net interest incomeon a constant base of earning assets as com-pared to an increase in the earning asset basewith a concurrent proportional increase in netinterest income. Any improvement in net inter-est income as a percentage of earning assetsmay reflect favorably on management’s abilityto invest its funds at favorable yields or itsability to find less expensive sources of funds.


Nonbanks: Credit Extending(Leverage) Section 4030.3

As a general rule, credit-extending nonbank sub-sidiaries are funded by the proceeds of parentcompany borrowings through instruments suchas commercial paper or medium to long-termdebt or a combination thereof. Equity generallyrepresents only a small portion of fundingresources. There are instances, however, wherethe nonbank subsidiary will arrange direct fund-ing from external sources. This is especially truein certain States where there are tax advantagesassociated with direct external funding.Heavy reliance on borrowed funds by a non-

bank subsidiary together with its limited capitalposition often results in a highly leveragedfinancial condition that is quite sensitive tochanges in money market cost of funds. Anexaminer should consider what a change in thecompany’s cost of funds might do to its netinterest margin and earnings.Many BHCs operate on the premise that a

nonbank subsidiary needs little capital of itsown as long as the parent company is ade-quately capitalized. Implicit in this operatingpractice is management’s belief that the parentcould act as a source of financial strength to itssubsidiary in the event of difficulty at the sub-sidiary level. However, experience has indicatedthat in many cases, once trouble has developedin the subsidiary, the parent is hesitant to directadditional funds to the subsidiary, arguing that itis best to limit losses and exposure and it isimprudent for the parent to inject additionalcapital at this time. Given this experience, it isoften considered appropriate for an examiner tocomment on a subsidiary’s extended leveragedposition, indicating to management that the

company has little, if any, capital ‘‘cushion’’with which to absorb any asset ‘‘shrinkage’’ orloss. The examiner may then conclude and pos-sibly recommend that additional capital be pro-vided for the credit-extending nonbank subsidi-ary so that its leverage may be reduced and itscapital structure altered to reflect more closelyan independent organization in the same or sim-ilar industry.Funding should be reviewed to determine that

the subsidiary (or the parent) is not mismatchingmaturities by borrowing short-term funds andapplying them to long-term assets that are notreadily convertible into cash. A mismatch ofmaturities can lead to serious liquidity problems.A primary concern of the holding company

examiner is to determine whether the nonbanksubsidiary has the capacity to service its debt inan orderly manner. Does the credit-extendingnonbank subsidiary have sufficient liquidity andhow much will it have to rely on the parentcompany for funds to retire debt to unaffiliatedparties? Factors to be considered include:1. The subsidiary’s asset quality and its abil-

ity to convert assets into cash at or near currentcarrying value. Consider the maturities of bor-rowings and whether they align with the sched-uled assets that will be converted to cash.2. The subsidiary’s and the parent’s back-up

bank lines of credit available in the event com-mercial paper cannot be refinanced.3. The parent company’s ability to require its

bank or other nonbank subsidiaries to upstreamextra dividends to support the illiquid positionof one or more of its nonbank subsidiaries.


Nonbanks: Credit Extending(Leverage) Section 4030.3

As a general rule, credit-extending nonbank sub-sidiaries are funded by the proceeds of parentcompany borrowings through instruments suchas commercial paper or medium to long-termdebt or a combination thereof. Equity generallyrepresents only a small portion of fundingresources. There are instances, however, wherethe nonbank subsidiary will arrange direct fund-ing from external sources. This is especially truein certain States where there are tax advantagesassociated with direct external funding.Heavy reliance on borrowed funds by a non-

bank subsidiary together with its limited capitalposition often results in a highly leveragedfinancial condition that is quite sensitive tochanges in money market cost of funds. Anexaminer should consider what a change in thecompany’s cost of funds might do to its netinterest margin and earnings.Many BHCs operate on the premise that a

nonbank subsidiary needs little capital of itsown as long as the parent company is ade-quately capitalized. Implicit in this operatingpractice is management’s belief that the parentcould act as a source of financial strength to itssubsidiary in the event of difficulty at the sub-sidiary level. However, experience has indicatedthat in many cases, once trouble has developedin the subsidiary, the parent is hesitant to directadditional funds to the subsidiary, arguing that itis best to limit losses and exposure and it isimprudent for the parent to inject additionalcapital at this time. Given this experience, it isoften considered appropriate for an examiner tocomment on a subsidiary’s extended leveragedposition, indicating to management that the

company has little, if any, capital ‘‘cushion’’with which to absorb any asset ‘‘shrinkage’’ orloss. The examiner may then conclude and pos-sibly recommend that additional capital be pro-vided for the credit-extending nonbank subsidi-ary so that its leverage may be reduced and itscapital structure altered to reflect more closelyan independent organization in the same or sim-ilar industry.Funding should be reviewed to determine that

the subsidiary (or the parent) is not mismatchingmaturities by borrowing short-term funds andapplying them to long-term assets that are notreadily convertible into cash. A mismatch ofmaturities can lead to serious liquidity problems.A primary concern of the holding company

examiner is to determine whether the nonbanksubsidiary has the capacity to service its debt inan orderly manner. Does the credit-extendingnonbank subsidiary have sufficient liquidity andhow much will it have to rely on the parentcompany for funds to retire debt to unaffiliatedparties? Factors to be considered include:1. The subsidiary’s asset quality and its abil-

ity to convert assets into cash at or near currentcarrying value. Consider the maturities of bor-rowings and whether they align with the sched-uled assets that will be converted to cash.2. The subsidiary’s and the parent’s back-up

bank lines of credit available in the event com-mercial paper cannot be refinanced.3. The parent company’s ability to require its

bank or other nonbank subsidiaries to upstreamextra dividends to support the illiquid positionof one or more of its nonbank subsidiaries.


Nonbanks: Credit Extending(Reserves) Section 4030.4

The purpose of a credit-extending nonbank sub-sidiary’s reserve for bad debts is to provide forknownand potential losses in its assets. Althoughthere is no specific formula for measuring theadequacy of a reserve for bad debts, prudencedictates that the reserve account should be main-tained at a ‘‘reasonable’’ level. What is reason-able depends on the quality of the subsidiary’sassets, its collection history and other facts.However, from a supervisory perspective, thereserve for bad debts should at least providetotal coverage for all assets classified ‘‘loss’’and still be sufficient to absorb future, unidenti-fied, ‘‘normal’’ losses, that are estimated basedon the ‘‘doubtful’’ and ‘‘substandard’’ classifica-tions and the company’s historic experience.Valuation reserves for a going concern are notconsidered adequate unless they can absorb100 percent of identified losses and still have abalance sufficient to absorb future losses fromcontinued operations.

Examiners should recommend the mainte-nance of valuation reserves sufficient to offsetclassified lossesandmay recommend (asopposedto require) thatmanagement charge-off the lossesto the reserve account. The charge-off of classi-fied losses is considered appropriate in orderto assure that financial statements accuratelyreflect the company’s financial condition. TheFederal Reserve System has the responsibility tomonitor the bank holding company’s nonbanksubsidiary statements for accuracy and com-pleteness. Failure by management to reflectaccurately the financial condition of the subsidi-ary and/or parent company could result in aformal corrective action to require charge-offsor other adjustments to financial statements.For additional information, see Manual sec-

tion 4030.1, ‘‘Classifications.’’


Nonbanks: Noncredit ExtendingSection 4040.0

The noncredit-extending nonbank subsidiariesprovide services or financial products other thanextensions of credit. Some of these companiesare insurance agencies, credit life and creditaccident and health insurance underwritingcompanies, electronic data processing centers,management consulting firms and advisorycompanies.The operations of some insurance agencies

are conducted on the premises of the bank sub-sidiary(ies) by personnel who often serve asofficers or employees of the bank. These compa-nies usually incur little or no liabilities andrequire only nominal capitalization because riskis limited. However, their commission income isoften substantial and a steady source of fundsfor the parent company. Nevertheless, insurance‘‘underwriters’’ typically have strong capitalbases, good liquidity and profitable operations.Furthermore, their operating risks are generallystable and predictable.Electronic data processing centers are often

established under section 4(c)(8) of the Act,which permits them to sell their services toaffiliated and unaffiliated customers. Section4050.0 of this Manual cites examples of how anEDP servicer can have an unfavorable impacton the parent company or its affiliates. Manage-ment consulting firms and advisory companiesusually require little capitalization and no fund-ing and generate favorable earnings. Of thenoncredit-extending subsidiaries, insuranceunderwriters and EDP servicers are generallythe only companies requiring capital and fund-ing in significant amounts.However, all subsidiaries are subject to some

level of risk, which could impact on the BHC.In the case of insurance underwriters, insurancebenefits paid could exceed actuarial estimates.Such a situation, however rare, could necessitatefinancial support from the parent company. EDPservicers could, as a result of excessive com-puter down-time or equipment obsolescence,impact on consolidated earnings or require addi-tional capital contributions. In addition, contin-gent liabilities, resulting from legal actions orfailure to perform, could be a large multiple of asubsidiary’s capital and may affect the parent.

4040.0.1 EARNINGS

In analyzing these subsidiaries, the examinershould consider the following:1. Are any noncredit-extending subsidiaries

operating at a loss or incurring low levels ofearnings? If so, what is the cause and doesit have a material impact on consolidatedearnings?2. Does the loss result in the subsidiary’s

reliance on the parent company or bank subsid-iary(ies) for financial support? If so, in whatform is the support provided?3. If a loss has been incurred, has manage-

ment initiated corrective measures? If not, whynot?4. Are the fees charged by the parent for

services rendered limited to theirfair marketvalue? The answer to this question will almostalways depend on information supplied by man-agement. Management should be aware of thefair market rates charged by their competitorsfor similar services rendered.5. Are the rates charged affiliates commensu-

rate with the services provided and similar torates charged nonaffiliated customers?

4040.0.2 RISK EXPOSURE

In noncredit-extending subsidiaries, risk expo-sure, of any meaningful magnitude, is oftenrelated to possible losses arising from legalactions for failure to perform services as con-tracted. The examiner should determine that thesubsidiaries are being operated effectively byexperienced and competent personnel under thedirection of satisfactory management. Theexaminer should further determine that parentcompany management exercises appropriatecontrols over the activities of the subsidiary.Becauseofpotential liability, theexaminershouldascertain whether the subsidiaries have adequateinsurance coverage (i.e., errors and omissions,public liability, etc.). The examiner should bealert to any contingent liabilities that wouldhave a significant impact of the parent com-pany. For example, the parent company mightguarantee the payment of debt or leases for thesubsidiary.


Nonbanks: Noncredit Extending (Service Charters)Section 4050.0

The internalservicessubsidiariesgenerallyderivetheir business only from the parent companyand its affiliates. Examples of such companiesinclude forms printing firms, owners and opera-tors of banking premises, and EDP servicingcompanies. Banking premises subsidiaries areestablished to hold or operate properties usedwholly or substantially by the parent’s subsidi-ary for its banking business. Generally, theiroperations do not impact unfavorably on theparent company. However, in instances wherethe banking premises are not wholly occupiedby a banking subsidiary, the examiner shouldascertain that the excess space is fully leased/rented. A high vacancy level could result inunprofitable operations or result in an abnormalrental charge to the banking subsidiary in orderto operate the subsidiary on a profitable, orbreak even, basis.EDP service centers provide bookkeeping or

data processing services for the internal opera-tions of the holding company and its subsidi-aries, and store and process other banking, finan-cial or related economic data. Generally, these

service centers do not have a material effect onconsolidated earnings performance as they pro-vide essential services at costs comparable orbelow their independent counterparts. They usu-ally operate on a break-even basis or at a nomi-nal profit. However, there are some subsidiaries,including EDP servicers, which also provideservices indirectly to unaffiliated concerns. EDPservicers operating under section 4(c)(1)(C) ofthe Act, may provide services to customers ofits bank affiliates, provided that the service con-tract is between the bank and the customer. EDPservicers that operate as independent subsidi-aries under section 4(c)(8) of the Act are notsimilarly restricted and are not considered ‘‘notfor profit’’ organizations.A financial analysis of a ‘‘not for profit’’

service subsidiary should concentrate on theorganization’s ability to control its expenses andits ability to provide its services to its affiliatesat fair market value. Failure to control expensesmay result in excessive charges to affiliates tothe detriment of the affiliate.


Consolidated(Earnings) Section 4060.0

For purposes of an analysis of earnings, analystsof bank holding companies have placed consid-erable weight on consolidated BHC financialdata. Consolidated data, however, can be verymisleading since bank assets and revenues arelarge in relation to their profit margins. On theother hand, the volume of nonbank assets isgenerally not nearly as large, but profit margins(or losses) tend to be much more substantial.The organizational structure of a holding com-pany is of prime importance and must first betaken into consideration before attempting toanalyze consolidated earnings. As an example,in the case of nonoperating shell bank holdingcompanies with no nonbank subsidiaries, theearnings of the bank subsidiary should be nearlyidentical with consolidated earnings for theorganization. Therefore, in these instances, theviews and ratings of the applicable bank regula-tory agency would normally be accepted andwould apply to consolidated earnings of theBHC. This treatment would not apply to one-bank and multi-bank holding companies withsubstantial credit-extending nonbank subsidi-aries. These holding companies require anin-depth analysis of earnings because of theadverse impact that a poorly operated subsidiarycan have upon the consolidated earnings of theBHC.In order to properly analyze consolidated

earnings, it is best to review and study a consol-idating statement of income and expense for thepurpose of determining each entity’s contribu-tion to earnings. It is important to recognize thatthere need be no direct correlation between theasset size of a subsidiary and its relative contri-bution to total consolidated earnings. For exam-ple, a subsidiary accounting for a minute portionof consolidated assets could substantially negatesatisfactory earnings of its larger asset base affil-iates because of poor operations and sizeablelosses.When evaluating consolidated earnings, it is

important to review the component parts ofearnings for prior interim or fiscal periods forcomparative purposes in order to determinetrends. Considerable attention is to be focusedon the various income and expense categories.The net interest income (difference betweeninterest income and interest expense) of a com-pany is highly revealing as it will give an indica-tion of management’s ability to borrow at attrac-tive rates and employ those funds withmaximumprofitable results.Items having a significant impact on earnings

include the noncash charge, ‘‘provisions for loan

losses’’ and the volume of nonaccrual and rene-gotiated or restructured credits. A large provi-sion for loan losses is made necessary by poorquality assets which result in large charge-offsto valuation reserves. In order to replenish thereserve for loan losses to adequate levels toprovide ample coverage against known andpotential losses, large amounts of revenues mustbe ‘‘set aside.’’ Nonperforming and renegotiatedcredits either provide no income or provide areduced rate of income to the extent that theassets are no longer profitable relative to thecost of funds and the cost of doing business. Insituations where earnings are below average orunsatisfactory, acommentconcerning theamountof provision for loan losses and volume of non-performing loans is warranted in the financialanalysis.Other items of significance include taxes, par-

ticularly where tax credits are indicative of lossoperations, and extraordinary or nonrecurringitems. Extraordinary gains or losses are not theresult of the normal operations of a companyand should be analyzed independently fromoperatingearnings.Generally,extraordinary itemsresult from the sale of current or fixed assets.When significant amounts are involved, examin-ers should determine the underlying reasons be-hind such transactions.After an analysis has been made of the perti-

nent components of earnings, analyze the ‘‘bot-tom line’’ or net income of the consolidatedcompany. Generally, analysts relate net incometo several benchmarks in order to evaluate per-formance. The ratios of earnings as a percentageof average equity capital or average assets aremost widely used. Conclude the analysis with acomparison of a company’s ratios in relation toits peer group.Comparatively low earnings relative to its

peer group may be a reflection of problems andweaknesses such as lax or speculative creditpractices (resulting in nonearning assets or loanlosses), high interest costs resulting from exces-sive debt, or rapid expansion into competitiveindustries subject to wide variations in incomepotential.Earnings on a consolidated basis are the best

measure of performance. Moreover, while theearnings of individual subsidiaries must not beignored, the ability of holding company man-agement to control the level of reported earn-ings in any one subsidiary reaffirms the practi-


cality of using the consolidated approach toanalyze holding company profitability.Essentially, the following points summarize

areas which should be considered when analyz-ing consolidated earnings:1. The returnonconsolidatedassetsandequity

capital, as well as historical trends and peergroup comparisons.2. The ability of earnings to provide for capi-

tal growth, especially when taking into consider-ation recentandplannedassetanddeposit growth.3. The ‘‘quality’’ of earnings is affected by

the sufficiency of the provision to loan lossreserves and the asset quality of the organiza-tion. A high level of earnings that did notinclude sufficient provisions to the loan lossreserve during a period of high charge-offs mayresult in reductions in the reserve balance andthereby call to question the merits of high earn-ings in the face of declining reserve balances.4. The ability of management to prepare real-

istic earnings projections in light of the riskstructure and quality of assets.

Consolidated (Earnings) 4060.0


Consolidated(Asset Quality) Section 4060.1

The evaluation of asset quality based on classifi-cations of ‘‘substandard, doubtful and loss,’’ isone of the most important elements to be takeninto consideration when performing a financialanalysis of a holding company because of thesevere impact that poor quality assets can haveon the overall condition of the organization.Procedures to measure asset quality of banksinvolve the use of the relationship of weightedclassified assets to Tier 1 capital funds and totalclassifications to total capital funds. Accordingly,consolidated asset quality could be based on therelationship of aggregate weighted classifiedassets of the parent company, bank subsid-iary(ies) and nonbank subsidiary(ies), to Tier 1capital.However, a problem encountered when view-

ing asset quality on a consolidated basis is thefact that in multi-bank holding companies thereis usually a large timing difference between thedates of examinations of the banking subsidi-aries. Therefore, the aggregating of classifiedbank assets from reports prepared at differenttimes, reduces the currentness and validity ofconclusions drawn. This problem can only beeliminated by using common examinationand inspection dates which are not generallyavailable.Despite the shortcoming of using classifica-

tion information from different dates, an exam-iner may determine that there is a sufficientmeasure of validity in using the data and maypresent an analysis based on consolidatedweighted classifications. For example, if thereare a small number of bank subsidiaries and ifthe examination dates are near a common pointin time, timing differences may be inconsequen-tial. Or, if a review of several years of a bank’s

examinations reveals a relatively constant orstable level of classifications, then the timing ofthe most recent examination would not invali-date use of the analytical tool. As such, thetechnique may be employed when circum-stances permit.Other factors to be considered in determining

asset quality include the levels of nonaccrualand renegotiated loans, other real estate ownedand past due loans. While these assets may notbe subject to classification, they usually repre-sent former or emerging problem loans. More-over, in the aggregate, they may represent asignificant proportion of the asset portfolio. Ifsuch is the case, they should be taken intoconsideration when the examiner determines hisoverall rating of asset quality.It is difficult to rely on the adequacy of con-

solidated reserves because they are ‘‘fractured’’and protect portfolios in different organizationsand may not be interchangeable or transferable.The reserve of each entity in the corporate struc-ture must be reviewed or analyzed individually.For example, if consolidated reserves appearinadequate, there is no consolidated reserveaccount per se that could be increased to ade-quate proportions. Consequently, the inadequacywould have to be identified at the parent orsubsidiary level. Conversely, if consolidatedreserves appear to adequately cover the aggre-gate of all ‘‘loss’’ and a certain portion of‘‘doubtful,’’ it does not insure that all subsidi-aries have adequate reserves. Nevertheless, de-spite the shortcomings of using consolidatedreserves, the analyst should not hesitate to calcu-late and present a measure of the relationship ofconsolidated reserves to consolidated loans.


Consolidated Capital (Examiners’ Guidelinesfor Assessing the Capital Adequacy of BHCs) Section 4060.3


Effective January 2011, this section has beenrevised to

1. delete the discussions about excluding cer-tain consolidated bank holding company(BHC)-sponsored asset-backed commercialpaper (ABCP) programs from the computa-tion of risk-weighted assets; also delete arelated exclusion from tier 1 capital—anyminority interest in a consolidated ABCPprogram that is not included in risk-weightedassets. This change was the result of a Janu-ary 2010, risk-based capital rule change(effective date, March 29, 2010). (See 12C.F.R. 225, appendix A and 75 Fed. Reg.4636, January 28, 2010.)

2. include, effective January 29, 2009, amend-ment to the risk-based capital rule that per-mits BHCs to reduce the amount of goodwillthat must be deducted from tier 1 capital bythe amount of any deferred tax liability asso-ciated with that goodwill. (See 73 Fed. Reg.79602, December 30, 2008.)

3. provide information on the implementationof a limit, on the aggregate amount of aBHC’s restricted core capital elements, whichincludes trust preferred securities, of 25 per-cent of total core capital elements (net ofgoodwill) that can be included in the tier 1capital of a BHC. This limit is effective onMarch 31, 2011.

4. discuss the inclusion, without limit, in tier 1capital of senior perpetual preferred stockissued to the U.S. Department of the Treasuryunder the Trouble Asset Relief Program(TARP), established by the Emergency Eco-nomic StabilizationAct of 2008 (EESA), whichwill be considered qualifying noncumulativeperpetual preferred stock, including its relatedsurplus.

5. clarify the assignment of a 20 percent risk-weight to the guaranteed portion of loss onassets subject to a loss-sharing agreementbetween the FDIC and acquirers of assetsfrom failed institutions—considered condi-tional guarantees for risk-based capital pur-poses. (See SR-10-4 and its attachment)

6. include in tier 1 capital, of subordinateddebentures issued to the Treasury under theTARP—TARP Subordinated Securities (1) bya BHC that has made a valid election to betaxed under Subchapter S of the InternalRevenue Code (S-Corp BHC) or (2) by a

BHC organized in mutual form (Mutual BHC).The inclusion of TARP subordinated securi-ties in tier 1 capital counts toward the limiton the amount of restricted core capital ele-ments that can be included in tier 1 capital.

4060.3.1 INTRODUCTION TOEXAMINER GUIDELINES FORRISK-BASED CAPITAL

To assist in assessing the capital adequacy ofbank holding companies, the Board has estab-lished two measures of capital adequacy: therisk-based capital measure and the tier 1 lever-age measure. Throughout this section, refer-ences to a ‘‘section’’ that are followed by out-line numbers and letters (for example, sectionII.B.) mean the risk-based capital guidelines forbank holding companies (12 C.F.R. 225, appen-dix A). The tier 1 leverage measure is discussedin section 4060.4.

4060.3.2 OVERVIEW OF RISK-BASEDCAPITAL GUIDELINES

The Board’s risk-based capital guidelines (theguidelines) focus principally on the credit risksassociated with the nature of banking organiza-tions’ on- and off-balance-sheet assets and on thetype and quality of their capital. The informationprovided in this section should be used inconjunction with the risk-based capital guide-lines in verifying the bank holding company’srisk-based capital. Examiners must refer toRegulation Y (12 C.F.R. 225, appendix A) fora complete description of the risk-based capi-tal adequacy guidelines for bank holdingcompanies.

The guidelines do not incorporate other fac-tors that may also affect the financial conditionof banking organizations. These factors includeoverall interest-rate risk exposure; liquidity, fund-ing, and market risks; the quality and level ofearnings; the effectiveness of loan and invest-ment policies on operational results and thequality of assets; and management’s ability tomonitor and control financial and operating risks.

The major objectives of the guidelines are tomake regulatory capital requirements moresensitive to differences in credit-risk profilesamong banking organizations; to factor off-balance-sheet exposures into the assessment of


capital adequacy; to minimize disincentives toholding liquid, low-risk assets; and to achievegreater consistency in the evaluation of thecapital adequacy of major banking organizationsworldwide.

The guidelines set forth minimum supervisorycapital standards for banking organizations.Therefore, banking organizations are expectedto operate with capital levels above the mini-mum ratios. This requirement is particularly truefor banking organizations that are undertakingsignificant expansion or that are exposed to highor unusual levels of risk.

The risk-based guidelines apply on a consoli-dated basis to any bank holding company withconsolidated assets of $500 million or more.The risk-based guidelines also apply on a con-solidated basis to any bank holding companywith consolidated assets of less than $500 mil-lion if the holding company (1) is engaged insignificant nonbanking activities either directlyor through a nonbank subsidiary; (2) conductssignificant off-balance-sheet activities (includ-ing securitization and asset management oradministration) either directly or through a non-bank subsidiary; or (3) has a material amount ofdebt or equity securities outstanding (other thantrust preferred securities) that are SEC-registered. BHCs with consolidated assets ofless than $500 million would generally be exemptfrom the calculation and analysis of risk-basedcapital ratios on a consolidated holding com-pany basis, subject to certain terms and restric-tions. The Federal Reserve may apply the risk-based guidelines at its discretion to any bankholding company, regardless of asset size, ifsuch action is warranted for supervisory purposes.

By year-end 1992 and thereafter, the risk-based capital guidelines required all bank hold-ing companies to meet a standard—a minimumratio of total capital to risk-weighted assets of8 percent and a minimum ratio of tier 1 capitalto risk-weighted assets of 4 percent.

The risk-based capital guidelines were intendedto better reflect the differences in credit-riskprofiles among banking organizations and toexplicitly factor off-balance sheet exposures intothe assessment of capital adequacy by weightingon- and off-balance sheet items by perceiveddegrees of credit risk. The basic elements of theframework include definitions of capital thatinclude core elements and supplementary ele-ments, the assignment of on- and off-balance-sheet items to broad categories of credit risk,and the methodology for computing risk-based

capital ratios for banking organizations on aninterim and final basis.

The Federal Reserve may determine that theregulatory capital treatment for a banking orga-nization’s exposure or other relationship to anentity not consolidated on the banking organiza-tion’s balance sheet is not commensurate withthe actual risk relationship of the banking orga-nization to the entity. In making this determina-tion, the Federal Reserve may require the bank-ing organization to treat the entity as if it wereconsolidated onto the balance sheet of the bank-ing organization for risk-based capital purposesand calculate the appropriate risk-based capitalratios accordingly, all as specified by the Fed-eral Reserve.

Market-Risk Rule. Examiners should be awarethat when certain organizations that engage intrading activities calculate their risk-based capi-tal ratio under appendix A, they must also referto appendix E of Regulation Y, which incorpo-rates capital charges for certain market risksinto the risk-based capital ratio. Examiners shouldalso refer to the Trading and Capital-MarketsActivities Manual for more-detailed supervisoryguidance. When calculating their risk-based capi-tal ratio under appendix A, such organizationsare required to refer to appendix E for supple-mental rules to determine qualifying and excesscapital, calculate risk-weighted assets, calculatemarket-risk-equivalent assets, and calculate risk-based capital ratios adjusted for market risk.

BHCs are responsible for identifying theirtrading and other market risks and for imple-menting a sound risk-management program com-mensurate with those risks. Such programs shouldinclude appropriate quantitative metrics as wellas ongoing qualitative analysis performed bycompetent, independent risk-management staff.At a minimum, BHCs should reassess annuallyand adjust their market-risk management pro-grams, taking into account changing firm strate-gies, market developments, organizational incen-tive structures, and evolving risk-managementtechniques. In August 1996, the Federal Reserveamended its risk-based capital framework toincorporate a measure for market risk for BHCs.The market-risk rule is found in Regulation Y(12 C.F.R. 225), appendix E. 1 Under the market-risk rule, certain BHCs with significant expo-

1. On February 6, 2006 (effective February 22, 2006), theBoard approved a revision to its market-risk rule. The amend-ment lessened and aligned the capital requirement of BHCs(that have adopted the market-risk rule) to the risk involvedwith certain cash collateral that is posted in connection withsecurities-borrowing transactions. It also broadened the scopeof counterparties for which the favorable capital treatment

Consolidated Capital (Examiners’ Guidelines for Assessing the Capital Adequacy of BHCs) 4060.3


sure to market risk must measure that risk usingtheir internal value-at-risk (VaR) measurementmodel and, subject to parameters in the market-risk rule, hold sufficient levels of capital tocover the exposure. The market-risk rule appliesto any BHC (on a worldwide consolidated basis)whose trading activity (the gross sum of itstrading assets and liabilities) equals (1) 10 per-cent or more of its total assets or (2) $1 billionor more. On a case-by-case basis, the FederalReserve may require a BHC that does not meetthese criteria to comply with the market-riskrule if deemed necessary for safe and soundbanking practices. The Federal Reserve mayalso exclude a BHC from appendix E that other-wise meets the criteria as a consequence ofaccounting, operational, or similar consider-ations, if such exclusion is deemed to be consis-tent with safe and sound banking practices. Themarket-risk rule supplements the risk-based capi-tal rules for credit risk; a BHC applying themarket-risk rule remains subject to the require-ments of the credit-risk rules but must adjust itsrisk-based capital ratio to reflect market risk.

In January 2009, the Board issued SR-09-1,‘‘Application of the Market Risk Rule in BankHolding Companies and State Member Banks,’’which reiterated some of the market-risk rule’score requirements, provided guidance on certaintechnical aspects of the rule, and clarified sev-eral issues. SR-09-1 discusses (1) the corerequirements of the market-risk rule, (2) themarket-risk rule capital computational require-ments, and (3) the communication and FederalReserve requirements in order for a BHC to useits VaR models. A BHC that is applying themarket-risk rule must hold capital to support itsexposure to two types of risk: (1) general mar-ket risk arising from broad fluctuations in inter-est rates, equity prices, foreign exchange rates,and commodity prices, including risk associatedwith all derivative positions and (2) specific riskarising from changes in the market value of debtand equity positions in the trading account dueto factors other than broad market movements,including the credit risk of an instrument’sissuer. A BHC’s covered positions include alltrading-account positions as well as all foreignexchange and commodity positions, whether ornot they are in the trading account. BHCs thatare subject to the market-risk capital rules areprecluded from applying those rules to positionsheld in the BHC’s trading portfolio that act, inform or in substance, as liquidity facilities sup-porting asset-backed commercial paper (ABCP).

(See the definition of covered positions in appen-dix E, section 2(a).) Any facility held in thetrading portfolio whose primary function, inform or in substance, is to provide liquidity toABCP—even if the facility does not qualify asan eligible ABCP liquidity facility under therule—will be subject to the BHC’s risk-basedcapital requirements. Specifically, organizationswill be required to convert the notional amountof all trading portfolio positions that provideliquidity to ABCP to credit-equivalent amountsby applying the appropriate credit-conversionfactors. For example, the full notional amountof all eligible ABCP liquidity facilities with anoriginal maturity of one year or less will besubject to a 10 percent conversion factor, asdescribed previously, regardless of whether thefacility is carried in the trading account or non-trading account.

4060.3.2.1 Definition of Capital

For the purposes of the risk-based capital guide-lines, a banking organization’s qualifying totalcapital consists of two types of capital compo-nents: ‘‘core capital elements’’ (tier 1 capitalelements) and ‘‘supplementary capital ele-ments’’ (tier 2 capital elements). To qualify asan element of tier 1 or tier 2 capital, an instru-ment must be fully paid up and effectively unse-cured. Accordingly, if a banking organizationhas purchased, or has directly or indirectly fundedthe purchase of, its own capital instrument, thatinstrument generally is disqualified from inclu-sion in regulatory capital. A qualifying tier 1 ortier 2 capital instrument must be subordinated toall senior indebtedness of the organization. Ifissued by a bank, it also must be subordinated toclaims of depositors. In addition, the instrumentmust not contain or be covered by any cov-enants, terms, or restrictions that are inconsis-tent with safe and sound banking practices.

4060.3.2.1.1 Tier 1 Capital

Tier 1 capital generally is defined as the sum ofcore capital elements less any amounts of good-will, other intangible assets, interest-only stripsreceivable,deferred taxassets, nonfinancial equityinvestments, and other items that are required tobe deducted by section II.B. Tier 1 capital mustrepresent at least 50 percent of qualifying totalcapital. The core capital elements (tier 1 capitalelements) qualifying for inclusion in the tier 1

would be applied. (See 71 Fed. Reg. 8932, February 22,2006.)



component of a banking organization’s qualify-ing total capital are—

1. qualifying common stockholders’ equity;2. qualifying noncumulative perpetual preferred

stock (including related surplus) and seniorperpetual preferred stock issued to the U.S.Department of the Treasury (Treasury) underthe Troubled Asset Relief Program (TARP),under the Emergency Economic Stabiliza-tion Act of 2008 (EESA), which shall beconsidered qualifying noncumulative per-petual preferred stock, including relatedsurplus;

3. minority interest related to qualifying com-mon or noncumulative perpetual preferredstock directly issued by a consolidated U.S.depository institution or foreign bank subsid-iary (class A minority interest);

4. restricted core capital elements. Restrictedcore capital elements are defined to include—a. qualifying cumulative perpetual preferred

stock (including related surplus);b. minority interest related to qualifying

cumulative perpetual preferred stockdirectly issued by a consolidated U.S.depository institution or foreign bank sub-sidiary (class B minority interest);

c. minority interest related to qualifying com-mon stockholders’ equity or perpetual pre-ferred stock issued by a consolidated sub-sidiary that is neither a U.S. depositoryinstitution nor a foreign bank (class Cminority interest); and

d. qualifying trust preferred securities.5. subordinated debentures issued to the Trea-

sury under the TARP (TARP SubordinatedSecurities), and under the EESA, by a bankholding company that has made a valid elec-tion to be taxed under Subchapter S of Chap-ter 1 of the U.S. Internal Revenue Code(S-Corp BHC) or by a bank holding com-pany organized in mutual form (Mutual BHC).

4060.3.2.1.1.1 Limits in Effect UntilMarch 31, 2011

Until March 31, 2011, 1a the aggregate amountof qualifying cumulative perpetual preferred

stock (including related surplus) and qualifyingtrust preferred securities that a banking organi-zation may include in tier 1 capital is limited to25 percent of the sum (including cumulativeperpetual preferred stock and trust preferredsecurities) of the following core capital ele-ments: qualifying common stockholders’ equity,qualifying noncumulative and cumulative per-petual preferred stock (including related sur-plus), qualifying minority interest in the equityaccounts of consolidated subsidiaries, and quali-fying trust preferred securities. Amounts of quali-fying cumulative perpetual preferred stock(including related surplus) and qualifying trustpreferred securities in excess of this limit maybe included in tier 2 capital.

Until March 31, 2011, internationally activebanking organizations are generally expected tolimit the amount of qualifying cumulative per-petual preferred stock (including related sur-plus) and qualifying trust preferred securitiesincluded in tier 1 capital to 15 percent of thesum of core capital elements set forth in thepreceding paragraph (section II.A.1.b.ii.2.).

4060.3.2.1.1.2 Limits That Become EffectiveMarch 31, 2011

Effective March 31, 2011, the aggregate amountof restricted core capital elements that may beincluded in the tier 1 capital of a banking orga-nization must not exceed 25 percent of the sumof all core capital elements, including restrictedcore capital elements, net of goodwill less anyassociated deferred tax liability. Stated differ-ently, the aggregate amount of restricted corecapital elements is limited to one-third of thesum of core capital elements, excluding restrictedcore capital elements, net of goodwill less anyassociated deferred tax liability. Notwithstand-ing the foregoing, the full amount of TARPSubordinated Securities issued by an S-CorpBHC or Mutual BHC may be included in itstier 1 capital, provided that the banking organi-zation must include the TARP SubordinatedSecurities in restricted core capital elements forthe purposes of determining the aggregate amountof other restricted core capital elements thatmay be included in tier 1 capital in accordancewith this section.

In addition, the aggregate amount of restrictedcore capital elements (other than qualifyingmandatory convertible preferred securities 1b)

1a. The Board decided to delay implementation of thislimit until March 31, 2011, citing prevailing market condi-tions. It was noted that BHCs should focus their efforts onincreasing their overall capital levels. (See 74 Fed. Reg.12076, March 23, 2009.)

1b. Qualifying mandatory convertible preferred securitiesgenerally consist of the joint issuance by a bank holdingcompany to investors of trust preferred securities and a for-



that may be included in the tier 1 capital of aninternationally active banking organization2 mustnot exceed 15 percent of the sum of all corecapital elements, including restricted core capi-tal elements, net of goodwill less any associateddeferred tax liability.

Amounts of restricted core capital elements inexcess of this limit generally may be included intier 2 capital. The excess amounts of restrictedcore capital elements that are in the form ofclass C minority interest and qualifying trustpreferred securities are subject to further limita-tion within tier 2 capital in accordance withsection II.A.2.d.iv. Specifically, the aggregateamount of term subordinated debt (excludingmandatory convertible debt) and limited-lifepreferred stock as well as, beginning March 31,2011, qualifying trust preferred securities andclass C minority interest in excess of the 15 and25 percent tier 1 capital limits that may beincluded in tier 2 capital is limited to 50 percentof tier 1 capital, net of goodwill and otherintangible assets required to be deducted. Abanking organization may attribute excessamounts of restricted core capital elements firstto any qualifying cumulative perpetual preferredstock or to class B minority interest, and secondto qualifying trust preferred securities or to classC minority interest, which are subject to the tier2 sublimit. Amounts in excess of the tier 2sublimit are taken into account in the overallassessment of a BHC’s funding and financialcondition.

Prior to March 31, 2011, a banking organiza-tion with restricted core capital elements in

amounts that cause it to exceed the 25 and15 percent tier 1 capital limits must consult withthe Federal Reserve on a plan for ensuring thatthe banking organization is not unduly relyingon these elements in its capital base and, whereappropriate, for reducing such reliance to ensurethat the organization complies with these limitsas of March 31, 2011.

4060.3.2.1.1.3 Qualifying CommonStockholders’ Equity

Qualifying common stockholders’ equity is lim-ited tocommonstock; relatedsurplus; andretainedearnings, including capital reserves and adjust-ments for the cumulative effect of foreign-currency translation, net of any treasury stock,less net unrealized holding losses on available-for-sale equity securities with readily determin-able fair values. For this purpose, net unrealizedholding gains on such equity securities and netunrealized holding gains (losses) on available-for-sale debt securities are not included in quali-fying common stockholders’ equity.

There are restrictions on the terms and fea-tures of qualifying stockholders’ equity. A capi-tal instrument that has a stated maturity date orthat has a preference with regard to liquidationor the payment of dividends is not deemed to bea component of qualifying common stockhold-ers’ equity, regardless of whether or not it iscalled common equity. Terms or features thatgrant other preferences also may call into ques-tion whether the capital instrument would bedeemed to be qualifying common stockholders’equity. Features that require, or provide signifi-cant incentives for, the issuer to redeem theinstrument for cash or cash equivalents willrender the instrument ineligible as a componentof qualifying common stockholders’ equity.

Although section II.A.1. allows for the inclu-sion of elements other than common stockhold-ers’ equity within tier 1 capital, voting commonstockholders’ equity, which is the most desir-able capital element from a supervisory stand-point, generally should be the dominant elementwithin tier 1 capital. Thus, banking organiza-tions should avoid overreliance on preferredstock and nonvoting elements within tier 1 capi-tal. Such nonvoting elements can include por-tions of common stockholders’ equity where,for example, a banking organization has a classof nonvoting common equity, or a class of vot-ing common equity that has substantially fewer

ward purchase contract, which the investors fully collateralizewith the securities, that obligates the investors to purchase afixed amount of the bank holding company’s common stock,generally in three years. Typically, prior to exercise of thepurchase contract in three years, the trust preferred securitiesare remarketed by the initial investors to new investors, andthe cash proceeds are used to satisfy the investors’ obligationto buy the BHC’s common stock. The common stock replacesthe initial trust preferred securities as a component of theBHC’s tier 1 capital, and the remarketed trust preferred secu-rities are excluded from the BHC’s regulatory capital. A bankholding company wishing to issue mandatory convertiblepreferred securities and include them in tier 1 capital mustconsult with the Federal Reserve prior to issuance to ensurethat the securities’ terms are consistent with tier 1 capitaltreatment. See section 4060.3.9.1 for the Board’s January 23,2006, legal interpretation regarding the appropriate risk-basedcapital treatment for a BHC’s issuance of trust preferredsecurities that are mandatorily convertible into noncumulativeperpetual preferred securities.

2. For this purpose, an internationally active banking orga-nization is a banking organization that (1) as of its most recentyear-end FR Y-9C reports total consolidated assets equal to$250 billion or more or (2) on a consolidated basis, reportstotal on-balance-sheet foreign exposure of $10 billion or moreon its filings of the most recent year-end FFIEC 009 CountryExposure Report.



voting rights per share than another class ofvoting common equity. Where a banking organi-zation relies excessively on nonvoting elementswithin tier 1 capital, the Federal Reserve gener-ally will require the banking organization toallocate a portion of the nonvoting elements totier 2 capital.

4060.3.2.1.1.4 Qualifying Perpetual PreferredStock

Perpetual preferred stock qualifying for inclu-sion in tier 1 capital has no maturity date andcannot be redeemed at the option of the holder.Perpetual preferred stock will qualify for inclu-sion in tier 1 capital only if it can absorb losseswhile the issuer operates as a going concern.

There are restrictions on the terms and fea-tures of perpetual preferred stock. Perpetual pre-ferred stock included in tier 1 capital may nothave any provisions restricting the banking orga-nization’s ability or legal right to defer or waivedividends, other than provisions requiring prioror concurrent deferral or waiver of payments onmore-junior instruments. The Federal Reservegenerally expects instruments to contain such aprovision, which is consistent with the notionthat the most junior capital elements shouldabsorb losses first. Dividend deferrals or waiv-ers for preferred stock, which the Federal Reserveexpects will occur either voluntarily or at itsdirection when an organization is in a weakenedcondition, must not be subject to arrangementsthat would diminish the ability of the deferral toshore up the banking organization’s resources.Any perpetual preferred stock with a featurepermitting redemption at the option of the issuermay qualify as tier 1 capital only if the redemp-tion is subject to prior approval of the FederalReserve. Features that require, or create signifi-cant incentives for, the issuer to redeem theinstrument for cash or cash equivalents willrender the instrument ineligible for inclusion intier 1 capital. For example, perpetual preferredstock thathasacredit-sensitivedividend feature—that is, a dividend rate that is reset periodicallybased, in whole or in part, on the banking orga-nization’s current credit standing—generally doesnot qualify for inclusion in tier 1 capital.3 Simi-

larly, perpetualpreferredstock thathasadividend-rate step-up or a market-value conversionfeature—that is, a feature whereby the holdermust or can convert the preferred stock intocommon stock at the market price prevailing atthe time of conversion—generally does notqualify for inclusion in tier 1 capital.4 Perpetualpreferred stock that does not qualify for inclu-sion in tier 1 capital generally will qualify forinclusion in tier 2 capital.

Perpetual preferred stock included in tier 1capital may provide for dividend waivers oneither a cumulative or noncumulative basis. Per-petual preferred stock that is noncumulativegenerally may not permit the accumulation orpayment of unpaid dividends in any form, includ-ing in the form of common stock. Perpetualpreferred stock that provides for the accumula-tion or future payment of unpaid dividends isdeemed to be cumulative, regardless of whetheror not it is called noncumulative.

The Board has noted that it generally is per-missible (1) for perpetual preferred stock toprovide voting rights to investors upon the non-payment of dividends or (2) for junior subordi-nated debt and trust preferred securities to pro-vide voting rights to investors upon the deferralof interest and dividends, respectively. How-ever, these clauses conferring voting rights maycontain only customary provisions, such as theability to elect one or two directors to the boardof the BHC issuer, and may not be so adverse asto create a substantial disincentive for the bank-ing organization to defer interest and dividendswhen necessary or prudent.

4060.3.2.1.1.5 Qualifying Minority Interest inthe Equity Accounts of ConsolidatedSubsidiaries

Minority interest in the common and preferredstockholders’ equity accounts of a consoli-dated subsidiary (minority interest) representsstockholders’ equity associated with common orpreferred equity instruments issued by a bank-ing organization’s consolidated subsidiary thatare held by investors other than the bankingorganization. Minority interest is included in

3. Traditional floating-rate or adjustable-rate perpetual pre-ferred stock (that is, perpetual preferred stock in which thedividend rate is not affected by the issuer’s credit standing orfinancial condition but is adjusted periodically in relation toan independent index based solely on general market interest

rates), however, generally qualifies for inclusion in tier 1capital provided all other requirements are met.

4. Notwithstanding this provision, senior perpetual pre-ferred stock issued to the Treasury under the TARP, under theEESA, may be included in tier 1 capital. Traditional convert-ible perpetual preferred stock, which the holder must or canconvert into a fixed number of common shares at a presetprice, generally qualifies for inclusion in tier 1 capital pro-vided all other requirements are met.



tier 1 capital because, as a general rule, itrepresents equity that is freely available toabsorb losses in the issuing subsidiary. Nonethe-less, minority interest typically is not availableto absorb losses in the banking organization as awhole, a feature that is a particular concernwhen the minority interest is issued by a sub-sidiary that is neither a U.S. depository institu-tion nor a foreign bank. For this reason, thecapital guidelines distinguish among three typesof qualifying minority interest. Class A minor-ity interest is minority interest related toqualifying common and noncumulativeperpetual preferred stock issued directly (that is,not through a subsidiary) by a consolidated U.S.depository institution5 or foreign bank6 sub-sidiary of a banking organization. Class Aminority interest is not subject to a formallimitation within tier 1 capital. Class B minor-ity interest is minority interest related toqualifying cumulative perpetual preferred stockissued directly by a consolidated U.S. deposi-tory institution or foreign bank subsidiary of abanking organization. Class B minority inter-est is a restricted core capital element subject tothe limitations set forth in section II.A.1.b.i. ofthe capital guidelines (12 C.F.R. 225, appendixA), but it is not subject to a tier 2 sublimit. ClassC minority interest is minority interest related toqualifying common or perpetual preferred stockissued by a banking organization’s consoli-dated subsidiary that is neither a U.S. deposi-tory institution nor a foreign bank. Class Cminority interest is eligible for inclusion in tier1 capital as a restricted core capital element andis subject to the limitations set forth in sec-tions II.A.1.b.i. and II.A.2.d.iv.

4060.3.2.1.1.6 Minority Interests in SmallBusiness Investment Companies

Minority interests in small business investmentcompanies (SBICs), in investment funds thathold nonfinancial equity investments, and insubsidiaries engaged in nonfinancial activities

are not included in the banking organization’stier 1 or total capital base if the banking organi-zation’s interest in the company or fund is heldunder one of the legal authorities listed in sec-tion II.B.5.b.

4060.3.2.1.1.7 Minority Interests inConsolidated Asset-Backed Commercial PaperPrograms

Minority interests in consolidated asset-backedcommercial paper (ABCP) programs that aresponsored by a banking organization are includedin the organization’s tier 1 or total capital.

4060.3.2.1.1.8 Qualifying Trust PreferredSecurities

Trust preferred securities are undated cumula-tive preferred securities issued out of a special-purpose entity (SPE), usually in the form of atrust, in which a BHC owns all of the commonsecurities. A key advantage of trust preferredsecurities to BHCs is that for tax purposes thedividends paid on trust preferred securities, unlikethose paid on directly issued preferred stock, area tax-deductible interest expense. The InternalRevenue Service ignores the trust and focuseson the interest payments on the underlying sub-ordinated note.

In 2000, the first pooled issuance of trustpreferred securities came to market. Pooled issu-ances generally constitute the issuance of trustpreferred securities by a number of BHCs to apooling entity that issues to the market asset-backed securities representing interests in theBHCs’ pooled trust preferred securities. Suchpooling arrangements, which have becomeincreasingly popular and typically involve 30 ormore separate BHC issuers, have made the issu-ance of trust preferred securities possible foreven very small BHCs, most of which had notpreviously enjoyed capital-market access forraising tier 1 capital.

BHCs in deteriorating financial conditionhave deferred dividends on trust preferredsecurities to preserve cash flow. In addition,trust preferred securities have proven to be auseful source of capital funding for BHCs, whichoften downstream the proceeds in the form ofcommon stock to subsidiary banks, therebystrengthening the banks’ capital bases. Trustpreferred securities are available to absorb losses

5. U.S. depository institutions are defined to include branches(foreign and domestic) of federally insured banks and deposi-tory institutions chartered and headquartered in the 50 statesof the United States, the District of Columbia, Puerto Rico,and U.S. territories and possessions. The definition encom-passes banks, mutual or stock savings banks, savings orbuilding and loan associations, cooperative banks, creditunions, and international banking facilities of domestic banks.

6. For this purpose, a foreign bank is defined as an institu-tion that engages in the business of banking; is recognized asa bank by the bank supervisory or monetary authorities of thecountry of its organization or principal banking operations;receives deposits to a substantial extent in the regular courseof business; and has the power to accept demand deposits.


BHC Supervision Manual January 2011Page 6.1

throughout the BHC and do not affect the BHC’sliquidity position. In addition, trust preferredsecurities are relatively simple, standardized,and well-understood instruments that are widelyissued by both corporate and banking organiza-tions. Moreover, issuances of trust preferredsecurities tend to be broadly distributed andtransparent and, thus, easy for the market totrack. A banking organization that wishes toissue trust preferred securities and include themin tier 1 capital must first consult with the Fed-eral Reserve.

A key consideration of the Board has beenthe ability of trust preferred securities to providefinancial support to a consolidated BHC becauseof their deep subordination and the ability of theBHC to defer dividends for up to 20 consecutivequarters. Trust preferred securities, like otherforms of minority interest, are not included inGAAP equity and cannot forestall a BHC’sinsolvency. Nevertheless, trust preferred securi-ties are available to absorb losses more broadlythan most other minority interest in the consoli-dated banking organization is able to becausethe issuing trust’s sole asset is a deeply subordi-nated note of its parent BHC. Thus, if a BHCdefers payments on its junior subordinated notesunderlying the trust preferred securities, theBHC can use the cash flow anywhere within theconsolidated organization.

Qualifying trust preferred securities must allowfor dividends to be deferred for at least 20consecutive quarters without an event of default,except that the note may provide for an event ofdefault and the acceleration of principal andunpaid interest, giving investors the right to takehold of the subordinated note issued by theBHC, upon (1) nonpayment for 20 or moreconsecutive quarters or (2) termination of thetrust without redemption of the trust preferredsecurities, distribution of the notes to investors,or assumption of the obligation by a successorto the BHC. The required notification period forsuch deferral must be reasonably short, no morethan 15 business days prior to the payment date.

The sole asset of the trust must be a juniorsubordinated note issued by the sponsoring bank-ing organization that has a minimum maturity of30 years and is subordinated with regard to bothliquidation and priority of periodic payments toall senior and subordinated debt of the sponsor-ing banking organization (other than other juniorsubordinated notes underlying trust preferredsecurities). Otherwise the terms of a junior sub-ordinated note must mirror those of the pre-

ferred securities issued by the trust. 6a The notemust comply with section II.A.2.d. of the capitalguidelines and the Federal Reserve’s sub-ordinated debt policy statement set forth in12 C.F.R. 250.1666b except that the note mayprovide for an event of default and the accelera-tion of principal and accrued interest upon (1) non-payment of interest for 20 or more consecutivequarters or (2) termination of the trust withoutredemption of the trust preferred securities, dis-tribution of the notes to investors, or assumptionof the obligation by a successor to the bankingorganization.

In the last five years before the maturity ofthe note, the outstanding amount of the associ-ated trust preferred securities is excluded fromtier 1 capital and included in tier 2 capital,where the trust preferred securities are subjectto the amortization provisions and quantitativerestrictions set forth in sections II.A.2.d.iii. andiv. as if the trust preferred securities were limited-life preferred stock.

When a banking organization hedges trustpreferred stock through an interest-rate swapwith a deferral feature, the deferral terms on theswap must be symmetrical for both the organi-zation and its counterparty and must not have

6a. 1 Under generally accepted accounting principles(GAAP), the trust issuing the preferred securities generally isnot consolidated on the banking organization’s balance sheet;rather the underlying subordinated note is recorded as aliability on the organization’s balance sheet. Only the amountof the trust preferred securities issued, which generally isequal to the amount of the underlying subordinated note lessthe amount of the sponsoring banking organization’s commonequity investment in the trust (which is recorded as an asseton the banking organization’s consolidated balance sheet),may be included in tier 1 capital. Because this calculationmethod effectively deducts the banking organization’s com-mon stock investment in the trust in computing the numeratorof the capital ratio, the common equity investment in the trustshould be excluded from the calculation of risk-weightedassets in accordance with footnote 17 of the capital guide-lines. Where a banking organization has issued trust preferredsecurities as part of a pooled issuance, the organization gener-ally must not buy back a security issued from the pool. Wherea banking organization does hold such a security (for exam-ple, as a result of an acquisition of another banking organiza-tion), the amount of the trust preferred securities includable inregulatory capital must, consistent with section II.(i) of thecapital guidelines, be reduced by the notional amount of thebanking organization’s investment in the security issued bythe pooling entity.

6b. 2 Trust preferred securities issued before April 15,2005, generally would be includable in tier 1 capital despitenoncompliance with sections II.A.1.c.iv. or II.A.2.d. of thecapital guidelines or 12 C.F.R. 250.166 provided the non-complying terms of the instrument (1) have been commonlyused by banking organizations, (2) do not provide an unrea-sonably high degree of protection to the holder in circum-stances other than bankruptcy of the banking organization,and (3) do not effectively allow a holder in due course of thenote to stand ahead of senior or subordinated debt holders inthe event of bankruptcy of the banking organization.



the effect of draining the organization’s resourcesin a time of stress. The swap contract, for exam-ple, must not provide that the counterparty maydefer, on a cumulative basis, its swap paymentsdue to the banking organization during a trustpreferred deferral period when the banking orga-nization must continue to make payments to thecounterparty. A plain-vanilla swap, when nei-ther the banking organization nor its counter-party may defer payments, generally is an accept-able instrument for hedging the interest-rate riskon trust preferred stock included in tier 1 capi-tal. Trust preferred stock issues may not beincluded in tier 1 capital if they are covered byan interest-rate derivative contract with asym-metrical deferral terms. (See SR-02-10.)

4060.3.2.1.1.9 GAAP Accounting for TrustPreferred Securities

The Financial Accounting Standards Board(FASB) revised the accounting treatment of trustpreferred securities in January 2003 through theissuance of its FASB Interpretation No. 46,‘‘Consolidation of Variable Interest Entities (FIN46).’’ Since then the accounting industry andBHCs have dealt with the application of FIN 46to the consolidation by BHC sponsors of trustsissuing trust preferred securities. In late Decem-ber 2003, when FASB issued a revised versionof FIN 46 (FIN 46R), the accounting authoritiesgenerally concluded that such trusts must bedeconsolidated from their BHC sponsors’ finan-cial statements under generally accepted account-ing principles (GAAP). Therefore, for GAAPaccounting purposes, trust preferred securitiesgenerally will continue to be accounted for asequity at the level of the trust that issues them,but the instruments may no longer be treated asminority interest in the equity accounts of aconsolidated subsidiary on a BHC’s consoli-dated balance sheet. Instead, under FIN 46 andFIN 46R, a BHC must reflect on its consolidatedbalance sheet the deeply subordinated note theBHC issued to the deconsolidated SPE.

A change in the GAAP accounting for acapital instrument does not necessarily changethe regulatory capital treatment of that instru-ment. Although GAAP informs the definition ofregulatory capital, the Board may decide not touse GAAP accounting concepts in its definitionof tier 1 or tier 2 capital. Regulatory capitalrequirements are regulatory constructs designedto ensure the safety and soundness of bankingorganizations, not accounting designations estab-lished to ensure the transparency of financialstatements. These differences are only between

the definition of equity for purposes of GAAPand the definition of tier 1 capital for purposesof the Board’s regulatory capital requirementsfor banking organizations.

Nevertheless, consistent with long-standingBoard direction, BHCs are required to followGAAP for regulatory reporting purposes. Thus,BHCs should, for both accounting and regula-tory reporting purposes, determine the appropri-ate application of GAAP (including FIN 46 andFIN 46R) to their trusts issuing trust preferredsecurities. Accordingly, there should be no sub-stantive difference in the treatment of trust pre-ferred securities issued by such trusts, or theunderlying junior subordinated debt, for pur-poses of regulatory reporting and GAAPaccounting.

4060.3.2.1.1.10 Asset-Driven PreferredSecurities

In addition to issuing trust preferred securities,banking organizations have also issued asset-driven securities, particularly real estate invest-ment trust (REIT) preferred securities. REITpreferred securities generally are issued by SPEsubsidiaries of a bank that qualify as REITs fortax purposes. In most cases, the REIT issuesnoncumulative perpetual preferred securities,generally noncumulative, to the market and usesthe proceeds to buy mortgage-related assetsfrom its sole common shareholder, its parentbank. By qualifying as a REIT under the taxcode, the SPE’s income is not subject to tax atthe entity level but is taxable only as income tothe REIT’s investors upon distribution. Two keyqualifying criteria for REITs are that REITsmust hold predominantly real estate assets andmust pay out annually a substantial portion oftheir income to investors. To avoid a situation inwhich preferred stock investors in a REIT sub-sidiary of a failing bank are effectively overcol-lateralized by high-quality mortgage assets ofthe parent bank, the federal banking agencieshave required REIT preferred securities to havean exchange provision to qualify for inclusionin tier 1 capital. The exchange provision pro-vides that upon the occurrence of certain events,such as the parent bank’s becoming undercapi-talized or being placed into receivership, theREIT preferred securities will be exchangedupon the directive of the parent bank’s primaryfederal supervisor for directly issued perpetualpreferred securities of the parent bank with gen-



erally identical terms. In the absence of theexchange provision, the REIT preferred securi-ties would provide little support to a deteriorat-ing or failing parent bank or to the FDIC,despite possibly comprising a substantial amountof the parent bank’s tier 1 capital (in the form ofminority interest).

While some banking organizations have issueda limited amount of REIT preferred and otherasset-driven securities, most BHCs prefer toissue trust preferred securities because they arerelatively simple and standard instruments, donot tie up liquid assets, are easier and morecost-efficient to issue and manage, and are moretransparent and better understood by the market.Also, BHCs generally prefer to issue trust pre-ferred securities at the holding company levelrather than isisue REIT preferred securities atthe bank level because doing so gives themgreater flexibility in using the proceeds of suchissuances.

4060.3.2.1.1.11 Inclusion of an OperatingSubsidiary’s Perpetual Preferred Stock inMinority Interest

Whenever a banking organization has includedperpetual preferred stock of an operating subsid-iary in minority interest, a possibility exists thatsuch capital has been issued in excess of thesubsidiary’s needs, for the purpose of raisingcheaper capital. Stock issued under these cir-cumstances may, in substance if not in legalform, be secured by the subsidiary’s assets. Ifthe subsidiary fails, the outside preferred inves-tors would have a claim on the subsidiary’sassets that is senior to the claim that the bankingorganization, as a common shareholder, has onthose assets. Therefore, as a general rule, issu-ances in excess of a subsidiary’s needs do notqualify for inclusion in capital. The possibilitythat a secured arrangement exists should beconsidered if the subsidiary lends significantamounts of funds to the parent banking organi-zation, is unusually well capitalized, has cashflow in excess of its operating needs, holds asignificant amount of assets with minimal creditrisk (for example, U.S. Treasury securities) thatare not consistent with the subsidiary’s opera-tions, or has issued preferred stock at a signifi-cantly lower rate than the parent could obtainfor a direct issue.

Some bank holding companies may use anonoperating subsidiary or SPE to issue per-petual preferred stock to outside investors. Sucha subsidiary may be set up offshore so that it canreceive favorable tax treatment for the dividendspaid on the stock. In such arrangements, a strongpresumption exists that the stock is, in effect,secured by the assets of the subsidiary. Preferredstock issued by a subsidiary and collateralizedby the subsidiary’s assets is not included in tier1 or tier 2 capital unless approved by the Fed-eral Reserve because of the need to verify theincorporation of prudential features warrantingcapital inclusion.

Banking organizations may also use operat-ing or nonoperating subsidiaries to issue subor-dinated debt. As with perpetual preferred stockissued through such subsidiaries, it is possiblethat such debt is in effect secured and thereforenot includable in capital.

4060.3.2.1.1.12 Forward Equity Transactions

Banking organizations have engaged in varioustypes of forward transactions relating to therepurchase of their common stock. In thesetransactions, the banking organization entersinto an arrangement with a counterparty, usuallyan investment bank or another commercial bank,under which the counterparty purchases com-mon shares of the banking organization, eitherin the open market or directly from the institu-tion. The banking organization agrees that itwill repurchase those shares at an agreed-onforward price at a later date (typically threeyears or less from the execution date of theagreement). These transactions are used to lockin stock repurchases at price levels that areperceived to be advantageous and are also ameans of managing regulatory capital ratios.

Banking organizations have generally contin-ued to treat shares under forward equity arrange-ments as tier 1 capital. However, these transac-tions can impair the permanence of the sharesand typically have certain features that are unde-sirable from a supervisory point of view. Forthese reasons, shares covered by these arrange-ments have qualities that are inconsistent withtier 1 capital status.6c Accordingly, any com-mon stock covered by forward equity transac-tions entered into after the issuance of SR-01-27(November 9, 2001) will be excluded from the

6c. Section 4060.3.2.1.1.1 states that ‘‘a capital instrumentthat is not permanent...is not deemed to be common stock,regardless of whether it is called common stock.’’ See alsosection 3020.1 of the Commercial Bank Examination Manual.



tier 1 capital of a bank holding company (or astate member bank), other than those transac-tions specified for deferred compensation orother employee benefit plans. This exclusionapplies even if the transactions were executedunder a currently existing master agreement.The amount to be excluded is equal to thecommon stock, surplus, and retained earningsassociated with the shares. This guidance doesnot apply to shares covered under traditionalstock buyback programs that do not involveforward agreements.

4060.3.2.1.2 Tier 2 Capital

Tier 2 capital consists of (1) a limited amount ofthe allowance for loan and lease losses;6d (2)perpetualpreferredstock (original termof20yearsor more) including related surplus (also includescumulative perpetual preferred stock exceedingits tier 1 limitation, including auction-rate pre-ferred stock, or any other perpetual preferredstock in which the dividend rate is reset periodi-cally, in whole or in part, based on the holdingcompany’s financial condition); (3) hybrid capi-tal instruments, perpetual debt, and mandatoryconvertible debt securities; (4) limited amounts(50 percent of tier 1 capital net of goodwill andother intangibles) of term subordinated debt andintermediate-term preferred stock, includingrelated surplus; and (5) limited unrealized hold-ing gains on equity securities. Tier 2 capital maynot exceed tier 1 capital (net of goodwill, otherintangible assets, and interest-only strips receiv-able and nonfinancial equity investments thatare required to be deducted in accordance withsection II.B).

The amount of mandatory convertible securi-ties that have the proceeds of common or per-petual preferred stock dedicated to retire orredeem them and that have a maximum maturityof 12 years should be treated as term subordi-nated debt. Mandatory convertible securities,net of the stock dedicated to redeem or retire theissues, are included within tier 2 on an unlimitedbasis.

There is a limit on the amount of unrealizedholding gains on equity securities and the unre-alized gains (losses) on other assets. Up to45 percent of pretax net unrealized holdinggains (that is, the excess, if any, of the fair valueover historical cost) on available-for-sale equitysecurities, with readily determinable fair values,may be included in supplementary capital. How-

ever, the Federal Reserve may exclude all or aportion of these unrealized gains from tier 2capital if it determines that the equity securitiesarenotprudentlyvalued.Unrealizedgains (losses)on other types of assets, such as bank premisesand available-for-sale debt securities, are notincluded in supplementary capital. The FederalReserve may take these unrealized gains (losses)into account as additional factors when assess-ing an institution’s overall capital adequacy.

4060.3.2.1.2.1 Subordinated Debt andIntermediate-Term Preferred Stock

Subordinated debt and intermediate-term pre-ferred stock must have an original weightedaverage maturity of at least five years to qualifyas tier 2 capital. If the holder has the option torequire the issuer to redeem, repay, or repur-chase the instrument prior to the original statedmaturity, maturity would be defined, for risk-based capital purposes, as the earliest possibledate on which the holder can put the instrumentback to the issuing banking organization. Theaverage maturity of an obligation whose princi-pal is repayable in scheduled periodic payments(for example, a so-called serial redemption issue)is the weighted average of the maturities of allsuch scheduled repayments.

A state member bank may not repay, redeem,or repurchase a subordinated debt issue withoutthe Federal Reserve’s prior written approval.Prior written approval is not required for BHCs.They should consult with the Federal Reservebefore redeeming subordinated debt. (See 12C.F.R. 250.166(f)(2).)

Close scrutiny should be given to terms thatpermit the holder to accelerate payment of prin-cipal upon the occurrence of certain events. Theonly acceleration clauses acceptable in a subor-dinated debt issue included in tier 2 capital arethose that are triggered by bankruptcy or thereceivership of a major banking subsidiary (inthe case of a bank holding company) or receiv-ership (in the case of a bank.)6e (See SR-92-37.)Terms that permit the holder to accelerate pay-ment of principal upon the occurrence of other

6d. This allowance is limited to 1.25 percent of risk-weighted assets.

6e. A provision in bank holding company subordinateddebt that permits acceleration in the event a major banksubsidiary enters into receivership would not jeopardize theissue’s tier 2 capital status. A provision permitting accelera-tion in the event that any other type of affiliate of the issuerentered into bankruptcy or receivership would not be accept-able in a subordinated debt issue included in capital.



events jeopardize the subordination of the debtbecause such terms could permit debtholders ina troubled institution to be paid out before thedepositors. In addition, debt whose terms permitholders to accelerate payment of principal uponthe occurrence of events other than insolvencydoes not meet the minimum five-year maturityrequirement for debt capital instruments. Hold-ers of such debt have the right to put the debtback to the issuer upon the occurrence of thenamed events, which could happen on a datewell in advance of the debt’s stated maturity.

Close scrutiny should also be given to theterms of those debt issues if an event of defaultis defined more broadly than insolvency or afailure to pay interest or principal when due.There is a strong possibility that such terms areinconsistent with safe and sound banking prac-tice and that, accordingly, the debt issue shouldnot be included in capital. Concern is height-ened when an event of default gives the holderthe right to accelerate payment of principal orwhen other borrowings contain cross-defaultclauses. Some events of default, such as makingadditional borrowings in excess of a certainamount, may unduly restrict the day-to-dayoperations. Other events of default, such aschange of control or disposal of a banking orga-nization subsidiary, may limit the flexibility ofmanagement or supervisors to work out theproblems of a troubled organization. Still otherevents of default, such as failure to maintaincertain capital ratios or rates of return or to limitthe amount of nonperforming assets or char-geoffs to a certain level, may be intended toallow the debtholder to be made whole before adeteriorating banking organization becomes trulytroubled. Debt issues that include any of thesetypes of events of default are not truly subordi-nated and should not be included in capital.Likewise, bank holding companies should notinclude in capital debt issues that otherwisecontain terms or covenants that could adverselyaffect the issuer’s liquidity; unduly restrict man-agement’s flexibility to run the organization,particularly in times of financial difficulty; orlimit the regulator’s ability to resolve problemsituations.

Certain terms found in subordinated debt,however, may provide protection to investorswithout adversely affecting the overall benefitsof the instrument to the organization, and thuswould be acceptable for subordinated debt to beincluded in capital. Among such acceptableterms would be a provision that prohibits a bank

holding company from merging, consolidating,or selling substantially all of its assets unless thenew entity assumes the subordinated debt.Another acceptable provision would be the inclu-sion as an event of default of the failure to payprincipal and interest on a timely basis or tomake mandatory sinking-fund deposits, so longas such event of default does not allow thedebtholders to accelerate the repayment of prin-cipal. (See SR-92-37.)

Debt issues, including mandatory convertiblesecurities, that tie interest payments to the finan-cial condition of the borrower generally shouldnot be included in capital. Such payments maybe linked to the financial condition of an institu-tion through various ways, such as (1) an auction-rate mechanism, which is a preset schedule-mandating interest-rate increase either over thepassage of time or as the credit rating of thebank holding company declines,6f or (2) a termthat raises the interest rate if payment is notmade in a timely fashion. As the financial condi-tion of a bank holding company declines, it isfaced with higher and higher payments on itscredit-sensitive subordinated debt at a time whenit most needs to conserve its resources. Thus,credit-sensitive debt does not provide the sup-port expected of a capital instrument to an insti-tution whose financial condition is deteriorating;rather, the credit-sensitive feature can acceleratedepletion of the organization’s resources andincrease the likelihood of default on the debt.While such terms may be acceptable in per-petual preferred stock qualifying for tier 2 capi-tal, they are not acceptable in a capital debtissue because a banking organization in a dete-riorating financial condition may not have theoption available in equity issues of eliminatingthe higher payments without going into default.If a bank holding company has included in itscapital subordinated debt issued by an operatingor nonoperating subsidiary, it is possible that thedebt is in effect secured and, thus, not includ-able in capital.

Subordinated debt included in tier 2 capital

6f. Although payment on debt whose interest rate increasesover time may not on the surface appear to be directly linkedto the financial condition of the issuing banking organization,such debt (sometimes referred to as expanding- or exploding-rate debt) has a strong potential to be credit-sensitive insubstance. Banking organizations whose financial conditionhas strengthened are more likely to be able to refinance thedebt at a lower rate than that mandated by the preset increase,whereas those banking organizations whose condition hasdeteriorated are less likely to be able to do so. Moreover, justwhen these latter institutions would be in the most need ofconserving capital, they would be under strong pressure toredeem the debt as an alternative to paying higher rates andtherefore would accelerate depletion of their resources.



must comply with the Federal Reserve’s sub-ordinated debt policy statement set forth in12 C.F.R. 250.166.6g Accordingly, such sub-ordinated debt must meet the followingrequirements:

1. The subordinated debt must be unsecured.2. The subordinated debt must clearly state on

its face that it is not a deposit and is notinsured by a federal agency.

3. The subordinated debt must not have credit-sensitive features or other provisions that areinconsistent with safe and sound bankingpractice.

4. Subordinated debt issued by a subsidiary U.S.depository institution or foreign bank of abank holding company must be subordinatedin right of payment to the claims of all theinstitution’s general creditors and depositors,and generally must not contain provisionspermitting debt holders to accelerate pay-ment of principal or interest upon the occur-rence of any event other than receivership ofthe institution. Subordinated debt issued by abank holding company or its subsidiaries thatare neither U.S. depository institutions norforeign banks must be subordinated to allsenior indebtedness of the issuer; that is, thedebt must be subordinated at a minimum toall borrowed money, similar obligations aris-ing from off-balance sheet guarantees anddirect-credit substitutes, and obligations asso-ciated with derivative products such asinterest-rate and foreign-exchange contracts,commodity contracts, and similar arrange-ments. Subordinated debt issued by a bankholding company or any of its subsidiariesthat is not a U.S. depository institution orforeign bank must not contain provisions per-mitting debt holders to accelerate the pay-ment of principal or interest upon the occur-rence of any event other than the bankruptcyof the bank holding company or the receiver-ship of a major subsidiary depository institu-tion. Thus, a provision permitting accelera-tion in the event that any other affiliate of the

bank holding company issuer enters intobankruptcy or receivership makes the instru-ment ineligible for inclusion in tier 2 capital.

As a limited-life capital instrument approachesmaturity, it begins to take on characteristics of ashort-term obligation. For this reason, the out-standing amount of term subordinated debt andlimited-life preferred stock eligible for inclusionin tier 2 capital is reduced, or discounted, asthese instruments approach maturity: One-fifthof the outstanding amount is excluded each yearduring the instrument’s last five years beforematurity. When remaining maturity is less thanone year, the instrument is excluded from tier 2capital.

The aggregate amount of term subordinateddebt (excluding mandatory convertible debt) andlimited-life preferred stock as well as, beginningMarch 31, 2009, qualifying trust preferred secu-rities and class C minority interest in excess ofthe limits set forth in section II.A.1.b.i. that maybe included in tier 2 capital is limited to 50 per-cent of tier 1 capital (net of goodwill and otherintangible assets required to be deducted inaccordance with section II.B.1.b.). Amounts ofthese instruments in excess of this limit, althoughnot included in tier 2 capital, will be taken intoaccount by the Federal Reserve in its overallassessment of a banking organization’s fundingand financial condition.

4060.3.2.1.3 Deductions from Tier 1and Tier 2 Capital

The risk-based capital guidelines require that50 percent of the aggregate amount of capitalinvestments in unconsolidated banking andfinance subsidiaries should be deducted fromthe bank holding company’s tier 1 capital and50 percent from its tier 2 capital. If the amountof tier 2 capital is insufficient for the requireddeduction, the additional amount needed wouldbe deducted from tier 1 capital. Reciprocal hold-ings of other banking organizations’ capitalinstruments are to be deducted from the sum oftier 1 and tier 2 capital.

4060.3.2.2 Procedures for Risk Weightingof On- and Off-Balance Sheet Items

The risk-based capital guidelines establish fourgeneral categories of credit risk. These catego-

6g. The subordinated debt policy statement set forth in 12C.F.R. 250.166 notes that certain terms found in subordinateddebt may provide protection to investors without adverselyaffecting the overall benefits of the instrument to the issuingbanking organization and, thus, would be acceptable for sub-ordinated debt included in capital. For example, a provisionthat prohibits a bank holding company from merging, consoli-dating, or selling substantially all of its assets unless the newentity redeems or assumes the subordinated debt or thatdesignates the failure to pay principal and interest on a timelybasis as an event of default would be acceptable, so long asthe occurrence of such events does not allow the debt holdersto accelerate the payment of principal or interest on the debt.



ries of credit risk reflect the nature and qualityof collateral, guarantees, and organizations issu-ing or backing obligations. Assets and credit-equivalent amounts of off-balance sheet itemsare allocated to the various categories, whichare assigned weights of 0 percent, 20 percent,50 percent, and 100 percent, depending on theperceived level of credit risk to the bankingorganization. (See 12 C.F.R. 225, appendix A,section III, for a more detailed listing of theassets assigned to each risk-weight category.)

The majority of the items will fall in the100 percent risk-weight category. A brief expla-nation of the components of each category fol-lows. For more detailed information, see thecapital adequacy guidelines.

4060.3.2.2.1 Risk Categories

4060.3.2.2.1.1 Category 1: Zero Percent

Category 1 includes cash (domestic and foreign)owned and held in all offices of the bank or intransit, as well as gold bullion held in the bank’sown vaults or in another bank’s vaults on anallocated basis to the extent it is offset by goldbullion liabilities. The category also includes alldirect claims on (including securities, loans, andleases), and the portions of claims that aredirectly and unconditionally guaranteed by, thecentral governments of the Organization forEconomic Cooperation and Development(OECD) countries and U.S. government agen-cies, as well as all direct local currency claimson,6h and the portions of local currency claimsthat are directly and unconditionally guaranteedby, the central governments of non-OECD coun-tries, to the extent that the bank has liabilitiesbooked in that currency. A claim is not consid-ered to be unconditionally guaranteed by a cen-tral government if the validity of the guaranteedepends on some affirmative action by the holderor a third party. Generally, securities guaranteed

by the U.S. government or its agencies that areactively traded in financial markets, such asGovernment National Mortgage Association(GNMA) securities, are considered to be uncon-ditionally guaranteed. This zero percent cate-gory also includes claims collateralized (1) bycash on deposit in the bank or (2) by securitiesissued or guaranteed by OECD central govern-ments or U.S. government agencies for which apositive margin of collateral is maintained on adaily basis, fully taking into account any changein the bank’s exposure to the obligor or counter-party under a claim in relation to the marketvalue of the collateral held in support of thatclaim. This category also includes ABCP (1) pur-chased by a BHC on or after September 19,2008, from an SEC-registered open-end invest-ment company that holds itself out as a moneymarket mutual fund under SEC Rule 2a-7 (17CFR 270.2a-7) and (2) pledged by the BHC to aFederal Reserve Bank to secure financing fromthe ABCP lending facility (AMLF) establishedby the Board on September 19, 2008. (See 12C.F.R. 225, appendix A and 74 Fed. Reg. 6224,February 6, 2009.)

4060.3.2.2.1.2 Category 2: 20 percent

Category 2 includes cash items in the process ofcollection, both foreign and domestic; short-term claims on (including demand deposits),and the portions of short-term claims that areguaranteed by, U.S. depository institutions andforeign banks; and long-term claims on, and theportions of long-term claims that are guaranteedby, U.S. depository institutions and OECD banks.This category also includes the portions of claimsthat are conditionally guaranteed by OECD cen-tral governments and U.S. governmentagencies,6i as well as the portions of local cur-rency claims that are conditionally guaranteedby non-OECD central governments, to the extentthat the bank has liabilities booked in that cur-rency. In addition, this category includes claimson, and the portions of claims that are guaran-teed by, U.S. government–sponsored agenciesand claims on, and the portions of claims guar-anteed by, the International Bank for Recon-struction and Development (the World Bank),the International Finance Corporation, the Inter-American Development Bank, the Asian Devel-

6h. Direct claims on and claims unconditionally guaran-teed by the FDIC, such as FDIC-insured deposits, pre-paidassessments of deposit insurance premiums, debt guaranteedunder the FDIC’s Temporary Liquidity Guarantee Program,and similarly guaranteed debt, may be assigned a zero riskweight. Because the structural arrangements for these agree-ments vary depending on the specific terms of each agree-ment, BHCs and institutions should consult with their primaryfederal regulator to determine the appropriate risk-based capi-tal treatment for specific loss-sharing agreements. (See SR-10-4 and its interagency attachment.)

6i. Loss-sharing agreements entered into by the FDICwith acquirers of assets from failed institutions are consideredconditional guarantees for risk-based capital purposes due tocontractual conditions that acquirers must meet. The guaran-teed portion of assets subject to a loss-sharing agreement maybe assigned a 20 percent risk weight.



opment Bank, the African Development Bank,the European Investment Bank, the EuropeanBank for Reconstruction and Development, theNordic Investment Bank, and other multilaterallending institutions or regional developmentbanks in which the U.S. government is a share-holder or contributing member. General obliga-tion claims on, or portions of claims guaranteedby the full faith and credit of, states or otherpolitical subdivisions of the United States orother countries of the OECD-based group arealso assigned to this category. Category 2 alsoincludes the portions of claims (including repur-chase transactions) that are (1) collateralized bycash on deposit in the bank or by securitiesissued or guaranteed by OECD central govern-ments or U.S. government agencies that do notqualify for the zero percent risk-weight cate-gory; (2) collateralized by securities issued orguaranteed by U.S. government–sponsored agen-cies; or (3) collateralized by securities issued bymultilateral lending institutions or regional de-velopment banks in which the U.S. governmentis a shareholder or contributing member.

This risk category also includes claims6j on,and claims guaranteed by, a qualifying securi-ties firm6k incorporated in the United States oranother member of the OECD-based group ofcountries provided that (1) the qualifying securi-ties firm has a long-term issuer credit rating, ora rating on at least one issue of long-term debt,in one of the three highest investment-graderating categories from a nationally recognizedstatistical rating organization, 6l and (2) the claimis guaranteed by the firm’s parent company, andthe parent company has such a rating. If ratingsare available from more than one rating agency,

the lowest rating will be used to determinewhether the rating requirement has been met.This category also includes certain collateral-ized claims on, or guaranteed by, a qualifyingsecurities firm in such a country, without regardto satisfaction of the rating standard, providedthat the claim arises under a contract that(1) is a reverse-repurchase/repurchase agree-ment or securities-lending/borrowing transac-tion executed using standard industry documen-tation; (2) is collateralized by debt or equitysecurities that are liquid and readily marketable;(3) is marked to market daily; (4) is subject to adaily margin-maintenance requirement underthe standard industry documentation; and (5) can

6j. Claims on a qualifying securities firm that the firm, orits parent company, uses to satisfy its applicable capitalrequirements are not eligible for this risk weight.

6k. With regard to securities firms incorporated in theUnited States, qualifying securities firms are those securitiesfirms that are broker-dealers registered with the Securities andExchange Commission (SEC) and that are in compliance withthe SEC’s net capital rule, 17 C.F.R. 240.15c3-1.With regardto securities firms incorporated in other countries in theOECD-based group of countries, qualifying securities firmsare those securities firms that a banking organization is able todemonstrate are subject to consolidated supervision and regu-lation (covering their direct and indirect subsidiaries, but notnecessarily their parent organizations) comparable to thatimposed on banks in OECD countries. Such regulation mustinclude risk-based capital requirements comparable to thoseapplied to banks under the Basel Accord.

6l. A nationally recognized statistical rating organization(NRSRO) is an entity recognized by the Division of MarketRegulation of the Securities and Exchange Commission, (thecommission) or any successor division, as a nationally recog-nized statistical rating organization for various purposes,including the commission’s uniform net capital requirementsfor brokers and dealers (17 C.F.R. 240.15c3-1).



be liquidated, terminated, or accelerated imme-diately in bankruptcy or a similar proceeding,and the security or collateral agreement will notbe stayed or avoided, under applicable law ofthe relevant jurisdiction.7


Category 3 includes loans fully secured by firstliens on one- to four-family residential proper-ties (either owner-occupied or rented), or onmultifamily residential properties, that meet cer-tain criteria. To be included in category 3, loansmust have been made in accordance with pru-dent underwriting standards, be performing inaccordance with their original terms, and not be90 days or more past due or carried in nonac-crual status. The following additional criteriamust be applied to a loan secured by a multifam-ily residential property that is included in thiscategory: (1) All principal and interest paymentson the loan must have been made on time for atleast the year preceding placement in this cate-gory, or, in the case of an existing propertyowner who is refinancing a loan on that prop-erty, all principal and interest payments on theloan being refinanced must have been made ontime for at least the year preceding placement inthis category; (2) amortization of the principaland interest must occur over a period of notmore that 30 years, and the minimum originalmaturity for repayment of principal must not beless than seven years; and (3) the annual netoperating income (before debt service) gener-ated by the property during its most recent fiscalyear must not be less than 120 percent of theloan’s current annual debt service (115 percentif the loan is based on a floating interest rate) or,in the case of a cooperative or other not-for-profit housing project, the property must gener-ate sufficient cash flow to provide comparableprotection to the institution.

Also included in category 3 are privatelyissued mortgage-backed securities, provided that(1) the structure of the security meets the crite-ria described in section III.B.3. of the risk-basedcapital guidelines (12 C.F.R. 225, appendix A);(2) if the security is backed by a pool of conven-

tional mortgages on one- to four-family residen-tial or multifamily residential properties, eachunderlying mortgage meets the criteria de-scribed above for eligibility for the 50 percentrisk category at the time the pool is originated;(3) if the security is backed by privately issuedmortgage-backed securities, each underlying se-curity qualifies for the 50 percent risk category;and (4) if the security is backed by a pool ofmultifamily residential mortgages, principal andinterest payments on the security are not 30days or more past due. Privately issued mortgage-backed securities that do not meet these criteriaor that do not qualify for a lower risk weight aregenerally assigned to the 100 percent risk cate-gory. Also assigned to category 3 are revenue(nongeneral obligation) bonds or similar obliga-tions, including loans and leases, that are obliga-tions of states or other political subdivisions ofthe United States (for example, municipal rev-enue bonds) or other countries of the OECD-based group, but for which the governmententity is committed to repay the debt with rev-enues from the specific projects financed, ratherthan from general tax funds. Credit-equivalentamounts of derivative contracts involving stan-dard risk obligors (that is, obligors whose loansor debt securities would be assigned to the100 percent risk category) are included in the50 percent category, unless they are backed bycollateral or guarantees that allow them to beplaced in a lower risk category.


All assets not included in the categories aboveare assigned to category 4, which comprisesstandard risk assets. The bulk of the assets typi-cally found in a loan portfolio would be assignedto the 100 percent category.

Category 4 includes long-term claims on, andthe portions of long-term claims that are guaran-teed by, non-OECD banks, and all claims onnon-OECD central governments that entail somedegree of transfer risk. This category includesall claims on foreign and domestic private-sector obligors not included in the categoriesabove (including loans to nondepository finan-cial institutions and bank holding companies);claims on commercial firms owned by the pub-lic sector; customer liabilities to the bank onacceptances outstanding that involve standardrisk claims, investments in fixed assets, prem-ises, and other real estate owned; common andpreferred stock of corporations, including stock

7. For example, a claim is exempt from the automatic stayin bankruptcy in the United States if it arises under a securi-ties contract or a repurchase agreement subject to section 555or 559 of the Bankruptcy Code, respectively (11 U.S.C. 555 or559); a qualified financial contract under section 11(e)(8) ofthe Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)); or anetting contract between financial institutions under sections401–407 of the Federal Deposit Insurance CorporationImprovement Act of 1991 (12 U.S.C. 4401–4407) or theBoard’s Regulation EE (12 C.F.R. 231).



acquired for debts previously contracted; allstripped mortgage-backed securities and similarinstruments; and commercial and consumer loans(except those assigned to lower risk categoriesdue to recognized guarantees or collateral andloans secured by residential property that qualifyfor a lower risk weight).

This category also includes industrial-development bonds and similar obligations issuedunder the auspices of states or political subdivi-sions of the OECD-based group of countries forthe benefit of a private party or enterprise whenthat party or enterprise, not the governmententity, is obligated to pay the principal andinterest. All obligations of states or politicalsubdivisions of countries that do not belong tothe OECD-based group are also assigned tocategory 4. The following assets are assigned arisk weight of 100 percent if they have not beendeducted from capital: investments in unconsoli-dated companies, joint ventures, or associatedcompanies; instruments that qualify as capitalthat are issued by other banking organizations;and any intangibles, including those that mayhave been grandfathered into capital.

4060.3.2.2.2 Application of the RiskWeights

The appropriate aggregate dollar value of theamount in each category is multiplied by therisk weight associated with that category. Theresulting weighted values for each of the riskcategories are added together.

Off-balance-sheet items are incorporated intothe risk-based capital ratio through a two-stepprocess. First, a credit-equivalent amount8 forthe item, except for direct-credit substitutes andrecourse obligations, is calculated by multiply-ing the item by a credit-conversion factor. Sec-ond, the credit-equivalent amount of the off-balance-sheet item is then categorized in thesame manner as on-balance-sheet items, that is,by credit risk, according to the obligor or, ifrelevant, the guarantor or nature of the collat-eral. The credit-conversion factors, that is, fac-

tors ranging from 0 to 100 percent,9 are intendedto reflect the risk characteristics of the activityin terms of an on-balance-sheet equivalent. Theresulting sum of the risk-adjusted on- and off-balance-sheet items is the bank holding compa-ny’s total risk-weighted assets, which comprisesthe denominator of the risk-based capital ratio.Generally, if an item may be assigned to morethan one risk category, that item should beassigned to the category that has the lowest riskweight.

Collateral guarantees and other considerations.Under the guidelines, the primary determinantof the risk category of a particular on- or off-balance-sheet item is the obligor or, if relevant,the guarantor or nature of the collateral. To alimited extent, collateral or guarantees securingsome obligations may be used to place an itemor items in lower risk weights than would beavailable to the obligor. The forms of collateralthat are formally recognized and available forthis purpose are cash on deposit in subsidiarylending institutions;10 securities issued or guar-anteed by the central governments of the OECD-based group of countries, U.S. government agen-cies, or U.S. government–sponsored agencies;and securities issued by multilateral lending insti-tutions or regional development banks. Obliga-tions that are fully secured by such collateral areassigned to the 20 percent risk category.

In order for a claim to be considered collater-alized for risk-based capital purposes, the under-lying arrangements must provide that the claimwill be secured by recognized collateral through-out its term. A commitment may be consideredcollateralized for risk-based capital purposes tothe extent that its terms provide that advancesmade under the commitment will be securedthroughout their term.

The market value of eligible securities usedas collateral should be used to determine whetheran obligation is partially or fully secured. Forpartially secured obligations, the secured por-tion is assigned a 20 percent risk weight. Anyunsecured portion is assigned the risk weightappropriate for the obligor or guarantor, if any.

8. For interest-rate and foreign-exchange contracts, thecredit-equivalent amount is determined by multiplying thenotional amount by a conversion factor (which is different forcontracts maturing in one year or less and those maturing inover a year) and adding the resulting amount to the positivemark-to-market values of the contracts. The maximum riskweight applied to interest-rate and exchange-rate contracts is50 percent.

9. Interest-rate and exchange-rate contracts use conversionfactors significantly below those used for other off-balance-sheet activities. These factors are assigned by remaining matu-rity, one year or less or more than one year, and range from0 to 5 percent.

10. With regard to syndicated credits secured by cash ondeposit in the lead institution, there is a limited exception tothe rule that cash must be on deposit in the lending institutionto be recognized as collateral. A lending institution participat-ing in the syndication may treat its pro rata share of the creditas collateralized if it has a perfected interest in its pro ratashare of the collateral.



The extent to which an off-balance-sheet item issecured by collateral is determined by the degreeto which the collateral covers the face amountof the item before it is converted to a credit-equivalentamountandassigned toa riskcategory.

Certain guarantees are recognized for risk-based capital purposes as follows: guarantees ofthe OECD and non-OECD central govern-ments; U.S. government agencies and U.S.government–sponsored agencies; state and localgovernments of the OECD-based group of coun-tries;multilateral lending institutionsandregionaldevelopment banks; and U.S. depository institu-tions and foreign banks. If an obligation is par-tially guaranteed, the portion that is not fullycovered is assigned the risk weight appropriatefor the obligor or collateral, if any. An obliga-tion that is covered by two types of guaranteeshaving different risk weights is apportionedbetween the two risk categories appropriate forthe guarantors. Direct-credit substitutes, assetstransferred with recourse, and securities issuedin connection with asset securitizations and struc-tured financings are treated as described in sec-tion 4060.3.5.3.

4060.3.3 IMPLEMENTATION

The guidelines apply to those bank holdingcompanies having $500 million or more in assetson a consolidated basis. For bank holding com-panies havingless than $500 million in assetson a consolidated basis, the guidelines willapply only to their subsidiary banks unless(1) the parent bank holding company is engagedin a nonbank activity involving significant lever-age (including off-balance-sheet activity) or(2) the parent holding company has a significantamount of outstanding debt that is held by thegeneral public.

By year-end 1992 and thereafter, bankingorganizations are expected to meet the mini-mum risk-based capital ratio. The minimumratio of capital to risk-weighted assets should be8 percent or more with at least 4 percent takingthe form of tier 1 capital. An assessment of thebanking organization’s capital adequacy shouldreflect the level and severity of the classifiedassets summarized in the examination andinspection.

Banking organizations that do not meet theminimum risk-based capital ratios, or that areconsidered to lack sufficient capital to supporttheir activities, are expected to develop andimplement capital plans acceptable to the Fed-eral Reserve for achieving adequate levels ofcapital that will satisfy the provisions of the

guidelines or that will satisfy agreed-uponarrangements established with the FederalReserve for designated banking organizations.In addition, such banking organizations shouldavoid any actions, including increased risk-taking or unwarranted expansion, that wouldlower or further erode their capital positions. Inthese cases, examiners are to review and com-ment on banking organizations’ capital plansand their progress in meeting minimum risk-based capital requirements.

It would be appropriate to include commentson risk-based capital in the open section of theexamination or inspection report when assessingthe organization’s capital adequacy. Bankingorganizations should be encouraged to establishas soon as possible capital levels and ratios thatare consistent with their overall financial pro-files. Examiner comments should address theadequacy of the banking organization’s plansand progress toward meeting and maintainingthe minimum capital ratios, according to theguidelines.

4060.3.4 DOCUMENTATION

Banking organizations are expected to haveadequate systems in place to compute theirrisk-based capital ratios. Such systems shouldbe sufficient to document the composition ofthe ratios for regulatory reporting and othersupervisory purposes. Generally, supportingdocumentation will be expected to establish howbanking organizations track and report theircapital components and on- and off-balance-sheet items that are given preferential treatment.It may be necessary for examiners to reassignon- or off-balance-sheet items that are given apreferential risk weight to a weight of 100 per-cent, when supporting documentation isinadequate. Examiners are expected to verifythat bank holding companies are correctlyreporting the information requested on the hold-ing companies’ consolidated financial state-ments (FR Y-9C), which are used to computethe organization’s risk-based capital ratios.

4060.3.5 SUPERVISORYCONSIDERATIONS FORCALCULATING AND EVALUATINGRISK-BASED CAPITAL

Examiners must consider certain requirements



and factors when assessing the risk-based capitalratios and the overall capital adequacy of bank-ing organizations. Analysis of these requirementsand factors may have a material impact on theamount of capital banking organizations musthold to appropriately support certain activitiesfor on- and off-balance-sheet items. The treat-ment of the following such activities must beused when assessing compliance with the guide-lines and overall capital adequacy of bankingorganizations.

• Certain capital-adjustment considerations:— investments and advances to unconsoli-

dated banking and finance subsidiaries— review and monitoring of goodwill and

certain other intangible assets— certaincredit-enhancing interest-only strips

(I/Os)— reciprocal holdings of banking organiza-

tions’ capital instruments— deferred tax assets— nonfinancial equity investments

• Certain balance-sheet activity considerations:— investment in shares of a mutual fund— mortgage-backed securities— loans secured by first liens on one- to

four-family residential properties• Certain off-balance-sheet activity consider-

ations:— small-business loans and leases on per-

sonal property— assets sold with recourse (FAS 140 sales)— securities lent— unused commitments— financial and performance standby letters

of credit— avoidance of double-counting of interest-

rate and exchange-rate contracts— treatment of commodity and equity swaps— netting of swaps and similar contracts— assets sold with recourse

• Considerations in the overall assessment ofcapital adequacy:— unrealized asset values— terms of subordinated debt and inter-

mediate-term preferred stock— ineligible collateral and guarantees— overall asset quality— interest-only and principal-only strips— interest-rate risk— claimson, andclaimsguaranteedby,OECD

central governments

If the terms and conditions of a particularinstrument cause uncertainty as to how theinstrument should be treated for capital pur-poses, it may be necessary to consult with Fed-eral Reserve staff for a final determination. TheFederal Reserve will, on a case-by-case basis,determine whether a capital instrument has char-acteristics that warrant its inclusion in tier 1 ortier 2 capital, as well as any quantitative limit onthe amount of an instrument that will be countedas an element of tier 1 or tier 2 capital. Inmaking this determination, the Federal Reservewill consider the similarity of the instrument toinstruments explicitly treated in the guidelines,the ability of the instrument to absorb losseswhile the bank holding company operates as agoing concern, the maturity and redemption fea-tures of the instrument, and other relevant termsand factors.

Redemptions of permanent equity or othercapital instruments before their stated maturitycould have a significant impact on a bank’soverall capital structure. Consequently, a bankholding company considering such a step shouldconsult with the Federal Reserve before redeem-ing any equity or debt capital instrument (beforematurity) if its redemption could have a materialeffect on the level or composition of the organi-zation’s capital base.11

4060.3.5.1 Investments in and Advancesto Unconsolidated Banking and FinanceSubsidiaries and Other Subsidiaries

Generally, debt and equity capital investmentsand any other instruments deemed to be capitalin unconsolidated banking and finance subsidi-aries 12 are to be deducted from the consolidatedcapital of the banking organizations, regardlessof whether the investment is made by a parentbank holding company or its direct or indirectsubsidiaries.13 Fifty percent of the investmentis to be deducted from tier 1 capital and 50 per-cent from tier 2 capital. In cases where tier 2capital is not sufficient to absorb the portion

11. Consultation would not ordinarily be necessary if aninstrument were redeemed with the proceeds of, or replacedby, a like amount of a similar or higher-quality capital instru-ment and the organization’s capital position is consideredfully adequate by the Federal Reserve.

12. A banking and finance subsidiary generally is definedas any company engaged in banking or finance in which theparent institution directly or indirectly holds more than 50 per-cent of the outstanding voting stock, or which is otherwisecontrolled or capable of being controlled by the parentorganization.

13. An exception to this deduction is to be made in thecase of shares acquired in the regular course of securing orcollecting a debt previously contracted in good faith.



(50 percent) of the investment allocated to it, theremainder (up to 100 percent) is to be deductedfrom tier 1 capital. In addition, capital invest-ments in certain other subsidiaries that, whileconsolidated for accounting purposes, are notconsolidated for certain supervisory or regula-tory purposes, such as to facilitate functionalregulation, are to be deducted from tier 1 andtier 2 capital of the banking organization in thesame proportion as for unconsolidated bankingand finance subsidiaries.

Advances to banking and finance subsidiaries(that is, loans, extensions of credit, guarantees,commitments, or any other credit exposures) notconsidered as capital are included in risk assetsat the 100 percent risk weight (unless recog-nized collateral or guarantees dictate weight-ing at a lower percentage). However, suchadvances may be deducted from the parentbanking organization’ s consolidated capitalif the Federal Reserve finds that the risks associ-ated with the advances are similar to the risksassociated with capital investments, or if suchadvances possess risk factors that warrant anadjustment to capital for supervisory purposes.These risk factors could include the absence ofcollateral support or the clear intention of bank-ing organizations to allow the advances, regard-less of form, to serve as capital to subsidiaries.

The Board does not automatically deductinvestments in other unconsolidated subsid-iaries or investments in joint ventures andassociated companies. Nonetheless, resourcesinvested in these entities support assets thatare not consolidated with the rest of thebank holding company and, therefore, may notbe generally available to support additionalleverage or absorb losses of affiliated institu-tions. Moreover, experience has shown thatbanking organizations often stand behind thelosses of affiliated institutions in order toprotect the reputation of the organization asa whole. In some cases, this support has led tolosses that have exceeded the investments inthese entities.

Accordingly, the level and nature of suchinvestments should be closely monitored. Forrisk-based capital purposes, on a case-by-casebasis, a bank holding company may be requiredto deduct such investments from total capital, toapply an appropriate risk-weighted capital chargeagainst its pro rata share of the assets of theaffiliated entity, to perform a required line-by-line consolidation of the entity, or to operatewith a risk-based capital ratio above the mini-mum. In determining the appropriate capitaltreatment for such actions, the Board will gener-ally take into account whether (1) the banking

organization has significant influence over thefinancial or managerial policies or operations ofthe affiliated entity, (2) the banking organizationis the largest investor in the entity, or (3) othercircumstances prevail (such as the existence ofsignificant guarantees from the bank holdingcompany) that appear to closely tie the activitiesof the affiliated company to the bankingorganization.

4060.3.5.1.1 Review and Monitoring ofIntangible Assets

For bank holding companies, tier 1 capital isgenerally defined as the sum of core capitalelements less goodwill and other intangible assetsrequired to be deducted in accordance with sec-tion II.B.1.b. of the risk-based measure of thecapital adequacy guidelines for BHCs. Certainintangible assets are not required to be deductedfrom capital.

4060.3.5.1.1.1 Certain Assets That May BeIncluded in Capital

All servicing assets, including servicing assetson assets other than mortgages (that is,nonmortgage-servicing assets), are deemed iden-tifiable intangible assets. The only types of iden-tifiable intangible assets that may be includedin, that is, not deducted from, an organization’scapital are readily marketable mortgage-servicing assets, nonmortgage-servicing assets,purchased credit-card relationships (PCCRs),and credit-enhancing I/Os. The total amount ofthese assets that are included in capital, in theaggregate, cannot exceed 100 percent of tier 1capital. Nonmortgage-servicing assets and pur-chased credit-card relationships are subject to aseparate sublimit of 25 percent of tier 1 capital.The total amount of credit-enhancing I/Os (bothpurchased and retained) that may be included incapital cannot exceed 25 percent of tier 1 capi-tal.14 The total amount of credit-enhancing I/Os(both purchased and retained) that may be

14. Amounts of mortgage-servicing rights and purchasedcredit-card relationships in excess of these limitations, as wellas all other identifiable intangible assets, including coredeposit intangibles and favorable leaseholds, are to be deductedfrom an organization’s core capital elements in determiningtier 1 capital. Identifiable intangible assets, however, exclu-sive of mortgage-servicing assets and purchased credit-cardrelationships, acquired on or before February 19, 1992, gener-ally will not be deducted from capital for supervisory pur-poses. They will, however, continue to be deducted for appli-cations purposes.



included in capital cannot exceed 25 percent oftier 1 capital.

Purchased mortgage-servicing assets are iden-tifiable intangible assets associated with theright to service mortgage loans. They usuallyarise when the rights are purchased from theentity that originated the mortgage loans. Anorganization that acquires purchased mortgage-servicing assets (PMSAs) has the obligation tocollect principal and interest payments and escrowaccounts from the mortgagor and to ensure thatall amounts collected from the mortgagor arepassed on to the appropriate parties. For per-forming these services, the servicer receives afee, which is generally based on the remainingprincipal amount due on the mortgages beingserviced.

Originated mortgage-servicing assets(OMSAs) generally represent the servicing rightsacquired when an organization originates mort-gage loans and subsequently sells the loans butretains the servicing rights. OMSAs are capital-ized as balance-sheet assets in the same manneras PMSAs as a result of a Financial AccountingStandards Board decision, FAS 140, ‘‘Account-ing for the Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities.’’ FAS140 requires the right to service mortgage loansfor others to be separately recognized as a ser-vicing asset or liability, however the rights wereacquired. Servicing becomes a distinct asset orliability only when it is contractually separatedfrom the underlying assets by sale or securitiza-tion of the assets with servicing retained or byseparate purchase or assumption of the servic-ing. See section 3070.0.6 for information on,and accounting for, mortgage-servicing assets.

Purchased credit-card relationships are identi-fiable intangible assets associated with the rightto provide future advances and other services tocredit card holders and to provide correspondent-merchant processing under credit card arrange-ments that have been originated by, and pur-chased from, another entity. PCCRs usuallyarise when a credit card portfolio is bought, andthe purchaser acquires the current advances out-standing under the credit card arrangements,which are tangible assets, as well as the right toprovide future services to the cardholders, whichis an intangible asset. The value of PCCRs isderived from the anticipated profit the purchaserwill earn from interest on future advances andfrom fees charged for other future credit card–related services, after covering expenses andother operating costs such as credit losses.

When calculating the limitations on mortgage-servicing assets, nonmortgage-servicing assets,purchased credit-card relationships, and credit-enhancing I/Os, the definition of tier 1 capitalwill be the sum of core capital elements, net ofgoodwill and net of all identifiable intangibleassets and similar assets other than mortgage-servicing assets, nonmortgage-servicing assets,and purchased credit-card relationships, regard-less of when they were acquired. (This calcula-tion of tier 1 is before the deduction of anydisallowed mortgage-servicing assets, any disal-lowed nonmortgage-servicing assets, any disal-lowed purchased credit-card relationships, anydisallowed credit-enhancing I/Os (purchased orretained), and any disallowed deferred tax assets.)

4060.3.5.1.1.2 Valuation Review

Bank holding companies must review the bookvalue of all intangible assets at least quarterlyand make adjustments to these values as neces-sary. The fair market values of all intangibleassets, nonmortgage-servicing assets, purchasedcredit-card relationships, and credit-enhancingI/Os also must be determined at least quarterly.This determination is to include adjustments forany significant changes made to the originalvaluation assumptions, including changes in pre-payment estimates or account-attrition rates.

Examiners will review both the book valueand the fair market value assigned to theseassets, together with supporting documentation,during the inspection process. In addition, theFederal Reserve may require, on a case-by-casebasis, an independent valuation of a BHC’sintangible assets and credit-enhancing I/Os.

4060.3.5.1.1.3 Fair-Value and Book-ValueLimits

The amount of mortgage-servicing rights,nonmortgage-servicing assets, and purchasedcredit-card relationships that a bank holdingcompany may include in capital is limited to thelesser of 90 percent of their fair value (as deter-mined according to the guidance herein), or100 percent of their book value, as adjusted forcapital purposes in accordance with the instruc-tions to the Consolidated Financial Statementsfor Bank Holding Companies (FR Y-9C Report).If both the application of the limits on mortgage-servicing assets, nonmortgage-servicing assets,and purchased credit-card relationships and theadjustment of the balance-sheet amount for theseassets would result in an amount being deductedfrom capital, the BHC would deduct only the



greater of the two amounts from its core capitalelements in determining tier 1 capital.

The amount of credit-enhancing interest-onlystrips (I/Os) that a bank holding company mayinclude in capital is their fair value. Such I/Osare on-balance-sheet assets that, in form or sub-stance, represent the contractual right to receivesome or all of the interest due on transferredassets. I/Os expose the bank holding companyto credit risk directly or indirectly associatedwith transferred assets that exceeds a pro ratashare of the bank holding company’s claim onthe assets, whether through subordination provi-sions or other credit-enhancement techniques.Such I/Os, whether purchased or retained, andincluding other similar ‘‘ spread’’ assets, may beincluded in, that is, not deducted from, a bankholding company’s capital subject to the fairvalue and tier 1 limitations. Both purchased andretained credit-enhancing I/Os, on a non-tax-adjusted basis, are included in the total amountthat is used for purposes of determining whethera bank holding company exceeds the tier 1limitation. In determining whether an I/O orother types of spread assets serve as a creditenhancement, the Federal Reserve will look tothe economic substance of the transaction.

Bank holding companies may elect to deductdisallowed mortgage-servicing assets, any disal-lowed nonmortgage-servicing assets, and anydisallowed credit-enhancing I/Os (purchased andretained) on a basis that is net of any associateddeferred tax liability. Deferred tax liabilities net-ted in this manner cannot also be netted againstdeferred tax assets when determining the amountof deferred tax assets that are dependent uponfuture taxable income.

4060.3.5.1.1.4 Growing Organizations

Banking organizations experiencing substantialgrowth, whether internally or by acquisition, areexpected to maintain strong capital positionssubstantially above minimum supervisory lev-els, without significant reliance on intangibleassets or credit-enhancing I/Os.

4060.3.5.1.1.5 Examiners’ Review ofIntangibles

During on-site examinations and inspections,examiners are to review the evidence of title toand the accounting for intangible assets, includ-ing their respective amortization schedules andsupporting documentation. Carrying values ofintangible assets and fair market values assigned

to these assets that are overstated or not ade-quately supported with documentation on howthe carrying values were originated, amortized,or adjusted should be excluded from bankingorganizations’ risk-based capital calculations.Intangible assets in excess of 25 percent of tier 1capital should be closely scrutinized along withany unusual items and, if supervisory concernswarrant, deducted from tier 1 capital. Anarrangement whereby a bank holding companyenters into a licensing or leasing agreement orsimilar transaction to avoid booking an intan-gible asset should be subject to particularlyclose scrutiny. Normally, such arrangements willbe dealt with by adjusting the bank holdingcompany’s capital calculation in an appropriatemanner. In making their evaluation of intangibleassets, examiners are to consider a number offactors, including—

1. the reliability and predictability of any cashflows associated with the asset and the degreeof certainty that can be achieved in periodi-cally determining the asset’s useful life andvalue,

2. the existence of an active and liquid marketfor the asset, and

3. the feasibility of selling the asset apart fromthe banking organization or from the bulk ofits assets.

Intangible rights that have been allowed tolapse or that are no longer used should be rec-ommended for authorized write-off. Examinersshould reviewintangibleassets, suchasmortgage-servicing rights, nonmortgage-servicing rights(for example, core deposit intangibles and lease-holds), and purchased credit-card relationships,and determine that the organization properlymonitors their level and quality.

4060.3.5.1.2 Reciprocal Holdings ofBanking Organizations’ CapitalInstruments

Reciprocal holdings (intentional cross-holdings)of banking organizations’ capital instrumentsare to be deducted from the total capital of anorganization for the purpose of determining thetotal risk-based capital ratio. Reciprocal hold-ings are cross-holdings resulting from formal orinformal arrangements between banking organi-zations to swap or exchange each other’s capitalinstruments. Deductions of holdings of capital



securities also would not be made in the case ofinterstate ‘‘ stake-out’’ investments that complywith the Board’s policy statement on nonvotingequity investments (12 C.F.R. 225.143). In addi-tion, holdings of capital instruments issued byother banking organizations but taken in satis-faction of debts previously contracted would beexempt from any deduction from capital.

4060.3.5.1.3 Limit on Deferred TaxAssets

The amount of deferred tax assets that aredependent on future taxable income, net of thevaluation allowance for deferred tax assets, thatmay be included in, that is, not deducted from, abank holding company’s capital may not exceedthe lesser of—

1. the amount of these deferred tax assets thatthe bank holding company is expected torealize within one year of the calendar quarter–end, based on the projections of future tax-able income for that year,15 or

2. 10 percent of tier 1 capital.

The reported amount of deferred tax assets, netof any valuation allowance for deferred taxassets, in excess of the lesser of these twoamounts is to be deducted from a banking orga-nization’s core capital elements in determiningtier 1 capital. For purposes of calculating the10 percent limitation, tier 1 capital is defined asthe sum of the core capital elements, net ofgoodwill and net of all identifiable intangibleassets other than mortgage-servicing assets,nonmortgage-servicing assets, and purchasedcredit-card relationships, before the deductionof any disallowed mortgage-servicing assets,any disallowed nonmortgage-servicing assets,

any disallowed purchased credit-card relation-ships, any disallowed credit-enhancing I/Os, anydisallowed deferred tax assets, and any nonfi-nancial equity investments. There generally isno limit in tier 1 capital on the amount ofdeferred tax assets that can be realized fromtaxes paid in prior carry-back years and fromfuture reversals of existing taxable temporarydifferences.

4060.3.5.1.4 Nonfinancial EquityInvestments

A bank holding company must deduct from itscore capital elements the sum of the appropriatepercentages (as determined below) of the adjustedcarrying value of all nonfinancial equity invest-ments held by the parent bank holding companyor by its direct or indirect subsidiaries. Invest-ments held by a bank holding company includeall investments held directly or indirectly by thebank holding company or any of its subsidiaries.The adjusted carrying value of investments isthe aggregate value at which the investments arecarried on the balance sheet of the consolidatedbank holding company reduced by any unreal-ized gains on those investments that are re-flected in such carrying value but excluded fromthe bank holding company’s tier 1 capital andassociated deferred tax liabilities. For example,for investments held as available-for-sale (AFS),the adjusted carrying value of the investmentswould be the aggregate carrying value of theinvestments (as reflected on the consolidatedbalance sheet of the bank holding company) lessany unrealized gains on those investments thatare included in other comprehensive income andnot reflected in tier 1 capital, and associateddeferred tax liabilities.16

A nonfinancial equity investment, subject tothe risk-based capital rule (the rule), is anyequity investment held by the bank holdingcompany (1) under the merchant banking author-ity of section 4(k)(4)(H) of the Bank HoldingCompany Act (the BHC Act) and subpart J ofthe Board’s Regulation Y (12 C.F.R. 225.175 etseq.); (2) under section 4(c)(6) or 4(c)(7) of theBHC Act in a nonfinancial company or in acompany that makes investments in nonfinan-cial companies; (3) in a nonfinancial companythrough a small business investment company(SBIC) under section 302(b) of the Small Busi-

15. To determine the amount of expected deferred taxassets realizable in the next 12 months, a banking organiza-tion should assume that all existing temporary differencesfully reverse as of the report date. Projected future taxableincome should not include net operating loss carry-forwardsto be used during that year or the amount of existing tempo-rary differences a bank holding company expects to reversewithin the year. Such projections should include the estimatedeffect of tax-planning strategies that the organization expectsto implement to realize net operating losses or tax-creditcarry-forwards that would otherwise expire during the year. Anew 12-month projection does not have to be prepared eachquarter. Rather, on interim report dates, banking organizationsmay use the future-taxable-income projections for their cur-rent fiscal year, adjusted for any significant changes that haveoccurred or are expected to occur.

16. Unrealized gains on AFS investments may be includedin supplementary capital to the extent permitted by the risk-based capital guidelines. In addition, the unrealized losses onAFS equity investments are deducted from tier 1 capital.



ness Investment Act of 1958;17 (4) in a nonfi-nancial company under the portfolio investmentprovisions of the Board’s Regulation K (12C.F.R. 211.8(c)(3)); or (5) in a nonfinancialcompany under section 24 of the Federal DepositInsurance Act (other than section 24(f)).18

A nonfinancial company is an entity that engagesin any activity that has not been determined tobe financial in nature or incidental to financialactivities under section 4(k) of the Bank Hold-ing Company Act (12 U.S.C. 1843(k)).

The bank holding company must deduct fromits core capital elements the sum of the appropri-ate percentages, as stated in table 1, of theadjusted carrying value of all nonfinancial equityinvestments held by the bank holding company.The amount of the percentage deduction increasesas the aggregate amount of nonfinancial equityinvestments held by the bank holding companyincreases as a percentage of the bank holdingcompany’s tier 1 capital.

Table 1—Deduction for Nonfinancial Equity Investments

Aggregate adjusted carrying value ofall nonfinancial equity investmentsheld directly or indirectly by thebank holding company (as apercentage of the tier 1 capitalof the parent banking organization)1

Deduction from core capital elements (asa percentage of the adjusted carryingvalue of the investment)

Less than 15 percent 8 percent

15 percent to 24.99 percent 12 percent

25 percent and above 25 percent

1. For purposes of calculating the adjusted carrying valueof nonfinancial equity investments as a percentage of tier 1capital, tier 1 capital is defined as the sum of core capitalelements net of goodwill and net of all identifiable intangibleassets other than MSAs, NMSAs, and PCCRs, but before

the deduction for any disallowed MSAs, any disallowedNMSAs, any disallowed PCCRs, any disallowed credit-enhancing I/Os (both purchased and retained), any disalloweddeferred tax assets, and any nonfinancial equity investments.

These deductions are applied on a marginalbasis to the portions of the adjusted carryingvalue of nonfinancial equity investments thatfall within the specified ranges of the parentholding company’s tier 1 capital. For example,if the adjusted carrying value of all nonfinancialequity investments held by a bank holding com-pany equals 20 percent of the tier 1 capital ofthe bank holding company, then the amount ofthe deduction would be 8 percent of the adjustedcarrying value of all investments up to 15 per-cent of the company’s tier 1 capital, and 12 per-cent of the adjusted carrying value of all invest-ments in excess of 15 percent of the company’stier 1 capital. The total adjusted carrying valueof any nonfinancial equity investment that issubject to deduction is excluded from the bankholding company’s risk-weighted assets for pur-

poses of computing the denominator of the com-pany’s risk-based capital ratio.19

The rule establishes minimum risk-based capi-tal ratios, and banking organizations are at alltimes expected to maintain capital commensu-rate with the level and nature of the risks towhich they are exposed. The risk to a bankingorganization from nonfinancial equity invest-ments increases with its concentration in suchinvestments, and strong capital levels above theminimum requirements are particularly impor-tant when a banking organization has a highdegree of concentration in nonfinancial equity

17. An equity investment made under section 302(b) of theSmall Business Investment Act of 1958 in an SBIC that is notconsolidated with the parent banking organization is treatedas a nonfinancial equity investment.

18. See 12 U.S.C. 1843(c)(6), (c)(7), and (k)(4)(H); 15U.S.C. 682(b); 12 C.F.R. 211.5(b)(1)(iii); and 12 U.S.C.1831a. In a case in which the board of directors of the FDIC,acting directly in exceptional cases and after a review of theproposed activity, has permitted a lesser capital deduction foran investment approved by the board of directors under sec-tion 24 of the Federal Deposit Insurance Act, such deductionshall also apply to the consolidated bank holding companycapital calculation so long as the bank’s investments under

section 24 and SBIC investments represent, in the aggregate,less than 15 percent of the tier 1 capital of the bank.

19. For example, if 8 percent of the adjusted carrying valueof a nonfinancial equity investment is deducted from tier 1capital, the entire adjusted carrying value of the investmentwill be excluded from risk-weighted assets in calculating thedenominator for the risk-based capital ratio.



investments (for example, in excess of 50 per-cent of tier 1 capital).

The Federal Reserve intends to monitor bank-ing organizations and apply heightened supervi-sion to equity investment activities as appropri-ate, including where the banking organizationhas a high degree of concentration in nonfinan-cial equity investments, to ensure that each orga-nization maintains capital levels that are appro-priate in light of its equity investment activities.The Federal Reserve also reserves authority toimpose a higher capital charge in any casewhere the circumstances, such as the level ofrisk of the particular investment or portfolioof investments, the risk-management systems ofthe banking organization, or other information,indicate that a higher minimum capital require-ment is appropriate.

4060.3.5.1.4.1 SBIC Investments

No deduction is required for nonfinancial equityinvestments that are held by a bank holdingcompany through one or more SBICs that areconsolidated with the bank holding company orin one or more SBICs that are not consolidatedwith the bank holding company to the extentthat all such investments, in the aggregate, donot exceed 15 percent of the aggregate of thebank holding company’s pro rata interests in thetier 1 capital of its subsidiary banks. Any nonfi-nancial equity investment that is held through orin an SBIC and not required to be deductedfrom tier 1 capital will be assigned a 100 per-cent risk weight and included in the parentholding company’s consolidated risk-weightedassets.20

To the extent the adjusted carrying value ofall nonfinancial equity investments that a bankholding company holds through one or moreSBICs that are consolidated with the bank hold-ing company or in one or more SBICs that arenot consolidated with the bank holding com-pany exceeds, in the aggregate, 15 percent ofthe aggregate tier 1 capital of the company’ssubsidiary banks, the appropriate percentage ofsuch amounts (as set forth in table 1) must bededucted from the bank holding company’s corecapital elements. In addition, the aggregate ad-justed carrying value of all nonfinancial equityinvestments held through a consolidated SBICand in a nonconsolidated SBIC (including anyinvestments for which no deduction is required)must be included in determining, for purposesof table 1, the total amount of nonfinancialequity investments held by the bank holdingcompany in relation to its tier 1 capital.

No deduction is required to be made withrespect to the adjusted carrying value of anynonfinancial equity investment (or portion ofsuch an investment) that was made by the bankholding company before March 13, 2000, orthat was made after such date pursuant to abinding written commitment21 entered into bythe bank holding company before March 13,2000, provided that in either case the bank hold-ing company has continuously held the invest-ment since the relevant investment date.22 Anonfinancial equity investment made beforeMarch 13, 2000, includes any shares or otherinterests received by the bank holding company

20. If a bank holding company has an investment in anSBIC that is consolidated for accounting purposes but that isnot wholly owned by the bank holding company, the adjustedcarrying value of the bank holding company’s nonfinancialequity investments through the SBIC is equal to the holdingcompany’s proportionate share of the adjusted carrying valueof the SBIC’s equity investments in nonfinancial companies.The remainder of the SBIC’s adjusted carrying value (that is,the minority interest holders’ proportionate share) is excludedfrom the risk-weighted assets of the bank holding company. Ifa bank holding company has an investment in an SBIC that isnot consolidated for accounting purposes and has currentinformation that identifies the percentage of the SBIC’s assetsthat are equity investments in nonfinancial companies, thebank holding company may reduce the adjusted carryingvalue of its investment in the SBIC proportionately to reflectthe percentage of the adjusted carrying value of the SBIC’sassets that are not equity investments in nonfinancial compa-nies. If a bank holding company reduces the adjusted carryingvalue of its investment in a nonconsolidated SBIC to reflect

financial investments of the SBIC, the amount of the adjust-ment will be risk weighted at 100 percent and included in thebank’s risk-weighted assets.

21. A ‘‘ binding written commitment’’ means a legallybinding written agreement that requires the banking organiza-tion to acquire shares or other equity of the company, or makea capital contribution to the company, under terms and condi-tions set forth in the agreement. Options, warrants, and otheragreements that give a banking organization the right toacquire equity or make an investment, but do not require thebanking organization to take such actions, are not considereda binding written commitment.

22. For example, if a bank holding company made anequity investment in 100 shares of a nonfinancial companybefore March 13, 2000, that investment would not be subjectto a deduction. However, if the bank holding company madeany additional equity investment in the company after March13, 2000, such as by purchasing additional shares of thecompany (including through the exercise of options or war-rants acquired before or after March 13, 2000) or by making acapital contribution to the company, and such investment wasnot made pursuant to a binding written commitment enteredinto before March 13, 2000, the adjusted carrying value of theadditional investment would be subject to a deduction. Inaddition, if the bank holding company sold and repurchasedshares of the company after March 13, 2000, the adjustedcarrying value of the reacquired shares would be subject to adeduction.



through a stock split or stock dividend on aninvestment made before March 13, 2000, pro-vided the bank holding company provides noconsideration for the shares or interests receivedand the transaction does not materially increasethe bank holding company’s proportional inter-est in the company. The exercise on or afterMarch 13, 2000, of options or warrants acquiredbefore March 13, 2000, is not considered to bean investment made before March 13, 2000, ifthe bank holding company provides any consid-eration for the shares or interests received uponexercise of the options or warrants. Any nonfi-nancial equity investment (or portion thereof)that is not required to be deducted from tier 1capital must be included in determining the totalamount of nonfinancial equity investments heldby the bank holding company in relation to itstier 1 capital for purposes of table 1. In addition,any nonfinancial equity investment (or portionthereof) that is not required to be deducted fromtier 1 capital will be assigned a 100 percent riskweight and included in the bank holding compa-ny’s consolidated risk-weighted assets.

As discussed above for consolidated SBICs,some equity investments may be in companiesthat are consolidated for accounting purposes.For investments in a nonfinancial company thatis consolidated for accounting purposes undergenerally accepted accounting principles, theparent banking organization’s adjusted carryingvalue of the investment is determined under theequity method of accounting (net of any intan-gibles associated with the investment that arededucted from the consolidated bank holdingcompany’s core captial). Even though the assetsof the nonfinancial company are consolidatedfor accounting purposes, these assets (as well asthe credit-equivalent amounts of the company’soff-balance-sheet items) should be excluded fromthe banking organization’s risk-weighted assetsfor regulatory capital purposes.

4060.3.5.1.4.2 Equity Investments

The term ‘‘ equity investment’’ means any equityinstrument (including common stock, preferredstock, partnership interests, interests in limited-liability companies, trust certificates, and war-rants and call options that give the holder theright to purchase an equity instrument), anyequity feature of a debt instrument (such as awarrant or call option), and any debt instrumentthat is convertible into equity. An investment inany other instrument (including subordinateddebt) may be treated as an equity investment if,in the judgment of the Federal Reserve, the

instrument is the functional equivalent of equityor exposes the banking organization to essen-tially the same risks as an equity instrument.

4060.3.5.1.5 Revaluation Reserves

Revaluation reserves reflect the formal balance-sheet restatement or revaluation for capital pur-poses of asset carrying values to reflect thecurrent market values. The Federal Reserve gen-erally has not included unrealized asset appreci-ation in capital-ratio calculations, although ithas long taken such values into account as aseparate factor in assessing the overall financialstrength of a banking organization.

Consistent with long-standing supervisorypractice, the excess of market values over bookvalues for assets held by bank holding compa-nies will generally not be recognized in supple-mentary capital or in the calculation of the risk-based capital ratio. However, all bank holdingcompanies are encouraged to disclose theirequivalent of premises (building) and security-revaluation reserves. The Federal Reserve willconsider any appreciation, as well as any depre-ciation, in specific asset values as additionalconsiderations inassessingoverall capital strengthand financial condition.

4060.3.5.2 Certain Balance-Sheet-Activity Considerations

4060.3.5.2.1 Investment in Shares of aMutual Fund

An exception to the general rule exists for aninvestment in shares of a fund that invests invarious securities or money market instrumentsthat are eligible to be assigned to different riskcategories. In this case, the total investmentwould generally be assigned to the risk categoryappropriate to the highest risk-weighted assetthe fund may hold, in accordance with the statedlimits set forth in the prospectus. Bank holdingcompanies have the option of assigning theinvestment on a pro rata basis to different riskcategories according to the investment limits inthe fund’s prospectus. Regardless of the risk-weighting method used, the total risk weight ofa mutual fund must not be less than 20 percent.If the bank holding company chooses to assign afund investment on a pro rata basis, and the sumof the investment limits for all asset categories,



as described in the fund’s prospectus, exceeds100 percent, it must assign risk weights indescending order based on the assumption thatthe fund invests the largest possible percentageof its assets in the highest risk-weighted catego-ries.23 If, in order to maintain a necessary de-gree of short-term liquidity, a fund is permittedto hold an insignificant amount of its assets inshort-term, highly liquid securities of superiorcredit quality that do not qualify for a preferen-tial risk weight, then those securities may bedisregarded in determining the fund’s risk weight.

The prudent use of hedging instruments by afund to reduce the risk of its assets will notincrease the risk weighting of the fund invest-ment. For example, the use of hedging instru-ments by a fund to reduce the interest-rate riskof its government bond portfolio will not increasethe risk weight of that fund above the 20 percentcategory. Nonetheless, if a fund engages in anyactivities that appear speculative in nature or thefund has any other characteristics that are incon-sistent with the preferential risk weightingassigned to the fund’s assets, holdings in thefund will be assigned to the 100 percent risk-weight category.

4060.3.5.2.2 Loans Secured by FirstLiens on One- to Four-Family ResidentialProperties or Multifamily ResidentialProperties

Qualifying one- to four-family residentialproperties, either owner-occupied or rented, ormultifamily residential properties (as listed inthe instructions to the bank holding companyFR Y-9C Report), are accorded preferential risk-weighting treatment under the guidelines. Theseloans include loans to builders with substantialproject equity for the construction of one- tofour-family residential properties that have beenpresold under firm contracts to purchasers whohave obtained firm commitments for permanent

qualifying mortgage loans and have made sub-stantial earnest-money deposits.24 Effective withan April 1, 1999, amendment, such loans tobuilders will be considered prudently underwrit-ten only if the bank holding company has obtainedsufficient documentation that the buyer of thehome intends to purchase the home (that is, hasa legally binding written sales contract). Thebuyer must have the ability to obtain a mortgagesufficient to purchase the home (that is, has afirm written commitment for permanent financ-ing of the home upon completion).

To ensure that only qualifying residentialmortgage loans are assigned to the 50 percentrisk-weight category, examiners are to reviewthe real estate loans that are included in thatcategory. Such loans are not eligible for prefer-ential treatment unless the loans are made sub-ject to prudent credit-underwriting standards;the loan-to-value ratios are conservative;25 theloan-to-value ratios 26 are based on the mostcurrent appraisal or evaluation 27 of the proper-ties, with such appraisal or evaluation conform-ing to both the Board’s real estate appraisalregulations and guidelines and the banking orga-nization’s internal appraisal guidelines; and theloans are performing in accordance with theiroriginal terms and are not 90 days or more pastdue or carried in nonaccrual status. Where ex-aminers find that some residential mortgageloans do not meet all the specified criteria or aremade for the purpose of speculative real estatedevelopment, such loans should be assigned to

23. For example, assume that a fund’s prospectus permitsup to 30 percent of the fund’s assets to be invested in100 percent risk-weighted assets, up to 40 percent of thefund’s assets to be invested in 50 percent risk-weighted assets,and up to 60 percent of the fund’s assets to be invested in20 percent risk-weighted assets. In such a case, the bankholding company must assign 30 percent of the total invest-ment to the 100 percent risk category, 40 percent to the50 percent risk category, and 30 percent to the 20 percent riskcategory. It may not minimize its capital requirement byassigning 60 percent of the total investment to the 20 percentrisk category and 40 percent to the 50 percent risk category.

24. An amendment, effective December 29, 1992, loweredfrom 100 percent to 50 percent the risk weight on loans tofinance the construction of one- to four-family residences thathave been presold.

25. Prudent underwriting standards dictate that a loan-to-value ratio used in the case of originating a loan to acquire aproperty would not be deemed conservative unless the valueis based on the lower of the acquisition cost of the property orthe appraised (or, if appropriate, evaluated) value. Otherwise,the loan-to-value ratio generally would be based on the valueof the property as determined by the most current appraisal or,if appropriate, the most current evaluation. All appraisals andevaluations must be made in a manner consistent with thefederal banking agencies’ real estate appraisal regulations andguidelines and with the banking organization’s own appraisalguidelines.

26. If a banking organization holds the first and juniorlien(s) on a residential property and no other party holds anintervening lien, the transaction is treated as a single loansecured by a first lien for the purposes of determining theloan-to-value ratio and assigning a risk weight.

27. Appraisals made at the inception of one- to four-familyresidential property loans are to be used in calculating loan-to-value ratios. Subsequent appraisals showing increased prop-erty values may be used to support higher loan-to-value ratios.However, to avoid penalizing banking organizations doingbusiness in markets with declining real estate values, appraisalsof residential properties as conducted at inception are to beused in calculating loan-to-value ratios, even though morecurrent appraisals showing decreases in values are available.



the 100 percent risk-weight category in accor-dance with the guidelines.

Examiners should keep in mind that loanssecured by multifamily residential property mustmeet additional criteria to be included in the50 percent risk-weight category. These includethe requirement that all principal and interestpayments on the loan must have been made ontime for at least the year preceding the place-ment of the loan in this risk-weight category. Ifthe existing property owner is refinancing a loanon that property, all principal and interest pay-ments on the loan being refinanced must havebeen made on time for at least the year preced-ing placement in this risk-weight category. Inaddition, amortization of the principal andinterest must occur over a period of not morethan 30 years, and the minimum original matu-rity for repayment of principal must not be lessthan seven years. Also, the annual net operatingincome (before debt service) generated by theproperty during its most recent fiscal year mustnot be less than 120 percent of the loan’s currentannual debt service (115 percent if the loan isbased on a floating interest rate) or, in the caseof a cooperative or other not-for-profit housingproject, the property must generate sufficientcash flow to provide comparable protection tothe institution.

If examiners find material evidence of resi-dential mortgage loans having questionable eli-gibility for preferential risk weighting but can-not readily identify the amounts that wereinappropriately weighted, the overall evaluationof the banking organization’s capital adequacyshould reflect a higher capital requirement thanotherwise would be the case.

4060.3.5.3 Certain Off-Balance-Sheet-Activity Considerations

Off-balance-sheet transactions include recourseobligations and direct-credit substitutes. Thetreatment fordirect-credit substitutes, assets trans-ferred with recourse, and securities issued inconnection with asset securitizations and struc-tured financings is described below. The terms‘‘asset securitizations’’ or ‘‘securitizations,’’ asused in this subsection, include structuredfinancings as well as asset-securitization trans-actions. Securitization is the pooling and repack-aging by a special-purpose entity of assets orother credit exposures into securities that can besold to investors. Securitization includes trans-actions that create stratified credit-risk positionswhose performance is dependent on an under-

lying pool of credit exposures, including loansand commitments.

4060.3.5.3.1 Assets Sold with Recourse

For risk-based capital adequacy purposes,‘‘recourse’’ means a bank holding company’sretention, in form or in substance, of any creditrisk directly or indirectly associated with anasset it has transferred that exceeds a pro ratashare of the bank holding company’s claim onthe asset. If a bank holding company has noclaim on a transferred asset, then the retentionof any risk of credit loss is recourse. A recourseobligation typically arises when a bank holdingcompany transfers assets and retains an explicitobligation to repurchase the assets or absorblosses due to a default on the payment of princi-pal or interest or any other deficiency in theperformance of the underlying obligor or someother party.

Recourse may also exist implicitly if a bankholding company provides credit enhancementbeyond any contractual obligation to supportassets it has sold. The following are examples ofrecourse arrangements:

1. credit-enhancing representations and warran-ties made on the transferred assets

2. loan-servicing assets retained pursuant to anagreement under which the bank holdingcompany will be responsible for credit lossesassociated with the loans being serviced(Mortgage-servicer cash advances that meetthe conditions of section III.B.3.a.x. of theguidelines (12 C.F.R. 225, appendix A) arenot recourse arrangements.)

3. retained subordinated interests that absorbmore than their pro rata share of losses fromthe underlying assets

4. assets sold under an agreement to repur-chase, if the assets are not already includedon the balance sheet

5. loan strips sold without contractual recourse,when the maturity of the transferred loan isshorter than the maturity of the commitmentunder which the loan is drawn

6. credit derivatives issued that absorb morethan the bank holding company’s pro ratashare of losses from the transferred assets

7. clean-up calls at inception that are greaterthan 10 percent of the balance of the originalpool of transferred loans or of the outstand-ing principal amount of securities (Clean-up



calls that are 10 percent or less of the origi-nal pool balance that are exercisable at theoption of the bank holding company are notrecourse arrangements.)

8. liquidity facilities that provide liquidity sup-port to ABCP (other than eligible ABCPliquidity facilities).

To qualify as an asset sale with recourse, atransfer of assets must first qualify as a saleaccording to the GAAP criteria set forth inparagraph 14 of the Financial Accounting Stan-dards Board’s Statement No. 140 (FAS 140),‘‘Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments ofLiabilities.’’ If a transfer of assets does not meetthese criteria, the assets must remain on thebank holding company’s balance sheet and thusthey are subject to the appropriate risk-basedcapital charge.

If a transfer of assets qualifies as a sale underGAAP but the bank holding company retainsany risk of loss or obligation for payment ofprincipal or interest, then the transfer is consid-ered to be a sale with recourse. A more detaileddefinition of an asset sale with recourse may befound in the ‘‘Summary Description of the Risk-Based Capital Treatment of Recourse Arrange-ments’’ in the glossary to the ConsolidatedFinancial Statements for Bank Holding Compa-nies, the FR Y-9C Report instructions. Althoughthe assets are removed from a bank holdingcompany’s balance sheet in an asset sale withrecourse, the credit-equivalent amount is assignedto the risk category appropriate to the obligor inthe underlying transaction, after considering anyassociated guaranties or the nature of the collat-eral. This assignment also applies when thecontractual terms of the recourse agreementlimit the seller’s risk to a percentage of thevalue of the assets sold or to a specific dollaramount.

If, however, the risk retained by the seller islimited to some fixed percentage of any lossesthat might be incurred and there are no otherprovisions resulting in the direct or indirectretention of risk by the seller, the maximumamount of possible loss for which the sellingbank holding company is at risk (the statedpercentage times the amount of assets to whichthe percentage applies) is subject to risk-basedcapital requirements. The remaining amount ofassets transferred would be treated as a sale thatis not subject to the risk-based capital require-

ments. For example, a seller would treat a saleof $1 million in assets with a recourse provisionthat the seller and buyer proportionately share inlosses incurred on a 10 percent and 90 percentbasis, respectively, and with no other retentionof risk by the seller, as a $100,000 asset salewith recourse and as a $900,000 sale not subjectto risk-based capital requirements.

There are exceptions to the general reportingrule for recourse transactions. The first excep-tion applies to recourse transactions for whichthe amount of recourse the bank holding com-pany is contractually liable for is less than thecapital requirement for the assets transferredunder the recourse agreement. For such transac-tions, a bank holding company must hold capitalequal to its maximum contractual recourse obli-gation. For example, assume that a bank holdingcompany transfers a $100 pool of commercialloans and retains a recourse obligation of 2 per-cent. Ordinarily, it would be subject to an 8 per-cent capital charge, or $8. Because the recourseobligation is only 2 percent, however, the bankholding company would be required to holdcapital of $2 against the recourse exposure. Thiscapital charge may be reduced further by thebalance of any associated noncapital GAAPrecourse liability account.

A second exception to the general rule appliesto the transfer of small-business loans and to thetransfer of leases on personal property withrecourse. A bank holding company should includein risk-weightedassetsonly theamountof retainedrecourse—instead of the entire amount of assetstransferred—in connection with a transfer ofsmall-business loans or a transfer of leases onpersonal property with recourse, provided twoconditions are met. First, the transaction mustbe treated as a sale under GAAP; second, thebank holding company must establish a non-capital reserve that is sufficient to cover itsestimated liability under the recourse arrange-ment. The total outstanding amount of recourseretained under such transactions may not exceed15 percent of a BHC’s total risk-based capitalwithout Board approval.

4060.3.5.3.2 Definitions

The capital adequacy guidelines provide specialtreatment for recourse obligations, direct-creditsubstitutes, residual interests, and asset- andmortgage-backed securities involved in asset-securitization activities. A brief discussion ofsome of the other primary definitions follows.



4060.3.5.3.2.1 Direct-Credit Substitutes

The term ‘‘direct-credit substitute’’ refers to anarrangement in which a bank holding companyassumes, in form or in substance, credit riskassociated with an on- or off-balance-sheet assetor exposure that was not previously owned bythe bank holding company (third-party asset),and the risk assumed by the bank holding com-pany exceeds the pro rata share of its interest inthe third-party asset. If the bank holding com-pany has no claim on the third-party asset, thenthe bank holding company’s assumption of anycredit risk on the third-party asset is a direct-credit substitute.

The term ‘‘direct-credit substitute’’ explicitlyincludes items such as purchased subordinatedinterests, agreements to cover credit losses thatarise from purchased loan-servicing rights, creditderivatives, and lines of credit that providecredit enhancement. Some purchased subordi-nated interests, such as credit-enhancing I/Ostrips, are also residual interests for regulatorycapital purposes.

Direct-credit substitutes include, but are notlimited to—

1. financial standby letters of credit that supportfinancial claims on a third party that exceed abank holding company’s pro rata share oflosses in the financial claim;

2. guarantees, surety arrangements, creditderivatives, and similar instruments backingfinancial claims that exceed a bank holdingcompany’s pro rata share in the financialclaim;

3. purchased subordinated interests or securi-ties that absorb more than their pro rata shareof losses from the underlying assets;

4. credit-derivative contracts under which thebank holding company assumes more thanits pro rata share of credit risk on a third-party exposure;

5. loans or lines of credit that provide creditenhancement for the financial obligations ofan account party;

6. purchased loan-servicing assets if the ser-vicer is responsible for credit losses or if theservicer makes or assumes credit-enhancingrepresentations and warranties with respectto the loans serviced (mortgage-servicer cashadvances that meet the conditions of sectionIII.B.3.a.viii. of the guidelines (12 C.F.R.225, appendix A) are not direct-creditsubstitutes);

7. clean-up calls on third-party assets (clean-upcalls that are 10 percent or less of the origi-nal pool balance that are exercisable at the

option of the bank holding company are notdirect-credit substitutes); and

8. liquidity facilities that provide liquidity sup-port to ABCP (other than eligible ABCPliquidity facilities).

4060.3.5.3.2.2 Residual Interests

Residual interests are defined as any on-balance-sheet asset (1) that represents an interest (includ-ing a beneficial interest) created by a transferthat qualifies as a sale (in accordance withGAAP) of a financial asset,28 whether through asecuritization or otherwise, and (2) that exposesthe bank holding company to credit risk directlyor indirectly associated with the transferred assetsthat exceeds a pro rata share of the bank holdingcompany’s claim on the assets, whether throughsubordination provisions or other credit-enhancement techniques. Examples of residualinterests (assets) include credit-enhancing I/Ostrips; spread accounts; cash-collateral accounts;retained subordinated interests; other forms ofovercollateralization; and similar on-balance-sheet assets that function as a credit enhance-ment. Residual interests also include those expo-sures that, in substance, cause the bank holdingcompany to retain the credit risk of an asset orexposure that had qualified as a residual interestbefore it was sold.

The functional-based definition reflects thefact that securitization structures vary in theway they use certain assets as credit enhance-ments. Residual interests therefore include anyretained on-balance-sheet asset that functions asa credit enhancement in a securitization, regard-less of how a bank holding company refers tothe asset in financial or regulatory reports.Residual interests generally do not include inter-ests purchased from a third party, except forcredit-enhancing I/Os.

In general, the definition of residual interestsincludes only an on-balance-sheet asset that rep-resents an interest created by a transfer of finan-cial assets treated as a sale under GAAP, inaccordance with FAS 140. Interests retained in asecuritization or transfer of assets accounted foras a financing under GAAP are generally excludedfrom the definition of residual interest. In the

28. ‘‘Financial asset’’ means cash or other monetary instru-ment, an evidence of debt, an evidence of an ownershipinterest in an entity, or a contract that conveys a right toreceive or exchange cash or another financial instrument fromanother party.



case of GAAP financings, the transferred assetsremain on the transferring bank holding compa-ny’s balance sheet and are, therefore, directlyincluded in both the leverage and risk-basedcapital calculations. Further, when a transactionis treated as a financing, no gain is recognizedfrom an accounting standpoint.

Sellers’ interests generally do not function asa credit enhancement. Thus, if a seller’s interestshares losses on a pro rata basis with investors,such an interest would not be considered aresidual interest. However, bank holding compa-nies should recognize that sellers’ interests thatare structured to absorb a disproportionate shareof losses will be considered residual interests.

The definition of residual interest also includesovercollateralization and spread accounts becausethese accounts are susceptible to the potentialfuture credit losses within the loan pools thatthey support, and thus are subject to valuationinaccuracies. Spread accounts and overcollater-alizations that do not meet the definition ofcredit-enhancing I/O strips generally do notexpose a bank holding company to the samelevel of risk as credit-enhancing I/O strips, andthus are excluded from the concentration limit.

The capital treatment for a residual interestapplies when a bank holding company effec-tively retains the risk associated with that residualinterest, even if the residual is sold. The eco-nomic substance of the transaction will be usedto determine whether the bank holding companyhas transferred the risk associated with theresidual-interest exposure. Bank holding compa-nies that transfer the risk on residual interests,either directly through a sale or indirectly throughguarantees or other credit-risk-mitigation tech-niques, and then reassume this risk in any formwill be required to hold risk-based capital asthough the residual interest remained on itsbooks. For example, if a bank holding companysells an asset that is an on-balance-sheet creditenhancement to a third party and then writes acredit derivative to cover the credit risk associ-ated with that asset, the selling bank holdingcompany must continue to risk-weight, and holdcapital against, that asset as a residual interest asif the asset had not been sold.

4060.3.5.3.2.3 Spread Accounts That Functionas Credit-Enhancing Interest-Only Strips

A spread account is an on-balance-sheet assetthat functions as a credit enhancement and that

can represent an interest in expected interest andfee cash flows derived from assets an organiza-tion has sold into a securitization. In those cases,the spread account is considered to be a ‘‘credit-enhancing interest-only strip’’ and is subject tothe concentration limit. (See SR-02-16.) How-ever, any portion of a spread account that repre-sents an interest in cash that has already beencollected and is held by the trustee is a ‘‘residualinterest’’ subject to dollar-for-dollar capital, butit is not a credit-enhancing interest-only stripsubject to the concentration limit. For example,assume that a bank holding company books asingle spread-account asset that is derived fromtwo separate cash-flow streams:

1. A receivable from the securitization trust thatrepresents cash that has already accumu-lated in the spread account. In accordancewith the securitization documents, the cashwill be returned to the bank holding com-pany at some date in the future after havingbeen reduced by amounts used to reimburseinvestors for credit losses. Based on the datewhen the cash is expected to be paid out tothe bank holding company, the present valueof this asset is currently estimated to be $3.

2. A projection of future cash flows that areexpected to accumulate in the spreadaccount. In accordance with the securitiza-tion documents, the cash, to the extent col-lected, will also be returned to the bankholding company at some date in the futureafter having been reduced by amounts usedto reimburse investors for credit losses. Basedon the date when the cash is expected to bepaid out to the bank holding company, thepresent value of this asset is currently esti-mated to be $2.

Both components of the spread account areconsidered to be residual interests under thecurrent capital standards because both representon-balance-sheet assets subject to more thantheir pro rata share of losses on the underlyingportfolio of sold assets. However, the $2 assetthat represents the banking holding company’sretained interest in future cash flows exposes theorganization to a greater degree of risk becausethe $2 asset presents additional uncertainty as towhether it will ever be collected. This additionaluncertainty associated with the recognition offuture subordinated excess cash flows results inthe $2 asset being treated as a credit-enhancinginterest-only strip, a subset of residual interests.

The face amount29 of all of the banking hold-

29. ‘‘Face amount’’ means the notional principal, or face



ing company’s credit-enhancing interest-onlystrips is first subject to a 25 percent of tier 1capital concentration limit. Any portion of thisface amount that exceeds 25 percent of tier 1capital is deducted from tier 1 capital. This limitwill affect both a bank holding company’s risk-based and leverage capital ratios. The remainingface amount of the bank holding company’scredit-enhancing interest-only strips, as well asthe face amount of the spread-account receiv-able for cash already held in the trust, is subjectto the dollar-for-dollar capital requirementestablished for residual interests, which affectsonly the risk-based capital ratios.

4060.3.5.3.2.4 Credit-Enhancing Interest-OnlyStrips

A credit-enhancing interest-only (I/O) strip is anon-balance-sheet asset that, in form or sub-stance, (1) represents the contractual right toreceive some or all of the interest due on trans-ferred assets and (2) exposes the bank holdingcompany to credit risk that exceeds its pro rataclaim on the underlying assets, whether throughsubordination provisions or other credit-enhancing techniques. Thus, credit-enhancingI/O strips include any balance-sheet asset thatrepresents the contractual right to receive someor all of the remaining interest cash flow gener-ated from assets that have been transferred intoa trust (or other special-purpose entity), aftertaking into account trustee and other administra-tive expenses, interest payments to investors,servicing fees, and reimbursements to investorsfor losses attributable to the beneficial intereststhey hold, as well as reinvestment income andancillary revenues30 on the transferred assets.

Credit-enhancing I/O strips are generally car-ried on the balance sheet at the present value ofthe expected net cash flow that the bankingorganization reasonably expects to receive infuture periods on the assets it has securitized,adjusted for some level of prepayments if rel-evant to that asset class, and discounted at anappropriate market interest rate. Typically, whenassets are transferred in a securitization transac-tion that is accounted for as a sale under GAAP,the accounting recognition given to the credit-enhancing I/O strip on the seller’s balance sheetresults in the recording of a gain on the portionof the transferred assets that has been sold. This

gain is recognized as income, thus increasingthe bank holding company’s capital position.The economic substance of a transaction will beused to determine whether a particular interestcash flow functions as a credit-enhancing I/Ostrip, and the Federal Reserve reserves the rightto identify other cash flows or spread-relatedassets as credit-enhancing I/O strips on a case-by-case basis. For example, including someprincipal payments with interest and fee cashflows will not otherwise negate the regulatorycapital treatment of that asset as a credit-enhancing I/O strip. Credit-enhancing I/O stripsinclude both purchased and retained interest-only strips that serve in a credit-enhancingcapacity, even though purchased I/O strips gen-erally do not result in the creation of capital onthe purchaser’s balance sheet.

4060.3.5.3.2.5 Credit Derivatives

Credit derivative means a contract that allowsone party (the protection purchaser) to transferthe credit risk of an asset or off-balance-sheetcredit exposure to another party (the protectionprovider). The value of a credit derivative isdependent, at least in part, on the credit perfor-mance of a ‘‘reference asset.’’

4060.3.5.3.2.6 Credit-EnhancingRepresentations and Warranties

When a bank holding company transfers assets,including servicing rights, it customarily makesrepresentations and warranties concerning thoseassets. When a bank holding company pur-chases loan-servicing rights, it may also assumerepresentations and warranties made by the selleror a prior servicer. These representations andwarranties give certain rights to other partiesand impose obligations on the seller or servicerof the assets. To the extent a bank holdingcompany’s representations and warranties func-tion as credit enhancements to protect assetpurchasers or investors from credit risk, theyare considered as recourse or direct-creditsubstitutes.

Banks and bank holding companies typicallymake a number of factual warranties that areunrelated to the ongoing performance or creditquality of transferred assets. These warrantiesentail operational risk, as opposed to the open-ended credit risk inherent in a financial guar-value, amount of an off-balance-sheet item; the amortized cost

of an asset not held for trading purposes; and the fair value ofa trading asset.

30. According to FAS 140, ancillary revenues include suchrevenues as late charges on the transferred assets.



anty, and are not considered recourse or a direct-credit substitute. Warranties that createoperational risk include warranties that assetshave been underwritten or collateral appraisedin conformity with identified standards, as wellas warranties that provide for the return of assetsin instances of incomplete documentation, fraud,or misrepresentation.

Warranties can impose varying degrees ofoperational risk. For example, a warranty thatasset collateral has not suffered damage frompotential hazards entails a risk that is offset tosome extent by prudent underwriting practicesrequiring the borrower to provide hazard insur-ance to the bank holding company. A warrantythat asset collateral is free of environmentalhazards may present acceptable operational riskfor certain types of properties that have beensubject to environmental assessment, dependingon the circumstances. The appropriate limits forthese operational risks are monitored throughsupervision of a bank holding company’s loan-underwriting, -sale, and -servicing practices.Also, a bank holding company that provideswarranties to loan purchasers and investors mustinclude associated operational risks in its riskmanagement of exposures arising from loan-sale or securitization-related activities. Bankholding companies should be prepared to dem-onstrate to examiners that operational risks areeffectively managed.

Recourse or direct-credit-substitute treatmentis required for warranties providing assurancesabout the actual value of asset collateral, includ-ing that the market value corresponds to itsappraised value or that the appraised value willbe realized in the event of foreclosure and sale.Warranties such as these, which make represen-tations about the future value of a loan or relatedcollateral, constitute an enhancement of the loantransferred, and thus are recourse arrangementsor direct-credit substitutes. When a seller repre-sents that it ‘‘has no knowledge’’ of circum-stances that could cause a loan to be other thaninvestment quality, the representation is notrecourse. Bank holding companies may limitrecourse exposure with warranties that directlyaddress the condition of the asset at the time oftransfer (that is, creation of an operational war-ranty) and by monitoring compliance with statedunderwriting standards. Alternatively, bank hold-ing companies might create warranties withexposure caps that would permit them to takeadvantage of the low-level-recourse rule.

The definition of credit-enhancing representa-

tions and warranties excludes warranties, suchas early-default clauses and similar warranties.Early-default clauses typically give the pur-chaser of a loan the right to return the loan tothe seller if the loan becomes 30 or more daysdelinquent within a stated period after the trans-fer, for example, four months after transfer.Early-default clauses can allow for a reasonable,but limited, period of time to review file docu-mentation. Once the stated period has expired,the early-default clause will no longer triggerrecourse treatment, provided there are no otherprovisions that constitute recourse.

Early-default clauses and warranties areexcluded from the definition of representationsand warranties if the clauses or warranties per-mit the return of or, in the case of premium-refund clauses, cover one- to four-family resi-dential first mortgage loans that qualify for a50 percent risk weight for a maximum period of120 days from the date of transfer. These war-ranties must cover only loans that were origi-nated within one year of the date of transfer.

A premium-refund clause is a warranty thatobligates a seller who has sold a loan at a pricein excess of par, that is, at a premium, to refundthe premium, either in whole or in part, if theloan defaults or is prepaid within a certainperiod of time. Premium-refund clauses thatcover assets guaranteed, in whole or in part, bythe U.S. government, a U.S. government agency,or a government-sponsored enterprise are notincluded in the definition of credit-enhancingrepresentations and warranties, provided thepremium-refund clauses are for a period not toexceed 120 days from the date of transfer. Thedefinition also does not include warrantiesthat permit the return of assets in instances ofmisrepresentation, fraud, or incompletedocumentation.

4060.3.5.3.2.7 Clean-Up Calls

A clean-up call is an option that permits aservicer or its affiliate (which may be the origi-nator) to take investors out of their positions in asecuritization before all of the transferred loanshave been repaid. The servicer accomplishesthis by repurchasing the remaining loans in thepool once the pool balance has fallen belowsome specified level. This option in a securitiza-tion raises long-standing agency concerns that abank holding company may implicitly assume acredit-enhancing position by exercising the optionwhen the credit quality of the securitized loansis deteriorating. An excessively large clean-upcall facilitates a securitization servicer’s abilityto take investors out of a pool to protect them



from absorbing credit losses, and thus may indi-cate that the servicer has retained or assumedthe credit risk on the underlying pool of loans.

Generally, clean-up calls (whether or not theyare exercised) are treated as recourse and direct-credit substitutes. The purpose of treating largeclean-up calls as recourse or direct-credit substi-tutes is to ensure that bank holding companiesare not able to provide credit to the trust inves-tors by repaying their investment when thecredit quality of the pool is deteriorating with-out holding capital against the exposure. Thefocus should be on the arrangement itself andnot the exercise of the call. Thus, the existence,not the exercise, of a clean-up call that does notmeet the requirements of the risk-based capitalrule will trigger treatment as a recourse obliga-tion or a direct-credit substitute. A clean-up callcan function as a credit enhancement because itsexistence provides the opportunity for a bankholding company (as servicer or an affiliate of aservicer) to provide credit support to investorsby taking an action that is within the contractualterms of the securitization documents. Becauseclean-up calls can also serve an administrativefunction in the operation of a securitization, alimited exemption therefore exists for theseoptions.

When an agreement permits a bank holdingcompany that is a servicer or an affiliate of theservicer to elect to purchase loans in a pool, theagreement is not considered a recourse obliga-tion or a direct-credit substitute if the agreementpermits the banking organization to purchasethe remaining loans in a pool when the balanceof those loans is equal to or less than 10 percentof the original pool balance. This treatment willalso apply to clean-up calls written with refer-ence to less than 10 percent of the outstandingprincipal amount of securities. If, however, anagreement permits the remaining loans to berepurchased when their balance is greater than10 percent of the original pool balance, theagreement is considered to be a direct-creditsubstitute. The exemption from direct-credit-substitute treatment for a clean-up call of 10 per-cent or less recognizes the real market need tobe able to call a transaction when the costs ofkeeping it outstanding are burdensome. How-ever, to minimize the potential for using such afeature as a means of providing support for atroubled portfolio, a bank holding company thatexercises a clean-up call should not repurchaseany loans in the pool that are 30 days or morepast due. Alternatively, the bank holding com-pany should repurchase the loans at the lower oftheir estimated fair value or their par value plusaccrued interest.

Bank holding companies that repurchase assetspursuant to a clean-up call may do so based onan aggregate fair value for all repurchased assets.Bank holding companies do not have to evalu-ate each individual loan remaining in the pool atthe time a clean-up call is exercised to deter-mine fair value. Rather, the overall repurchaseprice should reflect the aggregate fair value ofthe assets being repurchased so that the bankholding company is not overpaying for the assetsand, in so doing, providing credit support to thetrust investors.

Examiners will review the terms and condi-tions relating to the repurchase arrangements inclean-up calls to ensure that transactions aredone at the lower of fair value or par value plusaccrued interest. Bank holding companies shouldbe able to support their fair-value estimates. Ifthe Federal Reserve concludes that a bank hold-ing company has repurchased assets at a pricethat exceeds the lower of these two amounts, theclean-up call provisions in its future securitiza-tions may be treated as recourse obligations ordirect-credit substitutes. Regardless of the sizeof the clean-up call, the Federal Reserve willclosely scrutinize and take appropriate supervi-sory action for any transaction in which thebank holding company repurchases deteriorat-ing assets for an amount greater than a reason-able estimate of their fair value.

4060.3.5.3.2.8 Financial Standby Letters ofCredit

A financial standby letter of credit means aletter of credit or similar arrangement that repre-sents an irrevocable obligation to a third-partybeneficiary—

1. to repay money borrowed by, advanced to, orfor the account of a second party (the accountparty), or

2. to make payment on behalf of the accountparty, in the event that the account party failsto fulfill its obligation to the beneficiary.

4060.3.5.3.2.9 Loan-Servicing Arrangements

The definitions of recourse and direct-creditsubstitute cover loan-servicing arrangements ifthe bank holding company, as servicer, isresponsible for credit losses associated with theserviced loans. However, cash advances made



by residential mortgage servicers to ensure anuninterrupted flow of payments to investors orthe timely collection of the mortgage loans arespecifically excluded from the definitions ofrecourse and direct-credit substitute, providedthe residential mortgage servicer is entitled toreimbursement for any significant advances andthis reimbursement is not subordinate to otherclaims. To be excluded from recourse and direct-credit-substitute treatment, the bank holdingcompany, as servicer, should make an indepen-dent credit assessment of the likelihood ofrepayment of the servicer advance before advanc-ing funds, and should only make such an advanceif prudent lending standards are met. Risk-basedcapital is assessed only against the amount ofthe cash advance, and the advance is assigned tothe risk-weight category appropriate to the partyobligated to reimburse the servicer.

If a residential mortgage servicer is not entitledto full reimbursement, then the maximum pos-sible amount of any nonreimbursed advances onany one loan must be contractually limited to aninsignificant amount of the outstanding princi-pal on that loan. Otherwise, the servicer’s obli-gation to make cash advances will not be excludedfrom the definitions of recourse and direct-creditsubstitute. Bank holding companies that act asservicers should establish policies on serviceradvances and use discretion in determining whatconstitutes an ‘‘insignificant’’ servicer advance.The Federal Reserve will exercise its supervi-sory authority to apply recourse or direct-credit-substitute treatment to servicer cash advancesthat expose a bank holding company, acting asservicer, to excessive levels of credit risk.

4060.3.5.3.2.10 Liquidity Facility

A liquidity facility refers to a legally bindingcommitment to provide liquidity support to ABCPby lending to, or purchasing assets from, anystructure, program, or conduit in the event thatfunds are required to repay maturing ABCP.

4060.3.5.3.2.11 Mortgage-Servicer CashAdvance

A mortgage-servicer cash advance representsfunds that a residential mortgage loan serviceradvances to ensure an uninterrupted flow ofpayments, including advances made to coverforeclosure costs or other expenses to facilitate

the timely collection of the loan. A mortgage-servicer cash advance is not a recourse obliga-tion or a direct-credit substitute if—

1. the servicer is entitled to full reimbursementand this right is not subordinated to otherclaims on the cash flows from the underlyingasset pool, or

2. for any one loan, the servicer’s obligation tomake nonreimbursable advances is contrac-tually limited to an insignificant amount ofthe outstanding principal balance of that loan.

4060.3.5.3.3 Recourse Obligations,Direct-Credit Substitutes, ResidualInterests, and Asset- andMortgage-Backed Securities

The risk-based capital treatment for recourseobligations, direct-credit substitutes, residualinterests, and asset- and mortgage-backed secu-rities in connection with asset securitizationsand structured financings is described below.The capital treatment described in this subsec-tion applies to the bank holding company’s ownpositions.31 For bank holding companies thatcomply with the market-risk rules, except forliquidity facilities supporting ABCP (in form orin substance), positions in the trading book thatarise fromasset securitizations, including recourseobligations, residual interests, and direct-creditsubstitutes, should be treated according to themarket-risk rules. However, these bank holdingcompanies remain subject to the 25 percent con-centration limit for credit-enhancing I/O strips.

4060.3.5.3.3.1 Credit-Equivalent Amount

The credit-equivalent amount for a recourseobligation or a direct-credit substitute is the fullamount of the credit-enhanced assets for whichthe bank holding company directly or indirectlyretains or assumes credit risk, multiplied by a100 percent conversion factor. This treatment,however, does not apply to externally rated posi-tions (an instrument or obligation that has receiveda credit rating from a nationally recognized sta-tistical rating organization), senior positions notexternally rated, residual interests, certain inter-nally rated positions, and certain small-businessloans and leases on personal property trans-ferred with recourse.

31. The treatment also applies to BHCs that hold positionsin their trading book, but that are not otherwise subject to themarket-risk rules.



4060.3.5.3.3.2 Risk-Weight Factor forOff-Balance-Sheet Recourse Obligations andDirect-Credit Substitutes

To determine the bank holding company’s risk-weight factor for off-balance-sheet recourseobligations and direct-credit substitutes, thecredit-equivalent amount is assigned to the riskcategory appropriate to the obligor in the under-lying transaction, after considering any associ-ated guarantees or collateral. For a direct-creditsubstitute that is an on-balance-sheet asset (forexample, a purchased subordinated security), abank holding company must calculate risk-weighted assets using the amount of the direct-credit substitute and the full amount of the assetsit supports, that is, all the more senior positionsin the structure. Direct-credit substitutes thathave been syndicated or in which risk participa-tions32 have been conveyed or acquired are con-sidered off-balance-sheet items that are con-verted at a 100 percent conversion factor. (Seesection III.D.1. of the guidelines (12 C.F.R. 225,appendix A) for more capital treatment details.)

4060.3.5.3.4 Ratings-BasedApproach—Externally Rated Positions

Each loss position in an asset-securitizationstructure functions as a credit enhancement forthe more senior loss positions in the structure. Amultilevel, ratings-based approach is used toassess capital requirements on recourse obliga-tions, residual interests (except credit-enhancingI/O strips), direct-credit substitutes, and seniorand subordinated securities in asset securitiza-tions. The approach uses credit ratings from therating agencies to measure relative exposure tocredit risk and determine the associated risk-based capital requirement. Using these creditratings provides a way to use determinations ofcredit quality that are relied on by investors andother market participants to differentiate theregulatory capital treatment for loss positionsrepresenting different gradations of risk.

Under the ratings-based approach, the capitalrequirement for a position is computed by multi-plying the face amount of the position by theappropriate risk weight, determined in accor-dance with the following tables.33 Table 2 maps

long-term ratings to the appropriate risk weights.Table 3 maps short-term ratings for asset-backedcommercial paper to the appropriate risk weights.The Federal Reserve has the authority, however,to override the use of certain ratings or theratings on certain instruments, either on a case-by-case basis or through broader supervisorypolicy, if necessary or appropriate to address therisk that an instrument poses to a bank holdingcompany.

The ratings-based approach can be used forcertaindesignatedasset-backedsecurities (includ-ing asset-backed commercial paper), recourseobligations, direct-credit substitutes, and residualinterests (other than credit-enhancing I/O strips).Credit-enhancing I/O strips have been excludedfrom the ratings-based approach because of theirhigh riskprofile.While the ratings-basedapproachis available for both traded and untraded posi-tions, the approach applies different require-ments to each type of position.

Ratings-based qualification for corporate bondsor other securities. Corporate bonds or othersecurities not related in any way to a securitiza-tion or structured finance program do not qualifyfor the ratings-based approach. Only mortgage-and asset-backed securities, recourse obliga-tions, direct-credit substitutes, and residualinterests (except credit-enhancing I/O strips)retained, assumed, or issued in connection witha securitization or structured finance programqualify for the ratings-based approach.

A structured-finance program is defined as aprogram in which receivable interests and asset-backed securities issued by multiple participantsare purchased by a special-purpose entity thatrepackages those exposures into securities thatcan be sold to investors. Structured finance pro-grams allocate credit risks, generally, betweenthe participants and the credit enhancement pro-vided to the program. Corporate debt instru-ments, municipal bonds, and other securitiesthat are not related to a securitization or struc-tured finance program do not meet these defini-tions and thus do not qualify for the ratings-based approach.

4060.3.5.3.4.1 Traded Positions

A traded position is a position that is externallyrated and that is retained, assumed, or issued in

32. A risk participation is a participation in which theoriginating party remains liable to the beneficiary for the fullamount of an obligation (e.g., a direct-credit substitute) not-withstanding that another party has acquired a participation inthat obligation.

33. The rating designations (for example, AAA, BBB,A-1, and P-1) used in the tables are illustrative only and do

not indicate any preference for, or endorsement of, any par-ticular rating-agency designation system.



connection with an asset securitization, wherethere is a reasonable expectation that, in the nearfuture, the rating will be relied on by unaffiliatedinvestors to purchase the position or by an unaf-filiated third party to enter into a transactioninvolving the position, such as a purchase, loan,or repurchase agreement. A traded position isonly required to be rated by one rating agency.

For a traded position that has received anexternal rating on a long-term position that isone grade below investment grade or better, orthat has received a short-term rating that is

investment grade, the bank holding companymultiplies the face amount of the position by theappropriate risk weight, determined in accor-dance with tables 2 and 3. Stripped mortgage-backed securities and other similar instruments,such as interest-only or principal-only strips thatare not credit enhancements, must be assignedto the 100 percent risk category. If a tradedposition has received more than one externalrating, the lowest single rating will apply. More-over, if a rating changes, the bank holding com-pany must use the new rating.

Table 2—Risk-Weight Assignments for Externally Rated Long-Term Positions

Long-term rating categoryRating-designation

examples Risk weight

Highest or second-highest investment grade AAA, AA 20 percent

Third-highest investment grade A 50 percent

Lowest investment grade BBB 100 percent

One category below investment grade BB 200 percent

Table 3—Risk-Weight Assignments for Externally Rated Short-Term Positions

Short-term rating categoryRating-designation


Highest investment grade A-1, P-1 20 percent

Second-highest investment grade A-2, P-2 50 percent

Lowest investment grade A-3, P-3 100 percent

Table 3, for short-term ratings, is not identical totable 2, for long-term ratings, because the ratingagencies do not assign short-term ratings usingthe same methodology as they use for long-termratings. Each short-term rating category coversa range of longer-term rating categories.34 Forexample, a P-1 rating could map to a long-termrating that is as high as Aaa or as low as A3.

4060.3.5.3.4.2 Externally Rated, NontradedPositions

For a rated, but untraded, position to be eligiblefor the ratings-based approach, it must meetcertain conditions. To qualify, the position

(1) must be rated by more than one ratingagency; (2) must have received an external rat-ing on a long-term position that is one gradebelow investment grade or better or, for a short-term position, a rating that is investment gradeor better by all rating agencies providing a rat-ing; (3) must have ratings that are publiclyavailable; and (4) must have ratings that arebased on the same criteria used to rate tradedsecurities. If the ratings are different, the lowestsingle rating will determine the risk-weight cate-gory to which the position will be assigned. Thistreatment does not apply to credit-enhancing I/Ostrips.

Split or partially rated instruments. For instru-ments that have been assigned separate ratingsfor principal and interest (split or partially ratedinstruments), the Federal Reserve will apply tothe entire instrument the risk weight that corre-sponds to the lowest component rating. Forexample, a purchased subordinated security

34. See, for example, Moody’s Global Ratings Guide, June2001, p. 3.



whose principal component is rated BBB, butwhose interest component is rated B, is subjectto the gross-up treatment accorded to direct-credit substitutes rated B or lower. Similarly, if aportion of an instrument is unrated, the entireposition will be treated as if it was unrated. Inaddition to this regulatory capital treatment, theFederal Reserve may also, as appropriate,adversely classify and require write-downs foran other-than-temporary impairment on unratedand below-investment-grade securities, includ-ing split or partially rated securities. (See SR-02-16.)

4060.3.5.3.4.3 Senior Positions Not ExternallyRated

A position that is not externally rated (an unratedposition), but that is senior or preferred in allrespects (including collateralization and matu-rity) to a rated position that is traded, is treatedas if it had the rating assigned to the ratedposition. The bank holding company must sat-isfy the Federal Reserve that such treatment isappropriate. Senior unrated positions qualify forthe risk weighting of the subordinated ratedpositions in the same securitization transactionas long as the subordinated rated position (1) istraded and (2) remains outstanding for the entirelife of the unrated position, thus providing fullcredit support until the unrated positionmatures.

Recourse obligations and direct-credit substi-tutes (other than residual interests) that do notqualify for the ratings-based approach (or forthe internal-ratings, program-ratings, orcomputer-program-ratings approaches outlinedbelow) receive ‘‘gross-up’’ treatment, that is,the bank holding company holding the positionmust hold capital against the amount of theposition, plus all more senior positions, subjectto the low-level-exposure requirement.35 Thisgrossed-up amount is placed into a risk-weightcategory according to the obligor or, if relevant,according to the guarantor or nature of the col-lateral. The grossed-up amount multiplied by

both the risk weight and 8 percent is nevergreater than the full capital charge that wouldotherwise be imposed on the assets if they wereon the banking organization’s balance sheet.36

4060.3.5.3.5 Residual Interests

4060.3.5.3.5.1 Credit-Enhancing I/O Strips

After applying the concentration limit to credit-enhancing I/O strips (both purchased andretained), a bank holding company must main-tain risk-based capital for a credit-enhancing I/Ostrip (both purchased and retained), regardlessof the external rating on that position, equal tothe remaining amount of the credit-enhancingI/O strip (net of any existing associated deferredtax liability), even if the amount of risk-basedcapital required to be maintained exceeds thefull risk-based capital requirement for the assetstransferred. Transactions that, in substance, resultin the retention of credit risk associated with atransferred credit-enhancing I/O strip will betreated as if the credit-enhancing I/O strip wasretained by the bank holding company and nottransferred.

4060.3.5.3.5.2 Other Residual Interests

Residual interests that are not eligible for theratings-based approach receive dollar-for-dollartreatment. Dollar-for-dollar treatment means,effectively, that one dollar in total risk-basedcapital must be held against every dollar of aresidual interest retained on the balance sheet(net of any existing associated deferred tax lia-bility), even if the amount of risk-based capitalrequired to be maintained exceeds the full risk-based capital requirement for the assets trans-ferred.This capital treatmentapplies toall residualinterests, except for credit-enhancing I/O stripsthat have already been deducted from tier 1capital under the concentration limit.37 Transac-

35. Gross-up treatment means that a position is combinedwith all more senior positions in the transaction. The result isthen risk-weighted based on the obligor or, if relevant, theguarantor or the nature of the collateral. For example, if aBHC retains a first-loss position (other than a residual inter-est) in a pool of mortgage loans that qualify for a 50 percentrisk weight, the BHC would include the full amount of theassets in the pool, risk-weighted at 50 percent, in its risk-weighted assets for purposes of determining its risk-basedcapital ratio. The low-level-exposure rule provides that thedollar amount of risk-based capital required for assets trans-ferred with recourse should not exceed the maximum dollaramount for which a BHC is contractually liable.

36. For assets that are assigned to the 100 percent risk-weight category, the minimum capital charge is 8 percent ofthe amount of assets transferred, and banking organizationsare required to hold 8 cents of capital for every dollar of assetstransferred with recourse. For assets that are assigned to the50 percent risk-weight category, the minimum capital chargeis 4 cents of capital for every dollar of assets transferred withrecourse.

37. Residual interests that are retained or purchased credit-enhancing I/O strips are first subject to a capital concentrationlimit of 25 percent of tier 1 capital. For risk-based capital



tions that, in substance, result in the retention ofcredit risk associated with a transferred residualinterest will be treated as if the residual interestwas retained by the bank holding company andnot transferred.

When the aggregate capital requirement forresidual interests and other recourse obligationsin connection with the same transfer of assetsexceeds the full risk-based capital requirementfor those assets, a bank holding company mustmaintain risk-based capital equal to the greaterof the risk-based capital requirement for theresidual interest or the full risk-based capitalrequirement for the assets transferred.

Accrued interest receivables held on credit cardsecuritizations. The accrued interest receivable(AIR) asset constitutes a subordinated residual(retained) interest in the transferred securitizedassets, and it meets the definition of recourseexposure for risk-based capital purposes.Recourse exposures (such as the AIR asset)require risk-based capital against the full, risk-weighted amount of the assets transferred withrecourse, subject to the low-level-recourserule.38 The AIR asset serves as a credit enhance-ment to protect third-party investors in the secu-ritization from credit losses, and it meets thedefinition of a residual interest under the risk-based capital adequacy rules for the treatment ofrecourse arrangements. Under those rules, aninstitution must hold dollar-for-dollar capitalagainst residual interests, even if that amountexceeds the full equivalent risk-based capitalcharge on the transferred assets.39 The institu-tion is expected to hold risk-based capital in anamount consistent with the subordinated natureof the AIR asset.

In a typical credit card securitization, an insti-tution transfers a pool of credit card receivablesto a trust, as well as the rights to receive futurepayments of principal, interest, and fee incomefrom those receivables. If a securitization trans-

action qualifies as a sale under FAS 140, theselling institution removes the receivables thatwere sold from its reported assets and continuesto carry any retained interests in the transferredreceivables on its balance sheet; the right tothese future cash flows should be reported as anAIR asset.40 ,41 Any accrued amounts (cash flows)the institution collects (for example, accruedfees and finance charges) generally must betransferred to the trust and will be used first bythe trustee for the benefit of third-party inves-tors to satisfy more senior obligations and forthe payment of trust expenses (such as servicingfees, investor-certificate interest, and investor-principal charge-offs). Any remaining excessfee and finance charges will flow back to theseller.

In accounting for the sale, the AIR asset istreated as a subordinated retained interest ofcredit card receivables when computing the gainor loss on sale. Consistent with GAAP, thismeans that the value of the AIR, at the date oftransfer, must be adjusted based on its relativefair (market) value. This adjustment will typi-cally result in the carrying amount of the AIRbeing lower than its book (face) value prior tosecuritization. The AIR should be reported inregulatory reports as ‘‘Other Assets’’ and not asa loan receivable. (See SR-02-12 and SR-02-22.)

4060.3.5.3.6 Other Unrated Positions

A position (but not a residual interest) main-tained in connection with a securitization andthat is not rated by a rating agency may berisk-weighted based on the bank holding compa-ny’s internal determination of the credit ratingof the position, as specified in table 4 below,multiplied by the face amount of the position.The bank holding company may use threeapproaches to determine the capital require-ments for certain unrated direct-credit substi-tutes and recourse obligations. Under each ofthese approaches, the bank holding companymust satisfy the Federal Reserve that the use ofthe approach is appropriate for the particularbank holding company and for the exposure

purposes (but not for leverage capital purposes), once thisconcentration limit is applied, a bank holding company mustthen hold dollar-for-dollar capital against the face amount ofcredit-enhancing I/O strips remaining.

38. The low-level-recourse rule limits the maximum risk-based capital requirement to the lesser of a banking organiza-tion’s maximum contractual exposure or the full capitalcharge against the outstanding amount of assets transferredwith recourse.

39. For a complete description of the appropriate capitaltreatment for recourse, residual interests, and credit-enhancinginterest-only strips, see ‘‘Recourse, Direct Credit Substitutes,and Residual Interests in Asset Securitizations,’’ 66 Fed. Reg.59614 (November 29, 2001).

40. The AIR represents fees and finance charges that havebeen accrued on receivables that the institution has securitizedand sold to other investors. For example, in credit card securi-tizations, this AIR asset may include both finance chargesbilled but not yet collected and finance charges accrued butnot yet billed on the securitized receivables.

41. Some institutions may categorize part or all of thisreceivable as a loan, a ‘‘due from trust’’ account, a retainedinterest in the trust, or as part of an interest-only stripreceivable.



Table 4—Risk-Weight Assignments for Unrated Positions Using the AlternativeApproaches1

Rating categoryRating-designation


Highest or second-highest investment grade AAA, AA 100 percent

Third-highest investment grade A 100 percent

Lowest investment grade BBB 100 percent

One category below investment grade BB 200 percent

1. such as the internal-ratings approach

being evaluated. The risk weight that may beapplied to an exposure under these alterna-tive approaches is limited to a minimum of100 percent.

4060.3.5.3.6.1 Internal Risk-Rating Systemsfor Asset-Backed Commercial Paper Programs

A bank holding company that has a qualifyinginternal risk-rating system can use that systemto apply the ratings-based approach to itsunrated direct-credit substitutes in asset-backedcommercial paper programs. Internal risk rat-ings could be used to qualify such a creditenhancement for a risk weight of 100 per-cent or 200 percent under the ratings-basedapproach, but not for a risk weight of less than100 percent.

Most sophisticated banking organizations thatparticipate extensively in the asset-securitizationbusiness assign internal risk ratings to theircredit exposures, regardless of the form of theexposure. Usually, internal risk ratings morefinely differentiate the credit quality of a bank-ing organization’s exposures than the categoriesused to evaluate credit risk during bank holdingcompany inspections (pass, substandard, doubt-ful, or loss). An individual bank holding compa-ny’s internal risk ratings may be associated witha certain probability of default, loss in the eventof default, and loss volatility.

The credit enhancements that sponsors obtainfor their commercial paper conduits are rarelyrated or traded. If an internal risk-ratings approachwere not available for these unrated creditenhancements, the provider of the enhancementwould have to obtain two ratings solely to avoidthe gross-up treatment that would otherwiseapply to nontraded positions in asset securitiza-tions for risk-based capital purposes. However,before a provider of an enhancement decideswhether to provide a credit enhancement for aparticular transaction (and at what price), the

provider will generally perform its own analysisof the transaction to evaluate the amount of riskassociated with the enhancement. An internalrisk-ratings approach, therefore, is potentiallyless costly than a ratings-based approach thatrelies exclusively on ratings by the rating agen-cies for the risk weighting of these positions.

Internal risk ratings that correspond to therating categories of the rating agencies can bemapped to risk weights under the FederalReserve’s capital standards. This mapping canbe done in a way that would make it possible todifferentiate the riskiness of various unrateddirect-credit substitutes in asset-backed com-mercial paper programs based on credit risk.The use of internal risk ratings, however, mayraise concerns about the accuracy and consis-tency of the ratings, especially because the map-ping of ratings to risk-weight categories willgive bank holding companies an incentive torate their risk exposures in a way that minimizesthe effective capital requirement. A bank hold-ing company engaged in asset-backed commer-cial paper securitization activities that wishes touse the internal risk-ratings approach must there-fore be able to demonstrate to the satisfaction ofthe Federal Reserve, before relying on its inter-nal ratings, that the bank holding company’sinternal credit-risk rating system is adequate.Adequate internal risk-rating systems usuallyhave the following characteristics:

1. The internal risk ratings are an integral partof a bank holding company’s effective risk-management system that explicitly incorpo-rates the full range of risks arising from thebank holding company’s participation insecuritization activities. The system mustalso fully take into account the effect of suchactivities on the bank holding company’srisk profile and capital adequacy.



2. The internal credit ratings must link to mea-surable outcomes, such as the probabilitythat a position will experience any losses, theexpected losses on that position in the eventof default, and the degree of variance inlosses given default on that position.

3. The ratings separately consider the risk asso-ciated with the underlying loans or bor-rowers, as well as the risk associated withthe specific positions in a securitizationtransaction.

4. The ratings identify gradations of risk among‘‘pass’’ assets and other risk positions, andnot just among assets that have deterioratedto the point that they fall into ‘‘watch’’ grades.Although it is not necessary for a bank hold-ing company to use the same categories asthe rating agencies, its internal ratings mustcorrespond to the ratings of the rating agen-cies so that the Federal Reserve can deter-mine which internal risk rating correspondsto each rating category of the rating agen-cies. A bank holding company would beresponsible for demonstrating, to the satisfac-tion of the Federal Reserve, how these rat-ings correspond with the rating-agency stan-dards that are used as the framework for theasset-securitization portion of the risk-basedcapital rule. This correlation is necessary sothat the mapping of credit ratings to risk-weight categories in the ratings-basedapproach can be applied to internal ratings.

5. The ratings classify assets into each riskgrade using clear, explicit criteria, includingsubjective factors.

6. Independent credit-risk-management or loan-review personnel assign or review the credit-risk ratings. These personnel should haveadequate training and experience to ensurethat they are fully qualified to perform thisfunction.

7. An internal audit procedure periodically veri-fies that internal risk ratings are assigned inaccordance with the bank holding company’sestablished criteria.42

8. The performance of internal ratings is trackedover time to evaluate how well risk gradesare being assigned; adjustments are beingmade to the rating system when the perfor-

mance of the rated positions diverges fromassigned ratings; and the individual ratingsare adjusted accordingly.

9. Credit-risk rating assumptions are consistentwith, or more conservative than, the credit-risk rating assumptions and methodologiesof the rating agencies.

If it determines that a bank holding compa-ny’s rating system is not adequate, the FederalReserve may preclude the bank holding com-pany from applying the internal risk-ratingsapproach to new transactions for risk-basedcapital purposes until the deficiencies have beenremedied. Additionally, depending on the sever-ity of the problems identified, the Federal Reservemay decline to rely on the internal risk ratingsthat the bank holding company had applied toprevious transactions for purposes of determin-ing its regulatory capital requirements.

4060.3.5.3.6.2 Ratings of Specific UnratedPositions in Structured Financing Programs

A bank holding company may also use a ratingobtained from a rating agency for an unrateddirect-credit substitute or recourse obligation(other than a residual interest) that is assumed orretained in connection with a structured financeprogram, if a rating agency has reviewed theterms of the program (according to the specifi-cations set by the rating agency) and stated arating for positions associated with the program.If the program has options for different combi-nations of assets, standards, internal creditenhancements, and other relevant factors, and ifthe rating agency specifies ranges of rating cate-gories to them, the bank holding company mayapply the rating category that corresponds to thebank holding company’s position. To rely on aprogram rating, the bank holding company mustdemonstrate to the Federal Reserve’s satisfac-tion that the credit-risk rating assigned to theprogram meets the same standards generallyused by rating agencies for rating tradedpositions.

The bank holding company must also demon-strate to the Federal Reserve’s satisfaction thatthe criteria underlying the rating agency’sassignment of ratings for the structured financ-ing program are satisfied for the particular posi-tion. If a bank holding company participates in asecuritization sponsored by another party, theFederal Reserve may authorize the bank holdingcompany to use this approach based on a pro-grammatic rating obtained by the sponsor of theprogram.

42. The audit may be performed by any group within theorganization that is qualified to audit the system and is inde-pendent of both the group that makes the decision to extendcredit to the asset-baked commercial paper program and thegroups that develop and maintain the internal credit-risk rat-ing system. (See SR-02-16.)



Bank holding companies with limitedinvolvement in securitization activities may findthe above alternative to be useful. In addition,some bank holding companies extensivelyinvolved in securitization activities already relyon ratings of the credit-risk positions under theirsecuritization programs as part of their risk-management practices. Such bank holding com-panies can rely on these ratings for regulatorycapital purposes if the ratings are part of a soundoverall risk-management process and the ratingsreflect the risk of nontraded positions to thebank holding companies. This approach in astructured financing program can be used toqualify a direct-credit substitute or recourseobligation (but not a residual interest) for a riskweight of 100 percent or 200 percent of the facevalue of the position under the ratings-basedapproach, but not for a risk weight of less than100 percent.

4060.3.5.3.6.3 Credit-Assessment ComputerPrograms

A bank holding company (particularly a bankholding company with limited involvement insecuritization activities) may use an internalratings-based approach if it is using an accept-able credit-assessment computer program,developed by a rating agency, to determine therating of a direct-credit substitute or a recourseobligation (but not a residual interest) issued inconnection with a structured finance program.To be used by a bank holding company forrisk-based capital purposes, a computer pro-gram must have been developed by a ratingagency. Further, the bank holding company mustdemonstrate to the satisfaction of the FederalReserve that the computer program’s creditassessments correspond credibly and reliably tothe rating standards of the rating agencies fortraded positions in securitizations and with therating of traded positions in the financial mar-kets. The latter would generally be shown ifinvestors and other market participants signifi-cantly used the computer program for risk-assessment purposes. In addition, the bank hold-ing company must demonstrate to the FederalReserve’s satisfaction that the program wasdesigned to apply to its particular direct-creditsubstitute or recourse exposure and that it hasproperly implemented the computer program. Ingeneral, sophisticated bank holding companieswith extensive securitization activities shouldonly use this approach if the computer programis an integral part of their risk-management sys-tems and if the bank holding company’s sys-

tems fully capture the risks from its securitiza-tion activities. This computer-program approachcan be used to qualify a direct-credit substituteor recourse obligation (but not a residual inter-est) for a risk weight of 100 percent or 200 per-cent of the face value of the position under theratings-based approach, but not for a risk weightof less than 100 percent.

4060.3.5.3.7 Limitations on Risk-BasedCapital Requirements

4060.3.5.3.7.1 Low-Level Exposure

If a bank holding company’s maximum contrac-tual exposure to loss retained or assumed inconnection with a recourse obligation or a direct-credit substitute, except for a residual interest, isless than the effective risk-based capital require-ment for the enhanced assets, the risk-basedcapital requirement is limited to the maximumcontractual exposure, less any recourse liabilityaccount established in accordance with GAAP.This limitation does not apply when a bankholding company provides credit enhancementbeyond any contractual obligation to supportassets it has sold.

4060.3.5.3.7.2 Mortgage-Related Securities orParticipation Certificates Retained in aMortgage Loan Swap

If a bank holding company holds a mortgage-related security or a participation certificate as aresult of a mortgage loan swap with recourse,capital is required to support the recourse obli-gation plus the percentage of the mortgage-related security or participation certificate that isnot covered by the recourse obligation. The totalamount of capital required for the on-balance-sheet asset and the recourse obligation, how-ever, is limited to the capital requirement for theunderlying loans, calculated as if the bank hold-ing company continued to hold the loans ason-balance-sheet assets.

4060.3.5.3.7.3 Related On-Balance-SheetAssets

If a recourse obligation or a direct-credit substi-tute also appears as a balance-sheet asset, thebalance-sheet asset is not included in a bank



holding company’s risk-weighted assets to theextent the value of the balance-sheet asset isalready included in the off-balance-sheet credit-equivalent amount for the recourse obligation ordirect-credit substitute. In the case of loan-servicing assets and similar arrangements withembedded recourse obligations or direct-creditsubstitutes, both the on-balance-sheet assets andthe related recourse obligations and direct-creditsubstitutes must be separately risk-weighted andincorporated into the risk-based capitalcalculation.

4060.3.5.3.8 Risk-Based CapitalTreatment of Certain Other Types ofOff-Balance-Sheet Items and Transactions

4060.3.5.3.8.1 Distinction Between Financialand Performance Standby Letters of Credit

For risk-based capital purposes, the vast major-ity of standby letters of credit a bank holdingcompany issues are considered financial in nature.On the one hand, in issuing a financial standbyletter of credit, a bank holding company guaran-tees that the account party will fulfill a contrac-tual financial obligation that involves paymentof money. On the other hand, in issuing a perfor-mance standby letter of credit, a bank holdingcompany guarantees that the account party willfulfill a contractual nonfinancial obligation,that is, an obligation that does not entail thepayment of money. For example, a standby let-ter of credit that guarantees that an insurancecompany will pay as required under the terms ofa policy is deemed to be financial and is con-verted at 100 percent, while a letter of credit thatguarantees a contractor will pave a streetaccording to certain specifications is deemed tobe performance-related and is converted at50 percent. Financial standby letters of credithave a higher conversion factor in large partbecause, unlike performance standby lettersof credit, they tend to be drawn down only whenthe account party’s financial condition hasdeteriorated.

4060.3.5.3.8.2 Sale and RepurchaseAgreements and Forward Agreements

Forward agreements are legally binding contrac-tual obligations to purchase assets with certain

drawdown at a specified future date. Such obli-gations include forward purchases, forward for-ward deposits placed,43 and partly paid sharesand securities; they do not include commitmentsto make residential mortgage loans or forwardforeign-exchange contracts.

4060.3.5.3.8.3 Participations ofOff-Balance-Sheet Transactions

If a standby letter of credit or commitment hasbeen participated to other institutions in theform of a syndication, as defined in the instruc-tions to the Call Report, that is, if each bankholding company is responsible only for its prorata share of loss and there is no recourse to theoriginating bank holding company, each bankholding company includes only its pro rata shareof the standby or commitment in its risk-basedcapital calculation.

The treatment differs, however, if the partici-pation takes the form of a conveyance of a riskparticipation. In such a participation, the origi-nating bank holding company remains liable tothe beneficiary for the full amount of the standbyor commitment if the institution that has acquiredthe participation fails to pay when the instru-ment is drawn. Under this arrangement, theoriginating bank holding company is exposed tothe credit risk of the institution that has acquiredthe conveyance rather than that of the accountparty. Accordingly, for risk-based capital pur-poses, the originating bank holding companyshould convert the full amount of the standby orcommitment to an on-balance-sheet credit-equivalent amount. The credit-equivalent amountof the portion of the credit that has not beenconveyed is assigned to the risk category appro-priate to the obligor, after giving effect to anycollateral or guarantees. The portion that hasbeen conveyed is assigned either to the samerisk category as the obligor or to the risk cate-gory appropriate to the institution acquiring theparticipation, whichever category carries thelower risk weight. Any remainder is assigned tothe risk category appropriate to the obligor,guarantor, or collateral. For example, the prorata share of the full amount of the assets sup-ported, in whole or in part, by a direct-creditsubstitute conveyed as a risk participation to aU.S. domestic depository institution or foreignbank holding company is assigned to the 20 per-cent risk category. Risk participations with a

43. Forward forward deposits accepted are treated as interest-rate contracts.



remaining maturity of over one year that areconveyed to non-OECD banks are to be assignedto the 100 percent risk category, unless a lowerrisk category is appropriate to the obligor, guar-antor, or collateral.

4060.3.5.3.9 Small-Business Loans andLeases on Personal Property Transferredwith Recourse (FAS 140 Sales)

A qualifying banking organization (that is,a bank holding company) that has transferredsmall-business loans and leases on personalproperty (small-business obligations) withrecourse can include in weighted-risk assetsonly the amount of retained recourse, providedtwo conditions are met. First, the transactionmust be treated as a FAS 140 sale underGAAP and, second, the banking organizationmust establish pursuant to GAAP a noncapitalreserve sufficient to meet the organization’s rea-sonably estimated liability under the recoursearrangement. Only loans and leases to busi-nesses that meet the criteria for a small-businessconcern established by the Small BusinessAdministration under section 3(a) of the SmallBusiness Act are eligible for this capitaltreatment.

A banking organization qualifies if it meetsthe criteria for well capitalized or, by order ofthe Board, adequately capitalized, as those crite-ria are set forth in the Board’s prompt-corrective-action regulation for state member banks(12 C.F.R. 208.40). For purposes of determiningwhether an organization meets these criteria, itscapital ratios must be calculated without regardto the capital treatment for transfers of small-business obligations with recourse. The totaloutstanding amount of recourse retained by aqualifying banking organization on transfers ofsmall-business obligations receiving the prefer-ential capital treatment cannot exceed 15 per-cent of the organization’s total risk-based capi-tal. By order, the Board may approve a higherlimit.

If a bank holding company ceases to bequalifying or exceeds the 15 percent capitallimitation, the preferential capital treatment willcontinue to apply to any transfers of small-business obligations with recourse that wereconsummated during the time that the organiza-tion was qualifying and did not exceed the capi-tal limit.

4060.3.5.3.10 Securities Lent

Examiners are to review securities-lent transac-tions of banking organizations and verify that,when banking organizations have risk of loss aseither principal or agent, the transaction isconverted at 100 percent and assigned to theappropriate risk-weight category. The guide-lines treat securities lent in two ways, dependingon the nature of the transactions and the risk ofloss. If, however, banking organizations are act-ing as their customers’ agent and do not indem-nify their customers against loss, the amount ofsecurities lent is excluded from risk-based capitalcalculations. If banking organizations lend theirown securities or, acting as an agent for a cus-tomer, lend the customers’ securities andindemnify their customersagainst loss, theamountof securities lent is converted at 100 percent andassigned the risk weight appropriate to the obli-gor or, if applicable, to any collateral deliveredto the lending organization or the independentcustodian acting on the lending organization’sbehalf. Where a banking organization is actingas agent for a customer in a transaction involv-ing the lending or sale of securities that is collat-eralized by cash delivered to the banking organi-zation, the transaction is deemed to becollateralized by cash on deposit in a subsidiarydepository institution for purposes of determin-ing the appropriate risk-weight category—provided that (1) any indemnification is limitedto no more than the difference between themarket value of the securities and the cash col-lateral received and (2) any reinvestment riskassociated with that cash collateral is borne bythe customer.

If securities lent are secured by cash on depositin subsidiary depository institutions, the appro-priate risk weight is either zero or 20 percent,depending on qualification criteria. Claims col-lateralized by cash on deposit in subsidiarydepository institutions for which a margin ofcollateral is maintained on a daily basis—fullytaking into account any change in the bank’sexposure to the obligor or counterparty under aclaim in relation to the market value of thecollateral held in support of that claim—areassigned the zero risk weight. When securitieslent are collateralized by cash on deposit insubsidiary lending institutions for which a dailymargin is not maintained, the cash collateral isassigned a 20 percent risk weight.



4060.3.5.3.11 Commitments

Commitments are defined as any legally bindingarrangements that obligate a bank holding com-pany to extend credit in the form of loans orleases; to purchase loans, securities, or otherassets; or to participate in loans and leases.Commitments also include overdraft facilities,revolving credit, home equity and mortgagelines of credit, eligible ABCP liquidity facili-ties, and similar transactions. Normally, com-mitments involve a written contract or agree-ment and a commitment fee, or some other formof consideration. Commitments are included inweighted-risk assets regardless of whether theycontain ‘‘material adverse change’’ clauses orother provisions that are intended to relieve theissuer of its funding obligation under certainconditions. In the case of commitments struc-tured as syndications, where the bank holdingcompany is obligated solely for its pro ratashare, only the bank holding company’s propor-tional share of the syndicated commitment istaken into account in calculating the risk-basedcapital ratio.

4060.3.5.3.11.1 Commitments to MakeOff-Balance-Sheet Transactions

A commitment to make a standby letter of creditis considered to be a standby letter of credit.Accordingly, such a commitment should be con-verted to an on-balance-sheet credit-equivalentamount at 100 percent if it is a commitment tomake a financial standby letter of credit or at50 percent if it is a commitment to make aperformance standby letter of credit.

A commitment to make a commitment istreated as a single commitment whose maturityis the combined maturity of the two commit-ments. For example, a 6-month commitment tomake a 1-year commitment is considered to be asingle 18-month commitment. Since the matu-rity is over one year, such a commitment wouldbe accorded the 50 percent conversion factorappropriate to long-term commitments, ratherthan the zero percent conversion factor thatwould be accorded to separate unrelated short-term commitments of six months and one year.

A commitment to make a commercial letterof credit may be treated as either a commitmentor a commercial letter of credit, whicheverresults in the lower conversion factor. Normally,this would mean that a commitment under oneyear to make a commercial letter of credit would

be treated as a commitment and converted atzero percent, while a similar commitment ofover one year would be treated as a commercialletter of credit and converted at 20 percent.

If a commitment facility is structured so thatit can be drawn down in several forms, such as astandby letter of credit, a loan, or a commercialletter of credit, the entire facility should betreated as a commitment to extend credit in theform that incurs the highest capital charge.Thus, if a facility could be drawn down in anyof the three forms just cited, the entire facilitywould be treated as a commitment to issue astandby letter of credit and would be convertedat 100 percent rather than being treated as acommitment to make a loan or commercial letterof credit, which would have a lower conversionfactor.

4060.3.5.3.11.2 Unused Commitments

Except for eligible ABCP liquidity facilities,44

unused portions of commitments (includingunderwriting commitments and commercial andconsumer credit commitments) that have anoriginal maturity of one year or less are con-verted at zero percent.

Unused commitments with an original matu-rity of over one year are converted at 50 percent.For this purpose, ‘‘original maturity’’ is definedas the length of time between the date the com-mitment is issued and the earliest date on which(1) the banking organization can, at its option,unconditionally cancel 45 the commitment and(2) the banking organization is scheduled to(and as a normal practice actually does) reviewthe facility to determine whether or not theunused commitment should be extended. (SeeSR-90-23 regarding loan commitments and putoptions.)

Banking organizations must continue to reviewunused commitments at least annually to deter-mine that they qualify for short-term commit-ment treatment. Examiners are to review unusedcommitments to determine that they meet theconditions for being treated as short-term orlong-term and are appropriately weighted forrisk-based capital calculations.

A commitment may be issued that expireswithin one year with the understanding that thecommitment will be renewed upon expirationsubject to a thorough credit review of the obli-

44. Unused portions of eligible ABCP liquidity facilitieswith an original maturity of one year or less are converted at10 percent.

45. This does not refer to material adverse change clauses.



gor. Such a commitment may be converted atzero percent only if (1) the renegotiation pro-cess is carried out in good faith, involves a fullcredit assessment of the obligor, and allows thebank holding company the flexibility to alter theterms and conditions of the new commitment;(2) the bank holding company has absolute dis-cretion to decline renewal or extension of thecommitment; and (3) the renegotiated commit-ment expires within 12 months from the time itis made. Some commitments contain unusualrenegotiation arrangements that would give theborrower a considerable amount of advancenotice that a commitment would not be renewed.Provisions of this kind can have the effect ofcreating a rolling-commitment arrangement thatshould be treated for risk-based capital purposesas a long-term commitment and, thus, be con-verted to a credit-equivalent amount at 50 per-cent. Normally, the renegotiation process shouldtake no more than six to eight weeks, and inmany cases it should take less time. The renego-tiation period should immediately precede theexpiration date of the commitment. The reasonsfor provisions in a commitment arrangementthat would appear to provide for a protractedrenegotiation period should be thoroughly docu-mented by the bank holding company andreviewed by the examiner.

A commitment may be structured to be drawndown in a number of tranches, some exercisablein one year or less and others exercisable in overone year. The full amount of such a commitmentis deemed to be over one year and converted at50 percent. Some long-term commitments maypermit the customer to draw down varyingamounts at different times to accommodate, forexample, seasonal borrowing needs. The 50 per-cent conversion factor should be applied to themaximum amount that could be drawn downunder such commitments.

4060.3.5.3.12 Asset-Backed CommercialPaper Program Assets

An asset-backed commercial paper (ABCP) pro-gram typically is a program through which abank holding company provides funding to itscorporate customers by sponsoring and adminis-tering a bankruptcy-remote special-purpose entitythat purchases asset pools from, or extends loansto, those customers.46 The asset pools in an

ABCP program might include, for example,trade receivables, consumer loans, or asset-backed securities. The ABCP program raisescash to provide funding to the banking organiza-tion’s customers, primarily (that is, more than50 percent of the ABCP’s issued liabilities)through the issuance of externally rated com-mercial paper into the market. Typically, thesponsoring bank holding company providesliquidity and credit enhancements to the ABCPprogram. These enhancements aid the programin obtaining high credit ratings that facilitate theissuance of the commercial paper.47

As a result of FIN 46-R, bank holding compa-nies are to include all assets of consolidatedABCP programs as part of their on-balance-sheet assets for purposes of calculating the tier 1leverage capital ratio.

4060.3.5.3.12.1 Liquidity Facilities SupportingABCP

Liquidity facilities supporting ABCP often takethe form of commitments to lend to, or purchaseassets from, the ABCP programs in the eventthat funds are needed to repay maturing com-mercial paper. Typically, this need for liquidityis due to a timing mismatch between cash col-lections on the underlying assets in the programand scheduled repayments of the commercialpaper issued by the program.

A bank holding company that provides liquid-ity facilities to ABCP is exposed to credit riskregardless of the term of the liquidity facilities.For example, an ABCP program may require aliquidity facility to purchase assets from theprogram at the first sign of deterioration in thecredit quality of an asset pool, thereby removingsuch assets from the program. In such an event,a draw on the liquidity facility exposes the bankholding company to credit risk.

Short-term commitments with an originalmaturity of one year or less expose bank hold-ing companies to a lower degree of credit riskthan longer-term commitments. This differencein the degree of credit risk is reflected in the

46. The definition of ‘‘ABCP program’’ generally includesstructured investment vehicles (entities that earn a spread byissuing commercial paper and medium-term notes and usingthe proceeds to purchase highly rated debt securities) and

securities arbitrage programs.47. A bank is considered the ‘‘sponsor of an ABCP pro-

gram’’ if it establishes the program; approves the sellerspermitted to participate in the program; approves the assetpools to be purchased by the program; or administers theprogram by monitoring the assets, arranging for debt place-ment, compiling monthly reports, or ensuring compliancewith the program documents and with the program’s creditand investment policy.



risk-based capital requirement for the differenttypes of exposure. The Board’s capital guide-lines impose a 10 percent credit-conversionfactor on eligible short-term liquidity facilitiessupporting ABCP. A 50 percent credit-conversion factor applies to eligible long-termABCP liquidity facilities. These credit-conversion factors apply regardless of whetherthe structure issuing the ABCP meets the rule’sdefinition of an ABCP program. For example, acapital charge would apply to an eligible short-term liquidity facility that provides liquiditysupport to ABCP where the ABCP constitutesless than 50 percent of the securities issued bythe program, thus causing the issuing structurenot to meet the rule’s definition of an ABCPprogram. However, if a bank holding company(1) does not meet this definition and must includethe program’s assets in its risk-weighted assetbase or (2) otherwise chooses to include theprogram’s assets in risk-weighted assets, thenno risk-based capital requirement will be assessedagainst any liquidity facilities provided by thebank holding company that support the pro-gram’s ABCP. Ineligible liquidity facilities willbe treated as recourse obligations or direct-credit substitutes for the purposes of the Board’srisk-based capital guidelines.

The resulting credit-equivalent amount wouldthen be risk-weighted according to the under-lying assets or the obligor, after considering anycollateral or guarantees, or external credit rat-ings, if applicable. For example, if an eligibleshort-term liquidity facility providing liquiditysupport to ABCP covered an asset-backed secu-rity (ABS)externally ratedAAA, then thenotionalamount of the liquidity facility would be con-verted at 10 percent to an on-balance-sheetcredit-equivalent amount and assigned to the20 percent risk-weight category appropriate forAAA-rated ABS.48

4060.3.5.3.12.2 Overlapping Exposures to anABCP Program

A bank holding company may have multipleoverlapping exposures to a single ABCP pro-gram (for example, both a program-wide creditenhancement and multiple pool-specific liquid-ity facilities to an ABCP program that is notconsolidated for risk-based capital purposes). A

bank holding company must hold risk-basedcapital only once against the assets covered bythe overlapping exposures. Where the overlap-ping exposures are subject to different risk-based capital requirements, the bank holdingcompany must apply the risk-based capital treat-ment that results in the highest capital charge tothe overlapping portion of the exposures.

For example, assume a bank holding com-pany provides a program-wide credit enhance-ment that would absorb 10 percent of the lossesin all of the underlying asset pools in an ABCPprogram and pool-specific liquidity facilitiesthat cover 100 percent of each of the underlyingasset pools. The bank holding company wouldbe required to hold capital against 10 percent ofthe underlying asset pools because it is provid-ing the program-wide credit enhancement. Thebank holding company would also be requiredto hold capital against 90 percent of the liquidityfacilities it is providing to each of the under-lying asset pools.

If different bank holding companies haveoverlapping exposures to an ABCP program,however, each organization must hold capitalagainst the entire maximum amount of its expo-sure. As a result, while duplication of capitalcharges will not occur for individual bank hold-ing companies, some systemic duplication mayoccur where multiple banking organizations haveoverlapping exposures to the same ABCPprogram.

4060.3.5.3.12.3 Asset-Quality Test

For a liquidity facility, either short- or long-term, that supports ABCP not to be considered arecourse obligation or a direct-credit substitute,it must meet the rule’s definition of an ‘‘eligibleABCP liquidity facility.’’49 An eligible ABCPliquidity facility must meet a reasonable asset-quality test that, among other things, precludesfunding assets that are 90 days or more past due

48. See section III.B.3.c. of the guidelines (12 C.F.R. 225,appendix A).

49. An ‘‘eligible ABCP liquidity facility’’ is a liquidityfacility that supports ABCP, in form or in substance, and issubject to an asset-quality test at the time of draw thatprecludes funding against assets that are 90 days or more pastdue or in default. In addition, if the assets that an eligibleABCP liquidity facility is required to fund against are exter-nally rated assets or exposures at the inception of the facility,the facility can be used to fund only those assets or exposuresthat are externally rated investment grade at the time offunding. Notwithstanding the eligibility requirements set forthin the two preceding sentences, a liquidity facility will beconsidered an eligible ABCP liquidity facility if the assetsthat are funded under the liquidity facility and that do notmeet the eligibility requirements are guaranteed, either condi-tionally or unconditionally, by the U.S. government or itsagencies or by the central government of an OECD country.



or in default. When assets are 90 days or morepast due, they typically have deteriorated to thepoint where there is an extremely high probabil-ity of default. Assets that are 90 days past due,for example, often must be placed on nonac-crual status in accordance with the agencies’Uniform Retail Credit Classification and AccountManagement Policy.50 Further, they generallymust also be classified Substandard under thatpolicy.

The rule’s asset-quality test specifically allowsa bank holding company to reflect certain guar-antees providing credit protection to the bankholding company providing the liquidity facil-ity. In particular, the ‘‘days-past-due limitation’’is not applied with respect to assets that areeither conditionally or unconditionally guaran-teed by the U.S. government or its agencies orby another OECD central government. To qualifyas an eligible ABCP liquidity facility, if theassets covered by the liquidity facility are ini-tially externally rated (at the time the facility isprovided), the facility can be used to fund onlythose assets that are externally rated investmentgrade at the time of funding.

The practice of purchasing assets that areexternally rated below investment grade out ofan ABCP program is considered the equivalentof providing credit protection to the commercialpaper investors. Thus, liquidity facilities permit-ting purchases of below-investment-grade secu-rities will be considered either recourse obliga-tions or direct-credit substitutes. However, the‘‘investment-grade’’ limitation is not applied inthe asset-quality test with respect to assets thatare conditionally or unconditionally guaranteedby the U.S. government or its agencies or byanother OECD central government. If the asset-quality tests are not met (that is, if a bankholding company actually funds through theliquidity facility assets that do not satisfy thefacility’s asset-quality tests), the liquidity facil-ity will be considered a recourse obligation or adirect-credit substitute and generally will beconverted at 100 percent.

4060.3.5.3.13 Derivative Contracts(Interest-Rate, Exchange-Rate, andCommodity- (Including Precious Metals)and Equity-Linked Contracts)

Credit-equivalent amounts are computed foreach of the following off-balance-sheet-derivative contracts:

1. interest-rate contractsa. single-currency interest-rate swapsb. basis swapsc. forward rate agreementsd. interest-rate options purchased (including

caps, collars, and floors purchased)e. any other instrument linked to interest

rates that gives rise to similar credit risks(including when-issued securities and for-ward forward deposits accepted)

2. exchange-rate contractsa. cross-currency interest-rate swapsb. forward foreign-exchange-rate contractsc. currency options purchasedd. any other instrument linked to exchange

rates that gives rise to similar credit risks3. equity derivative contracts

a. equity-linked swapsb. equity-linked options purchasedc. forward equity-linked contractsd. any other instrument linked to equities

that gives rise to similar credit risks4. commodity (including precious metal)

derivative contractsa. commodity-linked swapsb. commodity-linked options purchasedc. forward commodity-linked contractsd. any other instrument linked to commodi-

ties that gives rise to similar credit risks

Derivative-contract exceptions. Exchange-ratecontracts with an original maturity of 14 orfewer calendar days and derivative contractstraded on exchanges that require daily receiptand payment of cash-variation margin may beexcluded from the risk-based ratio calculation.Gold contracts are accorded the same treatmentas exchange-rate contracts except that gold con-tracts with an original maturity of 14 or fewercalendar days are included in the risk-basedratio calculation. Over-the-counter options pur-chased are included and treated in the same wayas other derivative contracts.

4060.3.5.3.13.1 Calculation ofCredit-Equivalent Amounts and theApplication of Risk Weights

The credit-equivalent amount of a derivativecontract that is not subject to a qualifying bilat-eral netting contract in accordance with subsec-tion 4060.3.5.3.15 is equal to the sum of—

1. the current exposure (sometimes referred toas the replacement cost) of the contract and

50. See 65 Fed. Reg. 36904 (June 12, 2000).



2. an estimate of the potential future creditexposure of the contract.

The current exposure is determined by themark-to-market value of the contract. If themark-to-market value is positive, then the cur-rent exposure is equal to that mark-to-marketvalue. If the mark-to-market value is zero ornegative, then the current exposure is zero.Mark-to-market values are measured in dollars,regardless of the currency or currencies speci-fied in the contract, and should reflect changesin the relevant rates, prices, and indices, as wellas in counterparty credit quality.

The potential future credit exposure of a con-tract, including a contract with a negative mark-to-market value, is estimated by multiplying thenotional principal amount of the contract by acredit-conversion factor. Banking organizationsshould use, subject to examiner review, theeffective rather than the apparent or statednotional amount in this calculation. The conver-sion factors (in percent) are listed on the nextpage.

For a contract that is structured such thaton specified dates any outstanding exposure issettled and the terms are reset so that the marketvalue of the contract is zero, the remainingmaturity is equal to the time until the next resetdate. For an interest-rate contract with a remain-ing maturity of more than one year that meetsthese criteria, the minimum conversion factor is0.5 percent.

For a contract with multiple exchanges ofprincipal, the conversion factor is multiplied bythe number of remaining payments in the con-tract. A derivative contract not included in thedefinitions of interest-rate, exchange-rate, equity,or commodity contracts as set forth in subsec-tion 4060.3.5.3.15 is subject to the same conver-sion factors as a commodity, excluding preciousmetals.

No potential future credit exposure is calcu-lated for a single-currency interest-rate swapin which payments are made based on twofloating-rate indices, so-called floating/floatingor basis swaps; the credit exposure on thesecontracts is evaluated solely on the basis of theirmark-to-market values.

The Board has noted that the following con-version factors, which are based on observedvolatilities of the particular types of instru-ments, are subject to review and modificationin light of changing volatilities or marketconditions.

100 Percent Credit-Conversion Factor forOff-Balance-Sheet Items for BHCs

1. direct-credit substitutes (These include gen-eral guarantees of indebtedness and allguarantee-type instruments, including standbyletters of credit backing the financial obliga-tions of other parties.)

2. in the case of direct-credit substitutes, riskparticipations that have been conveyed oracquired, or risk participations in banker’sacceptances conveyed to other institutions,and risk participations with a remainingmaturity of over one year that are conveyedto non-OECD banks (unless a lower riskcategory is appropriate to be assigned to theobligor, guarantor, or collateral)

3. sale and repurchase agreements, assets soldwith recourse that are not included on thebalance sheet, and ineligible ABCP liquidityfacilities

4. forward agreements to purchase assets, includ-ing financing facilities, on which drawdownis certain

5. securities lent for which the banking organi-zation is at risk

50 Percent Credit-Conversion Factor

1. transaction-related contingencies (Theseinclude bid bonds, performance bonds, war-ranties, and standby letters of credit relatedto particular transactions and performancestandby letters of credit, as well as acquisi-tions of risk participations in performancestandby letters of credit. Performance standbyletters of credit represent obligations backingthe performance of nonfinancial or commer-cial contracts or undertakings.)

2. unused portions of commitments, includingeligible ABCP liquidity facilities, with anoriginal maturity exceeding one year, includ-ing underwriting commitments and commer-cial and consumer credit commitments

3. revolving-underwriting facilities (RUFs),note-issuance facilities (NIFs), and other simi-lar arrangements


Short-term, self-liquidating, trade-related con-tingencies that arise from the movement ofgoods, including commercial letters of creditand other documentary letters of credit collater-alized by the underlying shipments.



CONVERSION FACTORS[in percent]

Remainingmaturity

Interest-rate

Exchange-rate and

gold Equity

Commodity,excludingpreciousmetals

Preciousmetals,exceptgold

One year or less 0.0 1.0 6.0 10.0 7.0

Over one to five years 0.5 5.0 8.0 12.0 7.0

Over five years 1.5 7.5 10.0 15.0 8.0


1. Unused portions of ABCP liquidity facilitieswith an original maturity of one year or less.

2. Bank holding companies that are subject tothe market-risk capital rules are precludedfrom applying those market-risk rules to posi-tions held in the bank holding company’strading book that act, in form or in substance,as liquidity facilities supporting asset-backedcommercial paper (ABCP). Bank holdingcompanies are required to convert the notionalamount of all eligible ABCP liquidity facili-ties, in form or in substance, with an originalmaturity of one year or less that are carried inthe trading account at 10 percent to deter-mine the appropriate credit-equivalent amounteven though those facilities are structured orcharacterized as derivatives or other trading-book assets. Liquidity facilities that supportABCP that are not eligible ABCP liquidityfacilities are to be considered recourse obli-gationsordirect-credit substitutesandassessedthe appropriate risk-based capital requirementin accordance with section III.B.3. of appen-dix A.

Zero Percent Credit-Conversion Factor

Unused portions of commitments (with theexception of eligible ABCP liquidity facilities)with an original maturity of one year or less, orwhich are unconditionally cancelable at anytime, provided a separate credit decision is madebefore each drawing under the facility.

See the risk-based capital guidelines for infor-mation on the use, treatment, and application ofcredit-conversion factors for off-balance-sheetitems and transactions.

4060.3.5.3.13.2 Applying Risk Weights

Once the credit-equivalent amount for a derivativecontract, or a group of derivative contracts sub-ject to a qualifying bilateral netting contract, hasbeen determined, that amount is assigned to therisk-weight category appropriate to the counter-party, or, if relevant, the guarantor or the natureofanycollateral.51 However, themaximumweightthat will be applied to the credit-equivalentamount of such contracts is 50 percent.

4060.3.5.3.13.3 Avoidance ofDouble-Counting of Derivative Contracts

In certain cases, credit exposures arising fromderivative contracts may be reflected, in part, onthe balance sheet. To avoid double-countingsuch exposures in the assessment of capital ade-quacy and, perhaps, assigning inappropriate riskweights, counterparty credit exposures arisingfrom the derivative instruments covered by theguidelines may need to be excluded by examin-ers from balance-sheet assets in calculating abanking organization’s risk-based capital ratios.This exclusion will eliminate the possibility thatan organization could be required to hold capitalagainst both an off-balance-sheet and on-balance-sheet amount for the same item. This treatmentis not accorded to margin accounts and accruedreceivables related to interest-rate and exchange-rate contracts.

The aggregate on-balance-sheet amountexcluded from the risk-based capital calculation

51. For derivative contracts, sufficiency of collateral orguarantees is determined by the market value of the collateralor the amount of the guarantee in relation to the credit-equivalent amount. Collateral and guarantees are subject tothe same provisions noted under section III.B. of appendix Aof Regulation Y.



is equal to the lower of—

1. each contract’s positive on-balance-sheetamount or

2. its positive market value included in the off-balance-sheet risk-based capital calculation.

For example, a forward contract that is markedto market will have the same market value onthe balance sheet as is used in calculating thecredit-equivalent amount for off-balance-sheetexposures under the guidelines. Therefore, theon-balance-sheet amount is not included in therisk-based capital calculation. Where either thecontract’s on-balance-sheet amount or its mar-ket value is negative or zero, no deduction fromon-balance-sheet items is necessary for thatcontract.

If the positive on-balance-sheet asset amountexceeds the contract’s market value, the excess(up to the amount of the on-balance-sheet asset)should be included in the appropriate risk-weight category. For example, a purchased optionwill often have an on-balance-sheet amountequal to the fee paid until the option expires. Ifthat amount exceeds market value, the excess ofcarrying value over market value would beincluded in the appropriate risk-weight categoryfor purposes of the on-balance-sheet portion ofthe calculation.

4060.3.5.3.14 Treatment of Commodityand Equity Contracts

Credit-equivalent amounts of swap agreementsand futures, forwards, and option contracts oncommodities, equities, and equity indexes arecalculated in the same way as credit-equivalentamounts of foreign-exchange-rate contracts.Contracts on commodities, equities, and equityindexes traded on exchanges that require dailypayment of variation margin are excluded fromthe risk-based capital calculation. Such a mar-gining arrangement requires the marking to mar-ket of contracts and the settling of the resultinggains and losses in cash on a daily basis.

4060.3.5.3.15 Netting of Swaps andSimilar Contracts

Netting refers to the offsetting of positive andnegative mark-to-market values in the determi-nation of a current exposure to be used in the

calculation of a credit-equivalent amount. Anylegally enforceable form of bilateral netting (thatis, netting with a single counterparty) of deriva-tive contracts is recognized for purposes of cal-culating the credit-equivalent amount providedthat—

1. the netting is accomplished under a writtennetting contract that creates a single legalobligation, covering all included individualcontracts, with the effect that the organiza-tion would have a claim to receive, or anobligation to receive or pay, only the netamount of the sum of the positive and nega-tive mark-to-market values on included indi-vidual contracts in the event that a counter-party, or a counterparty to whom the contracthas been validly assigned, fails to performdue to default, insolvency, liquidation, orsimilar circumstances;

2. the banking organization obtains written andreasoned legal opinions that in the event of alegal challenge—including one resulting fromdefault, insolvency, liquidation, or similarcircumstances—the relevant court andadministrative authorities would find the bank-ing organization’s exposure to be such a netamount under—a. the law of the jurisdiction in which the

counterparty is chartered or the equivalentlocation in the case of noncorporate enti-ties, and if a branch of the counterparty isinvolved, then also under the law of thejurisdiction in which the branch is located;

b. the law that governs the individual con-tracts covered by the netting contract; and

c. the law that governs the netting contract;3. the banking organization establishes and main-

tains procedures to ensure that the legal char-acteristics of netting contracts are kept underreview in light of possible changes in rel-evant law; and

4. the banking organization maintains in its filesdocumentation adequate to support the net-ting of rate contracts, including a copy of thebilateral netting contract and necessary legalopinions.

A contract containing a walkaway clause is noteligible for netting for purposes of calculatingthe credit-equivalent amount.52

By netting individual contracts for the pur-

52. A walkaway clause is a provision in a netting contractthat permits a nondefaulting counterparty to make lower pay-ments than it would make otherwise under the contract, or nopayment at all, to a defaulter or to the estate of a defaulter,even if the defaulter or the estate of the defaulter is a netcreditor under the contract.



pose of calculating credit-equivalent amountsof derivative contracts, a banking organizationrepresents that it has met the requirements of therisk-based measure of the capital adequacy guide-lines for BHCs and that all the appropriatedocuments are in the organization’s files andavailable for inspection by the Federal Reserve.The Federal Reserve may determine that a bank-ing organization’s files are inadequate or that anetting contract, or any of its underlying indi-vidual contracts, may not be legally enforceable.If such a determination is made, the nettingcontract may be disqualified from recognitionfor risk-based capital purposes, or underlyingindividual contracts may be treated as thoughthey are not subject to the netting contract.

The credit-equivalent amount of contracts thatare subject to a qualifying bilateral netting con-tract is calculated by adding—

1. the current exposure of the netting contract(net current exposure) and

2. the sum of the estimates of the potentialfuture credit exposures on all individual con-tracts subject to the netting contract (grosspotential future exposure) adjusted to reflectthe effects of the netting contract.53

The net current exposure of the netting con-tract is determined by summing all positive andnegative mark-to-market values of the indi-vidual contracts included in the netting contract.If the net sum of the mark-to-market values ispositive, then the current exposure of the nettingcontract is equal to that sum. If the net sum ofthe mark-to-market values is zero or negative,then the current exposure of the netting contractis zero. The Federal Reserve may determine thata netting contract qualifies for risk-based capitalnetting treatment even though certain individualcontracts may not qualify. In such instances, thenonqualifying contracts should be treated asindividual contracts that are not subject to thenetting contract.

Gross potential future exposure or Agross iscalculated by summing the estimates of poten-tial future exposure (determined in accordancewith section 4060.3.5.3.13.1) for each individualcontract subject to the qualifying bilateral net-ting contract.

The effects of the bilateral netting contract onthe gross potential future exposure are recog-

nized through the application of a formula thatresults in an adjusted add-on amount (Anet). Theformula, which employs the ratio of net currentexposure to gross current exposure (NGR), isexpressed as:

Anet = (0.4 × Agross) + 0.6(NGR × Agross)

The NGR may be calculated in accordance witheither the counterparty-by-counterparty approachor the aggregate approach.

Under the counterparty-by-counterpartyapproach, the NGR is the ratio of the net currentexposure for a netting contract to the grosscurrent exposure of the netting contract. Thegross current exposure is the sum of the currentexposures of all individual contracts subject tothe netting contract calculated in accordancewith section 4060.3.5.3.13.1. Net negativemarkto-market values for individual netting con-tracts with the same counterparty may not beused to offset net positive mark-to-market val-ues for other netting contracts with the samecounterparty.

Under the aggregate approach, the NGR isthe ratio of the sum of all the net current expo-sures for qualifying bilateral netting contracts tothe sum of all the gross current exposures forthose netting contracts (each gross current expo-sure is calculated in the same manner as insection 4060.3.5.3.13.1 (counterparty-by-counterparty approach)). Net negative mark-to-market values for individual counterparties maynot be used to offset net positive current expo-sures for other counterparties.

A banking organization must consistentlyuse either the counterparty-by-counterpartyapproach or the aggregate approach to calculatethe NGR. Regardless of the approach used, theNGR should be applied individually to eachqualifying bilateral netting contract to determinethe adjusted add-on for that netting contract.

In the event a netting contract covers con-tracts that are normally excluded from the risk-based ratio calculation—for example, exchange-rate contracts with an original maturity of 14 orfewer calendar days or instruments traded onexchanges that require daily payment of cash-variation margin—an institution may elect toeither include or exclude all mark-to-marketvalues of such contracts when determining netcurrent exposure, provided the method chosen isapplied consistently.

Examiners are to review the netting of off-53. For purposes of calculating potential future credit expo-

sure to a netting counterparty for foreign-exchange contractsand other similar contracts in which notional principal isequivalent to cash flows, total notional principal is defined asthe net receipts falling due on each value date in eachcurrency.



balance-sheet derivative contractual arrange-ments used by banking organizations when cal-culating or verifying risk-based capital ratios toensure that the positions of such contracts arereported gross unless the net positions of thosecontracts reflect netting arrangements thatcomply with the netting requirements listedpreviously.

4060.3.5.3.16 Financial Standby Lettersof Credit and Performance StandbyLetters of Credit

The determining characteristic of whether astandby letter of credit is financial or perfor-mance is the contractual obligation that triggerspayment. If the event that triggers payment isfinancial, such as a failure to pay money, thestandby letter of credit should be classified asfinancial. If the event that triggers payment isperformance-related, such as a failure to ship aproduct or provide a service, the standby letterof credit should be classified as performance.The vast majority of standby letters of credit abank issues are considered, for risk-based capi-tal purposes, to be financial standby letters ofcredit. (See SR-95-20 (SUP).)

4060.3.5.3.16.1 Financial Standby Letters ofCredit

The risk-based capital guidelines describe afinancial standby letter of credit as an irrevo-cable undertaking by a banking organization toguarantee repayment of a financial obligation.Such a guarantee is considered a direct-creditsubstitute and is converted to an on-balance-sheet credit-equivalent amount at 100 percent.The resulting credit-equivalent amount is thenrisk-weighted according to the type of counter-party or, if relevant, to any guarantee or collateral.

Financial standby letters of credit have ahigher conversion factor than performancestandby letters of credit. This is primarily because,unlike performance standby letters of credit,financial standby letters of credit tend to bedrawn down only when the account party’sfinancial condition has deteriorated.

A standby letter of credit guaranteeing theperformance of a contractual obligation to paymoney is viewed as a financial letter of credit.For example, a standby letter of credit backing apurchaser’s contractual obligation to pay for

delivered goods is a financial guarantee backingthe purchaser’s credit standing for the sale. Itwould not be viewed as a performance letter ofcredit guaranteeing the purchaser’s performanceto make payment under the contract.

A failure to perform a contractual obligationinvolving the payment of money can arise in avariety of situations, for example, failure to payinsurance premiums or deductibles, failure topay insurance claims, failure to pay workers’compensation obligations, or failure to pay for(or arrange) cleanup in the event the accountparty’s operations cause environmental damage.In each instance, the triggering event is thefailure to pay money under a contractual obli-gation. A standby letter of credit guaranteeingpayment in the event the account party fails toperform any of these contractual financial obli-gations or other circumstances should be treatedas a financial standby letter of credit and con-verted to an on-balance-sheet credit-equivalentamount at 100 percent.

4060.3.5.3.16.2 Performance Standby Lettersof Credit

A performance standby letter of credit is anirrevocable undertaking by the organization tomake payment in the event the customer fails toperform a nonfinancial contractual obligation.This type of letter of credit is considered atransaction-related contingency and is convertedto an on-balance-sheet credit-equivalent amountat 50 percent. The resulting credit-equivalentamount is then risk-weighted according to thetype of counterparty or, if relevant, to any guar-antee or collateral.

4060.3.5.3.17 Credit Derivatives

For purposes of risk-based capital, credit deriva-tives generally are to be treated as off-balance-sheet direct-credit substitutes. They are arrange-ments that allow one party (the ‘‘protectionpurchaser’’) to transfer the credit risk of anasset, which it often actually owns, to anotherparty (the ‘‘protection provider’’).54 The valueof a credit derivative is dependent, at least inpart, on the credit performance of the ‘‘refer-ence asset.’’

The notional amount of the contract shouldbe converted at 100 percent to determine thecredit-equivalent amount to be included in risk-

54. Credit derivatives that are held in a banking organiza-tion’s (a bank’s or bank holding company’s) trading accountare subject to the market-risk rules.



weighted assets of the guarantor.55 A bankingorganization providing a guarantee through acredit-derivative transaction should assign itscredit exposure to the risk category appropriateto the obligor of the reference asset or anycollateral. On the other hand, a banking organi-zation that owns the underlying asset upon whicheffective credit protection has been acquiredthrough a credit derivative may under certaincircumstances assign the unamortized portion ofthe underlying asset to the risk category appro-priate to the guarantor (for example, to the20 percent risk category if the guarantor is abank or, if a bank holding company, to the100 percent risk-weight category).

Whether the credit derivative is considered aneligible guarantee for purposes of risk-basedcapital depends on the degree of credit protec-tion actually provided, which may be limiteddepending on the terms of the arrangement. Forexample, a relatively restrictive definition of adefault event or a materiality threshold thatrequires a comparably high percentage of loss tooccur before the guarantor is obliged to paycould effectively limit the amount of credit riskactually transferred in the transaction. If theterms of the credit-derivative arrangement sig-nificantly limit the degree of risk transference,then the beneficiary bank cannot reduce the riskweight of the ‘‘protected’’ asset to that of theguarantor. On the other hand, even if the trans-fer of credit risk is limited, a banking organiza-tion providing limited credit protection througha credit derivative should hold appropriate capi-tal against the underlying exposure while theorganization is exposed to the credit risk of thereference asset.

Banking organizations providing a guaranteethrough a credit derivative may mitigate thecredit risk associated with the transaction byentering into an offsetting credit derivative withanother counterparty, a so-called ‘‘back-to-back’’ position. Organizations that have enteredinto such a position may treat the first creditderivative as guaranteed by the offsetting trans-action for risk-based capital purposes. Accord-ingly, the notional amount of the first creditderivative may be assigned to the risk categoryappropriate to the counterparty providing creditprotection through the offsetting credit-

derivative arrangement (for example, to the20 percent risk category if the counterparty is anOECD bank).

In some instances, the reference asset in thecredit-derivative transaction may not be identi-cal to the underlying asset for which the benefi-ciary has acquired credit protection. For exam-ple, a credit derivative used to offset the creditexposure of a loan to a corporate customer mayuse a publicly traded corporate bond of thecustomer as the reference asset, whose creditquality serves as a proxy for the on-balance-sheet loan. In such a case, the underlying assetwill still generally be considered guaranteed forcapital purposes as long as both the underlyingasset and the reference asset are obligations ofthe same legal entity and have the same level ofseniority in bankruptcy. In addition, bankingorganizations offsetting credit exposure in thismanner would be obligated to demonstrate toexaminers that there is a high degree of correla-tion between the two instruments; the referenceinstrument is a reasonable and sufficiently liquidproxy for the underlying asset so that the instru-ments can be reasonably expected to behavesimilarly in the event of default; and, at a mini-mum, the reference asset and underlying assetare subject to mutual cross-default provisions. Abanking organization that uses a credit deriva-tive, which is based on a reference asset thatdiffers from the protected underlying asset, mustdocument the credit derivative being used tooffset credit risk and must link it directly to theasset or assets whose credit risk the transactionis designed to offset. The documentation and theeffectiveness of the credit-derivative transactionare subject to examiner review. Banking organi-zations providing credit protection through sucharrangements must hold capital against the riskexposures that are assumed.

4060.3.5.3.18 Credit Derivatives Used toSynthetically Replicate CollateralizedLoan Obligations

Credit derivatives can be used to syntheticallyreplicate collateralized loan obligations (CLOs).Banking organizations (BOs) can use CLOs andtheir synthetic variants to manage their balancesheets and, in some instances, transfer creditrisk to the capital markets. Such transactionsallow economic capital to be more efficientlyallocated, resulting in, among other things,improved shareholders’ returns. Supervisors and

55. Guarantor banks or bank holding companies that havemade cash payments representing depreciation on referenceassets may deduct such payments from the notional amountwhen computing credit-equivalent amounts for capital pur-poses. For example, if a guarantor bank or bank holdingcompany makes a depreciation payment of $10 on a $100notional total-rate-of-return swap, the credit-equivalent amountwould be $90.



examiners need to fully understand these com-plex structures, and identify the relative degreeof transference and retention of the securitizedportfolio’s credit risk. They must also determinewhether the BO’s regulatory risk-based andleverage capital is adequate given the retainedcredit exposures.56

A CLO is an asset-backed security that isusually supported by a variety of assets, includ-ing whole commercial loans, revolving creditfacilities, letters of credit, banker’s acceptances,or other asset-backed securities. In a typicalCLO transaction, the sponsoring banking orga-nization (SBO) transfers the loans and otherassets to a bankruptcy-remote special-purposevehicle (SPV), which then issues asset-backedsecurities consisting of one or more classes ofdebt. This type of transaction represents aso-called cash-flow CLO that enables the SBOto reduce its leverage and risk-based capitalrequirements, improve its liquidity, and managecredit concentrations.

The first synthetic CLO (issued in 1997) usedcredit-linked notes (CLNs).57 Rather thantransferring assets to the SPV, the sponsoringbank issued CLNs to the SPV, individuallyreferencing the payment obligation of aparticular company or ‘‘reference obligor.’’ Thenotional amount of the CLNs issued equaled thedollar amount of the reference assets the spon-sor was hedging on its balance sheet. Otherstructures have evolved that use credit-defaultswaps to transfer credit risk and create differ-ent levels of risk exposure but that hedge only aportion of the notional amount of the overallreference portfolio.58

Traditional CLO structures usually transferassets into the SPV. In synthetic securitizations,the underlying exposures that make up the refer-ence portfolio remain in the BO’s bankingbook.59 The credit risk is transferred into the

SPV through credit-default swaps or CLNs. TheBO is thus able to maintain client confidentialityand avoid sensitive client-relationship issuesthat arise from loan-transfer-notification require-ments, loan-assignment provisions, and loan-participation restrictions

Corporate credits are assigned to the 100 per-cent risk-weighted asset category for risk-basedcapital calculation purposes. In the case of high-quality, investment-grade corporate exposures,the associated 8 percent capital requirement mayexceed the economic capital that the SBO setsaside to cover the credit risk of the transac-tion. Therefore, one of the apparent motivationsbehind CLOs and other securitizations is tomore closely align the SBO’s regulatory capitalrequirements with the economic capital requiredby the market.

Synthetic CLOs can raise questions abouttheir capital treatment when calculating the risk-based and leverage capital ratios. Capital treat-ments for three synthetic transactions follow.They are discussed from the perspective of theinvestors and the SBOs.

4060.3.5.3.18.1 Transaction 1—EntireNotional Amount of the Reference Portfolio IsHedged

In the first type of synthetic securitization, theSBO, through a synthetic CLO, hedges theentire notional amount of a reference asset port-folio. An SPV acquires the credit risk on areference portfolio by purchasing CLNs issuedby the SBO. The SPV funds the purchase of theCLNs by issuing a series of notes in severaltranches to third-party investors. The investornotes are in effect collateralized by the CLNs.Each CLN represents one obligor and the BO’scredit-risk exposure to that obligor, which couldtake the form of bonds, commitments, loans,and counterparty exposures. Since the notehold-ers are exposed to the full amount of credit riskassociated with the individual reference obli-gors, all of the credit risk of the reference port-folio is shifted from the SBO to the capitalmarkets. The dollar amount of notes issued toinvestors equals the notional amount of the ref-erence portfolio. In the example shown in figure1, this amount is $1.5 billion.

If the obligor linked to a CLN in the SPVdefaults, the SBO will call the individual CLNand redeem it based on the repayment termsspecified in the note agreement. The term ofeach CLN is set so that the credit exposure (towhich it is linked) matures before the maturityof the CLN, which ensures that the CLN will be

56. See SR-99-32 and its attached November 15, 1999,FRB-OCC capital interpretation on synthetic collateralizedloan obligations.

57. CLNs are obligations whose principal repayment isconditioned upon the performance of a referenced asset orportfolio. The assets’ performance may be based on a varietyof measures, such as movements in price or credit spread, orthe occurrence of default.

58. A credit-default swap is similar to a financial standbyletter of credit in that the BO writing the swap provides, for afee, credit protection against credit losses associated with adefault on a specified reference asset or pool of assets.

59. ‘‘Banking book’’ refers to nontrading accounts. See the‘‘trading account’’ definition in the Glossary for the instruc-tions to the Consolidated Financial Statements for Bank Hold-ing Companies, FR Y-9C.



in place for the full term of the exposure towhich it is linked.

An investor in the notes issued by the SPV isexposed to the risk of default of the underlyingreference assets, as well as to the risk that theSBO will not repay principal at the maturity ofthe notes. Because of the linkage between thecredit quality of the SBO and the issued notes, adowngrade of the sponsor’s credit rating mostlikely will result in the notes also being down-graded. Thus, a BO investing in this type ofsynthetic CLO should assign the notes to thehigher of the risk categories appropriate to theunderlying reference assets or the issuing entity.

For purposes of risk-based capital, the SBOsmay treat the cash proceeds from the sale ofCLNs that provide protection against underlyingreference assets as cash collateralizing theseassets.60 This treatment would permit the refer-ence assets, if carried on the SBO’s books, to beassigned to the zero percent risk category to theextent that their notional amount is fully collat-eralized by cash. This treatment may be appliedeven if the cash collateral is transferred directlyinto the general operating funds of the BO andis not deposited in a segregated account. Thesynthetic CLO would not confer any benefits to

the SBO for purposes of calculating its tier 1leverage ratio, however, because the referenceassets remain on the organization’s balance sheet.

4060.3.5.3.18.2 Transaction 2—High-Quality,Senior Risk Position in the Reference PortfolioIs Retained

In the second type of synthetic CLO transaction,the SBO hedges a portion of the reference port-folio and retains a high-quality, senior risk posi-tion that absorbs only those credit losses inexcess of the junior-loss positions. For somenoted synthetic CLOs, the SBO used a combina-tion of credit-default swaps and CLNs to trans-fer to the capital markets the credit risk of adesignated portfolio of the organization’s creditexposures. Such a transaction allows the SBO toallocate economic capital more efficiently andto significantly reduce its regulatory capitalrequirements.

In the structure illustrated in figure 2, theSBO purchases default protection from an SPVfor a specifically identified portfolio of banking-book credit exposures, which may include let-ters of credit and loan commitments. The creditrisk on the identified reference portfolio (whichcontinues to remain in the sponsor’s bankingbook) is transferred to the SPV through the useof credit-default swaps. In exchange for the

60. The CLNs should not contain terms that would signifi-cantly limit the credit protection provided against the under-lying reference assets, for example, a materiality thresholdthat requires a relatively high percentage of loss to occurbefore CLN payments are adversely affected, or a structuringof CLN post-default payments that does not adequately passthrough credit-related losses on the reference assets to inves-tors in the CLNs.

Figure 1—Transaction 1

Bank SPV

$1.5 billion Holds portfoliocredit portfolio of CLNs

$1.5 billion cashproceeds

$1.5 billionof CLNsissued by

bank

$1.5 billioncash proceeds

$1.5 billionof notes

X-year Y-yearnotes notes



credit protection, the SBO pays the SPV anannual fee. The default swaps on each of theobligors in the reference portfolio are structuredto pay the average default losses on all seniorunsecured obligations of defaulted borrowers.To support its guarantee, the SPV sells CLNs toinvestors and uses the cash proceeds to purchaseU.S. government Treasury notes. The SPV thenpledges the Treasuries to the SBO to cover anydefault losses.61 The CLNs are often issued inmultiple tranches of differing seniority and in anaggregate amount that is significantly less thanthe notional amount of the reference portfolio.The amount of notes issued typically is set at alevel sufficient to cover some multiple of expectedlosses, but well below the notional amount ofthe reference portfolio being hedged.

There may be several levels of loss in thistype of synthetic securitization. The first-lossposition may consist of a small cash reserve,sufficient to cover expected losses. The cashreserve accumulates over a period of years andis funded from the excess of the SPV’s income(that is, the yield on the Treasury securities plusthe credit-default-swap fee) over the interestpaid to investors on the notes. The investors inthe SPV assume a second-loss position throughtheir investment in the SPV’s senior and junior

notes, which tend to be rated AAA and BB,respectively. Finally, the SBO retains a high-quality, senior risk position that would absorbany credit losses in the reference portfolio thatexceed the first- and second-loss positions.

Typically, no default payments are made untilthe maturity of the overall transaction, regard-less of when a reference obligor defaults. Whileoperationally important to the SBO, this featurehas the effect of ignoring the time value ofmoney. Thus, the Federal Reserve expects thatwhen the reference obligor defaults under theterms of the credit derivative and when thereference asset falls significantly in value, theSBO should, in accordance with generallyaccepted accounting principles, make appropri-ate adjustments in its regulatory reports to reflectthe estimated loss that takes into account thetime value of money.

For risk-based capital purposes, the BOs invest-ing in the notes must assign them to the riskweight appropriate to the underlying referenceassets.62 The SBO must include in its risk-weighted assets its retained senior exposure inthe reference portfolio, to the extent theseunderlying assets are held in its banking book.The portion of the reference portfolio that iscollateralized by the pledged Treasury securities

61. The names of corporate obligors included in the refer-ence portfolio may be disclosed to investors in the CLNs.

62. Under this type of transaction, if a structure exposesinvesting BOs to the creditworthiness of a substantive issuer,for example, the SBO, then the investing BOs should assignthe notes to the higher of the risk categories appropriate to theunderlying reference assets or the SBO.


Bank

$5 billioncredit portfolio

Default payment andpledge of Treasuries

$5 billion of credit-default swapsand annual fee

SPV

Holds $400 millionof pledged Treasuries

$400 millionof CLNs

$400 millionof cash

Seniornotes

Juniornotes



may be assigned a zero percent risk weight.Unless the SBO meets the stringent minimumconditions for transaction 2 outlined in the sub-section ‘‘Minimum Conditions,’’ the remainderof the portfolio should be risk-weighted accord-ing to the obligor of the exposures.

When the SBO has virtually eliminated itscredit-risk exposure to the reference portfoliothrough the issuance of CLNs, and when theother minimum requirements are met, the SBOmay assign the uncollateralized portion of itsretained senior position in the reference port-folio to the 20 percent risk weight. However, tothe extent that the reference portfolio includesloans and other on-balance-sheet assets, theSBO would not realize any benefits in the deter-mination of its leverage ratio.

In addition to the three stringent minimumconditions, the Federal Reserve may imposeother requirements, as it deems necessary toensure that an SBO has virtually eliminated allof its credit exposure. Furthermore, the FederalReserve retains the discretion to increase therisk-based capital requirement assessed againstthe retained senior exposure in these structures,if the underlying asset pool deterioratessignificantly.

Federal Reserve staff will make a case-by-case determination, based on a qualitative review,as to whether the senior retained portion of anSBO’s synthetic securitization qualifies for the20 percent risk weight. The SBO must be ableto demonstrate that virtually all the credit risk ofthe reference portfolio has been transferred fromthe banking book to the capital markets. As theydo when BOs are engaging in more traditionalsecuritization activities, examiners must care-fully evaluate whether the SBO is fully capableof assessing the credit risk it retains in its bank-ing book and whether it is adequately capital-ized given its residual risk exposure. The Fed-eral Reserve will require the SBO to maintainhigher levels of capital if it is not deemed to beadequately capitalized given the retained residualrisks. In addition, an SBO involved in syntheticsecuritizations must adequately disclose to themarketplace the effect of its transactions on itsrisk profile and capital adequacy.

The Federal Reserve may consider an SBO’sfailure to require the investors in the CLNs toabsorb the credit losses that they contractuallyagreed to assume an unsafe and unsound bank-ing practice. In addition, such a failure generallywould constitute ‘‘implicit recourse’’ or supportto the transaction, which result in the SBO’slosing preferential capital treatment on its retainedsenior position.

If an SBO of a synthetic securitization does

not meet the stringent minimum conditions, itmay still reduce the risk-based capital require-ment on the senior risk position retained in thebanking book by transferring the remainingcredit risk to a third-party OECD bank throughthe use of a credit derivative. Provided thecredit-derivative transaction qualifies as a guar-antee under the risk-based capital guidelines,the risk weight on the senior position may bereduced from 100 percent to 20 percent. SBOsmay not enter into nonsubstantive transactionsthat transfer banking-book items into the tradingaccount to obtain lower regulatory capitalrequirements.63

4060.3.5.3.18.3 Minimum Conditions

The following stringent minimum conditions arethose that the SBOs must meet to use the syn-thetic securitization capital treatment for trans-action 2. The Federal Reserve may impose addi-tional requirements or conditions as deemednecessary to ascertain that an SBO has suffi-ciently isolated itself from the credit-risk expo-sure of the hedged reference portfolio.

Condition 1—Demonstration of transfer of vir-tually all the risk to third parties. Not all trans-actions structured as synthetic securitizationstransfer the level of credit risk needed to receivethe 20 percent risk weight on the retained seniorposition. To demonstrate that a transfer of virtu-ally all of the risk has been achieved, SBOsmust—

1. produce credible analyses indicating a trans-fer of virtually all the credit risk to substan-tive third parties;

2. ensure the absence of any early-amortizationor other credit performance–contingentclauses;64

3. subject the transaction to market discipline

63. For instance, a lower risk weight would not be appliedto a nonsubstantive transaction in which the SBO (1) entersinto a credit-derivative transaction to pass the credit risk ofthe senior retained portion held in its banking book to anOECD bank, and then (2) enters into a second credit-derivative transaction with the same OECD bank, in which itreassumes into its trading account the credit risk initiallytransferred.

64. Early-amortization clauses may generally be definedas features that are designed to force a wind-down of asecuritization program and rapid repayment of principal toasset-backed securities investors if the credit quality of theunderlying asset pool deteriorates significantly.



through the issuance of a substantive amountof notes or securities to the capital markets;

4. have notes or securities rated by a nationallyrecognized credit rating agency;

5. structure a senior class of notes that receivesthe highest possible investment-grade rating,for example, AAA, from a nationally recog-nized credit rating agency;

6. ensure that any first-loss position retained bythe SBO in the form of fees, reserves, orother credit enhancement—which effectivelymust be deducted from capital—is no greaterthan a reasonable estimate of expected losseson the reference portfolio; and

7. ensure that the SBO does not reassume anycredit risk beyond the first-loss positionthrough another credit derivative or any othermeans.

Condition 2—Demonstration of ability to evalu-ate remaining banking-book risk exposures andprovide adequate capital support. To ensure thatthe SBO has adequate capital for the credit riskof its unhedged exposures, it is expected to haveadequate systems that fully account for theeffect of these transactions on its risk profilesand capital adequacy. In particular, the SBO’ssystems should be capable of fully differentiat-ing the nature and quality of the risk exposuresit transfers from the nature and quality of therisk exposures it retains. Specifically, to gaincapital relief SBOs are expected to—

1. have a credible internal process for gradingcredit-risk exposures, including the follow-ing:a. adequate differentiation of risk among risk

gradesb. adequate controls to ensure the objectivity

and consistency of the rating processc. analysis or evidence supporting the accu-

racy or appropriateness of the risk-gradingsystem;

2. have a credible internal economic capital-assessment process that defines the SBO tobe adequately capitalized at an appropriateinsolvency probability and that readjusts, asnecessary, its internal economic capitalrequirements to take into account the effectof the synthetic securitization transaction. Inaddition, the process should employ a suffi-ciently long time horizon to allow necessaryadjustments in the event of significant losses.The results of an exercise demonstrating thatthe organization is adequately capitalized

after the securitization transaction must bepresented for examiner review;

3. evaluate the effect of the transaction on thenature and distribution of the nontransferredbanking-book exposures. This analysis shouldinclude a comparison of the banking book’srisk profile and economic capital require-ments before and after the transaction, includ-ing the mix of exposures by risk grade andby business or economic sector. The analysisshould also identify any concentrations ofcredit risk and maturity mismatches. Addi-tionally, the SBO must adequately manageand control the forward credit exposure thatarises from any maturity mismatch. The Fed-eral Reserve retains the flexibility to requireadditional regulatory capital if the maturitymismatches are substantive enough to raise asupervisory concern. Moreover, as statedabove, the SBO must demonstrate that itmeets its internal economic capital require-ment subsequent to the completion of thesynthetic securitization; and

4. perform rigorous and robust forward-lookingstress testing on nontransferred exposures(remaining banking-book loans and commit-ments), transferred exposures, and exposuresretained to facilitate transfers (credit enhance-ments). The stress tests must demonstratethat the level of credit enhancement is suffi-cient to protect the SBO from losses underscenarios appropriate to the specifictransaction.

Condition 3—Provide adequate public disclo-sures of synthetic CLO transactions regardingtheir risk profile and capital adequacy. In their10-K and annual reports, SBOs must adequatelydisclose to the marketplace the accounting, eco-nomic, and regulatory consequences of syn-thetic CLO transactions. In particular, SBOs areexpected to disclose—

1. the notional amount of loans and commit-ments involved in the transaction;

2. the amount of economic capital shed throughthe transaction;

3. the amount of reduction in risk-weightedassets and regulatory capital resulting fromthe transaction, both in dollar terms and interms of the effect in basis points on therisk-based capital ratios; and

4. the effect of the transaction on the distribu-tion and concentration of risk in the retainedportfolio by risk grade and sector.



4060.3.5.3.18.4 Transaction 3—First-LossPosition Is Retained

In the third type of synthetic transaction, theSBO may retain a subordinated position thatabsorbs the credit risk associated with a firstloss in a reference portfolio. Furthermore, throughthe use of credit-default swaps, the SBO maypass the second- and senior-loss positions to athird-party entity, most often an OECD bank.The third-party entity, acting as an intermediary,enters into offsetting credit-default swaps withan SPV, thus transferring its credit risk associ-ated with the second-loss position to the SPV.65

The SPV then issues CLNs to the capital mar-kets for a portion of the reference portfolio andpurchases Treasury collateral to cover somemultiple of expected losses on the underlyingexposures.

Two alternative approaches could be used todetermine how the SBO should treat the overalltransaction for risk-based capital purposes. Thefirst approach employs an analogy to the low-level capital rule for assets sold with recourse.Under this rule, a transfer of assets with recoursethat contractually is limited to an amount lessthan the effective risk-based capital require-ments for the transferred assets is assessed atotal capital charge equal to the maximum amountof loss possible under the recourse obligation. Ifthis rule applied to an SBO retaining a 1 percentfirst-loss position on a synthetically securitized

portfolio that would otherwise be assessed 8 per-cent capital, the SBO would be required to holddollar-for-dollar capital against the 1 percentfirst-loss risk position. The SBO would not beassessed a capital charge against the second-and senior-risk positions.66

The second approach employs a literal read-ing of the capital guidelines to determine theSBO’s risk-based capital charge. In this instance,the 1 percent first-loss position retained by theSBO would be treated as a guarantee, that is, adirect-credit substitute, which would be assessedan 8 percent capital charge against its face valueof 1 percent. The second-loss position, which iscollateralized by Treasury securities, would beviewed as fully collateralized and subject to azero percent capital charge. The senior-lossposition guaranteed by the intermediary bankwould be assigned to the 20 percent risk cate-gory appropriate to claims guaranteed by OECDbanks.67

65. Because the credit risk of the senior position is nottransferred to the capital markets but remains with the inter-mediary bank, the SBO should ensure that its counterparty isof high credit quality, for example, at least investment grade.

66. The SBO would not realize any benefits in the determi-nation of its leverage ratio since the reference assets remainon the SBO’s balance sheet.

67. If the intermediary is a BO, then it could place both


IntermediaryOECD Bank

Credit-default-swap fee

Default paymentand pledge of

Treasuries equalto $400 million tocover losses above

1% of thereference assets

SponsoringBanking

Organization

$5 billion creditportfolio

Credit-default-swapfee (basis points per year)

Default payment andpledge of Treasuries

SPV

Holds $400 millionof pledged Treasuries

$400 millionof CLNs

$400 millionof cash

Seniornotes

Juniornotes



The second approach may result in a higherrisk-based capital requirement than the dollar-for-dollar capital charge imposed by the firstapproach, depending on whether the referenceportfolio consists primarily of loans to privateobligors or undrawn long-term commitments.The latter generally have an effective risk-basedcapital requirement one-half of the requirementfor loans because these commitments are con-verted to an on-balance-sheet credit-equivalentamount using the 50 percent conversion factor.If the reference pool consists primarily of drawnloans to private obligors, then the capitalrequirement on the senior-loss position wouldbe significantly higher than if the reference port-folio contained only undrawn long-term com-mitments. As a result, the capital charge for theoverall transaction could be greater than thedollar-for-dollar capital requirement set forth inthe first approach.

SBOs will be required to hold capital againsta retained first-loss position in a synthetic secu-ritization equal to the higher of the two capitalcharges resulting from application of the firstand second approaches, as discussed above. Fur-ther, although the SBO retains only the creditrisk associated with the first-loss position, it stillshould continue to monitor all the underlyingcredit exposures of the reference portfolio todetect any changes in the credit-risk profile ofthe counterparties. This is important to ensurethat the SBO has adequate capital to protectagainst unexpected losses. Examiners shoulddetermine whether the SBO has the capability toassess and manage the retained risk in its creditportfolio after the synthetic securitization iscompleted. For risk-based capital purposes, BOsinvesting in the notes must assign them to therisk weight appropriate to the underlying refer-ence assets.68

4060.3.5.3.19 Reservation of Authority

The Federal Reserve reserves its authority todetermine, on a case-by-case basis, the appropri-ate risk weight for assets and credit-equivalentamounts and the appropriate credit-conversionfactor for off-balance-sheet items. The FederalReserve’s exercise of this authority may resultin a higher or lower risk weight for an asset orcredit-equivalent amount, or in a higher or lowercredit-conversion factor for an off-balance-sheetitem. This reservation of authority explicitlyrecognizes that the Federal Reserve retains suf-ficient discretion to ensure that bank holdingcompanies, as they develop novel financial assets,will be treated appropriately under the regula-tory capital standards. Under this authority, theFederal Reserve reserves its right to assign riskpositions in securitizations to appropriate riskcategories on a case-by-case basis, if the creditrating of the risk position is determined to beinappropriate.

4060.3.5.3.20 Board Exceptions(Reservation of Authority) for SecuritiesLending

Securities lent by a bank are treated in one oftwo ways, depending upon whether the lender isat risk of loss. If a bank, as agent for a customer,lends the customer’s securities and does notindemnify the customer against loss, then thetransaction is excluded from the risk-based capi-tal calculation. Alternatively, if a bank lends itsown securities or, acting as agent for a customer,lends the customer’s securities and indemnifiesthe customer against loss, the transaction is con-verted at 100 percent and assigned to the risk-weight category appropriate to the obligor, or, ifapplicable, to any collateral delivered to thelending bank or the independent custodian act-ing on the lending bank’s behalf. When a bankis acting as agent for a customer in a transactioninvolving the lending or sale of securities that iscollateralized by cash delivered to the bank, thetransaction is deemed to be collateralized bycash on deposit for purposes of determining theappropriate risk-weight category, provided that(1) any indemnification is limited to no morethan the difference between the market value ofthe securities and (2) the cash collateral receivedand any reinvestment risk associated with thatcash collateral is borne by the customer. See4060.3.2.2 for the procedures for risk-weightingon- and off-balance-sheet items and the discus-sion on securities lending in 2140.0.

sets of credit-default swaps in its trading account and, ifsubject to the Federal Reserve’s market-risk capital rules, useits general market-risk model and, if approved, specific-riskmodel to calculate the appropriate risk-based capital require-ment. If the specific-risk model has not been approved, thenthe SBO would be subject to the standardized specific-riskcapital charge.

68. Under this type of transaction, if a structure exposesinvesting BOs to the creditworthiness of a substantive issuer,for example, the SBO, then the investing BOs should assignthe notes to the higher of the risk categories appropriate to theunderlying reference assets or the SBO.



Certain agency securities-lending arrangements(May 2003 exception for ‘‘cash-collateral trans-actions’’). In response to a bank’s inquiry, theBoard issued a May 14, 2003, interpretation forthe risk-based capital treatment of certain Euro-pean agency securities’ lending arrangements inwhich the bank, acting as agent, lends securitiesof a client and receives cash collateral from theborrower. The transaction is marked-to-marketdaily and a positive margin of cash collateralrelative to the market value of the securities lentis maintained at all times. If the borrowingcounterparty defaults on the securities loanedthrough, for example, failure to post marginwhen required, the transaction is immediatelyterminated and the cash collateral is used by thebank to repurchase in the market the securitieslent, in order to restore them to the client. Thebank indemnifies its client against the risk that,in the event of counterparty default, the amountof cash collateral may be insufficient to repur-chase the amount of securities lent. Thus, theindemnification is limited to the differencebetween the value of the cash collateral and therepurchase price of the replacement securities.In addition, the bank, again acting as agent,reinvests, on the client’s behalf, the cash collat-eral received from the borrower. The reinvest-ment transaction takes the form of a cash loan toa counterparty that is fully collateralized bygovernment or corporate securities (through, forexample, a reverse-repurchase agreement). Likethe first transaction, the reinvestment transac-tion is subject to daily marking-tomarket andremargining and is immediately terminable inthe event of counterparty default. The bankissues an indemnification to the client againstthe reinvestment risk, which is similar to theindemnification the bank gives on the originalsecurities-lending transaction.

The Federal Reserve Board’s current risk-based capital guidelines treat indemnificationsissued in connection with agency securities lend-ing activities as off-balance-sheet guaranteesthat are subject to capital charges. Under theguidelines, the bank’s first indemnification wouldreceive the risk weight of the securities-borrowing counterparty because of the bank’sindemnification of the client’s reinvestment riskon the cash collateral. (See 12 CFR 208 and225, appendix A, section III.D.1.c.) The bank’ssecond indemnification would receive the lowerof the risk weight of the reverse-repurchasecounterparty or the collateral, unless it was fullycollateralized with margin by OECD govern-ment securities, which would qualify for a zeropercent risk weight. (See 12 CFR 208 and 225,appendix A, sections III.D.1.a. and b.)

The bank inquired about the possibility ofassigning a zero percent risk weight for bothindemnifications, given the low risk they pose tothe bank. The Board approved an exception toits risk-based capital guidelines for the bank’sagency securities-lending transactions. The Boardapproved this exception under the reservation ofauthority provision contained in the guidelines.This provision permits the Board, on a case-by-case basis, to determine the appropriate riskweight for any asset or off-balance-sheet itemthat imposes risks on a bank that are incommen-surate with the risk weight otherwise specifiedin the guidelines. (See 12 CFR 208 and 225,appendix A, section III.A.)

This exception applies to the bank’s agencysecurities-lending transactions collateralized bycash where the bank indemnifies its client against(1) the risk that, in the event of default by thesecurities borrower, the amount of cash collat-eral may be insufficient to repurchase the amountof securities lent and (2) the reinvestment riskassociated with lending the cash collateral in atransaction fully collateralized by securities (forexample, in a reverse-repurchase transaction).

The capital treatment the Board approved forthese transactions relies upon an economic mea-surement of the amount of risk exposure thebank has to each of its counterparties. Underthis approved approach, the bank does not usethe notional amount of underlying transactionsthat are subject to client indemnifications as theexposure amount for risk-based capital pur-poses. Rather, the bank must use an economicexposure amount that takes into account themarket value of collateral and the market pricevolatilities of (1) the instruments delivered bythe bank to the counterparty and (2) the instru-ments received by the bank from the counter-party. This approach builds on best practices ofbanks formeasuring their credit exposureamountsfor purposes of managing internal single-borrower exposure limits, as well as upon exist-ing concepts incorporated in the Basel Accordand the Board’s risk-based capital and marketrisk rules. The bank, under this exception, isrequired to determine an unsecured loan equiva-lent amount for each of the counterparties towhich, as agent, the bank lends securities collat-eralized by cash or lends cash collateralized bysecurities. As described below, the unsecuredloan equivalent amount will be assigned the riskweight appropriate to the counterparty.

To determine the unsecured loan equivalentamount, the bank must add together its current



exposure to the counterparty and a measure forpotential future exposure (PFE) to the counter-party. The current exposure is the sum of themarket value of all securities and cash lent tothe counterparty under the bank’s indemnifiedarrangements, less the sum of all securities andcash received from the counterparty as collateralunder the indemnified arrangements. The PFEcalculation is to be based on the market volatili-ties of the securities lent and the securitiesreceived, as well as any foreign exchange ratevolatilities associated with any cash or securitieslent or received.

The Board considered two methods for incor-porating market volatilities into the PFE calcula-tion: (1) the bank’s own estimates of thosevolatilities based on a year’s historical observa-tion of market prices with no recognition ofcorrelation effects and (2) a value-at-risk (VaR)type model. The bank was calculating daily,counterparty VaR estimates for its agency lend-ing transactions and it had a VaR model that hadbeen approved for purposes of the Board’s mar-ket risk rule. The Board determined that thebankt could use a VaR model to calculate thePFE for each of its counterparties.

The bank must calculate the VaR using afive-day holding period and a 99th percentileone-tailed confidence interval based on marketprice data over a one-year historical observationperiod. The data set used should be updated noless frequently than once every three months andshould be reassessed whenever market prices aresubject to material changes. For each counter-party, the bank is required to calculate daily anunsecured loan equivalent amount, including theVaR PFE component. These calculations will besubject to supervisory review to ensure they arein line with the quarter-end calculations used todetermine regulatory capital requirements.

To qualify for the capital treatment outlinedabove, the securities-lending and cash loan trans-actions covered by the bank’s indemnificationmust meet the following conditions:

1. The transactions are fully collateralized.2. Any securities lent or taken as collateral are

eligible for inclusion in the trading book andare liquid and readily marketable.

3. Any securities lent or taken as collateral aremarked-to-market daily.

4. The transactions are subject to a daily marginmaintenance requirement.

Further, the transactions must be executed

under a bilateral netting agreement or an equiva-lent arrangement. These arrangements must(1) provide the non-defaulting party the right topromptly terminate and close-out all transac-tions under the agreement upon an event ofdefault, including in the event of insolvency orbankruptcy of the counterparty; (2) provide forthe netting of gains and losses on transactions(including the value of any collateral) termi-nated and closed out under the agreement sothat a single net amount is owed by one party tothe other; (3) allow for the prompt liquidation orsetoff of collateral upon the occurrence of anevent of default; (4) be conducted, together withthe rights arising from the conditions required inprovisions 1 and 3 above, under documentationthat is legally binding on all parties and legallyenforceable in each relevant jurisdiction uponthe occurrence of an event of default and regard-less of the counterparty’s insolvency or bank-ruptcy; and (5) be conducted under documenta-tion for which the bank has completed sufficientlegal review to verify it meets provision 4 aboveand for which the bank has a well-founded legalbasis for reaching this conclusion.

With regard to the counterparty VaR modelthat the bank uses, the bank is required toconduct regular and rigorous backtestingprocedures, which are subject to supervisoryreview, to ensure the validity of the correla-tion factors used by the bank and the stability ofthese factors over time. The bank was notsubject to a formal backtesting procedurerequirement at the time the letter was issued.However, if supervisory review determines thatthe bank’s counterparty VaR model or itsbacktesting procedures have material deficien-cies and the bank does not take appropriate andexpeditious steps to rectify those deficiencies,supervisors may take action to adjust the bank’scapital calculations. Such action could rangefrom imposing a multiplier on the VaRestimates of PFE calculated by the bank todisallowing the use of its counterparty VaRmodel and requiring use of the own-estimatesapproach to determine the PFE component ofthe unsecured loan equivalent amounts.

The capital treatment that the Board approvedin the letter has been, and will be made, avail-able to similarly situated institutions that requestand receive Board approval for such treatment.

Certain agency securities-lending arrangements(August 2006 exception for ‘‘securities-collateral transactions’’). In response to aninquiry made by a bank, a Board interpretationissued on August 15, 2006, discussed the regula-tory capital treatment of certain securities-



lending transactions. In these transactions, thebank, acting as agent for its clients, lends itsclients’ securities and receives liquid securitiescollateral in return (the securities-collateral trans-actions).69 Each securities loan is marked tomarket daily, and the bank calls for additionalmargin as needed to maintain a positive marginof collateral relative to the market value of thesecurities lent at all times. The bank also agreesto indemnify its clients against the risk that, inthe event of borrower default, the market valueof the securities collateral is insufficient to repur-chase the amount of securities lent.

If the borrower were to default, the bankwould be in a position to terminate a securities-collateral transaction and sell the collateral inorder to purchase securities to replace thesecurities that were originally lent. The bank’sexposure under a securities-collateral transac-tion would be limited to the difference betweenthe purchase price of the replacement securi-ties and the market value of the securitiescollateral.

The bank requested that the Federal ReserveBoard approve another exception to the capitalguidelines that would permit the bank to mea-sure its exposure amounts for risk-based capitalpurposes with respect to the securities-collateraltransactions under the methodology of the bank’sprior May 14, 2003, approval (the prior approval).Again, the Board determined that, under its cur-rent risk-based capital guidelines, the capitalcharges for these securities-lending arrangementswould exceed the amount of economic riskposed to the bank, which would result in capitalcharges that would be significantly out of pro-portion to the risk posed. The Board thereforeapproved an August 15, 2006, exception to itsrisk-based capital guidelines according to theprior approval, allowing the bank to compute itsregulatory capital for these transactions using aloan-equivalent methodology. In so doing, thebank would assign the risk weight of the coun-terparty to the exposure amount of all suchtransactions with the counterparty. Specifically,the Board granted the bank its request to use anunsecured loan-equivalent amount (calculatedas current exposure plus a VaR-modeled PFE)for the securities-collateral transactions for risk-based capital purposes. The Board approved theexception under the reservation-of-authority pro-vision contained in its capital guidelines.

4060.3.5.3.21 (Reservation of Authority)Regulation T Margin Debits—RegulationT Margin Loans

A BHC requested that the Board grant it anexception to its risk-based capital guidelines (12C.F.R. 225, appendix A) so that it could assign alower risk weight to the Regulation T margindebits (Reg. T margin loans) held by a regis-tered U.S. broker-dealer subsidiary. The guide-lines require that a 100 percent risk weight beassigned to Reg. T margin loans, which resultsin a risk-based capital requirement of 8 percent.

The BHC contended that a lower risk weightfor Reg. T margin loans would more closelyalign the regulatory capital requirement for suchloans to their credit risk, given their high levelof collateralization and the company’s long his-tory of low loss rates on such loans. It noted thatits internal economic capital charge for creditrisk on Reg. T margin loans is de minimis. Itstated also that a lower risk weight for Reg. Tmargin loans would be appropriate to, amongother things, reduce competitive disadvantagesthat the BHC (through its U.S. broker-dealersubsidiary) has relative to U.S. broker-dealersthat are not consolidated subsidiaries of BHCsand to non-U.S. banks and broker-dealers.

A margin account at a broker-dealer registeredwith the Securities and Exchange Commission(SEC) is a leveraged account, through whichsecurities can be purchased, sold short, carried,or traded using a loan from the broker-dealer anda deposit of cash or securities by the customer.The amount of leverage available to a customeris limited by (1) the Board’s Regulation T (12C.F.R. 220), (2) the margin-maintenance rules ofthe Financial Industry Regulatory Authority(FINRA) (NYSE Rule 431 and NASD Rule2520), and (3) the lender’s internal margin-maintenance requirements. 69a

69. The liquid securities collateral includes governmentagency, government-sponsored entity, corporate debt or equity,or asset-backed or mortgage-backed securities.

69a. For example, a customer who purchases $100 ofequity securities in a margin account may borrow only $50against those securities from the broker-dealer under Regula-tion T. If this transaction is the only one in the marginaccount, the loan will be 200 percent collateralized at the timeof purchase because the market value of the securities is twicethat of the margin loan. If, on a daily basis, the equity in theaccount falls below the required NYSE margin maintenanceof 25 percent—that is, if the value of the collateral falls below133 percent of the loan—the customer is required to postadditional collateral (either cash or securities) to eliminate themargin deficiency. If the customer does not meet the margincall within the required time, the broker-dealer must sellsufficient securities in the account to increase the accountequity to the required maintenance level.



The requesting BHC noted that it applies inmost instances (and in all instances when thecollateral is equities or non-investment-gradebonds) internal margin-maintenance require-ments that exceed those in NYSE Rule 431. 69b

It represented that its Reg. T margin loans aretypically collateralized by liquid and readilymarketable securities, which generally can beterminated on demand at any time. The BHCrepresented also that it marks to market the Reg.T margin loans and associated securities collat-eral on a daily basis and that it makes dailymargin-maintenance calls for any collateral defi-ciencies. It also concluded that the collateral fora Reg. T margin loan should generally be avail-able for prompt liquidation even in the event ofthe borrower’s bankruptcy.

The BHC’s request contended that otherdomestic and foreign firms—including foreignbanking organizations that own U.S. broker-dealers, as well as U.S. broker-dealers andconsolidated supervised entities (‘‘CSEs’’) regu-lated by the SEC—are currently required to holdeither no or de minimis regulatory capital againstReg. T margin loans. It maintained that the muchhigher regulatory capital requirement that U.S.BHCs incur for Reg. T margin loans places U.S.broker-dealers owned by U.S. BHCs at adisadvantage in competing for this low-riskbusiness.

After carefully considering the request, andsubject to the listed conditions below, the Boardapproved, under certain circumstances, an excep-tion to the guidelines that permits the requestingBHC to apply a 10 percent risk weight to itsReg. T margin loans. The Board approved thisexception to the guidelines under the reservation-of-authority provision contained in the guide-lines (12 C.F.R. 225, appendix A, III.A). Thisprovision permits the Board, on a case-by-casebasis, to determine the appropriate risk weightfor any asset or off-balance-sheet item thatimposes risks on a BHC that are incommensu-rate with the risk weight otherwise specified inthe guidelines.

To qualify for the capital treatment on anexception basis, Reg. T margin loans must meetthe following conditions:

1. The securities collateral for the Reg. T mar-gin loans is liquid and readily marketable;

2. The Reg. T margin loans and associated col-lateral are marked to market each businessday;

3. The Reg. T margin loans are subject to initialmargin requirements under Regulation T anddaily margin-maintenance requirements underFINRA regulations (NYSE Rule 431) orNASD Rule 2520; and

4. The BHC has a reasonable basis for conclud-ing that it would be able to liquidate thecollateral for the Reg. T margin loans with-out undue delay, even in the case of bank-ruptcy or insolvency of the borrower.

The Board concluded that this capital treat-ment for Reg. T margin loans provides a morerisk-sensitive treatment for these transactionsthan their treatment under the guidelines. The(1) combination of initial margin requirementsunder Regulation T, (2) ongoing margin-maintenance requirements under FINRA regula-tions, (3) generally higher ongoing margin-maintenance requirements under the BHC’sinternal policies, (4) the BHC’s daily mark-to-market and margin-call policies, (5) the highliquidity of the collateral, (6) the BHC’s typicalright to terminate the loan at any time, and(7) the BHC’s general protection from the auto-matic stay in bankruptcy makes these loans alow-credit-risk product that warrants a 10 per-cent risk weight.

The Board noted that this 10 percent risk-weight exception treatment for Reg. T marginloans would be made available to similarly situ-ated institutions that request and receive Boardapproval for such treatment. BHCs should beaware that the Board may in the future impose aregulatory capital treatment for Reg. T marginloans that differs from the exception. As for thisBHC’s request, any Board determination will beconditioned on the requesting BHC’s compli-ance with the commitments and representationsmade to the Board in connection with its requestand, as such, may be enforced in proceedingsunder applicable law. Further, this exceptionwill also consider specific facts and circum-stances described in the request and in discus-sions with Federal Reserve staff. See the Board’slegal interpretation issued June 15, 2007, andother similar legal interpretations issued onAugust 29, September 17, November 5, Decem-ber 17, and December 18, 2007.

4060.3.5.4 Considerations in the OverallAssessment of Capital Adequacy

Examiners are to take into account the follow-

69b. Regulation T initial margin requirements and NYSEmargin-maintenance requirements fordebt securitiesandoptionsdiffer from those applicable to equity securities.



ing factors when assessing the overall capitaladequacy of banking organizations.

4060.3.5.4.1 Unrealized Asset Values

Banking organizations often have assets on theirbooks that are carried at significant discountsbelow current market values. This differencebetween book value (historical cost or acquisi-tion value) and market value of any asset,particularly for banking premises, may representpotential capital to the banking organization.These ‘‘unrealized asset values’’ are notincluded in the risk-based capital calculation.Examiners should take into consideration suchunrecognized capital when assessing capitaladequacy. Particular attention should be givento the nature of the asset, the reasonableness ofits valuation, its marketability, and the likeli-hood of its sale.

4060.3.5.4.2 Ineligible Collateral andGuarantees

The risk-based capital guidelines recognize col-lateral and guarantees in only a limited numberof cases. Other types of collateral and guaran-tees support the asset mix of banking organiza-tions, particularly within their loan portfolios.Such collateral or guarantees may serve tosubstantially improve the overall quality of loanportfolios and of other credit exposures andshould be considered by examiners when theyare arriving at their overall assessment of capitaladequacy.

4060.3.5.4.3 Overall Asset Quality

The conclusions drawn by banking organiza-tions from calculating their risk-based capitalratios may be significantly different from con-clusions drawn by examiners. The main reasonfor these differences is the assessment of assetquality. Examiners must assess the capital ade-quacy of banking organizations, taking intoaccount examination or inspection findings, par-ticularly those findings regarding the severity ofproblem and classified assets and investment orloan-portfolio concentrations, as well as the ade-quacy of the banking organization’s allowancefor loan and lease losses.

4060.3.5.4.4 Interest-Only Strips andPrincipal-Only Strips

Interest-only strips (IOs) and principal-only strips(POs) have highly volatile price characteristicsas interest rates change, and they are generallynot considered appropriate investments for mostbanking organizations. However, somesophisticated banking organizations may useIOs and POs as hedging vehicles. The Boarddoes not want to discourage the legitimate useof IOs and POs as hedging vehicles. Examiners’assessments of capital adequacy should reflectbanking organizations’ appropriate use of hedg-ing instruments, including IOs and POs. Bank-ing organizations that have appropriately hedgedtheir interest-rate exposure may be permitted tooperate with lower levels of capital than thosebanking organizations that are vulnerable tointerest-rate changes.

4060.3.5.4.5 Interest-Rate Risk

Examiners are to continue to scrutinize bankingorganizations’ interest-rate risk exposure care-fully and to require that organizations withundue levels of interest-rate risk strengthen theircapital positions even though they may meet theminimum risk-based capital standards.

4060.3.5.4.6 Claims on, and ClaimsGuaranteed by, OECD CentralGovernments

The risk-based capital guidelines assign a zeropercent risk weight to all direct claims (includ-ing securities, loans, and leases) on the centralgovernments of the OECD-based group of coun-tries and U.S. government agencies. Generally,the only direct claims banking organizationshave on the U.S. government and its agenciesare in the form of Treasury securities. Zero-coupon securities—that is, single-payment Trea-sury securities trading under the U.S. Treasury’sSeparate Trading of Registered Interest andPrincipal of Securities (STRIPS) program—areassigned to the zero percent risk category. Asecurity that has been stripped by a private-sector entity, such as a brokerage firm, is consid-ered an obligation of that entity and, accordingly,is assigned to the 100 percent risk category.

Claims that are directly and unconditionallyguaranteed by an OECD-based central govern-



ment or a U.S. government agency are alsoassigned to the zero percent risk category. Suchclaims that are not unconditionally guaranteedare assigned to the 20 percent risk category. Aclaim is not considered to be unconditionallyguaranteed by a central government if the valid-ity of the guarantee depends on some affirma-tive action by the holder or a third party. Gener-ally, securities guaranteed by the U.S. governmentor its agencies that are actively traded in finan-cial markets are considered to be uncondition-ally guaranteed. These include GovernmentNational Mortgage Association (GNMA) andSmall Business Administration (SBA) securities.

Banking organizations are permitted to assignto the zero percent risk category claims collater-alized by cash on deposit in the banking organi-zation or by OECD central governments or U.S.government agency securities for which a posi-tive collateral margin is maintained on a dailybasis, fully taking into account any change inthe banking organization’s exposure to the obli-gor or counterparty under a claim in relation tothe market value of the collateral held in supportof that claim. The Board is not requiring that a



specific minimum margin of collateral be main-tained on collateralized transactions assigned tothe zero percent risk category. The Board ex-pects that banking organizations will establish,as a part of prudent operating procedures, aminimum level of margin for these transactions,based on such factors as the volatility of thesecurities involved, so as to avoid unduly fre-quent margin calls.

A limited number of U.S. government agency–guaranteed loans are deemed to be uncondition-ally guaranteed and, hence, can be assigned tothe zero percent risk category. These includemost loans guaranteed by the Export-ImportBank (Exim Bank),70 loans guaranteed by theU.S. Agency for International Development(AID) under its Housing Guarantee Loan Pro-gram, SBA loans subject to a secondary parti-cipation guarantee (in accordance with SBAForm 1086), and Farmers Home Administration(FmHA) loans subject to an assignment guaran-tee agreement in accordance with FmHAForm 449–36.

Apart from the exceptions noted in thepreceding paragraph, loans guaranteed by theU.S. government or its agencies are consideredconditionally guaranteed. The guaranteed por-tion of the loans is assigned to the 20 percentcategory. These loans include, but are notlimited to, loans guaranteed by the Commod-ity Credit Corporation (CCC), the Federal Hous-ing Administration (FHA), the Foreign CreditInsurance Association (FCIA), the OverseasPrivate Investment Corporation (OPIC), andthe Veterans Administration (VA), and, exceptas indicated above, portions of loans guaranteedby the FmHA and the SBA. Loan guaranteesoffered by FCIA and OPIC often guaranteeagainst political risk. However, only that portionof a loan guaranteed by FCIA or OPIC againstcommercial or credit risk may receive a prefer-ential 20 percent risk weight. The portion ofgovernment trust certificates issued to pro-vide funds for the refinancing of foreign mili-tary sales loans made by the Federal FinancingBank or the Defense Security Assistance Agencythat are indirectly guaranteed by the U.S. gov-ernment also qualify for the 20 percent riskweight.

4060.3.5.4.7 Accounting for DefinedBenefit Pension and Other PostretirementPlans

In September 2006, the Financial Accounting

Standards Board adopted the Statement of Finan-cial Accounting Standard No. 158, ‘‘EmployersAccounting for Defined Benefit Pension andOther Postretirement Plans’’ (FAS 158). Thestandard requires, as early as December 31,2006, that a bank, bank holding company, orother banking or thrift organization that spon-sors a single-employer defined benefit postre-tirement plan—such as a pension plan or healthcare plan—to recognize the overfunded or under-funded status of each such plan as an asset orliability on its balance sheet with correspondingadjustments recognized in accumulated othercomprehensive income (AOCI), a component ofequity capital. After a banking organization ini-tially applies FAS 158, changes in the benefitplan asset or liability reported on the organiza-tion’s balance sheet will be recognized in theyear in which the changes occur and will resultin an increase or decrease in AOCI. Postretire-ment plan amounts carried in AOCI are adjustedas they are subsequently recognized in earningsas components of the plans’ net periodic benefitcost.

The Federal Reserve Board, along with otherfederal bank and thrift regulatory agencies (theAgencies71), issued a joint press release onDecember 14, 2006, in which they announcedthat FAS 158 will not affect a banking organiza-tions’ regulatory capital. The agencies decided,until they can determine otherwise, banks (andbank holding companies) should exclude fromregulatory capital any amounts recorded in AOCIresulting from the adoption and application ofFAS 158. The intent of the reversal is to neutral-ize the effect of the application of FAS 158 onregulatory capital, including the reporting of theleverage ratio and the risk-based capitalmeasures.

4060.3.6 DIFFERENCE INAPPLICATION OF THE RISK-BASEDCAPITAL GUIDELINES TO BANKINGORGANIZATIONS

The capital guidelines are generally the samefor state member banks and bank holding com-panies. Since year-end 1992, however, there hasbeen one significant difference: the manner inwhich capital is defined for use in computing

70. Loans guaranteed under Exim Bank’s Working CapitalGuarantee Program, however, receive a 20 percent risk weight.

71. The Office of the Comptroller of the Currency, theFederal Deposit Insurance Corporation, and the Office ofThrift Supervision.



the risk-based capital ratio. Specifically, per-petual preferred stock is handled differently forstate member banks than it is for bank holdingcompanies.

4060.3.6.1 Difference in Treatment ofPerpetual Preferred Stock

Bank holding companies may include unlimitedamounts of noncumulative perpetual preferredstock in tier 1 capital and limited amounts ofcumulative perpetual preferred stock. The aggre-gate amount of qualifying cumulative preferredstock and qualifying trust preferred securitiesthat a BHC may include in tier 1 capital islimited to 25 percent of the sum of qualifyingcommon stockholders’ equity, qualifying noncu-mulative and cumulative perpetual preferredstock, qualifying minority interest in the equityaccounts of consolidated subsidiaries, and quali-fying trust preferred securities. Any amount ofcumulative perpetual preferred stock and quali-fying trust preferred securities in excess of thislimit may be included as tier 2 capital. In con-trast, state member banks may include onlynoncumulative perpetual preferred stock in tier 1capital.

4060.3.6.2 Perpetual Preferred Stock(Terms Relating to Tier 1 Treatment)

Given the importance of core capital, the Fed-eral Reserve’s guidelines exclude from tier 1capital preferred stock (including auction-ratepreferred) in which the dividend rate is resetperiodically, based in whole or in part upon thebanking organization’s financial condition orcredit standing. Under such instruments, theobligation to pay out higher dividends in responseto a deterioration in an organization’s financialcondition is inconsistent with the essentialprecept that capital should provide both strengthand loss-absorption capacity to an organiza-tion during periods of adversity. Rather thanpaying out higher dividends, banking organiza-tions are expected to conserve capital duringsuch periods.

Ordinarily, fixed-rate preferred stock andtraditional floating- or adjustable-rate preferredstock—in which the dividend rate is based onan independent market index that is in no waytied to the issuer’s financial condition—do notraise significant supervisory concerns, espe-

cially if the adjustable-rate instrument isaccompanied by reasonable spreads and caprates. However, certain other features thathave been incorporated in, or mentioned forpossible inclusion in, some preferred stock issuesdo raise serious questions about whe-ther these issues will truly serve as a permanent,or even long-term, source of capital. Suchfeatures include step-up or similar mechanisms,whereby, after a specified period, the dividendrate automatically increases to a higher level orto a level that could create substantial incentivesfor the issuer to redeem the instrument. Per-petual preferred stock with this type of featurecould cause the banking organization to be facedwith higher dividend requirements at a futuredate when it is experiencing financial difficul-ties. Such preferred stock is not generally includ-able in tier 1 capital.

4060.3.7 CASH REDEMPTION OFPERPETUAL PREFERRED STOCK

Under the Federal Reserve’s risk-based capitalguidelines, two essential characteristics of core(tier 1) capital—as shown by the terms of com-mon stock and perpetual preferred stock—areloss-absorption capacity and stability. In addi-tion to existing laws and regulations that pertainto the redemption or repurchase of capital secu-rities, the Federal Reserve’s risk-based capitalguidelines generally provide that any bank hold-ing company contemplating the redemption ofmaterial amounts of permanent equity instru-ments, including perpetual preferred stock, shouldreceive Federal Reserve approval before takingsuch action.72 Any perpetual preferred stock ortrust preferred securities with a feature permit-ting redemption at the option of the issuer mayqualify as capital only if the redemption is sub-ject to prior approval of the Federal Reserve.

The guidelines indicate that consultation withthe Federal Reserve could be unnecessary if theinstrument is redeemed with the proceeds ofanother similar or higher-quality tier 1 instru-ment and the organization’s capital is consid-ered fully adequate. However, because of theneed to make supervisory judgments on theseconditions, as well as the objective of fosteringsound capital positions, banking organizationscontemplating material redemptions of core capi-tal are generally expected to discuss these planswith their appropriate supervisory authorities,regardless of the circumstances. This has long

72. This general principle also applies to the redemption oflimited-life capital instruments before their stated maturities.



been the expectation and practice of the FederalReserve. Prior consultation puts the supervisoryauthority in a position to take appropriate actionif any planned capital redemption could have anadverse impact on an organization’s financialcondition.

The Federal Reserve’s interest in the leveland composition of capital derives both from theSystem’s general supervisory responsibilities tomonitor and address any actions that coulderode an organization’s capital base and fromthe need to implement the letter and spirit ofsupervisoryguidelinesoncapital adequacy.Underthe Federal Reserve’s guidelines, to qualify ascapital an instrument may not contain or becovered by covenants, terms, or restrictions thatare inconsistent with safe and sound bankingpractice. Moreover, perpetual preferred stockcannot contain provisions that would requirefuture redemption of the issue, and the issuermust have the ability and legal right to defer oreliminate preferred dividends.

4060.3.7.1 Federal Reserve’s SupervisoryPosition on Cash Redemption of Tier 1Preferred Stock

To qualify for tier 1 treatment, redemption forcash or other nonstock assets, regardless ofsource, is permissible only at the issuer’s option.Moreover, in view of the importance of ensuringthe stability of tier 1 capital, tier 1 preferredstock instruments should also provide that cashredemption would be permitted only with theprior consent of the Federal Reserve. The Fed-eral Reserve expects that it would usually grantsuch approval, when consistent with the organi-zation’s overall financial condition, if the pre-ferred shares are redeemed with the proceeds ofan acceptable tier 1 capital instrument that wouldmaintain or strengthen the issuer’s capital base.Approval could also be granted if the FederalReserve determines that the issuer’s capital posi-tion after the redemption would clearly beadequate and that the issuer’s condition andcircumstances warrant the reduction of a sourceof permanent capital.

4060.3.8 COMMON STOCKREPURCHASES AND DIVIDENDINCREASES ON COMMON STOCK

The Federal Reserve has long emphasized theimportance of prudent levels of capital to theoverall safety and soundness of banking organi-zations. In pursuit of its supervisory objective to

achieve an adequate level of capitalization inbanking organizations, the Federal Reserve hasover time promulgated various rules, guidelines,and standards concerning capital levels and theacceptable characteristics of various capitalinstruments and transactions. With respect toredemptions of common stock for cash or othervaluable consideration, section 225.4(b)(1) ofRegulation Y requires bank holding companiesto give the Federal Reserve prior notice of anyrepurchase of common stock that would reducetotal equity capital by 10 percent or more aggre-gated over any 12-month period. The risk-basedcapital guidelines further request that bank hold-ing companies consult with the Federal Reservebefore any material redemption of permanentequity instruments.

Because of the need for banking organiza-tions to strengthen their capital positions gener-ally, the Board strongly recommends that bankholding companies deemed to be experiencingfinancial weaknesses (or those at significant riskof developing financial weaknesses) consult withthe appropriate Federal Reserve Bank beforeany cash redemption of common stock for cashor other valuable consideration. Similarly, anybank holding company considering expansion,either through acquisitions or through new activi-ties, is also requested to consult with the appro-priate Federal Reserve Bank before any cashredemption of common stock for cash or othervaluable consideration. Although there may belegitimate uses of repurchased shares (for ex-ample, in ESOP transactions), this request isintended to prevent an imprudent or untimelyrepurchase that would have an immediate orpotentially adverse impact on the financial con-dition of the banking organization. In general,Reserve Banks should discourage bank holdingcompanies from repurchasing their shares ifthere would be an adverse effect on the capitalof the organization. A similar procedure wasadopted for redemptions of perpetual preferredstock. (See section 4060.3.7 or SR-89-20.)

Further, because the banking organizations’ability to gain access to capital markets can befurther diminished by rating-agency down-grades, the Federal Reserve considers internalcapital generation an important element in abanking organization’s capital planning. There-fore, bank holding companies in general, butparticularly those experiencing any degree offinancial weakness, are requested to consultwith the appropriate Federal Reserve Bankbefore increasing the rate of cash dividends



paid on common stock, an action that reducescapital-generation rates for companies experi-encing financial weakness. It is the intentionof the Federal Reserve to ensure that the finan-cial condition, future earnings prospects, andcapital level of the banking organization areconsistent with any proposed increase individends. (See Regulation Y, section 225.4(b)(1)and appendix A, section II.)

4060.3.9 QUALIFYING MANDATORYCONVERTIBLE DEBT SECURITIESAND PERPETUAL DEBT

Mandatory convertible debt securities are essen-tially subordinated debt instruments that may beconverted into common or perpetual preferredstock within a specified period of time, not toexceed 12 years. Qualifying mandatory convert-ible preferred securities generally consist of thejoint issuance by a BHC to investors of trustpreferred securities and a forward purchase con-tract, which the investors fully collateralize withthe securities, that obligates the investors topurchase a fixed amount of the BHC’s commonstock, generally in three years. Typically, priorto exercise of the purchase contract generally inthree years, the trust preferred securities areremarketed by the initial investors to new inves-tors, and the cash proceeds are used to satisfythe initial investors’ obligation to buy the BHC’scommon stock. The common stock replaces theinitial trust preferred securities as a componentof the BHC’s tier 1 capital, and the remarketedtrust preferred securities are excluded from theBHC’s regulatory capital. A BHC wishing toissue mandatory convertible preferred securitiesand include them in tier 1 capital must consultwith the Federal Reserve prior to their issuanceto ensure that the securities’ terms are consistentwith tier 1 capital treatment.

4060.3.9.1 Trust Preferred SecuritiesMandatorily Convertible intoNoncumulative Perpetual PreferredSecurities

A bank holding company requested approval toinclude in its tier 1 capital trust preferred securi-ties that are mandatorily convertible into noncu-mulative perpetual preferred securities on thesame terms and subject to the same quantitativelimit as trust preferred securities that mandato-

rily convert into common stock. The BHC alsoasked the Board to clarify whether trust pre-ferred securities that mandatorily convert tononcumulative perpetual preferred stock are eli-gible for the exception to the 15 percent limitafforded to qualifying mandatory convertiblepreferred securities under the capital guidelines.(See sections 4060.3.2.1.1.1 and 4060.3.2.1.1.2for a more detailed discussion of the limitationson including certain restricted core capital ele-ments in a BHC’s tier 1 capital.)

The Board noted that although the regulatorydefinition of qualifying mandatory convertiblepreferred securities specifically describes an in-strument convertible into common stock, theregulatory definition describes the typical, andnot the exclusive, form of qualifying mandatoryconvertible preferred securities. For several rea-sons, the Board determined that qualifying man-datory convertible preferred securities also in-clude instruments convertible into noncumulativeperpetual preferred securities.

The Board based its favorable treatment ofmandatory convertible preferred securities prin-cipally on the certainty that the issuer will,within a relatively short time period, replace thesecurities with a tier 1 capital component that isnot a restricted core capital element. The inter-pretation notes that although common stockremains the highest form of tier 1 capital, noncu-mulative perpetual preferred stock is also a highform of tier 1 capital and is not a restricted corecapital element. Like common stock, noncumu-lative perpetual preferred securities are perpetu-ally available to absorb losses incurred by theissuer, constitute equity under generally acceptedaccounting principles, and allow the issuer towaive dividends on a noncumulative basis. Byallowing the noncumulative waiver of divi-dends, noncumulative perpetual preferred secu-rities avoid the accumulation of deferred divi-dends, which could possibly impede an issuer’sability to raise additional equity during times ofstress.

The interpretation conveys the Board’s deter-mination that qualifying mandatory convertiblepreferred securities that convert to noncumula-tive perpetual preferred securities qualify forinclusion in the tier 1 capital of internationallyactive BHCs (and other BHCs) in excess of the15 percent limit applicable to the restricted corecapital elements of internationally active BHCs,if all other terms and conditions of the securitiesmeet the Board’s requirements. (See the January23, 2006, Board staff legal interpretation.)




1. To determine the adequacy of capital in rela-tion to the risks inherent in the transactionsand activities of the banking organization.

2. To determine compliance with the risk-basedand tier 1 leverage measures of the capitaladequacy guidelines as they apply to bankholding companies. (See section 4060.4.)

3. To determine if management and operatingpolicies, practices, and procedures for capitalare adequate, and whether they reflect therequirements of the capital adequacy guide-lines, if applicable.

4. To evaluate the performance of the bankholding company’s officers and employees inadministering and controlling the capital po-sition of the organization, including its bank-ing and nonbanking subsidiaries.

5. To evaluate the propriety and consistency ofthebankingorganization’spresent andplannedlevel of capitalization in light of the risk-based and leverage capital measures, asrequired, as well as existing conditions andfuture plans.

6. To initiate corrective action, in conjunctionwith the inspection process, when policies,procedures, or capital is deficient.


Section 4060.3.5 lists items that examiners shouldconsider during their analysis of capital ade-quacy with regard to the risk-based measure.The instructions in that section are to be fol-lowed in addition to the inspection procedureslisted below.

4060.3.11.1 Verification of theRisk-Based Capital Ratio

Examiners should verify that the bank holdingcompany has adequate systems in place tocompute and document its risk-based capitalratios.

1. Determine if the bank holding companyis correctly reporting the risk-based capitalinformation requested on the FederalReserve’s FR Y-9C Reports of Conditionand Income and supplementary schedules.

2. If the bank holding company has consoli-dated assets of less than $500 million, deter-mine whether the bank holding companyrisk-based capital guidelines still applybecause—

a. the bank holding company isengaged in nonbank activity involvingsignificant leverage (includes off-balance-sheet activities) or

b. the parent company has a significantamount of outstanding debt that is heldby the general public.

For the qualifying components of capital(the numerator of the ratio):

3. Determine if management is adhering to theunderlying terms of any currently outstand-ing stock issues.

4. Review common stock to ensure that thebank holding company is in compliancewith the terms of any underlying agree-ments and to determine if more than oneclass exists. If more than one class exists,review the terms for any preference or non-voting features. If the terms include suchfeatures, determine whether the class ofcommon stock qualifies for inclusion intier 1 capital.

5. Review any perpetual and long-term pre-ferred stock for the following:a. compliance with terms of the underlying

agreements, carefully noting—• adherence to the cumulative or noncu-

mulative nature of the stock and• adherence to any conversion rights.

b. proper categorization as tier 1 or tier 2for capital adequacy purposes, noting thefollowing requirements:• Tier 1 perpetual preferred stock must

have the following characteristics:— no maturity date— not redeemable at the option of the

holder— unsecured— ability to absorb losses— ability and legal right for the issuer

to defer or eliminate dividends orto issue waivers for preferred stock

— any issuer-redemption feature sub-ject to prior Federal Reserveapproval

— fixed-rate or traditional floating- oradjustable-rate

— no features that would require orcreate significant incentives for theissuer to (1) redeem the instrumentfor cash, cash equivalents, or otherconsideration of value (for ex-



ample, a credit-sensitive dividendfeature) or (2) repurchase the instru-ment, such as an ‘‘exploding rate,’’an auction-rate pricing mechanism,or a feature (for example, adividend-rate step-up or a market-conversion feature) that allows thestock to be converted into increas-ing numbers of common shares

• Perpetual preferred stock, includablewithin tier 2 capital without a sublimit,must have the characteristics listed in5.b. above for tier 1 perpetual pre-ferred stock. But perpetual preferredstock qualified for inclusion in tier 2capital may not qualify for inclusion intier 1 capital. For example, cumulativeor auction-rate perpetual preferredstock, which does not qualify for tier 1capital, may be includable in tier 2capital.

6. Verify that minority interest in equity ac-counts of consolidated subsidiaries includedin tier 1 capital consists only of tier 1 quali-fying capital elements. Determine whetherany perpetual preferred stock of a subsid-iary that is included in minority interest,without explicit Federal Reserve approval,is secured by the subsidiary’s assets. If so,that stock may not be included in capital.

7. For the BHC’s trust preferred securities thatare included in tier 1 capital, determine ifthe following requirements have been met:a. The supervising Federal Reserve Bank

was consulted before the securities wereissued and included in tier 1 capital.

b. The BHC, for accounting and reportingpurposes, has determined the appropriateapplication of GAAP (including FIN 46R)to its trust issuing trust preferred secur-ities. Ascertain that there is no substan-tive difference in the treatment of trustpreferred securities issued by suchtrusts, or in the treatment of the underly-ing junior subordinated debt, for pur-poses of regulatory reporting and GAAPaccounting.

c. The securities allow for dividends to bedeferred for at least 20 consecutive quar-ters without an event of default, unlessan event of default leading to accelera-tion permitted under section II.A.1.c.iv.(2)has occurred.

d. The required notification period for defer-ral of dividends is no more than 15 busi-

ness days before the payment date.e. The securities have the same restrictions,

terms, and features as qualifying per-petual preferred stock.

f. the sole asset of the trust is a juniorsubordinated note issued by the sponsor-ing banking organization. The note musthave a minimum maturity of 30 yearsand be subordinated with regard to bothliquidation and priority of periodic pay-ments to all senior and subordinated debtof the sponsoring banking organization(other than other junior subordinated notesunderlying trust preferred securities).

g. The note complies with section II.A.2.d.and the Federal Reserve’s subordinateddebt policy statement. (See 12 C.F.R.250.166.) The note may, however, pro-vide for an event of default and theacceleration of principal and accrued in-terest upon (1) nonpayment of interestfor 20 or more consecutive quarters or(2) termination of the trust without re-demption of the trust preferred securi-ties, distribution of the notes to inves-tors, or assumption of the obligation by asuccessor to the banking organization.

h. In the last five years before the maturityof the note, the outstanding amount ofthe associated trust preferred securities isexcluded from tier 1 capital and includedin tier 2 capital, and the trust preferredsecurities are subject to the amortizationprovisions and quantitative restrictionsset forth in sections II.A.2.d.iii. and iv. asif the trust preferred securities werelimited-life preferred stock.

8. Review the intermediate-term preferred stockand subordinated debt instruments includedin capital for the following:a. compliance with the terms of the under-

lying agreements, noting that subordi-nated debt containing one or both of thefollowing terms may not be included incapital:• interest payments tied to the banking

organization’s financial condition• acceleration clauses or broad condi-

tions of events of default that areinconsistent with safe and sound bank-ing practices

b. compliance with restrictions on theinclusion of such instruments in capitalby verifying that the aggregate amountof both types of instruments, togetherwith trust preferred securities and otherrestricted core capital elements (otherthan cumulative perpetual preferred



stock), does not exceed 50 percent oftier 1 capital (net of all goodwill) andthat the portions includable in tier 2 capi-tal possess the following characteristics:• unsecured• minimum five-year original weighted

average maturity• in the case of subordinated debt, con-

tains terms stating that the debt is not adeposit, is not insured by a federalagency, does not have credit-sensitivefeatures or other provisions that areinconsistent with safe and sound bank-ing practice, does not contain provi-sions permitting debt holders to accel-erate the payment of principal or interestupon the occurrence of any event, can-not be redeemed without prior approvalfrom the Federal Reserve, and is sub-ordinated to depositors and generalcreditors

c. appropriate amortization, if the instru-ments have a remaining maturity of lessthan five years

9. By reviewing minutes of board of directorsmeetings, determine if a stock offering orsubordinated debt issue is being considered.If so, determine that management is awareof the risk-based capital requirements forinclusion in capital.

10. Verify that the transactions within theallowance for loan and lease losses havebeen properly accounted for during theinspection period, and verify that the amountincluded in tier 2 capital has been limited to1.25 percent of weighted-risk assets.

For the calculation of risk-weightedassets (the denominator of the ratio):

11. Determine whether the bank holding com-pany consolidates, in accordance with theFinancial Accounting Standards Board’s FIN46-R, the assets of any asset-backed com-mercial paper (ABCP) program that itsponsors.a. Determine whether the bank holding com-

pany’s ABCP program meets the defini-tion of a ‘‘sponsored ABCP program’’under the Federal Reserve’s risk-basedcapital guidelines. If the bank holdingcompany does consolidate the assets ofan ABCP program, review the documen-tation of its risk-based capital ratio cal-culations and determine (1) whether theassociated ABCP program’s assets andminority interests were excluded from

the bank holding company’s risk-weighted asset base and (2) if they wereexcluded from tier 1 capital—the ratio’snumerator. See section III.B.6.

b. Determine whether any of the bank hold-ing company’s liquidity facilities meetthe definition and requirements of an‘‘eligible ABCP liquidity facility’’ underthe Federal Reserve’s risk-based capitalguidelines. See section III.B.3.iv.

c. From the bank holding company’s sup-porting documentation of its risk-basedcapital ratios, determine whether the bankholding company held risk-based capitalagainst its eligible ABCP liquidityfacilities.

d. Determine whether the bank holding com-pany has applied the correct conversionfactors to the eligible ABCP liquidityfacilities when it determined the amountof risk-weighted assets for its risk-basedcapital ratios. See section III.D.• For those eligible ABCP liquidity

facilities having an original maturityof one year or less, determine if a10 percent credit-conversion factor wasused.

• For those eligible ABCP liquidityfacilities having an original maturityexceeding one year, determine if a50 percent credit-conversion factorshould have been used.

e. Determine if ineligible ABCP liquidityfacilities were treated as direct-creditsubstitutes or as recourse obligations,as required by the risk-based capitalguidelines.

12. Verify that each on- and off-balance-sheetitem has been assigned to the appropriaterisk category in accordance with the risk-based capital guidelines. Close attentionshould be paid to the underlying obligor,collateral, and guarantees, and to assign-ment to a risk category based on the termsof a claim. The claim should be assigned tothe risk category appropriate to the highestrisk option available under the terms of thetransaction. Verify that the bank holdingcompany’s documentation supports the as-signment of preferential risk weights. Ifnecessary, recalculate the value of risk-weighted assets.

13. Verify that all off-balance-sheet items havebeen properly converted to credit-



equivalent amounts, based on the risk-basedcapital guidelines. Close attention shouldbe paid to the proper reporting of assetssold with recourse, financial and perfor-mance standby letters of credit, participa-tions of off-balance-sheet transactions, andcommitments.

4060.3.11.2 Verification of the Tier 1Leverage Ratio

1. Verify that the bank holding company hascorrectly calculated tier 1 capital in accor-dance with the definition of tier 1 capital, asset forth in the risk-based capital guidelines.

2. Verify that the bank holding company hasproperly calculated average total consoli-dated assets.

4060.3.11.3 Overall Assessment ofCapital Adequacy

1. For bank holding companies that do notmeet the minimum risk-based tier 1 lever-age capital standard, as required, or that areotherwise considered to lack sufficient capi-tal to support their activities, examine thecapitalization plans for achieving adequatelevels of capital. Determine whether theplans are acceptable to the appropriate Fed-eral Reserve Bank’s management. Reviewand comment on these plans and on anyprogress achieved in meeting therequirements.

2. The analysis of capital adequacy requiresan evaluation of the propriety and consis-tency of the bank holding company’s presentand planned level of capitalization in lightof existing conditions and future plans. Inthis regard, the examiner assigned to assess-ing capital adequacy should do the following:a. Using the latest Bank Holding Company

Performance Report (BHCPR), analyzeapplicable ratios involving capital funds,comparing these ratios with those of itspeer group and investigating trends orsignificant variations from peer-groupaverages.

b. With regard to the bank holding compa-ny’s financial condition, determine thatcapital is sufficient to compensate forany instabilities or deficiencies in theasset and liability mix and its quality.

c. Determine if the bank holding compa-ny’s consolidated earnings performanceenables it to fund its expansion adequately,to remain competitive in the market, andto replenish or increase its capital fundsas needed.

d. Analyze trends in the levels of debt ver-sus equity funding, including double le-verage, to determine the level of borrow-ing to fund equity, if any.

e. If the allowance for loan and lease lossesis determined to be inadequate, analyzethe impact of current and potential losseson the bank holding company’s capitalstructure.

f. Consider the impact of any managementdeficiencies on present and projectedcapital.

g. Determine if there are any assets or con-tingent accounts whose quality repre-sents an actual or potential serious weak-ening of capital.

h. Consider the potential impact of any pro-posed changes in controlling ownership(if approved) on the projected capitalposition.

i. Analyze assets that are consideredundervalued on the balance sheet andcarried at below-market values. The ex-cess of fair value over cost may repre-sent an additional cushion to the bankholding company.

j. Consider the cushion for absorbing lossesthat may be provided by any subordi-nated debt, trust preferred securities, otherrestricted core capital elements, orintermediate-term preferred stock notincluded in tier 2 capital because of the50 percent of tier 2 capital limitation, ornot included in capital for tier 1 leverageratio purposes.

k. Analyze any collateral and guaranteessupporting assets that may not be takeninto account for risk-based or tier 1 lever-age capital purposes, and consider thesecollateral and guarantees in the overallassessment of capital adequacy. Thisanalysis should include guarantees pro-vided through credit-derivative transac-tions (see section 4060.3.5.3.17) in whichthe credit exposure is assigned to the riskcategory of the obligor of the referenceasset or any collateral. For the latter,determine whether adequate capital andreserves are held against the exposuresto reference assets.

l. Evaluate the consolidated asset qualityof the bank holding company, and deter-



mine whether it needs to strengthen itscapital position, based on the following:• the severity of problem and classified

assets• investment or loan-portfolio concen-

trations• the adequacy of loan-loss reserves

m. Analyze the bank holding company’smanagement of interest-rate risk and useof hedging instruments. Determine if thebank holding company should strengthenits capital position, based on undue lev-els of risk at any structural level withinthe organization. Review hedging instru-ments for the use of interest-only strips(IOs) and principal-only strips (POs) thatmay raise concerns, and review manage-ment’s expertise in using hedginginstruments.

3. Review capital adjustments for goodwilland other intangible assets (such as coredeposit intangibles, favorable leaseholdrights, organization costs, purchased trust-servicing rights, purchased investment-management relationships, purchased home-equity rights, and merchant-servicing rights),that are required to be deducted from capi-tal. An analysis of intangible assets thatmay be included in capital must also beperformed using the following procedures:a. Verify the existence of, the evidence of

title to, and the accounting for intangibleassets. Review and assess both the bookvalues and the fair values assigned tointangible assets. Also verify the adequacyof the documentation evidencing the val-ues, the amortization methods, andassigned amortization periods. Whenassessing the quality of a banking orga-nization’s intangible assets for purposesof evaluating its overall capital position,consider—• the reliability and predictability of any

cash flows associated with the assetsand the degree of certainty that can beachieved in periodically determiningthe asset’s useful life and fair value,

• the existence of an active and liquidmarket for the assets, and

• the feasibility of selling the asset apartfrom the banking organization or fromthe bulk of its assets.

b. Verify that intangibles are being reducedin accordance with the amortizationmethod and that, if the carrying amountexceeds its fair value, the book value ofthe intangible asset is reduced accord-ingly or is written off.

c. Determine if a quarterly review of thebook and fair values and of the level andquality of all intangibles is performed.

d. Verify that goodwill and other nonquali-fying identifiable intangibles are deductedfrom tier 1 capital.

e. Determine if the amount of mortgage-servicing rights or purchased credit-cardrelationships was within the establishedlimitations on the amount that may beincluded in tier 1 capital.

f. Ascertain whether the asset values of theintangible assets were reassessed duringthe annual audit.

4. In light of the overall capital adequacyanalysis, and in accordance with the FederalReserve’s capital adequacy guidelines, de-termine if any appropriate supervisory ac-tion is warranted because of deficient levelsof capital in relation to inherent risks of thebank holding company organization.

5. Review the following in preparation for dis-cussion with appropriate management:a. all noted deficiencies regarding the capi-

tal accountsb. the adequacy of present and projected

capital6. Ascertain through minutes, reports, etc., or

through discussions with management, howthe bank holding company’s future businessand operational plans will affect its assetquality, capital position, and other areas ofits balance sheet.

7. Prepare comments for the inspection reportbased on the bank holding company’s capi-tal position, including any comments ondeficiencies that were observed.

8. Update the appropriate workpapers withany information that will facilitate futureinspections.



4060.3.12 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws 1 Regulations 2 Interpretations 3 Orders

Capital adequacyguidelines—BHCs:

Measures:Risk-basedLeverage MeasureSmall Bank HoldingCompany PolicyStatement—Policy State-ment on Assessment ofFinancial and ManagerialFactorsTier 1 leverageMarket-risk measure

225, appendix A225, appendix B225, appendix C

225, appendix D225, appendix E

3–19203–19404–868

3–19553–1960

Bank holding companyshould be a source offinancial and managerialstrength to itssubsidiaries

225.4(a) 1981 FRB 344

Policy statement on theresponsibility of BHCsto act as a source ofstrength to theirsubsidiary banks

4–878 1987 FRB 441

Board Legal Division StaffInterpretation—Trustpreferred securities that aremanditorily convertibleinto noncumulativeperpetual preferredsecurities(January 23, 2006)





Risk-based capitaltreatment for certainindemnified securities-lending arrangementsapplying a loan-equivalent methodologyusing a bank’s internalVaR model

August 15, 2006,May 14, 2003

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.

3. Federal Reserve Regulatory Service reference.



Consolidated Capital(Tier 1 Leverage Measure) Section 4060.4

WHAT’S NEW IN THIS SECTION

Effective January 2011, this section has beenrevised to include the Board’s adoption (effec-tive January 30, 2009) of an exemption from itsBHC and state member bank leverage capitalrules for asset-backed commercial paper pro-grams held by depository institutions and BHCsas a result of their participation in the Asset-Backed Commercial Paper Money Market MutualFund Lending Facility (AMLF), which the Fed-eral Reserve System adopted on September 19,2008. The AMLF enables depository institutionsand BHCs to borrow from the Federal ReserveBank, on a nonrecourse basis, if they use theproceeds of the loan to purchase certain types ofasset-backed commercial paper from money mar-ket mutual funds. (See 12 C.F.R. 225, appendixD; and 74 Fed. Reg. 6224, February 6, 2009.)

4060.4.1 CAPITAL ADEQUACYGUIDELINES FOR BANK HOLDINGCOMPANIES: TIER 1 LEVERAGEMEASURE

The tier 1 leverage measure is found in appen-dix D of Regulation Y (12 C.F.R. 225). OnAugust 2, 1990, the Board issued capital lever-age guidelines, effective September 10, 1990.The Board established the capital leverage ratioto be applied in conjunction with the risk-basedcapital guidelines. The leverage ratio is designedto complement the risk-based capital ratios whenthe overall capital adequacy of banking organi-zations is being determined. This section includesthe subsequent revisions to the capital leverageguidelines.

4060.4.1.1 Overview of the Tier 1Leverage Measure for Bank HoldingCompanies

The Board of Governors of the Federal ReserveSystem has adopted a minimum ratio of tier 1capital to total assets to assist in the assessmentof the capital adequacy of bank holding compa-nies (banking organizations).1 The principalobjective of this measure is to place a constrainton the maximum degree to which a bankingorganization can leverage its equity capital base.

It is intended to be used as a supplement to therisk-based capital measure.

As approved by the Board on February 16,2006 (effective March 30, 2006), the tier 1leverage guidelines apply on a consolidatedbasis to any bank holding company with con-solidated assets of $500 million or more. Thetier 1 leverage guidelines also apply on a con-solidated basis to any bank holding companywith consolidated assets of less than $500 mil-lion if the holding company (1) is engaged insignificant nonbanking activities either directlyor through a nonbank subsidiary, (2) conductssignificant off-balance-sheet activities (includ-ing securitization and asset management oradministration) either directly or through a non-bank subsidiary, or (3) has a material amount ofdebt or equity securities outstanding (other thantrust preferred securities) that are registered withthe Securities and Exchange Commission. TheFederal Reserve may apply the tier 1 leverageguidelines at its discretion to any bank holdingcompany, regardless of asset size, if such actionis warranted for supervisory purposes.

The tier 1 leverage guidelines are to be usedin the inspection and supervisory process aswell as in the analysis of applications actedupon by the Federal Reserve. The Board willreview the guidelines from time to time and willconsider the need for possible adjustments inlight of any significant changes in the economy,financial markets, and banking practices.

4060.4.1.2 Tier 1 Leverage Ratio forBank Holding Companies

The Board has established a minimum ratio oftier 1 capital to total assets of 4.0 percent forbank holding companies. However, for strongbank holding companies (rated composite 1under the RFI/C(D) rating system of bank hold-ing companies) and for bank holding companiesthat have implemented the Board’s risk-basedcapital measure for market risk as set forth inappendixes A and E of part 225 of Regulation Y,the minimum ratio of tier 1 capital to total assetsis 3.0 percent. Banking organizations with super-visory, financial, operational, or managerial weak-nesses, as well as organizations that are antici-pating or experiencing significant growth, areexpected to maintain capital ratios well above

1. Supervisory ratios that related capital to total assets forstate member banks are outlined in appendix B of RegulationY.


the minimum levels. Moreover, higher capitalratios may be required for any bank holdingcompany, if warranted by its particular circum-stances or risk profile. In all cases, bank holdingcompanies should hold capital commensuratewith the level and nature of the risks, includingthe volume and severity of problem loans, towhich they are exposed.

A banking organization’s tier 1 leverage ratiois calculated by dividing its tier 1 capital (thenumerator of the ratio) by its average total con-solidated assets (the denominator of the ratio).The ratio will also be calculated using period-end assets, whenever necessary, on a case-by-case basis. For the purpose of this leverageratio, the definition of tier 1 capital, as set forthin the risk-based capital guidelines in appendixA of Regulation Y, will be used. As a generalmatter, average total consolidated assets aredefined as the quarterly average total assets(defined net of the allowance for loan and leaselosses) reported on the banking organization’sConsolidated Financial Statements (FR Y-9CReport), less goodwill; amounts of mortgage-servicing assets, nonmortgage-servicing assets,and purchased credit-card relationships that, inthe aggregate, are in excess of 100 percent oftier 1 capital; amounts of nonmortgage-servicingassets and purchased credit-card relationshipsthat, in the aggregate, are in excess of 25 per-cent of tier 1 capital; amounts of credit-enhancing interest-only strips that are in excessof 25 percent of tier 1 capital; all other identifi-able intangible assets; any investments in sub-sidiaries or associated companies that the Fed-eral Reserve determines should be deductedfrom tier 1 capital; deferred tax assets that aredependent upon future taxable income, net of

their valuation allowance, in excess of the limi-tation set forth in section II.B.4 of appendix Aof Regulation Y;2 and the amount of the totaladjusted carrying value of nonfinancial equityinvestments that is subject to a deduction fromtier 1 capital.

Whenever appropriate, including when anorganization is undertaking expansion, seekingto engage in new activities, or otherwise facingunusual or abnormal risks, the Board will con-tinue to consider the level of an individual orga-nization’s tangible tier 1 leverage ratio (afterdeducting all intangibles) in making an overallassessment of capital adequacy. This is consis-tent with the Federal Reserve’s risk-based capi-tal guidelines and long-standing Federal Reservepolicy and practice with regard to leverageguidelines. Organizations experiencing growth,whether internally or by acquisition, are expectedto maintain strong capital positions substantiallyabove minimum supervisory levels, without sig-nificant reliance on intangible assets.

Notwithstanding anything in the tier 1 lever-age capital rule to the contrary, a BHC maydeduct from its average total consolidated assetsthe amount of any asset-backed commercialpaper (1) purchased by the BHC on or afterSeptember 19, 2008, from an SEC-registeredopen-end investment company that holds itselfout as a money market mutual fund under SECRule 2a-7 (17 CFR 270.2a-7) and (2) pledgedby the BHC to the Federal Reserve Bank tosecure financing from the Asset-Backed Com-mercial Paper Money Market Mutual FundLending Facility established by the Board onSeptember 19, 2008. See 12 C.F.R. 225, appen-dix D; and 74 Fed. Reg. 6224, February 6, 2009.

2. Deductions from tier 1 capital and other adjustments arediscussed more fully in section II.B. of appendix A of Regula-tion Y.

Leverage Measure 4060.4


Capital Adequacy(Advanced Approaches) Section 4060.5


This revised section references the June 3, 2011,‘‘Interagency Guidance on the Advanced Mea-surement Approaches for Operational Risk.’’The guidance clarifies certain implementationissues related to the advanced measurementapproaches for operational risk in the federalbanking agencies’ advanced capital adequacyframework. In addition, the section is revised toinclude a summary of the June 14, 2011, revi-sions to the advance approaches rules, whichestablish a required permanent capital floorequal to the minimum risk-based capital require-ments under the general risk-based capitalrules.

The Board adopted an advanced capital adequacyframework, effective April 1, 2008, that imple-ments, in the United States, the revised interna-tional capital framework (Basel II) developedby the Committee on Banking Supervision (See12 C.F.R. 225, appendix G or 72 Fed. Reg.69287). The rule provides a risk-based capitalframework that requires some bank holdingcompanies (BHCs) and permits other qualifyingBHCs1 to use an internal ratings-based approachto calculate credit-risk capital requirements andadvanced measurement approaches (AMA) inorder to calculate regulatory operational-riskcapital requirements. The rule also describes thequalifying criteria for BHCs required or seekingto operate under the framework. See also therevisions effective March 29, 2010, at 75 Fed.Reg. 4636.2

4060.5.1 AMA INTERAGENCYGUIDANCE FOR OPERATIONAL RISK

On June 3, 2011, the federal banking agencies(the agencies) issued Interagency Guidance onthe Advanced Measurement Approaches forOperational Risk to address and clarify imple-mentation issues related to the AMA in apply-ing the agencies’ advanced capital adequacy

framework. This guidance focuses on the com-bination and use of the required AMA dataelements—(1) internal operational loss eventdata; (2) external operational loss event data;(3) business environment and internal controlfactors; and (4) scenario analysis, which is dis-cussed in greater detail. Governance and valida-tion are also discussed since they ensure theintegrity of a bank’s AMA framework. (SeeSR-11-8 and its attachment.)

4060.5.2 ESTABLISHMENT OF ARISK-BASED CAPITAL FLOOR

Section 171(b)(2) of the Dodd-Frank Wall StreetReform and Consumer Protection Act (Dodd-Frank Act) requires the agencies to establishminimum leverage and risk-based capital require-ments on a consolidated basis for insured deposi-tory institutions, depository institution holdingcompanies,3 and nonbank financial companiessupervised by the Board. These capital require-ments cannot be less than the generally applica-ble capital requirements that apply to insureddepository institutions.4

On June 28, 2011, the agencies published afinal rule (effective July 28, 2011) that amendedthe advanced approaches rules with a permanentfloor equal to the minimum risk-based capitalrequirements under the general risk-based capi-tal rules. (See the Board’s press release and 76Fed. Reg. 37620, June 28, 2011.) Under theamended rule, banking organizations subject tothe advanced approaches rules are required to,each quarter, calculate and compare their mini-mum tier 1 and total risk-based capital ratios ascalculated under the general risk-based capitalrules with the same ratios as calculated under

1. The rule also applies to state member banks.2. The revisions address the Financial Accounting Stan-

dards Board’s adoption of Statements of Financial Account-ing Standards Nos. 166 (ASC topic 860, ‘‘Transfers andServicing’’) and 167 (ASC subtopic 810-10, ‘‘Consolidation—Overall’’). These accounting standards make substantivechanges to how banking organizations account for manyitems, including securitized assets, that had been previouslyexcluded from these organizations’ balance sheets.

3. Section 171 of the Dodd-Frank Act (Pub. L. 111-203,section 171, 124 Stat. 1376, 1435-38 (2010)) defines ″deposi-tory institution holding company″ to mean a bank holdingcompany or a savings and loan holding company (as thoseterms are defined in section 3 of the Federal Deposit Insur-ance Act) that is organized in the United States, including anybank or savings and loan holding company that is owned orcontrolled by a foreign organization, but does not include theforeign organization. (See section 171 of the Dodd-Frank Act,12 U.S.C. 5371.)

4. The ‘‘generally applicable’’ capital requirements arethose established by the federal banking agencies to apply toinsured depository institutions, regardless of total asset size orforeign exposure, under the prompt corrective action provi-sions of the Federal Deposit Insurance Act. See 12 U.S.C.5371(a).


the advanced approaches risk-based capital rules.They are to compare the lower of the two tier 1risk-based capital ratios and the lower of thetwo total capital ratios to the minimum tier 1ratio requirement and total capital ratio require-ment of the advanced approaches rules to deter-mine whether the minimum capital require-ments are met.5 The amendment prevents theminimum capital requirements for a bankingorganization that has adopted the advancedapproaches rule from declining below the mini-mum capital requirements that apply to insureddepository institutions.

BHCs that are subject to the advancedapproaches rule are to calculate their floor ratiosunder the general risk-based capital rules forstate member banks.6 When calculating theratios, a BHC may include in capital certaindebt or equity instruments that were issuedbefore May 19, 2010, as specified in section 171of the Dodd-Frank Act.7

4060.5.3 LAWS, REGULATIONS, INTERPRETATIONS, ORDERS


Capital Adequacy Guidelinesfor BHCs: Internal-Ratings-Based and Advanced Measure-ment Approaches

225 appendix G 3-2027

Capital Adequacy Guidelinesfor Banks: Internal-Ratings-Based and Advanced Measure-ment Approaches

208 appendix F 3-1993

BHC and Bank Risk-BasedCapital Floor

5371(Section171(b)(2),Dodd-Frank Act)

225 appendixG, and 208appendix F

Supervisory Review Processof Capital Adequacy (Pillar 2)Related to the Implementationof the Advanced ApproachesFinal Rule

3-1506.33

Interagency Statement on U.S.Implementation of Basel IIAdvanced Approaches Frame-work

3-1506.332

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.3. Federal Reserve Regulatory Service reference.

5. 12 C.F.R. 208, appendix F, section 3 and 12 C.F.R. 225,appendix G, section 3.

6. 12 C.F.R. 208, appendix A.7. See 12 U.S.C. 5371(b)(4). Generally, section 171 pro-

vides that capital instruments issued before May 19, 2010,that would have to be deducted under section 171 may bededucted from regulatory capital over a three-year phase-inperiod beginning in 2013. Section 171 also provides addi-tional exemptions and phase-in periods for particular institu-tions.

Advanced Approaches 4060.5


Consolidated Risk-Based Capital—Direct-Credit SubstitutesExtended to ABCP Programs Section 4060.8

The Federal Reserve Board and the other fed-eral banking agencies (the Agencies)1 amendedtheir risk-based capital standards on November29, 2001, to adopt a new capital framework forbanking organizations (includes bank holdingcompanies) engaged in securitization activities(the Securitization Capital Rule).2 In March2005, the agencies issued interagency guidancethat clarifies how banking organizations are touse internal ratings that they assign to assetpools purchased by their asset-backed commer-cial paper (ABCP) programs in order to appro-priately risk weight any direct-credit substitutes(for example, guarantees) extended to such pro-grams. For bank holding company inspectionpurposes, the interagency guidance has beenreformatted for examiner use as inspectionobjectives, inspection procedures, and an inter-nal control questionnaire.

The guidance sets forth an analytical frame-work for assessing the broad risk characteristicsof direct-credit substitutes3 that a banking orga-nization provides to an ABCP program it spon-sors. The guidance provides specific informa-tion on evaluating direct-credit substitutes issuedin the form of program-wide credit enhance-ments, as well as an approach to determine therisk-based capital charge for these enhance-ments. (See SR-05-6 and its attachment. Also,see sections 2080.1 on short-term funding withcommercial-paper issuance and 2128.03 pertain-ing to credit-supported and asset-backed com-mercial paper.)

The Securitization Capital Rule permits bank-ing organizations with qualifying internal risk-rating systems to use those systems to apply theinternal-ratings approach to their unrated direct-credit substitutes extended to ABCP programs4

that they sponsor by mapping internal risk rat-ings to external rating equivalents. These exter-nal credit rating equivalents are organized into

three ratings categories: investment-grade creditrisk, high non-investment-grade (BB+ throughBB-) credit risk, and low non-investment-grade(below BB-) credit risk. These rating categoriescan then be used to determine whether a direct-credit substitute provided to an ABCP programshould be (1) assigned to a risk weight of100 percent or 200 percent or (2) subject to the‘‘gross-up’’ treatment, as summarized in thetable below.5 (See this section’s appendix A fora more detailed description of ABCP programs.)

As the table on the following page indicates,the minimum risk weight available under theinternal risk-ratings approach is 100 percent,regardless of the internal rating.6 Conversely,positions rated below BB- receive the gross-uptreatment. That is, the banking organizationholding the position must maintain capital againstthe amount of the position plus all more seniorpositions.7 Application of gross-up treatment, inmany cases, will result in a full dollar-for-dollarcapital charge (the equivalent of a 1,250 percentrisk weight) on direct-credit substitutes that fallinto the low non-investment-grade category. Inaddition, the risk-based capital requirementapplied to a direct-credit substitute is subject tothe low-level exposure rule. Under the rule, theamount of required risk-based capital would belimited to the lower of a full dollar-for-dollarcapital charge against the direct-credit substituteor the effective risk-based capital charge (forexample, 8 percent) for the entire amount ofassets in the ABCP program.8

The use of internal risk ratings under theSecuritization Capital Rule is limited to deter-mining the risk-based capital charge for unrateddirect-credit substitutes that banking organiza-

1. The Office of the Comptroller of the Currency, theFederal Deposit Insurance Corporation, and the Office ofThrift Supervision.

2. See 66 Fed. Reg. 59,614 (November 29, 2001). See also12 C.F.R. 225, appendix A, Section III.B.3.

3. Direct-credit substitute means an arrangement in whicha banking organization assumes, in form or in substance,credit risk associated with an on- or off-balance-sheet creditexposure that it did not previously own (that is, a third-partyasset) and the risk it assumes exceeds the pro rata share of itsinterest in the third-party asset. If the banking organizationhas no claim on the third-party asset, then the organization’sassumption of any credit risk with respect to the third-partyasset is a direct-credit substitute.

4. ABCP programs include multiseller ABCP conduits,credit arbitrage ABCP conduits, and structured investmentvehicles.

5. The rating designations (for example, ‘‘BBB-’’ and‘‘BB+’’) used in the table are illustrative only and do notindicate any preference for, or endorsement of, any particularrating designation system.

6. Exposures externally rated by a nationally recognizedstatistical rating organization (NRSRO) above BBB+ are eli-gible for lower risk weights (that is, 20 percent for AAA andAA, 50 percent for A).

7. Gross-up treatment means that a position is combinedwith all more senior positions in the transaction. The resultingamount is then risk-weighted based on the obligor or, ifrelevant, the guarantor or the nature of the collateral.

8. The low-level exposure rule provides that the dollaramount of risk-based capital required for a recourse obligationor direct-credit substitute should not exceed the maximumdollar amount for which a banking organization is contractu-ally liable. (See 12 C.F.R 225, appendix A, section III.B.3.g.i.)


Internal Risk-RatingEquivalent Ratings Category Rick Weighting

BBB- or better Investment grade 100%

BB+ to BB- High non-investmentgrade

200%

Below BB- Low non-investmentgrade

Gross-up treatment

tions provide to ABCP programs. Thus, bankingorganization may not use the internal-ratingsapproach to derive the risk-based capital require-ment forunrateddirect-credit substitutesextendedto other transactions. Approved use of the inter-nal rating-based approach for ABCP programsunder the Securitization Capital Rule will haveno bearing on the overall appropriateness of abanking organization’s internal risk-rating sys-tem for other purposes.

Most rated commercial paper issued out of anABCP program is supported by program-widecredit enhancement, which is a direct-credit sub-stitute. Often the sponsoring banking organiza-tion provides, in whole or in part, program-widecredit enhancement to the ABCP program.Program-wide credit enhancement may take anumber of different forms, including an irrevo-cable loan facility, a standby letter of credit, afinancial guarantee, or a subordinated debt.

The interagency guidance also discusses theweakest-link approach. This approach is usedfor calculating the risk-based capital require-ment and assumes that the risk of the program-wide credit enhancement is directly dependenton the quality (that is, internal rating) of theriskiest transaction(s) within the ABCP pro-gram. (See step 9 of the inspection proceduresin section 4060.8.4.11.) More specifically, theweakest-link concept presupposes the probabil-ity that the program-wide credit enhancementthat will be drawn is equal to the probability ofdefault of the transaction(s) with the weakesttransaction risk rating.

A process is provided that is designed to aidin determining the regulatory capital treatmentfor program-wide credit enhancements, pro-vided to an ABCP program. The key underlyingprinciples are as follows:

1. The determination of the credit quality of theprogram-wide credit enhancement shall bebased on the risk of draw and subsequentloss, which depends directly on the quality of

the credit-enhanced assets funded throughthe ABCP program.

2. An estimate of the risk of draw for theprogram-wide credit enhancement is derivedfrom the quality (rating) of the riskiest cred-it(s) within the ABCP program, which isoften indicated by the internal rating a bank-ing organization assigns to a transaction’spool-specific liquidity facility. Other creditrisks (for example, seller/servicer risk) to theprogram-wide credit enhancement may alsobe considered.

3. The weakest-link approach assigns risk-based capital against the program-wide creditenhancement in rank order of the internalratings starting with the lowest-rated posi-tions supported by the program-wide creditenhancement. Therefore, if all of the posi-tions supported by the program-wide creditenhancement are internally rated investmentgrade, the banking organization would riskweight the notional amount of the program-wide credit enhancement at 100 percent andthere would be no need to proceed further.However, for positions supported by theprogram-wide credit enhancement that arenon-investment grade, banking organizationscan use the formula-driven weakest-linkapproach illustrated in step 9 of the inspec-tion procedures to generate the appropriateamount of risk-based capital to be assessedagainst an unrated position.

4060.8.1 Assessment Of Internal RatingSystems

The guidance is organized in the form of adecision tree that (1) provides an outline of thekey decisions that examiners and sponsoringbanking organizations should consider whenreviewing internal risk-rating systems for ABCPprograms and (2) provides supervisors withmore-specific information on how to assess theadequacy of these systems. Many of the qualitative and quantitative factors used to evaluate

Supervisory Guidance—Direct-Credit Substitutes Extended to ABCP Programs 4060.8


risk in this guidance are comparable with ratingagency criteria (for example, criteria from S&P,Moody’s, and Fitch) because the ABCP pro-gram sponsors generally use the rating method-ologies of nationally recognized statistical rat-ing organizations (NRSROs) when assessing thecredit quality of their risk exposures to ABCPprograms. The guidance has two primary goals:

• provide information to banking organizationsto ensure the accuracy and consistency of theratings assigned to transactions in an ABCPprogram

• assist supervisors in assessing the adequacy ofa banking organization’s internal risk-ratingsystem based on the nine key criteria set forthin the Securitization Capital Rule9

4060.8.2 Inspection Objectives

Unless otherwise specified, examiners shouldweigh the importance and significance of theobjectives being assessed when he or she deter-mines a final conclusion.

4060.8.2.1 Internal Risk-Rating System

1. To determine if the banking organization hasa robust internal risk-rating system.

2. To determine if the banking organizationgenerally has sound risk-management prac-tices and principles.

4060.8.2.2 Internal Risk-Rating Systemfor ABCP Securitization Exposures

1. To determine the extent to which the bankintegrates its ABCP internal risk-rating pro-cess with its credit-risk managementframework.

2. To qualitatively assess the suitability of thebank’s risk-rating process relative to the trans-actions and type of assets securitized.

3. To assess the adequacy of the credit-approvalprocess.

4060.8.2.3 Internally Rated Exposures

1. To determine whether the banking organiza-tion applies its internal risk-rating system toliquidity facilities and credit enhancementsextended to ABCP programs.

2. To determine whether the assigned internalratings incorporate all of the risks associatedwith rated exposures extended to ABCPprograms.

4060.8.2.4 Monitoring of ABCPPrograms by Rating Agencies

1. To confirm whether the commercial paperissued by the ABCP programs is rated by oneor more NRSROs and further supplementedwith other due diligence, including internalratings.

2. To verify that NRSROs, internal ratings, andother due diligence information are used tomonitor the ABCP programs to ensure main-tenance of minimum standards for the respec-tive ABCP program’s rating.

4060.8.2.5 Underwriting Standards andManagement Oversight

1. To assess the quality and robustness of theunderwriting process.

4060.8.2.6 Internal Rating Consistencywith Ratings Issued by the RatingAgencies

1. To confirm that whenever ABCP programtransactions are externally rated, internal rat-ings are consistent with, or more conserva-tive than, those issued by NRSROs.

4060.8.2.7 First-Loss Position forProgram-Wide Credit Enhancement

1. To determine the rank order, if possible, ofthe risk assumed by the various direct-creditsubstitutes and liquidity facilities in the ABCPprogram by determining the order in whichvarious exposures would absorb losses.

2. To determine if third-party investors provideprogram-wide credit enhancement to theABCP conduit.

3. To determine if the spread that third-partyinvestors or the banking organization chargefor taking program-wide credit-enhancementrisk generally is within the market’sinvestment-grade pricing range.

9. 12 C.F.R. 208 and 225, appendix A, III.B.3.f.i.



4060.8.2.8 Concentrations ofNon-Investment Grade Seller/Servicers

1. To determine if the sponsoring banking orga-nization is exposed to an inordinate amountof seller/servicer risk.

4060.8.2.9 Underlying Assets of theABCP Program Structured toInvestment-Grade Risk

1. To obtain the internal rating for the program-wide credit enhancement to determine thebankingorganization’sassessmentof thecreditquality of the risk exposure.

2. To rank order the underlying transactions inthe ABCP program based on internal riskratings to determine the notional amount oftransactions falling in each of the three rat-ings categories: investment grade (BBB- orbetter), high non-investment grade (BB+ toBB-), and low non-investment grade (belowBB-).

3. To determine a risk-based capital require-ment for the program-wide credit enhance-ment.

4060.8.3 DECISION TREE

This decision tree is intended to assist examin-ers in determining the adequacy of the internalrating systems used for rating direct-credit sub-stitutes extended to ABCP programs. If examin-ers consider a banking organization’s internalrating system adequate, then the institution mayuse the internal ratings assigned to calculate therisk-based capital charge for unrated direct-credit substitutes, including program-wide creditenhancements. The determination process canessentially be broken down into individual stepsthat start by answering broad fundamental riskquestions and end with examining more-detailedABCP program-specific characteristics.

The first six steps (1–6) of the process focuson evaluating the banking organization’s risk-rating system, while the final three steps (7–9)are used to determine the amount of risk-basedcapital to be assessed against program-widecredit enhancements.


Examiners should be mindful that evaluatingthe adequacy of internal risk-rating systems gen-erally depends on both subjective judgmentsand objective information generated in each stepof the process. When performing the inspectionprocedures, the examiner may determine thatcertain observed weaknesses in meeting specificsupervisory expectations may not necessarily besevere enough to conclude that the internal risk-rating system is inadequate. In some cases, com-pensating strengths in components of the risk-rating system may offset observed weaknesses.However, examiners should take such weak-nesses into consideration in formulating theiroverall conclusion and consider them whendeveloping recommendations to improve theinternal risk-rating process. Failure to meet theregulatory requirements and follow the supervi-sory guidance typically is an indication of unsafeand unsound banking practices in the risk man-agement of ABCP programs. Where failures areobserved, examiners should conclude that use ofthe internal-ratings approach for exposures toABCP programs is inappropriate for purposes ofthe respective provisions of the risk-based capi-tal rule.

While this guidance has been designed toaddress common industry underwriting and risk-management practices, it may not sufficientlyaddress all circumstances. For unique cases notadequately addressed by the guidance, examin-ers should review the specific facts and circum-stances with the responsible Reserve Bank man-agement in conjunction with the Board’s BankingSupervision and Regulation staff before render-ing a final conclusion.

4060.8.4.1 Organizing the InspectionProcess

When organizing the inspection, examinersshould note if the banking organization operatesmultiple ABCP conduits. In some cases, a bank-ing organization may manage individual ABCPconduits out of different legal entities or lines ofbusiness, and each conduit may focus on differ-ent business strategies.

1. Before initiating the inspection process,determine—a. the number of ABCP conduits sponsored

by the banking organization,b. which ABCP conduits have direct-credit

substitutes provided by the banking orga-nization, and



Assessment of Internal Risk-Rating System Assessment of Program-wide Credity Enhancement

Begin

AcceptableRisk-Rating

System?

EstablishedRating System

for ABCPExposure?

RelevantExposuresInternally

Rated

ExposuresMonitored by

RatingAgencies?

SufficientUnderwritingStandards &Oversight?

Internal &External

Ratings areConsistent?

Use of Internal Risk-Rating System is

Approved

Use of InternalRisk-Rating

System ShouldNot be Approved

Exposure Isin the First

LossPosition?

Is Seller/Service

Risk High?

Are AllUnderlyingExposuresInvestment

Grade?

DetermineRisk-Based CapitalRequirement Using

Weakest-LinkFormula

Risk-weightProgram-wide

CreditEnhancement

at 100%

Program-wideCredit

May RequireGross-UpTreatment

Step 1

Step 2

Step 3

Step 4

Step 5

Step 6

Step 7

Step 8

Step 9

Yes

Yes

Yes

Yes

Yes

Yes

No

No

No

No

No

No

No

No

No

Yes

Yes

Yes



c. from what areas within the organizationthese activities are conducted.

2. When multiple ABCP conduits exist, assesswhether the bank applies the internal risk-rating system consistently to each programwith identical policies, procedures, and con-trols.

3. If the banking organization operates ABCPprogram activities out of different legal enti-ties or lines of business, or if the applicationof an internal rating system varies from pro-gram to program, evaluate the adequacy ofeach unique application.

4. Consider limiting any Federal Reserveapproval of the use of internal ratings tothose programs that have been inspected anddetermined to meet the requirements out-lined in this guidance.

Banking organizations may have estab-lished ABCP lines of business from whichthey coordinate client relationships, transac-tion origination activities, funding activities,and ABCP conduit management. An inspec-tion of such ‘‘ front office’’ operations canprovide important insight into the uniquecharacteristics of the banking organization’sABCP program. Examiners should focus theinspection’s review on the areas of the orga-nization where credit decisions and credit-risk management are housed and where over-sight of the internal risk-rating system ismaintained.

5. Consider the factors listed below while con-ducting the banking organization’s inspec-tion. When any of these factors are observed,perform a more thorough review of its inter-nal controls, risk management, and potentialweaknesses before approving the bankingorganization’s internal risk-rating system.

Although observation of a single factormay not be compelling enough for withhold-ing approval, the examiner’s observation ofone or more of these factors should result inthe adoption of a more conservative bias asthe inspection procedures are performed. If acombination of the risk factors identifiedbelow are observed during the inspectionprocess, the examiner may determine that theinternal risk-rating system should not berelied upon for assessing the risk-based capi-tal treatment for direct-credit substitutes pro-vided to ABCP programs.

The following factors should be considered:

1. The sponsoring banking organization has ashort track record and is inexperienced inthe management of an ABCP program.

2. The transaction-specific credit enhancementis solely in the form of excess spread.

3. Significantly higher ABCP program costsexist for program-wide credit enhancementas compared with the internal and externalbenchmarks for investment-grade risk.

4. The sponsoring banking organization failsto maintain historical ratings migration dataor the migration data of required credit-enhancement levels.

5. There is an excessive number of transactionrating migrations (both internal and exter-nal) or excessive collateral calls necessaryto enhance transaction-level credit enhance-ment to maintain an internal risk rating.

6. The transactional due diligence, approval,or execution documentation are poorlyprepared.

7. A significant number of problem transac-tions are taken out of the ABCP programthrough liquidity draws.

8. There is no independent review or oversightof the internal rating system or the assignedtransaction ratings. A review conducted byinternal parties within the sponsoring/administrating banking organization maystill be considered independent so long asthe business unit conducting the reviewdoes not report to the unit that is respon-sible for the ABCP program’s transactions.

9. The transaction underwriting and risk-management functions of an ABCP pro-gram sponsor/administrator, other than rou-tine outside audit reviews, are delegated tounaffiliated third parties.

10. The ABCP conduit commercial paper is notrated on an ongoing basis by the ratingagencies.

If examiners observe either of the followingtwo factors, the banking organization shouldnot receive Federal Reserve approval to usethe internal-ratings approach. (See theinspection procedures for more detail.)

11. The banking organization does not have, inthe examiner’s view, an established oracceptable internal risk-rating system toassess the credit quality of its exposures toits ABCP programs.

12. Relevant direct-credit substitutes or liquid-ity facilities are not internally risk rated.



4060.8.4.2 Step One—AcceptableInternal Risk-Rating Systems

1. Determine if the banking organization is ableto satisfactorily demonstrate how its internalrisk-rating system corresponds to the ratingagencies’ standards used as the frameworkfor complying with the securitization require-ments in the risk-based capital rule. Ascer-tain whether the credit ratings map to therisk-weight categories in the ratings-basedapproach so they can be applied to internalratings.

2. If a separate supervisory team has conducteda detailed evaluation of the robustness andeffectiveness of the banking organization’soverall internal ratings system, use the inspec-tion work to assess the application of internalratings specific to the banking organization’sABCP programs. Consider reducing the pro-cedures to a quick review of the previousinspection’s findings.

3. If there was no previous evaluation of thebanking organization’s risk-rating system orif documentation of the evaluation findings isunavailable, perform a full review of theorganization’s risk-rating system.

4. Ascertain whether the banking organization’soverall risk-rating process is generally con-sistent with the fundamental elements ofsound risk management and with the ratingassumptions and methodologies of the ratingagencies.a. Determine if the internal ratings are incor-

porated into the credit-approval processand are considered in the pricing of credit.

b. Find out if the internal lending and expo-sure limits are linked to internal ratings.

5. Verify that the internal risk-rating system forABCP programs contains the following ninecriteria:a. The internal credit-risk system is an inte-

gral part of the banking organization’srisk-management system, which explicitlyincorporates the full range of risks arisingfrom its participation in securitizationactivities.

b. Internal credit ratings are linked to mea-surable outcomes, such as the probabilitythat the position will experience any loss,the position’s expected loss given default,and the degree of variance in losses givendefault on that position.

c. The banking organization’s internal credit-risk system separately considers (1) therisk associated with the underlying loansor borrowers and (2) the risk associated

with the structure of a particular securiti-zation transaction.

d. The banking organization’s internal credit-risk system identifies gradations of riskamong ‘‘pass’’ assets and other risk posi-tions.

e. The banking organization has clear, explicitcriteria, including subjective factors, thatare used to classify assets into each inter-nal risk grade.

f. The banking organization has indepen-dent credit-risk management or loan reviewpersonnel assigning or reviewing the credit-risk ratings.

g. The banking organization has an internalaudit procedure that periodically verifiesthat internal risk ratings are assigned inaccordance with the organization’s estab-lished criteria.

h. The banking organization (1) monitors theperformance of the internal credit-risk rat-ings assigned to nonrated, nontraded direct-credit substitutes over time to determinethe appropriateness of the initial credit-risk rating assignment and (2) adjusts indi-vidual credit-risk ratings, or the overallinternal credit-risk ratings system, asneeded.

i. The internal credit-risk system makescredit-risk rating assumptions that are con-sistent with, or more conservative than,the credit-risk rating assumptions and meth-odologies of the NRSROs.

If all of the above supervisory guidance is notadhered to, the use of internal ratings under therisk-based capital rule should not be approved.

4060.8.4.3 Step Two—Use of anEstablished Internal Risk-Rating SystemTailored to ABCP SecuritizationExposures

1. Determine if an internal rating system existsthat assesses exposures (for example, liquid-ity facilities) provided to ABCP programs.

2. Ascertain whether there is evidence that theABCP internal risk-rating process is an inte-grated component of the enterprise-widecredit-risk management process. Thisincludes—• risk ratings that are a fundamental port-

folio management tool and• internal ratings that are considered in credit

and pricing decisions.



3. Evaluate whether the management team andstaff are experienced with the types of assetsand facilities internally rated for the ABCPprogram.

4. Determine if there is meaningful differentia-tion of risk. Verify that—a. separate ratings are applied to borrowers

and facilities that separately consider therisk associated with the underlying loansand borrowers, as well as the risk associ-ated with the specific positions in a securi-tization transaction, and

b. a distinct set of rating criteria exists foreach grade. The banking organizationshould have classified its assets into eachrisk grade using clear, explicit criteria,even for subjective factors.

5. Verify that the risk-ratings criteria for ABCPtransactions are documented with specificmethodologies detailed for different assettypes.

6. Find out if the banking organization includesa transaction summary10 as part of its credit-approval process. The transaction summaryshould include a description of the follow-ing: transaction structure, seller/servicer’srisk profile,11 relevant underwriting criteria,asset eligibility criteria, collection process,asset characteristics, dilution and historicalloss rates, and trigger and termination events.(See appendix B for a more detailed descrip-tion of the above transaction summarycategories.)

7. Before reaching a final assessment, consultwith the other examiners who have con-ducted reviews of the banking organization’sother risk-rating systems, including the cor-porate risk-rating system.

4060.8.4.4 Step Three—RelevantInternally Rated Exposures

1. Verify that the banking organization inter-nally rates all relevant exposures to ABCPprograms, such as pool-specific liquidityfacilities.

2. Ascertain if the banking organization supple-

ments its internal ratings with external rat-ings provided by NRSROs and with otherdue diligence to support the credit quality ofits decisions to invest.

4060.8.4.5 Step Four—ABCP ProgramMonitored by Rating Agencies

1. Verify that the commercial paper issued bythe ABCP program has been rated in thesecond-highest short-termratingcategory (A2,P2, or F2) or higher.

2. Confirm that there is evidence that ratingagencies are actively monitoring the structur-ing methodologies and credit quality of thetransactions purchased by the ABCP conduit.• Prescreened Programs: Confirm that

NRSROs are prescreening each new trans-action placed in the ABCP program.

• Post-Review Programs: Find out if ABCPprogram transactions are monitored by theNRSROs via monthly or quarterly reports.Determine if the banking organization ispromptly forwarding information on newtransactions and transactions experiencingdeterioration to the NRSROs (for example,through monthly reports).

4060.8.4.6 Step Five—SufficientUnderwriting Standards and ManagementOversight

1. Determine if the banking organization hasinternal policies addressing underwritingstandards that are applicable to ABCPprograms.

2. ForeachABCPtransaction,ascertainwhetherthe institution applies the following factorsin its underwriting process:

General Portfolio Characteristics:

• an understanding of the operations of thebusinesses that originates the assets beingsecuritized

• a review of the general terms offered tothe customer

• a determination of the quality of assetsand from which legal entity assets areoriginated

• a determination of customer, industry, andgeographic concentrations

• an understanding of the recent trends inthe business that may affect any historicalinformation about the assets

10. The transaction summary may not be specifically iden-tified, but its elements would be part of the credit-approvalprocess.

11. The seller/servicer risk profile may be developed by agroup within the banking organization other than the ABCPprogram group and incorporated into the transaction summaryby reference.



Legal Structure of the Transaction

• A general structuring of transactions as‘‘ bankruptcy remote’’ via a legal ‘‘ truesale’’ of assets rather than as securedloans. (This reduces the likelihood that acreditor of the seller can successfullychallenge the security interest in the assetpool in the event of seller insolvency.)Determine if the banking organizationmaintains copies of true sale opinions inthe facility file or as a part of the facility’slegal documents.

• An appropriate management level in thecredit-approval hierarchy that is respon-sible for reviewing transactions that donot have a bankruptcy-remote ‘‘ true sale’’structure.

• Uniform commercial code (UCC) filingsand searches on securitized assets. (UCCfilings are often needed to ensure thatasset transfers resist third-party attack[that is, are ‘‘ perfected’’ ]). UCC searchesoften ensure that asset transfers are notsubject to a higher-priority security inter-est (that is, that the banking organiza-tion’s interests are ‘‘fi rst priority’’ ). Ifsuch filings and searches have not beenperformed, examiners should make fur-ther inquiry. There may be a satisfactoryreason for not using the UCC filing system.

• Transactions that include a contractualrepresentation or a legal opinion ensuringthat there are no provisions, such as nega-tive pledges or limitations on the sale ofassets, that would prohibit the securitiza-tion transaction.

Transaction-Specific CreditEnhancements

Transaction-specific credit enhancementtakes a variety of forms depending upon theasset type. For instance, credit enhancementrelating to trade receivables may consist ofthe following types of reserves:• loss reserve—reserves related to obligor

default risk• dilution reserve—reserves related to non-

cash reductions of balances• servicing reserve—reserves related to fees

for servicing and trustees

The loss and dilution reserves typicallyaccount for most of the reserves. Reservesmay take a number of different forms, includ-ing recourse to the seller (if the seller is of

high credit quality), funded cash reserves,and overcollateralization.

3. Determine if the credit-approval chain care-fully scrutinizes transactions in whichreserves are in the form of recourse to aseller with weak credit quality.

4. Ascertain if the banking organization’s cri-teria for structuring the appropriate reservelevels are generally consistent with ratingagency criteria for a particular asset class.

5. Review and consider the relevant ratingagency methodology when evaluatingreserves for any particular transaction.

Eligibility Criteria

Eligibility criteria are structured into securi-tization transactions to restrict (or limit) theinclusion of certain categories of receiv-ables as appropriate to the particular trans-action. Examples of such restricted catego-ries may include:• delinquent receivables (based on a stated

aging policy, such as 30 days past due)• receivables of bankrupt obligors• foreign receivables• affiliate receivables• receivables of obligors with delinquent

balances above a certain amount• bill and hold receivables• unearned receivables• non-U.S.-dollar-denominated receivables• receivables subject to offset• disputed receivables• receivables with a payment date beyond a

specified time horizon• post-petition receivables

The above list is illustrative and should not beconsidered comprehensive.

6. Conduct further analysis when there is alack of any specific eligibility criteria (forexample, those listed above) that warrants afurther determination as to whether the bank-ing organization has taken appropriate mea-sures to alleviate any particular risk arisingfrom the lack of a specific feature.

Concentrations

7. Analyze obligor, industry, and geographicconcentrations.



8. Ascertain if the appropriate concentrationlimits have been established within transac-tion documents, often within the eligibilitycriteria.

Trigger Events and TerminationEvents

The inclusion of trigger and terminationevents plays a critical role in securitizationstructures. It is standard practice to havetrigger or termination events related to theperformance of the assets and, dependingupon the asset type, to the seller/servicer.Trigger events are comparable to perfor-mance covenants in corporate debt and pro-vide a lender with the ability to accelerate atransaction, when appropriate. In addition,such triggers create incentives that allowthe seller and the banking organization tonegotiate higher levels of credit enhance-ment or add further restrictions to eligibilitycriteria when the receivables’ performancemetrics indicate deterioration beyond anestablished trigger level. In a similar way,termination events are established to beginthe early termination of the transaction whenthe receivable performance deteriorates.Typical trigger events are based on one ormore of the following performance metrics:• asset coverage ratio• delinquencies• losses• dilution

Termination events may include these samemetrics but may also include the bank-ruptcy, insolvency, change of control of theseller/servicer, or the failure of the servicerto perform its responsibilities in full.

Due-Diligence Reviews

9. Ascertain if the banking organization con-ducts due-diligence reviews prior to closingits ABCP transactions. Determine if suchreviews were tailored to the asset type beingsecuritized and the availability of auditinformation. A frequent public asset-backedsecurities (ABS) issuer that accesses con-duit funding or a seller that has strong creditquality may be eligible for a post-closingreview, provided recent audit results are

obtained. If not, it should be subject topre-closing review. For example, a reviewtailored to trade receivables should focus onmost of the following:• Confirming the receivable information

(balances, sales, dilution, write-offs, etc.)previously provided by the seller, withthe seller’s books and records over atleast two reporting periods. Such a reviewmight be performed by a third-party audi-tor.

• Sampling invoices against the seller’s agedtrial balance to test the accuracy of agings.

• Sampling past invoices to determine ulti-mate resolution (paid, credited, written-off, etc.)

• Sampling credits against their respectiveinvoices to test the dilution horizon.

• Sampling write-offs to determine timingand reasons for write-offs.

• Reviewing significant customer concen-trations, including delinquent balances.

• Determining systems capability with re-spect to transaction reporting and compli-ance.

• Reviewing credit files for completenessand conformity with credit policies.

• Reviewing collection systems and deter-mining the portion of cash going intosegregated lockboxes or bank accounts.

• Reviewing internal and external auditorreports to the extent that such documentsare available for review.

• Noting any unusual items that may com-plicate the receivable transaction.

10. Determine if ABCP transactions are reviewedat least annually.a. Confirm that the banking organization

verifies the accuracy of the monthly ser-vicer’s transaction reports, including com-pliance with sale and servicing require-ments.

b. Determine if an increased review fre-quency is needed for any issues raised inprior reviews, transactions with higher-risk sellers, and transactions serviced outof multiple locations.

Cash Management

11. Assess a seller’s cash-management prac-tices. Commingling of cash collections cancause a loss in the perfected security inter-est of cash flows, particularly in the eventof seller insolvency.



a. Determine if, preferably, the bankingorganization requires that all paymentcollections flow into a single, segregatedlockbox account to minimize cash-commingling risk.

b. For trade receivables, find out if thebanking organization requires that thecash collections be reinvested in newreceivables to eliminate cash-commingling risk.

12. For higher-risk sellers, determine if thebanking organization—a. establishes an account in the name of the

trust or special-purpose vehicle (SPV)into which collections could be swept ona daily basis or

b. requires that settlement be done weekly,or daily, ensuring that there are alwayssufficient receivables to cover invest-ments and reserves.

Reporting

When underwriting a portfolio, it is important todecide what information should be required inthe monthly report.

13. Determine if quarterly, or more frequent,reports for a trade receivable transactioninclude the following:

• beginning balances• sales• cash collections• dilution or credits• write-offs• ending balances• delinquencies by aging bucket• ineligible assets• total eligible receivables• excess concentrations• net receivable balance• conduit investment• conduit’s purchased interest• calculation of receivable performance ter-

mination events• top 10 obligor concentrations

14. Ascertain if the banking organization hasestablished other special reporting require-ments based on the particular pool of receiv-ables being securitized.

Receivable Systems

15. Because of the significant reporting require-ments in a securitization transaction, verify

that the banking organization assesses—a. the seller’s receivable systems to deter-

mine if they will be sufficient to providethe required information and

b. the seller’s data backup and disaster recov-ery systems.

Quality of Seller/Servicer

16. Verify that the banking organization per-forms an assessment of the creditworthinessof the seller that is conducted from therelationship side.

17. Determine if the banking organization con-ducts a more focused assessment on theseller/servicer’s management team that isinvolved in the day-to-day receivables op-eration (that is, credit, accounting, sales,servicing, etc.).

Performance Monitoring

18. Find out whether the banking organizationhas developed and uses a performance-monitoring plan that periodically monitorsthe portfolio.a. Determine if there is appropriate moni-

toring that allows the designated admin-istrator to review relevant pool perfor-mance to evaluate the level of availablefunding under the asset-quality tests inthe related liquidity facility.

b. Determine if the banking organizationtests these conditions when the sellerreports performance data relating to anunderlying transaction (usually monthlyor quarterly).

Typically, a liquidity facility has a fundingcondition based on asset quality whereby theliquidity provider will not advance against anyreceivable that is considered defaulted. A per-formance monitoring plan may entail monitor-ing the run rate of defaulted assets so that thepotential losses do not exceed the loss protection.

Post-Closing Monitoring

19. Determine if the banking organization’ sunderwriting team assists the portfolio man-



agement team in developing all of the itemsthat should be tracked on the transaction,including the development of a spreadsheetthat ensures the capture and calculation ofthe appropriate information.

Underwriting Exceptions

20. If a banking organization approves a trans-action after it has agreed to an exceptionfrom standard underwriting procedures, findout if the banking organization closely moni-tors and periodically evaluates the policyexception.

Banking organizations may utilize variations ofthe above-listed underwriting standards.

21. Evaluate the robustness of the underwritingprocess and determine if it is comparable tostated rating agency criteria. If weaknessesin the underwriting process are found, deter-mine if there are any existing compensatingstrengths and any other relevant factors tobe considered when determining its overallassessment.

22. If the examiner determines that the supervi-sory expectations generally are not met, heor she should not recommend to the appro-priate Reserve Bank supervisory officialthat the use of internal ratings, under theSecuritization Capital Rule, be approved.

4060.8.4.7 Step 6—Consistency ofInternal Ratings of ABCP Program’sExposures with Ratings Issued by theRating Agencies

1. Find out if any underlying transactions fundedthrough ABCP programs are externally ratedby one or more rating agencies.

2. Confirm if the mapping of the internal rat-ings assigned to these transactions are consis-tent with, or more conservative than, thoseissued by NRSROs.

3. When the underlying transactions are splitrated by two or more rating agencies, deter-mine if the internal ratings are consistentwith the most conservative (lowest) externalrating.

4. Ascertain that the above exceptions do notrepresent more than a small fraction of thetotal number of transactions that are exter-

nally rated. If such exceptions exist, deter-mine if there are generally an equal or largerpercentage of externally rated transactionswhere internal ratings are more conservativethan the external rating.

If supervisory expectations are not met, then theinternal risk-rating system may not be appropri-ately mapped to the external ratings of anNRSRO. In such cases, further review of theadequacy of the banking organization’s risk-rating system must be undertaken before the useof internal ratings under the Securitization Capi-tal Rule can be approved.

4060.8.4.8 Determine Adequacy ofInternal Ratings Systems

If, through the inspection process, the internalrisk-rating system utilized for ABCP exposuresis found to be inadequate, then the bankingorganization may not apply the internal risk-ratings approach to ABCP exposures for risk-based capital purposes until the organization hasremedied the deficiencies. Banking organiza-tions that have adequate risk-rating systems thatare well integrated into risk-management pro-cesses applied to ABCP programs may beapproved for use of the internal risk-ratingsapproach.

Once a banking organization’s internal ratingsystem is deemed adequate, the organizationmay use its internal ratings to slot ABCP expo-sures, including pool-specific liquidity facilities,into the appropriate rating category (investmentgrade, high non-investment grade, and low non-investment grade), and apply the correspondingrisk weights. However, due to the unique natureof program-wide credit enhancements, furtherguidance is provided in steps 7 through 9 to helpestablish the appropriate capital requirement.

4060.8.4.9 Step 7—Determination ofWhether the Program-Wide CreditEnhancements Are in the First-LossPosition

1. Determine if the ABCP program documenta-tion confirms that the program-wide creditenhancement is not the first-loss creditenhancement for any transaction in the ABCPprogram and is, at worst, in the second-economic-loss position, usually aftertransaction-specific credit enhancements.



2. Verify if the spread charged for the program-wide credit enhancement is the spread rangeof investment-grade exposures of a termsecuritization. Consider other factors thatmay influence pricing, such as availability ofthe credit enhancement.

3. Find out if the financial guarantee providerssuch as AMBAC, FSA, and FGIC participatein a program-wide credit-enhancement trancheeither on a senior position or on a pari-passuposition with other providers. The risk takenby these institutions is usually investmentgrade.a. Compare the price of the guarantee charged

by these institutions to the pricing rangesof non-investment-grade and investment-grade exposures of the sponsoring bank-ing organization, the loan syndication mar-ket, and the bond market. This may be agauge as to whether a third party consid-ers the risk as investment grade or non-investment grade.

b. Reference such sources for reviewing mar-ket pricing as Loan Pricing Corporation’sGold Sheets and Bloomberg (for bondspreads). A range or average pricing forboth investment-grade and non-investment-grade syndicated loans can befound in the Gold Sheets.

c. Similarly, review also the price the sponsor/banking organization is charging for itsrespective portion of the program-widecredit enhancement.

4060.8.4.10 Step 8—Risk Levels Posedby Concentrations of Non-InvestmentGrade Seller/Servicers

1. Confirm that the banking organization’s inter-nal risk-rating systems properly account forthe existence of seller/servicer risk.

An asset originator (that is, the entity sell-ing the assets to the ABCP program) typi-cally is the servicer and essentially acts asthe portfolio manager for the ABCP pro-gram’s investment. The servicer identifiesreceivables eligible for the ABCP programand manages to preserve the investment onbehalf of the banking organization sponsor-ing the ABCP program. As previously dis-cussed, servicer risk can be partially miti-gated through seller allocation and structuringpayments to protect against commingling ofcash.

2. Determine if the banking organization hasspecific transaction structures in place tomitigate servicer risk.

3. Ascertain if exposure to an excessive numberof non-investment-grade servicers adverselyaffects the overall credit quality of the ABCPprogram, exposing the conduit to the higherbankruptcy risk that inherently exists withnon-investment-grade obligors.

4. Use the benchmarks below to assess thebanking organization’s potential exposuresto non-investment-grade seller/servicer con-centrations in its ABCP program. Dependingon the circumstances, concentrations exceed-ing these benchmarks may be considered asunsafe and unsound banking practices.a. Determine, based on the grid below, the

percentage of securitized assets from non-investment-grade servicers to the total out-standings of an ABCP program that has alower-weighted average rating of all thetransactions in the program. For example,if the ABCP program transactions have aweighted average rating equivalent to‘‘ BBB,’’ no more than 30 percent of thetotal outstandings of the ABCP programshould be represented by non-investment-grade seller/servicers. However, an ABCPprogram that has transactions structuredto a higher-weighted average rating, suchas a single ‘‘A’’ equivalent, could have upto 60 percent of the outstandings origi-nated by non-investment-grade seller/servicers without causing undue concerns.

WeightedAverage Rating

Equivalentof Transactions

ServicerPercentage

BelowInvestment Grade

AA 90%

AA– 80%

A+ 70%

A 60%

A– 50%

BBB+ 40%

BBB 30%

BBB– 20%

BB+ 10



4060.8.4.11 Step 9—The Portion ofUnderlying Assets of the ABCP ProgramStructured to Investment-Grade Risk

1. Determine the appropriate amount of risk-based capital that should be assessed againstthe program-wide credit enhancement basedon the internal risk ratings of the underlyingtransactions in the ABCP program.a. If all underlying transactions are rated

investment grade, risk weight the notionalamount of the program-wide creditenhancement at 100 percent.

b. If one or more of the underlying transac-tions are internally rated below invest-ment grade, then consider using the fol-lowing weakest-link approach to calculatean appropriate risk-based capital chargefor the program-wide credit enhancement.

The approach takes into account theinternal ratings assigned to each under-lying transaction in an ABCP program.These transaction-level ratings are typi-cally based on the internal assessment of atransaction’s pool-specific liquidity facil-ity and the likelihood of it being drawn.The transactions are rank ordered by theirinternal rating and then bucketed into thethree ratings categories: investment grade,high non-investment grade, and low non-investment grade. The program-wide creditenhancement is then assigned an appropri-ate risk weight based upon the notionalamount of transactions in each ratingsbucket.

Under the weakest-link approach, therisk of loss corresponds first to the weak-est transactions to which the program-wide credit enhancement is exposed. Bank-ing organizations should begin with thelowest bucket (low non-investment grade)and then move to the next highest ratingbucket until the entire amount of theprogram-wide credit enhancement has beenassigned. The assigned risk weights andtheir associated capital charges are thenaggregated. However, if the risk-basedcapital charge for the non-investment-grade asset pools equals or exceeds the8 percent charge against the entire amountof assets in the ABCP program, then therisk-based capital charge is limited to the8 percent against the program’s assets.

Banking organizations that sponsorABCP programs may have other method-

ologies to quantify risk across multipleexposures. For example, collateralized debtobligation (CDO) ratings methodologytakes into account both the probability ofloss on each underlying transaction andcorrelations between the underlying trans-actions. This and other methods may gen-erate capital requirements equal to or moreconservative than those arrived at via theweakest-link method. Regardless of theapproach used, well-managed institutionsshould be able to support their risk-basedcapital calculations.



Example 1

ABCP program size (PROG) = $1,000 MMProgram-Wide Credit Enhancement (PWC) =

$100 MMTotal Amount of Investment Grade (IG) =

$995 MMTotal Amount of High Non-Investment Grade

(NI1) = $4 MMTotal Amount of Low Non-Investment Grade

(NI2) = $1 MM

Weakest Link

RBC = IF [(0.16 * 4) + 1] ≥ (0.08 * 1,000), thenRBC = (0.08 * 1,000) = (0.64 + 1) =$1.64 MM < $80 MM

Else

RBC = [(0.08 * (100 - (4 + 1))] + (0.16 * 4) +(1) = (7.60) + (0.64) + (1) = $ 9.24 MM

Example 2



$940 MM

Total Amount of High Non-Investment Grade(NI1) = $50 MM

Total Amount of Low Non-Investment Grade(NI2) = $10 MM

Weakest Link

RBC = IF [(0.16 * 50) + 10] ≥ (0.08 * 1,000),then RBC = (0.08 * 1,000) = (8 + 10) =$18 MM < $80 MM

Else

RBC = [(0.08 * (150 - (50+10))] + (0.16 * 50) +(10) = (7.20) + (8.00) + (10) = $25.2MM

Example 3



$0 MMTotal Amount of High Non-Investment Grade

(NI1) = $500 MMTotal Amount of Low Non-Investment Grade

(NI2) = $500 MM

Weakest-Link Formula

IF [(0.16 * NI1) + NI2**] ≥ (0.08 * PROG), THEN RBC = (0.08 x PROG)Else

Capital = [0.08 * (PWC - (NI1 + NI2))] + * NI1] + [NI2**]

**Although the term NI2 should reflect a gross-up charge under the Securitization CapitalRule (that is, an effective 1,250 percent risk weight), for the sake of simplicity a dollar-for-dollar charge is used here. The reason for using dollar-for-dollar is based on the assumptionthat the NI2 portion of an ABCP pool is typically smaller than the gross-up charge would beon the entire pool. Thus, instead of grossing-up the NI2 portion and then applying thelow-level exposure rule (which, if NI2 is less than the gross-up charge, will yield a dollar-for-dollar capital charge), the term just assumes the dollar-for-dollar amount.

In any event, the risk-based capital charge on the program-wide credit enhancement willnever exceed the maximum contractual amount of that program-wide credit enhancement(that is, the low-level exposure rule).

RBC = Risk-based capitalPROG = Notional amount of all underlying exposures in the programPWC = Notional amount of program-wide credit enhancementIG = Notional amount of exposures rated BBB- or betterNI1 = Notional amount of exposures rated between BB+ and BB-NI2 = Notional amount of exposures rated below BB-



Weakest Link

RBC = IF [(0.16 * 500) + 500] ≥ (0.08 * 1,000),THEN RBC = (0.08 * 1,000) = (80 + 500) =

$580 MM > $80 MM

Therefore,

RBC = (0.08 * 1,000) = $80 MM

Because $580 MM is greater than the $80 MMcapital charge that would apply if all of theassets supported by the PWC were on-balance-sheet, the maximum risk-based capital charge is$80 MM.

When the sum of all non-investment-gradeasset pools (that is, NI1 + NI2) exceeds theamount of the program-wide credit enhance-ment, the weakest-link formula would result intoo much risk-based capital being assessed. Ifthis situation arises, banking organizations shouldfirst apply the gross-up treatment to the NI2asset pools and then assess 16 percent risk-based capital against an amount of the NI1 assetpools, that when added with the NI2 asset pools,would equal the amount of the program-widecredit enhancement. For example, if the program-wide credit enhancement is $100 on underlyingtransactions totaling $1,000, and the underlyingexposures are $10 low non-investment grade,$100 high non-investment grade, and $890 invest-ment grade, then risk weighting will be based onthe gross-up approach for $10 and assigning theremaining $90 to the 200 percent risk-weightcategory, as shown below:

$10 * 1,250* 8% = $10.00$90 * 200 * 8% = $14.40

Total $24.40

Finally, the aggregate capital charge, $24.40in this case, is then compared to the capitalcharge imposed on the underlying transactionsif all the program assets were on the bankingorganization’s balance sheet (that is, 0.08 *$1,000 = $80); the lower amount prevails. Thisestablishes the capital charge for the program-wide credit enhancement.

4060.8.5 INTERNAL CONTROLQUESTIONNAIRE

1. Does the banking organization have an accept-able risk-rating system?

2. Does the banking organization use an estab-lished internal risk-rating system tailored toABCP securitization exposures?

3. Are the relevant exposures internally rated?4. Are the ABCP programs monitored by rating

agencies?5. Are there sufficient underwriting standards

and management oversight?6. Are internal ratings of ABCP program expo-

sures consistent with ratings issued by therating agencies?

7. Is program-wide credit enhancement in thefirst-loss position?

8. Do concentrations of non-investment-gradeseller/services pose an excessive level ofrisk?

9. What portion of the underlying assets of theABCP programs is structured to investment-grade risk?

4060.8.6 APPENDIX A—OVERVIEWOF ABCP PROGRAMS

ABCP programs provide a means for corpora-tions to obtain relatively low-cost funding byselling or securitizing pools of homogenousassets (for example, trade receivables) to special-purpose entities (SPEs/ABCP programs). TheABCP program raises funds for purchase ofthese assets by issuing commercial paper intothe marketplace. The commercial paper inves-tors are protected by structural enhancementsprovided by the seller (for example, overcollat-eralization, spread accounts, early amortizationtriggers, etc.) and by credit enhancements (forexample, subordinated loans or guarantees) pro-vided by bank sponsors of the ABCP programand by other third parties. In addition, liquidityfacilities are also present to ensure the rapid andorderly repayment of commercial paper shouldcash-flow difficulties emerge. ABCP programsare nominally capitalized SPEs that issue com-mercial paper. A sponsoring bank establishesthe ABCP program but usually does not own theconduit’s equity, which is often held by unaffili-ated third-party management companies thatspecialize in owning such entities, and are struc-tured to be bankruptcy remote.

Typical Structure

ABCP programs are funding vehicles that banksand other intermediaries establish to provide analternative source of funding to themselves ortheir customers. In contrast to term securitiza-tions, which tend to be amortizing, ABCP pro-



grams are ongoing entities that usually issuenew commercial paper to repay maturing com-mercial paper. The majority of ABCP programsin the capital markets are established and man-aged by major international commercial banks.As with traditional commercial paper, which hasa maximum maturity of 270 days, ABCP isshort-term debt that may either pay interest orbe issued at a discount.

Types of ABCP Programs

Multiseller programs generally provide workingcapital financing by purchasing or advancingagainst receivables generated by multiple corpo-rate clients of the sponsoring bank. These pro-grams are generally well diversified across bothsellers and asset types.

Single-seller programs are generally establishedto fund one or more types of assets originatedby a single seller. The lack of diversification isgenerally compensated for by increased program-wide credit enhancement.

Loan-backed programs fund direct loans to cor-porate customers of the ABCP program’s spon-soring bank. These loans are generally closelymanaged by the bank and have a variety ofcovenants designed to reduce credit risk.

Securities-arbitrage programs invest in securi-ties that generally are rated AA- or higher. Theygenerally have no additional credit enhancementat the seller/transaction level because the securi-ties are highly rated. These programs are typi-cally well diversified across security types. The

arbitrage is mainly due to the difference betweenthe yield on the securities and the funding costof the commercial paper.

Structured-investment vehicles (SIVs) are a formof a securities arbitrage program. These ABCPprograms invest in securities typically rated AA-or higher. SIVs operate on a market-value basissimilar to market value CDOs in that they mustmaintain a dynamic overcollateralization ratiodetermined by analysis of the potential pricevolatility on securities held in the portfolio.SIVs are monitored daily, and must meet strictliquidity, capitalization, leverage, and concen-tration guidelines established by the ratingagencies.

Key Parties and Roles

Key parties for an ABCP program include thefollowing:

• program management/administrators• credit enhancement providers• liquidity facility providers• seller/servicers• commercial paper investors

Program Management

The sponsor of an ABCP program initiates thecreation of the program but typically does notown the equity of the ABCP program, which is

Pool-Specific CreditEnhancement

Asset Pools

Commercial-Paper Investors

ABCP Conduit

Program-WideCredit Enhancement

Pool-SpecificLiquidity Facility

Program Manager/Sponsor

Program-WideLiquidity Facility



provided by unaffiliated third-party investors.Despite not owning the equity of the ABCPprogram, sponsors usually retain a financialstake in the program by providing credit enhance-ment, liquidity support, or both, and they playan active role in managing the program. Spon-sors typically earn fees—such as credit-enhancement, liquidity-facility, and program-management fees—for services provided to theirABCP programs.

Typically, an ABCP program makes arrange-ments with various agents/servicers to conductthe administration and daily operation of theABCP program. This includes such activities aspurchasing and selling assets, maintaining oper-ating accounts, and monitoring the ongoing per-formance of each transaction. The sponsor isalso actively engaged in the management of theABCP program, including underwriting the assetspurchased by the ABCP program and the type/level of credit enhancements provided to theABCP program.

Credit-Enhancement Providers

The sponsoring bank typically provides pool-specific and program-wide liquidity facilities,and program-wide credit enhancements, all ofwhich are usually unrated (pool-specific creditenhancement, such as over-collateralization, isprovided by the seller of the assets). Theseenhancements are fundamental for obtaininghigh investment-grade ratings on the commer-cial paper issued to the market by the ABCPprogram. Seller-provided credit enhancementmay exist in various forms, and is generallysized based on the type and credit quality of theunderlying assets as well as the quality andfinancial strength of seller/servicers. Higher-quality assets may only need partial support toachieve a satisfactory rating for the commercialpaper. Lower-quality assets may need full support.

Liquidity-Facility Providers

The sponsoring bank, and, in some cases, unaf-filiated third parties, provide pool-specific orprogram-wide liquidity facilities. These backupliquidity facilities assure the timely repaymentof commercial paper under certain conditions,such as financial market disruptions or if cash-flow timing mismatches occur, but generally notunder conditions associated with the credit dete-

rioration of the underlying assets or the seller/servicer to the extent that such deterioration isbeyond what is permitted under the relatedasset-quality test.

Commercial-Paper Investors

Commercial-paper investors are typically insti-tutional investors such as pension funds, moneymarket mutual funds, bank trust departments,foreign banks, and investment companies. Com-mercial paper maturities range from 1 day to270 days, but most frequently are issued for 30days or less. There is a limited secondary mar-ket for commercial paper since issuers can closelymatch the maturity of the paper to the investors’needs. Commercial paper investors are gener-ally repaid from the reissuance of new commer-cial paper or from cash flows stemming fromthe underlying asset pools purchased by theprogram. In addition, to ensure timely repay-ment in the event that new commercial papercannot be issued or if anticipated cash flowsfrom the underlying assets do not occur, ABCPprograms utilize backup liquidity facilities. Pool-specific and program-wide credit enhancementsalso protect commercial-paper investors fromdeterioration of the underlying asset pools.

The Loss Waterfall for the exposures of a typi-cal ABCP program generally has four legallydistinct layers. However, most legal documentsdo not specify which form of credit or liquidityenhancement is in a priority position after pool-specific credit enhancement is exhausted due todefaults. For example, after becoming aware ofweakness in the seller/servicer or in asset perfor-mance, an ABCP program sponsor may pur-chase assets out of the conduit using pool-specific liquidity. Liquidity agreements must besubject to a valid asset-quality test that preventsthe purchase of defaulted or highly delinquentassets. Liquidity facilities that are not limited bysuch an asset-quality test are to be viewed ascredit enhancement and are subject to the risk-based capital requirements applicable to direct-credit substitutes.

Pool-Specific Credit Enhancement—The formand size of credit enhancement for each particu-lar asset pool is dependent upon the nature andquality of the asset pool and the seller/servicer’srisk profile. In determining the level of creditenhancement, consideration is given to the seller/servicer’s financial strength, quality as a ser-vicer, obligor concentrations, and obligor creditquality, as well as the historic performance of



the asset pool. Credit enhancement is generallysized to cover a multiple level of historicallosses and dilution for the particular asset pool.Pool-specific credit enhancement can take sev-eral forms, including overcollateralization, cashreserves, seller/servicer guarantees (for onlyhighly rated seller/servicers), and subordination.Credit enhancement can either be dynamic (thatis, increases as the asset pool’s performancedeteriorates) or static (that is, fixed percentage).Pool-specific credit enhancement is generallyprovided by the seller/servicer (or carved out ofthe asset pool in the case of overcollateraliza-tion), but may be provided by other third parties.

The ABCP program sponsor or administratorwill generally set strict eligibility requirementsfor the receivables to be included in the pur-chased asset pool. For example, receivable eligi-bility requirements will establish minimum creditratings or credit scores for the obligors and themaximum number of days the receivable can bepast due.

Usually the purchased asset pools are struc-tured (credit enhanced) to achieve a credit qual-ity equivalent of investment grade (that is, BBB

or higher). The sponsoring bank will typicallyutilize established rating agency criteria andstructuring methodologies to achieve the desiredinternal rating level. In certain instances, suchas when ABCP programs purchase ABS, thepool-specific credit enhancement is already builtinto the purchased ABS and is reflected in thesecurity’s credit rating. The internal rating onthe pool-specific liquidity facility provided tosupport the purchased asset pool will reflect theinclusion of the pool-specific credit enhance-ment and other structuring protections.

Program-Wide Credit Enhancement—The sec-ond level of contractual credit protection is theprogram-wide credit enhancement, which maytake the form of an irrevocable loan facility, astandby letter of credit, a surety bond from amonoline insurer, or an issuance of subordinateddebt. Program-wide credit enhancement pro-tects commercial-paper investors if one or moreof the underlying transactions exhaust the pool-

Program-Wide

Liquidity

Pool-SpecificLiquidity

Program-Wide CreditEnhancement

Pool-Specific CreditEnhancement

Last Loss

First Loss

The Loss Waterfall



specific credit enhancement and other structuralprotections. The sponsoring bank or third partyguarantors are providers of this type of creditprotection. The program-wide credit enhance-ment is generally sized by the rating agencies tocover the potential of multiple defaults in theunderlying portfolio of transactions within ABCPconduits, and takes into account concentrationrisk among seller/servicers and industry sectors.

Pool-Specific Liquidity—Pool-specific liquidityfacilities are an important structural feature inABCP programs because they ensure investorsof timely payments on the issued commercialpaper by smoothing timing differences in thepayment of interest and principal on the pooledassets and ensuring payments in the event ofmarket disruptions. The types of liquidity facili-ties may differ among various ABCP programsand may even differ among asset pools pur-chased by a single ABCP program. For instance,liquidity facilities may be structured either inthe form of (1) an asset-purchase agreement,which provides liquidity to the ABCP programby purchasing nondefaulted assets from a spe-cific asset pool, or (2) a loan to the ABCPprogram, which is repaid solely by the cashflows from the underlying assets.12 Some olderABCP programs may have both pool-specificliquidity and program-wide liquidity coverage,while more-recent ABCP programs tend to uti-lize only pool-specific facilities. Typically, theseller-provided credit enhancement continues toprovide credit protection on an asset pool that ispurchased by a liquidity banking organizationso that the institution is protected against creditlosses that may arise due to subsequent deterio-ration of the pool.

Pool-specific liquidity, when drawn prior tothe ABCP program’s credit enhancements, issubject to the credit risk of the underlying assetpool. However, the liquidity facility does notprovide direct-credit enhancement to the com-mercial paper holders. Thus, the pool-specificliquidity facility generally is in an economicsecond-loss position after the seller-providedcredit enhancements and prior to the program-wide credit enhancement even when the legaldocuments state that the program-wide creditenhancement would absorb losses prior to the

pool-specific liquidity facilities. This is becausethe sponsor of the ABCP program would mostlikely manage the asset pools in such a way thatdeteriorating portfolios or assets would be put tothe liquidity banking organizations prior to anydefaults that would require a draw against theprogram-wide credit enhancement.13 While theliquidity banking organization is exposed to thecredit risk of the underlying asset pool, the riskis mitigated by the seller-provided credit enhance-ment and the asset-quality test.14 At the timethat the asset pool is put to the liquidity bankingorganization, the facility is usually fully drawnbecause the entire amount of the pool that quali-fies under the asset-quality test is purchased bythe banking organization. However, with respectto revolving transactions (such as credit cardsecuritizations) it is possible to average lessthan 100 percent of the commitment.

Program-Wide Liquidity—The senior-most posi-tion in the waterfall, program-wide liquidity, isprovided in an amount sufficient to support thatportion of the face amount of all the commercialpaper that is issued by the ABCP program thatis necessary to achieve the desired external rat-ing on the issued paper. In some cases, a liquid-ity bank that extends a direct liquidity loan to anABCP program may be able to access theprogram-wide credit enhancement to cover losseswhile funding the underlying asset pool.

4060.8.7 Appendix B—Credit-ApprovalMemorandum

The credit-approval memorandum typicallyshould include a description of the following:

1. Transaction Structure. In the beginning ofthe credit-approval memorandum, the spon-soring banking organization will outline thestructure of the transaction, which includes adiscussion of the asset type that would bepurchased by the ABCP program and theliquidity facilities (and possibly creditenhancements) that the sponsoring banking

12. Direct-liquidity loans to an ABCP program may betermed a commissioning agreement (most likely in a foreignbank program) and may share in the security interest in theunderlying assets when commercial paper ceases to be issueddue to deterioration of the asset pool.

13. In fact, according to the contractual provisions of someconduits, a certain level of draws on the program-wide creditenhancement is a condition for unwinding the conduit pro-gram, which means that this enhancement is never meant tobe used.

14. An asset-quality test or liquidity-funding formula deter-mines how much funding the liquidity banking organizationwill extend to the conduit based on the quality of the under-lying asset pool at the time of the draw. Typically, liquiditybanking organizations will fund against the conduit’s pur-chase price of the asset pool less the amount of defaultedassets in the pool.



organization is providing to the transaction.Generally, the sponsoring banking organiza-tion indicates the type and dollar volume ofthe liquidity facility that the institution isseeking to extend to the transaction, such asa $250 million short-term pool-specific liquid-ity facility, as well as the type of first-losscredit enhancement that is provided by theseller, such as overcollateralization. The assetpurchase by the ABCP conduit from theseller may be described as a two-step salethat first involves the sale of the assets (forexample, trade receivables) to an SPV on atrue-sale basis and then involves the sale ofthe assets by the SPV to the ABCP program.Other features of the structure should bedescribed, such as if the transaction is arevolving transaction with a one-year revolv-ing period.

In addition, the sponsoring bankingorganization typically obtains true sale andnonconsolidation opinions from the seller’sexternal legal counsel. The opinions shouldidentify the various participants in thetransaction—including the seller, servicer,and trustee—as appropriate. For instance, theseller of the assets is identified as the partythat would act as the servicer of the assets andwho is responsible for all the representa-tions and warranties associated with the soldassets.

2. Asset Seller’s Risk Profile. The assessment ofthe asset seller’s risk profile should considerits past and expected future financial perfor-mance, its current market position andexpected competitiveness going forward, aswell as its current debt ratings. For example,the sponsor may review the seller’s leverage,generation of cash flow, and interest cover-age ratios, and whether the seller is at leastinvestment grade. Also, the sponsoring bank-ing organization may attempt to anticipatethe seller’s ability to continue to performunder more adverse economic conditions. Inaddition, some sponsors may take other infor-mation into account, such as KMV ratings, toconfirm their internal view of the seller’sfinancial strength.

3. Underwriting Standards. A discussion of theseller’s current and historical underwritingstandards should be included in the transac-tion summary. For certain types of assets,such as auto loans, the sponsoring bankingorganization should consider the seller’s useof credit scoring and the minimum accept-able loan score that may be included in theasset pool. In addition, the credit approvalmemorandum may include an indication of

whether the underwriting standards haveremained relatively constant over time orwhether there has been a recent tightening orloosening.

4. Asset-Eligibility Criteria. In order to reducethe ABCP program’s exposure to higher-risk assets, an ABCP program generallyspecifies minimum asset eligibility criteria.This is particularly true for revolvingtransactions since the seller’s underwritingstandards may change so that the credit qual-ity of the assets purchased by the ABCPprogram can be adversely affected. Whileeligibility criteria may be designed forspecific transactions, there is a common setof criteria that are generally applicable,including those that exclude the purchase ofdefaulted assets or assets past due more thana specified number of days appropriate forthe specific transaction; limiting excessconcentration to an individual obligor;excluding the purchase of assets of obligorsthat are affiliates of the seller; or limiting thetenor of the assets to be purchased. Othercriteria also may require that the obligor be aresident of a certain country and that theasset is payable in a particular currency. Allof these criteria are intended to reduce thecredit risk inherent in the asset pool to bepurchased by the ABCP program. A strongset of eligibility criteria may reduce thenecessary credit enhancement provided bythe selling organization.

5. Collection Process. Often, if the seller/servicer has a senior unsecured debt rating ofat least BBB-, cash collections may be com-mingled with the seller/servicer’s cash untilsuch time as periodic payments are requiredto be made to the ABCP program. Documen-tation should provide an ABCP program withthe ability to take steps to control the cashflows when necessary, and include covenantsto redirect cash flows or cause the segrega-tion of funds into a bankruptcy-remote SPEupon the occurrence of certain triggers. Adescription of how checks, cash, and debitpayments are to be handled may be dis-cussed. For instance, documentation maystate that payments by check must be pro-cessed on the same day they are received bythe lockbox and that after the checks clear,the cash is deposited in a segregated collec-tion account at the sponsoring banking orga-nization. Also, the documents may describethe types of eligible investments in which the



cash may be invested, which are usuallyhighly rated, liquid investments such as gov-ernment securities and A1/P1+ commercialpaper.

6. Assets’ Characteristics. Usually, a transac-tion summary will provide a description ofthe assets that will be sold into the programand outline relevant pool statistics. Forinstance, there likely will be a discussion ofthe weighted average loan balance, weightedaverage credit score (if appropriate), weightedaverage original term, and weighted averagecoupon, as well as the ranges of each charac-teristic. In addition, the portfolio may besegmented by the sponsoring banking organi-zation’s internal-rating grades to give anindication of each segment’s average creditquality (as evidenced by an average creditscore) and share of the portfolio’s balances.Many times, the sponsor will identify con-centrations to individual obligors or geo-graphic areas, such as states.

7. Dilution. Certain asset types (for example,trade receivables) purchased by ABCP pro-grams may be subject to dilution, which isthe evaporation of the asset due to customerreturns of sold goods, warranty claims, dis-putes between the seller and its customers, aswell as other factors. For instance, the sellerof the assets to the ABCP program maypermit its customers to return goods, at whichpoint the receivables cease to exist. The like-lihood of this risk varies by asset type and istypically addressed in the transaction sum-mary. For instance, in sales of credit cardreceivables to an ABCP program, the risk ofdilution is small due to the underlying diver-sity of the obligors and merchants. While thepool-specific liquidity facilities often absorbdilution initially, the sellergenerally is requiredto establish a reserve to cover a multiple ofexpected dilution, which is based on histori-cal information. The adequacy of the dilutionreserve is reviewed at the inception of thetransaction and may or may not be incorpo-rated in the seller-provided credit enhance-ment that is provided on the pool of assetssold to the ABCP program.

8. Historical Performance. As a prelude to siz-ing the pool-specific credit enhancement pro-vided by the seller, the sponsoring bankingorganization will review the historical perfor-mance of the seller’s portfolio, includingconsideration of losses (that is, loss rate andloss severity), delinquencies, dilutions, and

the turnover rate.15 An indication of thedirection of losses and delinquencies, and thereasons behind any increase or decrease areoften articulated. For instance, an increase inlosses may reflect losses due to specificindustry-related problems and general eco-nomic downturns. Typically, the rating agen-cies prefer at least three years’ worth ofhistorical information on the performance ofthe seller’s asset pools, although the ratingagencies periodically permit transactions tohave less information. As a result, a sponsor-ing banking organization likely will requirethe same degree of information as a ratingagency whether this is a full three-year his-tory or a lesser amount, as appropriate, whenassessing the credit quality of its liquidityand credit-enhancement exposures.

9. Termination Events. ABCP programs usuallyincorporate commercial paper stop-issuanceor wind-down triggers to mitigate losses thatmay result from a deteriorating asset pool orsome event that may hinder the ABCP pro-grams’ ability to repay maturing commercialpaper. Such triggers may be established ateither the pool level or program-wide level,and may, if hit, require the ABCP program toimmediately stop issuing commercial paperto fund (1) new purchases from a particularseller or (2) any new purchases regardless ofthe seller. In addition, such triggers mayrequire the ABCP program to begin liquidat-ing specific asset pools or its entire portfolio.

The rating agencies consider these struc-tural safeguards, which are designed to pro-tect the ABCP program from credit deteriora-tion over time, in determining the rating onan ABCP program’s commercial paper. Inmany ABCP programs, there may be a provi-sion that requires the program to wind downif a certain percentage of the program-widecredit enhancement has been used to coverlosses (for example, 25 percent).

Examples of pool-specific triggers includethe insolvency or bankruptcy of the seller/servicer; downgrade of the seller’s credit rat-ing below a specific rating grade; or deterio-ration of the asset pool to the point wherecharge-offs, delinquencies, or dilution risesabove predetermined levels. Program-widetriggers may include (1) the ABCP pro-gram’s failure to repay maturing commercial

15. The turnover rate of a receivables portfolio is a mea-sure of how fast the outstanding assets are paid off. Forexample, if a seller had sales of $4,000 in the prior year andan average portfolio balance of $1,000, then the turnover rateof the portfolio is four.



paper or (2) when draws reduce the program-wide credit enhancement below a statedthreshold.



Consolidated Capital Planning Processes (Payment of Dividends, Stock Redemptions,and Stock Repurchases at Bank Holding Companies) Section 4060.9

This supervisory guidance provides direction tosupervisory staff and bank holding companies(BHCs) on the declaration and payment ofdividends,1 capital redemptions, and capitalrepurchases by BHCs in the context of theircapital planning processes. The guidance estab-lishes Federal Reserve expectations that a BHCwill inform and consult with Federal Reservesupervisory staff sufficiently in advance of(1) declaring and paying a dividend that couldraise safety-and-soundness concerns (e.g.,declaring and paying a dividend that exceedsearnings for the period for which the dividendis being paid); (2) redeeming or repurchasingregulatory capital instruments when the BHCis experiencing financial weaknesses; or(3) redeeming or repurchasing common stockor perpetual preferred stock that would result ina net reduction as of the end of a quarter in theamount of such equity instruments outstandingcompared with the beginning of the quarter inwhich the redemption or repurchase occurred.

While these principles (as stated in SR-09-4)are applicable to all BHCs, they are especiallyrelevant for BHCs that are experiencing finan-cial difficulties and/or receiving public funds.Supervisory staff should document their analy-ses of the issues discussed below and includesuch documentation in workpapers related tosupervisory activities.2 Such documentation notonly provides a basis for constructive dialoguewith an organization’s management, but alsosupports current and future supervisory actionsor initiatives. Reserve Bank and Board staffwill develop a supervisory response in allinstances where concerns regarding depletion

of capital arise for a BHC that is experiencingfinancial difficulties. 3

4060.9.1 REVIEW OF CAPITALADEQUACY MANAGEMENT

A fundamental principle underlying the FederalReserve’s supervision and regulation of BHCsis that a BHC should serve as a source ofmanagerial and financial strength to its subsidi-ary banks.4 Consistent with this premise, theFederal Reserve expects an organization to holdcapital commensurate with its overall risk pro-file. The risk-based capital rules state that thecapital requirements are minimum standardsbased primarily on broad credit-risk consider-ations. The risk-based ratios do not take explicitaccount of the quality of individual asset port-folios or the range of other types of risk towhich banking organizations may be exposed(e.g., interest-rate, liquidity, market, and opera-tional risks). For this reason, banking organiza-tions are generally expected to operate withcapital positions well above the minimum ratios,with the amount of capital held by a bankingorganization corresponding to its broad riskexposure. Because an overall assessment ofcapital adequacy must take into account factorsbeyond those reflected in the minimum regula-tory capital ratios, supervisory assessments ofcapital adequacy may differ significantly fromconclusions based solely on the level of anorganization’s risk-based capital ratio.

Consequently, an organization’s internal pro-cess for assessing capital adequacy should re-flect a full understanding of its risks and ensurethat it holds capital corresponding to those risksto maintain overall capital adequacy. Key amongthese risks is the risk of illiquidity, particularlythat a perceived lack of financial strength (e.g., acapital shortfall relative to potential losses in astress scenario) may lead investors and counter-parties to withhold funds or otherwise ceaseengaging in business with the organization. Thisis particularly important for a banking organiza-

1. The term ‘‘dividends’’ as used in SR-09-4 refers todividends on common stock and preferred stock, as well asdividends or interest on the subordinated notes underlyingtrust preferred securities and other tier 1 capital instruments,in cash or other value (collectively, ‘‘dividends’’). Stock divi-dends (i.e., dividends in the form of common stock) areexcluded. The priority of payment of dividends is based onthe level of seniority of the instrument, which is establishedby contract between an issuer and its investors.

2. As discussed in SR-02-1, ‘‘Revisions to Bank HoldingCompany Supervision Procedures for Organizations withTotal Consolidated Assets of $5 Billion or Less,’’ risk-focusedsupervision of certain noncomplex BHCs with consolidatedassets of less than $1 billion relies extensively on off-sitemonitoring, surveillance, and the assessments of primarybanking supervisors of BHC subsidiaries. For such BHCs,supervisory staff generally will be able to rely to a large extenton off-site surveillance and monitoring activities to identifypotential supervisory issues related to capital adequacy asdiscussed in SR-09-4. Expectations for related documentationare likewise commensurate with the size and complexity ofthe BHC.

3. Notwithstanding the general guidance in SR-09-4, theFederal Reserve may establish more stringent institution-specific requirements under its supervisory or enforcementauthority. To the extent those requirements are more stringentthan this guidance, those requirements supersede this guid-ance.

4. See 12 C.F.R. 225.4(a)(1).


tion that is a core clearing and settlement organi-zation or that has a significant presence in criti-cal financial markets; such an organization isexpected to have especially rigorous and effec-tive internal processes for assessing capitaladequacy.5

In addition to evaluating the appropriatenessof a BHC’s capital level given its overall riskprofile, supervisory staff should focus on thequality of a BHC’s capital and trends in itscapital composition. In this regard, the Board’srisk-based capital rules state that voting com-mon stockholders’ equity, which is the mostdesirable capital element from a supervisorystandpoint, generally should be the dominantelement within tier 1 capital, and that bankingorganizations should avoid overreliance on non-common-equity capital elements.6 Accordingly,a BHC should place primary reliance on itscommon equity, followed by perpetual preferredstock, which is included in equity under gener-ally accepted accounting principles (GAAP) andabsorbs losses on a going-concern basis (that is,helps a BHC avoid insolvency despite losses onits assets). Tax-deductible hybrid capital instru-ments, such as trust preferred securities, providea limited supplement within tier 1 capital to aBHC’s common stock and preferred stock.

In assessing a BHC’s capital adequacy, super-visory staff should evaluate the comprehensive-ness and effectiveness of management’s capitalplanning. An effective capital planning processrequires a banking organization to assess therisks to which it is exposed and its processes formanaging and mitigating those risks, evaluateits capital adequacy relative to its risks, andconsider the potential impact on its earnings andcapital base from current and prospective eco-nomic conditions. A BHC’s capital planningprocess should be commensurate with the BHC’ssize, complexity, and risk profile7 and should

entail consideration of a variety of factors. Thesupervisory guidance within SR-09-4 is notintended to describe comprehensively all ele-ments of a BHC’s capital planning process, butrather to focus on those factors that a BHC’sboard of directors should take into account whenconsidering the payment of dividends, stockredemptions, or stock repurchases. Factors thatthe BHC’s board of directors should considerinclude the following:

1. overall asset quality, potential need to increasereserves and write down assets, and concen-trations of credit;

2. potential for unanticipated losses and declinesin asset values;

3. implicit and explicit liquidity and credit com-mitments, including off-balance-sheet andcontingent liabilities;

4. quality and level of current and prospectiveearnings, including earnings capacity under anumber of plausible economic scenarios;

5. current and prospective cash flow and liquid-ity;

6. ability to serve as an ongoing source of finan-cial and managerial strength to depositoryinstitution subsidiaries insured by the Fed-eral Deposit Insurance Corporation, includ-ing the extent of double leverage8 and thecondition of subsidiary depository institu-tions;

7. other risks that affect the BHC’s financialcondition and are not fully captured in regu-latory capital calculations;

8. level, composition, and quality of capital;and

9. ability to raise additional equity capital inprevailing market and economic conditions.

Supervisory findings in the areas discussed inSR-09-4 should be incorporated into the assess-ment of the ‘‘Capital’’ subcomponent for theBHC’s ‘‘Financial Condition’’ rating compo-nent in the RFI (Risk Management, FinancialCondition, and Impact) rating9 assigned to a

5. As discussed in SR-03-9, ‘‘Interagency Paper on SoundPractices to Strengthen the Resilience of the U.S. FinancialSystem,’’ core clearing and settlement organizations are definedas large-value payment system operators and market utilitiesthat provide critical clearing and settlement services for criti-cal financial markets. The term also includes firms that pro-vide clearing and settlement services that are integral to acritical financial market (i.e., their market share is significantenough to present systemic risk in the event of their suddenfailure to carry on those activities because there are no imme-diately viable alternatives). Firms that play significant roles incritical financial markets are those that consistently clear orsettle at least five percent of the value of transactions in acritical market.

6. See 12 C.F.R. 225, appendix A, section II.A.1.c.(3).7. Large BHCs and others with complex risk profiles

should have in place robust internal capital adequacy assess-ment processes, as noted in SR-99-18, ‘‘Assessing CapitalAdequacy in Relation to Risk at Large Banking Organizationsand Others with Complex Risk Profiles’’ (see section 4060.7).BHCs that use the advanced approaches in the risk-basedcapital adequacy framework based on Basel II may be subjectto further requirements in this regard.

8. Double leverage refers to situations in which debt isissued by the parent company and the proceeds are invested insubsidiaries as equity. In this regard, supervisory staff shouldalso consider the impact of any potential overreliance a BHCmay have on dividends received from subsidiaries as a sourceof payment for its liabilities.

9. See SR-04-18, ‘‘Bank Holding Company Rating Sys-

Payment of Dividends, Stock Redemptions, and Stock Repurchases at Bank Holding Companies 4060.9


BHC. See section 4060.9.3 for information thatsupervisory staff should seek from BHCs indeveloping this assessment.

4060.9.1.1 Dividends in Cash or OtherValue

Crucial to any capital plan are the effects on aBHC’s financial condition of the payment ofdividends on common stock10 and other tier 1capital instruments, as described previously infootnote 1. Consistent with the Board’s Novem-ber 14, 1985, ‘‘Policy Statement on the Paymentof Cash Dividends’’ (see section 2020.5, or theFRRS at 4-185), a banking organization shouldhave comprehensive policies on dividend pay-ments that clearly articulate the organization’sobjectives and approaches for maintaining astrong capital position and achieving the objec-tives of the policy statement. These policiesshould take into account the potential drain on aBHC’s resources posed by the payment not justof cash dividends, but also of non-cash divi-dends, which can take many different forms(e.g., the distribution of assets to shareholders,particularly insiders, or the assumption or guar-antee of certain shareholders’ liabilities), otherthan those in the form of common stock, whichgenerally do not raise supervisory concerns.

When a BHC’s board of directors is decidingon the level of dividends to declare,11 it shouldconsider, among other things, the factors dis-cussed above in 4060.9.1. It is particularly im-portant for a banking organization’s board ofdirectors to ensure that the dividend level isprudent relative to the organization’s financialposition and is not based on overly optimisticearnings scenarios. Supervisory staff shouldengage in discussions with a BHC on its overalldividend policies and practices as part of theongoing supervisory assessment of capitaladequacy. Moreover, because the period betweendeclaration of a dividend and the payment datemay be as much as 60 days, in making a decla-ration, the board of directors should considerany potential events that may occur before thepayment date that could affect its ability to pay

while still maintaining a strong financialposition.12

While many organizations place great impor-tance on consistently paying dividends, a boardof directors should strongly consider, after care-ful analysis of the factors described above under‘‘Review of Capital Adequacy Management’’(see section 4060.9.1), reducing, deferring, oreliminating dividends when the quantity andquality of the BHC’s earnings have declined orthe BHC is experiencing other financial prob-lems, or when the macroeconomic outlook forthe BHC’s primary profit centers has deterio-rated.13 As a general matter, the board of direc-tors of a BHC should inform the Federal Reserveandshouldeliminate,defer, or significantly reducethe BHC’s dividends if

1. The BHC’s net income available to share-holders for the past four quarters, net ofdividends previously paid during that period,is not sufficient to fully fund the dividends;

2. The BHC’s prospective rate of earnings reten-tion is not consistent with the BHC’s capitalneeds and overall current and prospectivefinancial condition; or

3. The BHC will not meet, or is in danger of notmeeting, its minimum regulatory capitaladequacy ratios.

Failure to do so could result in a supervisoryfinding that the organization is operating in anunsafe and unsound manner.

Moreover, a BHC should inform the FederalReserve reasonably in advance of declaring orpaying a dividend that exceeds earnings for theperiod (e.g., quarter) for which the dividend isbeing paid or that could result in a materialadverse change to the organization’s capitalstructure. Declaring or paying a dividend ineither circumstance could raise supervisory con-cerns. Likewise, a BHC should apprise the Fed-eral Reserve reasonably in advance of declaringany material increase in its common stock divi-dend to ensure that it does not raise safety-and-soundness concerns.

tem’’ and section 4070.0.10. This includes dividends paid on common stock by

BHCs qualifying under Subchapter S of Chapter 1 of theInternal Revenue Code. For regulatory and supervisory pur-poses, such dividends are treated the same as those paid byother BHCs.

11. As a general matter, the declaration of a dividend toshareholders establishes a legal obligation to pay that divi-dend and is recorded as a liability on the balance sheet.

12. Payments on trust preferred securities are not declared.Rather, the BHC must make a decision not to make a pay-ment; typically, this decision must be made 15 days beforepayment is due.

13. Contractual arrangements typically dictate that a bank-ing organization may not defer dividends on senior instru-ments (e.g., preferred stock) unless dividends have been fullydeferred on more junior instruments (e.g., common stock).



4060.9.1.2 Stock Redemptions andRepurchases

It is an essential principle of safety and sound-ness that a banking organization’s redemptionof instruments included in regulatory capitaland repurchases of common stock, preferredstock, and other regulatory capital instrumentsfrom investors be consistent with the organiza-tion’s current and prospective capital needs. Inassessing such needs, the board of directors andmanagement of a BHC should consider the fac-tors discussed above in section 4060.9.1.

Federal Reserve supervisory staff should con-tinue exercising their supervisory oversight andregulatory authority in evaluating BHCs’ capitalplanning processes, as discussed above, andconsulting with BHCs regarding their proposedredemptions and repurchases of common stock,preferred stock, and other regulatory capitalinstruments. There are explicit regulatory require-ments for Federal Reserve review of such trans-actions in several situations:

1. Certain non-exempted BHCs are requiredunder section 225.4(b)(1) of Regulation Y tonotify the Federal Reserve of actions thatwould reduce a BHC’s consolidated net worthby 10 percent or more.14

2. Under the Board’s risk-based capital rule forBHCs, most instruments included in tier 1capital15 with features permitting redemptionat the option of the issuing BHC (e.g., per-petual preferred stock and trust preferredsecurities) may qualify as regulatory capitalonly if redemption is subject to prior FederalReserve approval.16

3. The risk-based capital rule directs BHCs toconsult with the Federal Reserve before re-deeming any equity or other capital instru-ment included in tier 1 or tier 2 capital priorto stated maturity, if such redemption couldhave a material effect on the level or com-position of the organization’s capital base.17

In addition, Federal Reserve supervisory staffshould exercise the above regulatory authori-ties, as well as the Federal Reserve’s generalsupervisory and enforcement authority, toprevent a BHC from repurchasing its commonstock, preferred stock, trust preferred securi-ties, and other regulatory capital instruments inthe market, if such action would be inconsistentwith the BHC’s prospective capital needs andcontinued safe and sound operation. BHCsexperiencing financial weaknesses, or that are atsignificant risk of developing financial weak-nesses, should consult with the appropriate Fed-eral Reserve supervisory staff before redeem-ing or repurchasing common stock or otherregulatory capital instruments for cash or othervaluable consideration. Similarly, any BHCconsidering expansion, either through acquisi-tions or through new activities, also generallyshould consult with the appropriate FederalReserve supervisory staff before redeeming orrepurchasing common stock or other regula-tory capital instruments for cash or other valu-able consideration.

In evaluating the appropriateness of a BHC’sproposed redemption or repurchase of capitalinstruments, Federal Reserve supervisory staffsare directed to consider

1. the potential losses that a BHC may sufferfrom the prospective need to increase reservesand write down assets from continued assetdeterioration and

2. the BHC’s ability to raise additional com-mon stock and other tier 1 capital to replacecapital instruments that are redeemed orrepurchased.

In addition, supervisory staff should consider

14. Section 225.4(b)(1) of Regulation Y requires that aBHC that is not well capitalized or well managed, or that issubject to any unresolved supervisory issues, provide priornotice to the Federal Reserve for any repurchase or redemp-tion of its equity securities for cash or other value that wouldreduce by 10 percent or more the BHC’s consolidated networth aggregated over the preceding 12-month period. Allrepurchases and redemptions within a 12-month period areaggregated for the application of this rule, regardless of anyother approval or supervisory consultation process that wasfollowed by the BHC with regard to its repurchases andredemptions of equity securities.

15. As discussed in SR-01-27, ‘‘The Use of ForwardEquity Transactions by Banking Organizations,’’ commonshares covered by forward equity arrangements are excludedfrom tier 1 capital of a BHC. Such an arrangement is definedas an agreement by a banking organization to sell equity to acounterparty and purchase it back at a later date.

16. Unlike the process noted above for transactions requir-ing notification of the Federal Reserve under Regulation Y,such approvals and the consultative process for other repur-

chases and redemptions are part of the Federal Reserve’sgeneral supervisory processes and do not, therefore, requireformal applications.

17. See 12 C.F.R. 225, appendix A, section II.(iii). Suchconsultation by small BHCs subject to the Board’s SmallBank Holding Company Policy Statement (‘‘Small BHC Pol-icy Statement’’; see Regulation Y: 12 C.F.R. 225, appendixC), however, is only required for the redemption of instru-ments included in equity as defined under GAAP—such ascommon and perpetual preferred stock—and not for otherinstruments included in regulatory capital solely under therisk-based capital rule.



the potential negative effects on capital of aBHC

1. replacing common stock with lower-qualityforms of regulatory capital (e.g., hybrids orsubordinated debt) or

2. redeeming or repurchasing equity and othercapital instruments from investors, includingselective repurchases or redemptions frominsiders, with cash or other value that couldbe better used to strengthen the BHC’s regu-latory capital base or its overall financialcondition.

Furthermore, to facilitate such supervisoryoversight, a BHC should inform Federal Reservesupervisory staff of a redemption or repur-chase18 of common stock or perpetual preferredstock for cash or other value resulting in a netreduction of a BHC’s outstanding amount ofcommon stock or perpetual preferred stock belowthe amount of such capital instrument outstand-ing at the beginning of the quarter in which theredemption or repurchase occurs. It is not neces-sary to inform supervisory staff pursuant toSR-09-4 when reductions in a BHC’s tier 1capital during a quarter will result from othercauses, such as a reduction of the BHC’s retainedearnings due to negative earnings.

BHCs should advise Federal Reserve supervi-sory staff sufficiently in advance of such redemp-tions and repurchases to provide reasonableopportunity for supervisory review and possibleobjection should Federal Reserve supervisorystaff determine a transaction raises safety-and-soundness concerns. When informing FederalReserve supervisory staff of redemptions andrepurchases, including requests for approval ofredemptions under the risk-based capital rule asdiscussed above, a BHC may provide informa-tion either for a proposed transaction or for anumber of transactions within a given quarteron its tier 1 capital composition. Such informa-tion should include the dollar amount and per-centage breakdown of the BHC’s tier 1 capitalcomponents (that is, common equity, perpetualpreferred stock, and other tier 1 capital instru-ments), as well as its regulatory capital ratios, atthe beginning of the previous quarter and mostrecent four-quarter period, as well as pro formachanges to its capital composition and ratiosresulting from its proposed redemptions orrepurchases.


1. To analyze and document issues discussedabove that are present at the BHC and includesuch documentation in the inspection’s work-papers, including those related to supervisoryactivities.

2. To evaluate the quality of a BHC’s capitaland the trends in its capital composition.

3. To determine if the BHC has informed andconsulted with Federal Reserve supervisorystaff sufficiently in advance ofa. declaring and paying a dividend that could

raise safety-and-soundness concerns (forexample, declaring and paying a dividendthat exceeds earnings for the period forwhich the dividend is being paid);

b. redeeming or repurchasing regulatory capi-tal instruments when the BHC is experi-encing financial weaknesses; or

c. redeeming or repurchasing any commonstock or perpetual preferred stock thatwould result in a net reduction as of theend of a quarter in the amount of suchequity instruments outstanding comparedwith the beginning of the quarter in whichthe redemption or repurchase occurred.

4. To evaluate the comprehensiveness and effec-tiveness of management’s capital planning.

4060.9.3 INSPECTION PROCEDURES19

Capital Planning

1. Determine if the existing capital level isadequate for the BHC’s risk profile whenconsidering the following items:a. the level and trend of adversely classi-

fied assets;b. the adequacy of the allowance for loan

and lease losses;c. the volume of charged-off loans and

recoveries;d. the balance sheet structure and liquidity

needs;e. the level and type of concentrations;f. compliance with state and federal capital

requirements; and

18. Redemptions of most instruments (e.g., preferred stockor trust preferred securities) included in regulatory capitalrequire Federal Reserve approval under the risk-based capitalrule, but such redemptions by small BHCs are not requiredunder the small BHC policy statement.

19. These procedures are not intended to encompass com-prehensively a BHC’s capital planning, and are focused oninformation that may be useful in reviewing the impact ofdividends and repurchases or redemptions on capital ad-equacy. More comprehensive inspection procedures for assess-ing capital adequacy of BHCs are available in section 4060.3.11.



g. composition of elements of capital.2. Determine if earnings performance enables

the BHC to fund its growth, remain com-petitive in the marketplace, and support itsoverall risk profile. Consider the level andtrend of equity capital to total assets as wellas asset and equity growth rates.a. Review the current level of the provision

for loan and lease losses.b. Review whether the bank is relying on

core earnings or income from non-recurring events.

c. Determine if dividends are excessivewhen compared to current earnings orpotential capital needs, or could other-wise result in a material adverse changeto the organization’s capital structure.

3. Determine the effect of current capital lev-els on the future viability of the BHC andits subsidiary depository institutions.a. Assess management’s ability to reverse

deteriorating trends and to augment capi-tal through earnings.

b. Assess the ability of the BHC to raisecapital from existing shareholders, issuenew capital instruments, or access alter-native sources of capital.

c. Assess the reasonableness of capital plans.

Dividend in Cash or Other Value

4. Determine whether the BHC has a compre-hensive dividend policy at the holding com-pany and for each of its subsidiaries thathelp it in its capital planning processes.

5. Assess whether provisions contained in thepolicies and practices conform to the guid-ance outlined in the Federal Reserve Board’s1985 dividend policy statement.

6. Determine whether, and if so, how, theBHC has changed in any way its dividendpolicy to accommodate the current eco-nomic environment.

7. Assess whether dividends in cash or othervalue are consistent with the BHC’s currentand prospective capital needs, includinglikely future reserve increases and assetwrite-downs, as well as the feasibility in thenear term of the BHC raising additionalcapital in the market.

Stock Repurchases and Redemptions

8. Review schedule HI-A (Changes in EquityCapital) of the BHC’s FR Y-9C report forany changes in components of capital.

9. Review any correspondence from the BHCto the Federal Reserve that indicates anyplans to initiate common or preferred stockrepurchases or redemptions in the foresee-able future.

10. Review the BHC’s strategic plan for anymention of stock repurchases or redemp-tions.

11. Review the BHC’s capital plan for anymention of stock repurchases or redemp-tions.

12. Discuss with management whether they arein any other way contemplating stock repur-chases or redemptions, and if so, what thelikely magnitude and timeline of such repur-chases will be.

13. Assess whether such repurchases or redemp-tions foster sound capital positions, espe-cially if the organization is (or could be)experiencing financial weakness.





BHC should serve as a sourceof financial and managerialstrength to its subsidiaries

225.4(a)(1)

Purchase or redemption byBHC of its own securities

225.4(b)(1)

Voting common stockhold-ers’ equity should be the domi-nant form of tier 1 capital

225, appendix A,section II.A.1.c.(3)

Directed advance consulta-tion with Federal Reserve if aredemption of capital prior tostated maturity would materi-ally affect the level or compo-sition of BHC’s capital base

225, appendix A,section II.iii

Board policy on payment ofcash dividends

4-877

Small BHC Policy Statement 225, appendix C

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.

3. Federal Reserve Regulatory Service reference.



Consolidated Capital (Capital Planning)Section 4061.0


Effective January 2016, this section is revised toupdate the current text to the Capital Planningrule in Regulation Y (12 C.F.R. 225.8). Also seesections 4063.0 and 4065.0 in this manual.

4061.0.1 CAPITAL POSITIONS OFBANK HOLDING COMPANIES

The Federal Reserve has long held the view thatbank holding companies (BHCs) generally shouldoperate with capital positions well above theminimum regulatory capital ratios, with theamount of capital held being commensuratewith the BHC’s risk profile.1 BHCs should haveinternal processes for assessing their capitaladequacy that reflect a full understanding oftheir risks and ensure that they hold capitalcorresponding to those risks to maintain overallcapital adequacy.2 The Federal Reserve’s exist-ing supervisory expectation is that large BHCsshould have robust systems and processes thatincorporate forward-looking projections of rev-enue and losses to monitor and maintain theirinternal capital adequacy.3

The Board adopted amendments to Regula-tion Y, effective December 30, 2011, whichrequire top-tier large U.S. BHCs having totalconsolidated assets of $50 billion or more4

(large BHCs) to submit annual capital plans tothe Federal Reserve by the 5th of January of acalendar year (or other Federal Reserve Boarddesignated date) for review. For each capitalplan cycle beginning 2016 and thereafter, thecapital plan must be submitted by April 5th. Theamendments to Regulation Y are found in sec-

tion 225.8 of Regulation Y (12 C.F.R. 225.8)and at 76 Fed. Reg. 74631 (December 1, 2011),79 Fed. Reg. 64040 (October 27, 2014), and80 Fed. Reg. 75424 (December 2, 2015).5 LargeBHCs are also required to obtain the FederalReserve’s approval under certain circumstancesbefore making a capital distribution. This sec-tion of the manual discusses, in general, some ofthe significant rule provisions. The rule’s textand its preamble should be referred to for itsdetailed requirements.

The aim of the annual capital plan require-ment is to ensure that large BHCs have robust,forward-looking capital planning processes thataccount for their unique risks, and to help ensurethat BHCs have sufficient capital to continueoperations throughout times of economic andfinancial stress. Large BHCs will be expected tohave credible plans that show they have suffi-cient capital so that they can continue to lend tohouseholds and businesses, even under adverseconditions, and are well prepared to meet regu-latory capital standards agreed to by the BaselCommittee on Banking Supervision as they areimplemented in the United States. Boards ofdirectors of large BHCs will be required eachyear to review and approve capital plans beforesubmitting them to the Federal Reserve.

The Federal Reserve annually will evaluatelarge BHCs’ capital adequacy, internal capitaladequacy assessment processes, and their plansto make capital distributions, such as dividendpayments or stock repurchases. The FederalReserve may approve dividend increases orother capital distributions only for companieswhose capital plans are approved by supervisorsand are able to demonstrate sufficient financialstrength to operate as successful financial inter-mediaries under stressed macroeconomic andfinancial market scenarios, even after makingthe desired capital distributions.

The rule is designed to (1) establish commonminimum supervisory standards for capital plan-ning strategies and processes for certain largeBHCs; (2) describe how boards of directors and

1. See 12 C.F.R parts 217 and 225 (78 Fed. Reg. 62018,October 11, 2013). See also this manual’s sections 4063.0 and4065.0.

2. For institutions with less than $50 billion in total con-solidated assets, see SR-09-4, ‘‘Applying Supervisory Guid-ance and Regulations on the Payment of Dividends, StockRedemptions, and Stock Repurchases at Bank Holding Com-panies.’’ (February 29, 2009, revised March 27, 2009).

3. As in footnote 2, see SR-09-4.4. The calculation of a BHC’s consolidated assets for the

purposes of this rule consists of the average of a company’stotal consolidated assets over the previous four most recentconsecutive calendar quarters, as reflected on the BHCs ‘‘Con-solidated Financial Statements for Holding Companies’’ (FRY-9C). The rule also applies to any institution that the Boarddetermines, by order, shall be subject in whole or in part to therule’s requirements based on the institution’s size, level ofcomplexity, risk profile, scope of operations, or financialcondition.

5. The rule also makes conforming changes to section225.4(b) of Regulation Y (12 CFR 225.4(b)), which currentlyrequires prior notice to the Federal Reserve of certain pur-chases and redemptions of a BHC’s equity securities. Becausesuch approval of certain capital distributions will be sepa-rately required in the rule at section 225.8 of Regulation Y, theBoard amended section 225.4(b) to provide that it shall notapply to any BHC that is subject to section 225.8.


senior management of these BHCs should com-municate such strategies and processes, includ-ing any material changes thereto, to the FederalReserve; and (3) provide the Federal Reservewith an opportunity to review large BHCs’ pro-posed capital distributions under certain circum-stances.

4061.0.2 BOARD OF DIRECTORRESPONSIBILITIES

4061.0.2.1 Annual Capital PlanningRequirement

The rule requires a large BHC to develop andmaintain a capital plan. At least annually, andprior to the submission of the capital plan to theFederal Reserve, a large BHC’s board of direc-tors or a designated committee thereof is requiredto review the capital plan. The board of direc-tors or designated committee must (1) reviewthe robustness of the holding company’s processfor assessing capital adequacy, (2) ensure thatany deficiencies in the firm’s process for assess-ing capital adequacy are appropriately rem-edied, and (3) approve the BHC’s capital plan.6

Robustness of a large BHC’s capital adequacyprocess should be evaluated based on the fol-lowing elements:

1. A sound risk-management infrastructure thatsupports the identification, measurement, andassessment of all material enterprise-levelrisks arising from the exposures and businessactivities of the BHC;

2. An effective process for translating risk mea-sures into estimates of potential loss over arange of adverse scenarios andenvironments—using multiple, complemen-tary loss forecasting methodologies—and foraggregating those estimated losses across theBHC;

3. A clear definition of available capital resourcesand an effective process for forecasting avail-able capital resources (including any fore-casted revenues) over the same range ofadverse scenarios and environments used forloss forecasting;

4. A process for considering the impact of lossand resource estimates on capital adequacy,in line with the BHC’s stated goals for the

level and composition of capital, and takinginto account any limitations of the com-pany’s capital adequacy process and itscomponents;

5. A process, supported by the BHC’s capitalpolicy, to use its assessments of the impact oflossand resourceestimatesoncapital adequacyto make key decisions regarding the currentlevel and composition of capital, specificcapital actions, and capital contingency plansas they affect capital adequacy;

6. Robust internal controls governing capitaladequacy process components, including suf-ficient documentation, change control, modelvalidation and independent review, and audittesting; and

7. Effective board and senior management over-sight of the BHC’s capital adequacy process,including periodic review of capital goals,assessment of the appropriateness of adversescenarios considered in capital planning, regu-lar review of any limitations and uncertain-ties in the process, and approval of plannedcapital actions.

4061.0.2.2 Mandatory Elements of aCapital Plan

A capital plan is defined as a written presenta-tion of a large BHC’s capital planning strategiesand capital adequacy process that includes cer-tain mandatory elements. These mandatory ele-ments are organized into four main componentswith relevant subcomponents:

1. An assessment of the expected uses andsources of capital over the planning horizon(at least nine quarters, beginning with thequarter preceding the quarter in which theBHC submits its capital plan) that reflects theBHC’s size, complexity, risk profile, andscope of operations, assuming both expectedand stressful conditions. The subcomponentsincludea. estimates of projected revenues, losses,

reserves, and pro forma capital levels,including any minimum regulatory capitalratios (for example, leverage, tier 1 risk-based, and total risk-based capital ratios)and any additional capital measures deemedrelevant by the BHC, over the planninghorizon under expected conditions andunder a range of scenarios, including anyscenarios provided by the Federal Reserveand at least one BHC stress scenario ;

b. a discussion of the results of any stresstest required by law or regulation, and an

6. As part of this review, the board of directors shouldconsider any remaining uncertainties, limitations, and assump-tions associated with the BHC’s capital adequacy process.

Consolidated Capital (Capital Planning) 4061.0


explanation of how the capital plan takesthese results into account; and

c. a description of all planned capital actionsover the planning horizon.

2. A detailed description of the BHC’s processfor assessing capital adequacy, includinga. a discussion of how the BHC will, under

expected and stressful conditions, main-tain capital commensurate with its risks,maintain capital above the minimum regu-latory capital ratios, and serve as a sourceof strength to its subsidiary depositoryinstitutions; and

b. a discussion of how the BHC will, underexpected and stressful conditions, main-tain sufficient capital to continue its opera-tions by maintaining ready access to fund-ing, meeting its obligations to creditorsand other counterparties, and continuingto serve as a credit intermediary.

3. The BHC’s capital policy, which is the BHC’swritten assessment of the principles and guide-lines used for capital planning, capital issu-ance, usage and distributions, including inter-nal capital goals, the quantitative or qualitativeguidelines for dividend and stock repur-chases, the strategies for addressing potentialcapital shortfalls, and the internal gover-nance procedures around capital policy prin-ciples and guidelines; and

4. A discussion of any expected changes to theBHC’s business plan that are likely to have a

material impact on the firm’s capital adequacyor liquidity. For example, the capital planshould reflect any expected material effectsof new lines of business or activities on theBHC’s capital adequacy or liquidity, includ-ing revenue and losses.

4061.0.2.3 Net Capital DistributionLimitation

The capital plan rule limits the ability of a bankholding company with $50 billion or more intotal consolidated assets to make capital distri-butions if the bank holding company’s net capi-tal issuances are less than the amount indicatedin its capital plan.

4061.0.2.4 Data Collection

In connection with its submission of a capitalplan to the Federal Reserve, a large BHC isrequired to provide certain data to the FederalReserve. Data required by the Federal Reservemay include, but are not limited to, informationregarding the BHC’s financial condition includ-ing its capital, the BHC’s structure, assets, riskexposure, policies and procedures, liquidity, andmanagement.

Consolidated Capital (Capital Planning) 4061.0


Federal Reserve Supervisory Assessment ofCapital Planning and Positions for LISCC Firmsand Large and Complex Firms Section 4063.0

The Federal Reserve issued this guidance toexplain its supervisory expectations for capitalplanning at Large Institution Supervision Coor-dinating Committee (LISCC) and large and com-plex bank holding companies and intermediateholding companies of foreign banking organiza-tions, consistent with the broad supervisoryexpectations set forth in SR-12-17/CA-12-14,“Consolidated Supervision Framework for LargeFinancial Institutions.”1 Capital is central to afirm’s ability to absorb unexpected losses andcontinue to lend to creditworthy businesses andconsumers. Therefore, a firm’s processes formanaging and allocating its capital resources arecritical to its financial strength and resiliency,and also to the stability and effective function-ing of the U.S. financial system. The followingguidance provides the Federal Reserve’s corecapital planning expectations for LISCC andlarge and complex firms, building upon the capi-tal planning requirements in the Federal Reserve’scapital plan rule and stress test rules.2,3

The guidance outlines capital planning expec-tations for:

• Governance• Risk management• Internal controls• Capital policy• Scenario design, and• Projection methodologies.

Further, the guidance includes several appen-dices that detail supervisory expectations on afirm’s capital planning process. This guidancelargely consolidates the Federal Reserve’s exist-ing capital planning guidance, including:

• Capital Planning at Large Bank Holding Com-panies: Supervisory Expectations and Rangeof Current Practice (August 2013)4

• Comprehensive Capital Analysis and Review2015 Summary Instructions and Guidance(October 2014)5

• Instructions for the Capital Assessments andStress Testing information collection (Report-ing Form FR Y-14A), (OMB No. 7100-0341)6

• SR-11-7, “Supervisory Guidance on ModelRisk Management” (Refer to section 2126.0of this manual)

• SR-12-7, “Supervisory Guidance on StressTesting for Banking Organizations with MoreThan $10 Billion in Total Consolidated Assets”

• SR-12-17/CA-12-14, “Consolidated Supervi-sion Framework for Large Financial Institu-tions” (Refer to section 2124.05 of this manual)

(Refer to SR-15-18 and its attachment.)

4063.0.1 FEDERAL RESERVEGUIDANCE ON SUPERVISORYASSESSMENT OF CAPITALPLANNING AND POSITIONS FORLISCC FIRMS AND LARGE ANDCOMPLEX FIRMS (OMB CONTROLNUMBERS 7100-0341 AND 7100-0342)

I. Introduction

This guidance (the attachment to SR-15-18) pro-vides the Federal Reserve’s core capital plan-ning expectations for firms subject to the LargeInstitution Supervision Coordinating Commit-tee7 (LISCC) framework and other large andcomplex firms, building upon the capital plan-ning requirements included in the Board’s capi-tal plan rule and stress test rules. This guidance

1. The term “capital planning process,” as used herein,which aligns with terminology in SR-12-17/CA-12-14, isequivalent to the term “capital adequacy process” used inother Federal Reserve documents.

2. For the capital plan rule, refer to section 225.8 ofRegulation Y (12 C.F.R. 225.8). Regulation Q (12 C.F.R. 217)establishes minimum capital requirements and overall capitaladequacy standards for Federal Reserve-regulated institutions.Regulation YY (12 C.F.R. 252) establishes capital stress test-ing requirements for bank holding companies with total con-solidated assets of $50 billion or more, including require-ments to participate in the Federal Reserve’s annual supervisorystress test and conduct their own internal capital stress tests.

3. With the issuance of SR-15-18, SR-99-18, “AssessingCapital Adequacy in Relation to Risk at Large Banking Orga-nizations and Others with Complex Risk Profiles,” is super-seded. In addition, SR-09-4, “Applying Supervisory Guidanceand Regulations on the Payment of Dividends, Stock Redemp-tions, and Stock Repurchases at Bank Holding Companies,” issuperseded with respect to firms subject to this guidance.

4. Available at www.federalreserve.gov/bankinforeg/bcreg20130819a1.pdf.

5. Available at www.federalreserve.gov/newsevents/press/bcreg/bcreg20141017a1.pdf.

6. Available at www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDa2AwLR/gLe5DPhQFttuq/4.

7. The LISCC framework is designed to materially increasethe financial and operational resiliency of systemically impor-tant financial institutions to reduce the probability of, and costassociated with, their material financial distress or failure. Seewww.federalreserve.gov/bankinforeg/large-institution-supervision.htm.


http://www.federalreserve.gov/bankinforeg/bcreg20130819a1.pdf


http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20141017a1.pdf


http://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDa2AwLR/gLe5DPhQFttuq/4


http://www.federalreserve.gov/bankinforeg/large-institution-supervision.htm


outlines capital planning expectations8 for thesefirms in the following areas:

• Governance• Risk management• Internal controls• Capital policy• Incorporating stressful conditions and events,

and• Estimating impact on capital positions.

Further, this guidance provides detailed super-visory expectations on a firm’s capital planningprocess in the following appendices:

A. Use of Models and Other EstimationApproaches

B. Model OverlaysC. Use of Benchmark Models in the Capital

Planning ProcessD. Sensitivity Analysis and Assumptions Man-

agementE. Role of the Internal Audit Function in the

Capital Planning ProcessF. Capital PolicyG. Scenario DesignH. Risk-weighted Asset (RWA) ProjectionsI. Operational Loss Projections

This guidance applies to U.S. bank holdingcompanies and intermediate holding companiesof foreign banking organizations that are either(i) subject to the LISCC framework (referred toas a “LISCC Firm”) or (ii) have total consoli-dated assets of $250 billion or more or consoli-dated total on-balance sheet foreign exposure of$10 billion or more (referred to in this guidanceas a “Large and Complex Firm”).9,10 The guid-

ance is effective immediately for bank holdingcompanies that are subject to the capital planrule as of January 1, 2016. The guidance willbecome effective for intermediate holding com-panies beginning on January 1, 2017, which isthe date on which the capital plan rule applies tothese firms.

The Federal Reserve has different expecta-tions for sound capital planning and capitaladequacy depending on the size, scope of opera-tions, activities, and systemic importance of afirm. Concurrently with issuance of this guid-ance, the Federal Reserve is issuing separateguidance for U.S. bank holding companies andintermediate holding companies that have totalconsolidated assets of at least $50 billion butless than $250 billion, have consolidated totalon-balance sheet foreign exposure of less than$10 billion, and are not otherwise subject to theLISCC framework (referred to as a “Large andNoncomplex Firm”). This separate guidanceclarifies that expectations for LISCC Firms andLarge and Complex Firms are higher than theexpectations for Large and Noncomplex Firms.(See this manual’s section 4065.0.)

Within the group of firms subject to thisguidance, the Federal Reserve has significantlyheightened expectations for the LISCC Firms.This guidance sets forth only minimum expecta-tions, and LISCC Firms are consistently expectedto exceed those minimum standards and havethe most sophisticated, comprehensive, and ro-bust capital planning practices for all of theirportfolios and activities.

II. Regulatory Requirements for CapitalPositions and Planning

Sound capital planning for any firm begins withadherence to all applicable rules and regulationsrelating to capital adequacy. Three FederalReserve regulations form the basis of the regula-tory framework for capital positions and capitalplanning:

(1) Regulation Q (12 C.F.R. 217), Capital Ad-equacy Requirements for Board-regulated

8. Note that these expectations build upon the capital plan-ning requirements set forth in the Board’s capital plan ruleand stress test rules (12 C.F.R. 225.8; 12 C.F.R. 252, subpartsE and F). Other relevant rules pertaining to the Board’sregulatory regime for capital planning and positions aredescribed above in Section II, “Regulatory Requirements forCapital Positions and Planning.” The Federal Reserve maynot conduct or sponsor, and an organization (or a person) isnot required to respond to, a collection of information unlessit displays a currently valid OMB control number. The OMBcontrol numbers for this guidance are OMB No. 7100-0341and OMB No. 7100-0342.

9. Total consolidated assets equals the amount of totalassets reported on the firm’s Consolidated Financial State-ments for Holding Companies (FR Y-9C), measured as anaverage over the preceding four quarters. If a firm has notfiled the FR Y-9C for each of the four most recent consecutivequarters, a firm’s total consolidated assets are measured as theaverage of its total consolidated assets, as reported on the FRY-9C, for the most recent quarter or consecutive quarters, asapplicable. Consolidated total on-balance sheet foreign expo-

sure equals total cross-border claims less claims with headoffice or guarantor located in another country plus redistrib-uted guaranteed amounts to the country of head office orguarantor plus local country claims on local residents plusrevaluation gains on foreign exchange and derivative prod-ucts, calculated as of the most recent year-end in accordancewith the Federal Financial Institutions Examination Council(FFIEC) 009 Country Exposure Report.

10. This guidance does not apply to nonbank financialcompanies designated by the Financial Stability OversightCouncil for supervision by the Board of Governors.

Federal Reserve Supervisory Assessment of Capital Planning and Positions for LISCC 4063.0


Institutions;(2) Regulation YY (12 C.F.R. 252), Enhanced

Prudential Standards; and(3) Section 225.8 of Regulation Y (12 C.F.R.

225.8, also known as the capital plan rule).

Regulation Q establishes minimum capitalrequirements and overall capital adequacy stan-dards for Federal Reserve-regulated institutions.Among other things, Regulation YY establishescapital stress testing requirements for bank hold-ing companies with total consolidated assets of$50 billion or more, including requirements toparticipate in the Federal Reserve’s annual super-visory stress test and conduct their own internalcapital stress tests. The capital plan rule estab-lishes general capital planning requirements fora bank holding company with total consolidatedassets of $50 billion or more and requires a bankholding company to develop an annual capitalplan that is approved by its board of directors.

This guidance provides the Federal Reserve’score capital planning expectations for firms sub-ject to this guidance, building upon the capitalplanning requirements in the Federal Reserve’scapital plan rule and stress test rules.11

III. Capital Planning Expectations

Capital is central to a firm’s ability to absorbunexpected losses and continue to lend to credit-worthy businesses and consumers. A firm’s capi-tal planning processes are critical to its financialstrength and resiliency. At LISCC Firms andLarge and Complex Firms, sound capital plan-ning is also critical to the stability and effectivefunctioning of the U.S. financial system.

SR-12-17/CA-12-14, “Consolidated Supervi-sion Framework for Large Financial Institu-tions,” outlines core expectations for sound capi-tal planning for bank holding companies withtotal consolidated assets of $50 billion or more.This capital planning and positions guidanceprovides additional details around the FederalReserve’s core capital planning expectations forLISCC Firms and Large and Complex Firms,building on the capital planning requirementsincluded in the capital plan rule and the Board’sstress test rules.12 A firm should maintain a

sound capital planning process on an ongoingbasis, including in between submissions of itsannual capital plan.13

A. Governance

The Federal Reserve expects a firm to havesound governance over its capital planning pro-cess. In general, senior management shouldestablish the capital planning process and theboard of directors should review and periodi-cally approve that process.

1. Board of Directors

A firm’s board of directors is ultimately respon-sible and accountable for the firm’s capital-related decisions and for capital planning. Thefirm’s capital planning should be consistent withthe strategy and risk appetite set by the boardand with the firm’s risk levels, including howrisks at the firm may emerge and evolve understress. The board must annually review andapprove the firm’s capital plan.14

The board should direct senior managementto provide a briefing on their assessment of thefirm’s capital adequacy at least quarterly, andwhenever economic, financial, or firm-specificconditions warrant a more frequent update. Thebriefing should describe whether current capitallevels and planned capital distributions remainappropriate and consistent with capital goals(see Section III.D, “Capital Policy”). In theirbriefing, senior management should also high-light for the board any problem areas related tocapital planning identified by senior manage-ment, internal audit, or supervisors.

The board should hold senior managementaccountable for providing sufficient informationon the firm’s material risks and exposures toinform board decisions on capital adequacy andactions, including capital distributions. Informa-tion provided to the board should be clear, accu-rate, and timely. The board should direct seniormanagement to provide this information at leastquarterly and whenever economic, financial, orfirm-specific conditions warrant a more frequentupdate. The information presented to the board

11. Refer to footnote 3.12. The capital planning process described in this guidance

is broadly equivalent to an internal capital adequacy assess-ment process (ICAAP) under the Federal Reserve’s advancedapproaches capital guidelines. The expectations articulated inthis document are consistent with the U.S. federal bankingagencies’ supervisory guidance relating to the ICAAP (see 73Fed. Reg. 44620 (July 31, 2008)).

13. The term “capital planning process” used herein, whichaligns with terminology in SR-12-17/CA-12-14, is equivalentto the term “capital adequacy process” used in other FederalReserve documents.

14. 12 C.F.R. 225.8(e)(1)(iii).



should include consideration of a number offactors, such as

• macro-economic conditions and relevant mar-ket events;

• current capital levels relative to budgets andforecasts;

• post-stress capital goals and targeted real timecapital levels (see section III.D, “Capital Pol-icy”);

• enterprise-wide and line-of-business perfor-mance;

• expectations from stakeholders (includingshareholders, regulators, investors, lenders,counterparties, and rating agencies);

• potential sources of stress to the firm’s operat-ing performance; and

• risks that may emerge only under stressfulconditions.

After receiving the information, the boardshould be in a position to understand the majordrivers of the firm’s projections under a range ofconditions, including baseline and stress sce-narios.

The board should direct senior managementto provide information about the firm’s estima-tion approaches, model overlays, and assess-ments of model performance (see Appendix A,“Use of Models and Other Estimation Ap-proaches,” Appendix B, “Model Overlays,” andAppendix C, “Use of Benchmark Models in theCapital Planning Process”). The board shouldalso receive information about uncertaintiesaround projections of capital needs or limita-tions within the firm’s capital planning processto understand the impact of these weaknesses onthe process. This information should includekey assumptions and the analysis of sensitivityof a firm’s projections to changes in the assump-tions (see Appendix D, “Sensitivity Analysisand Assumptions Management”). The boardshould incorporate uncertainties in projectionsand limitations in the firm’s capital planningprocess into its decisions on capital adequacyand capital actions. It should also review andapprove mitigating steps to address capital plan-ning process weaknesses.

The board should direct senior managementto establish sound controls for the entire capitalplanning process. The board should approvepolicies related to capital planning, and reviewthem annually. The board should also approvecapital planning activities and strategies. Theboard of directors should maintain an accurate

record of its meetings pertaining to the firm’scapital planning process.

2. Senior Management

Senior management should direct staff to imple-ment board-approved capital policies, capitalplanning activities, and strategies in an effectivemanner. Senior management should make in-formed recommendations to the board regardingthe firm’s capital planning and capital adequacy,including post-stress capital goals and capitaldistribution decisions. Senior management’s pro-posed capital goals and capital distributionsshould have analytical support and take intoaccount the expectations of important stakehold-ers, including shareholders, rating agencies, coun-terparties, depositors, creditors, and supervisors.

Senior management should design and over-see the implementation of the firm’s capitalplanning process; identify and assess materialrisks and use appropriate firm-specific scenariosin the firm’s stress test; monitor and assesscapital planning practices to identify limitationsand uncertainties and develop remediation plans;understand key assumptions used throughout afirm’s capital planning process and assess thesensitivity of the firm’s projections to thoseassumptions (see Appendix D, “SensitivityAnalysis and Assumptions Management”); andreview the capital planning process at least quar-terly.

Senior management should establish a pro-cess for independent review of the firm’s capitalplanning process, including the elements out-lined in this guidance. The independent reviewprocess should be designed to identify the weak-nesses and limitations of the capital planningprocess and the potential impact of those weak-nesses on the process. Senior management shouldalso develop remediation plans for any identi-fied weaknesses affecting the reliability of capi-tal planning results. Both the specific identifiedweaknesses and the remediation plans should bereported to the board of directors in a timelymanner.

B. Risk Management

A firm should have a risk management infra-structure that appropriately identifies, measures,and assesses material risks and provides a strongfoundation for capital planning.15 This risk man-agement infrastructure should be supported bycomprehensive policies and procedures, clear

15. 12 C.F.R. 225.8(e)(2).



and well-established roles and responsibilities,and strong and independent internal controls. Inaddition, the risk management infrastructureshould be built upon sound information technol-ogy and management information systems. TheFederal Reserve’s supervisory assessment of thesufficiency of a firm’s capital planning processwill depend in large part on the effectiveness ofthe firm’s risk management infrastructure andthe strength of its process to identify uniquerisks under normal and stressful conditions, aswell as on the strength of its overall governanceand internal control processes.

1. Risk Identification andAssessment Process

A firm’s risk identification process should includea comprehensive assessment of risks stemmingfrom its unique business activities and associ-ated exposures. The assessment should includeon-balance sheet assets and liabilities, off-balance sheet exposures, vulnerability of thefirm’s earnings, and other major firm-specificdeterminants of capital adequacy under normaland stressed conditions. This assessment shouldalso capture those risks that only materialize orbecome apparent under stressful conditions.

The specifics of the risk identification processwill differ across firms given differences in orga-nizational structure, business activities, and sizeand complexity of operations. However, the riskidentification process at all firms subject to thisguidance should be dynamic, inclusive, andcomprehensive, and drive the firm’s capital ad-equacy analysis. A firm should

• evaluate material risks across the enterprise toensure comprehensive risk capture on an on-going basis;

• establish a formal risk identification processand evaluate material risks at least quarterly;

• actively monitor its material risks; and• use identified material risks to inform key

aspects of the firm’s capital planning, includ-ing the development of stress scenarios, theassessment of the adequacy of post-stresscapital levels, and the appropriateness of po-tential capital actions in light of the firm’scapital objectives.

A firm should be able to demonstrate howmaterial risks are accounted for in its capitalplanning process. For risks not well captured byscenario analysis, the firm should clearly articu-late how the risks are otherwise captured andaddressed in the capital planning process and

factored into decisions about capital needs anddistributions. The firm should also be able toidentify risks that may be difficult to quantifyand explain how these risks are addressed in thecapital planning process. The firm should appro-priately segment risks beyond generic catego-ries such as credit risk, market risk, and opera-tional risk.

The Federal Reserve expects a firm to seekinput from multiple stakeholders across the orga-nization (for example, senior management,finance and risk professionals, front office andline-of-business leadership) in identifying itsmaterial risks. In addition, a firm should updateits risk assessment at least quarterly to reflectchanges in exposures, business activities, and itsbroader operating environment.

2. Risk Measurement andRisk Materiality

A firm should have a sound risk measurementprocess that informs senior management aboutthe size and risk characteristics of exposuresand business activities under both normal andstressful operating conditions. A firm is gener-ally expected to use quantitative approachessupported by expert judgment, as appropriate,for risk-measurement.

Identified weaknesses, limitations, biases, andassumptions in the firm’s risk measurement pro-cesses should be assessed for their potentialimpact on the integrity of a firm’s capital plan-ningprocess (seeAppendixD,“SensitivityAnaly-sis and Assumptions Management”). A firmshould have a process in place for determiningmateriality in the context of material risk identi-fication and capital planning. This process shouldinclude a sound analysis of relevant quantitativeand qualitative considerations, including, but notlimited to, the firm’s risk profile, size, and com-plexity, and their effects on the firm’s projectedregulatory capital ratios in stressed scenarios.16

A firm should identify how and where itsmaterial risks are accounted for within the capi-tal planning process. The firm should be able tospecify material risks that are captured in itsscenario design, the approaches used to estimatethe impact on capital, and the risk drivers asso-

16. For simplicity, the terms “quantitative” and “qualita-tive” are used to describe two different types of approaches,with the recognition that all quantitative estimation ap-proaches involve some qualitative/judgmental aspects, andqualitative estimation approaches produce quantitative output.



ciated with each material risk.

As part of its risk measurement processes, afirm should identify and measure risk that isinherent to its business practices and closelyassess the reliability of assumptions about riskreduction resulting from risk transfer or riskmitigation techniques (see Appendix D, “Sensi-tivity Analysis and Assumptions Manage-ment”). Specifically, the firm should criticallyassess the enforceability and effectiveness ofany guarantees, netting, and collateral agree-ments. Assumptions about accessibility and valu-ation of collateral exposures should also beclosely reviewed for reliability given the likeli-hood that asset values will change rapidly in astressed market.

C. Internal Controls

A firm should have a sound internal controlframework that helps ensure that all aspects ofthe capital planning process are functioning asdesigned and result in sound assessments of thefirm’s capital needs. The framework shouldinclude

• an independent internal audit function;

• independent review and validation practices;and

• integrated management information systems,effective reporting, and change control pro-cesses.

A firm’s internal control framework shouldsupport its entire capital planning process, includ-ing: the sufficiency of and adherence to policiesand procedures; risk identification, measure-ment, and management practices and systemsused to produce input data; and the models,management overlays, and other methods usedto generate inputs to post-stress capital esti-mates. Any part of the capital planning processthat relies on manual procedures should receiveheightened attention. The internal control frame-work should also assess the aggregation andreporting process used to produce reports tosenior management and to the board of directorsand the process used to support capital adequacyrecommendations to the board.

In addition, the control framework shouldinclude an evaluation of the firm’s process forintegrating the separate components of the capi-tal planning process at the enterprise-wide level.

1. Comprehensive Policies, Procedures,and Documentation for Capital Planning

A firm should have policies and procedures thatsupport consistent and repeatable capital plan-ning processes.17 Policies and procedures shoulddescribe the capital planning process in a man-ner that informs internal and external stakehold-ers of the firm’s expectations for internal prac-tices, documentation, and business line controls.The firm’s documentation should be sufficientto provide relevant information to those makingdecisions about capital actions. The documenta-tion should also allow parties unfamiliar with aprocess or model to understand generally how itoperates, as well as its main limitations, keyassumptions, and uncertainties.

Policies and procedures should also clearlyidentify roles and responsibilities of staff in-volved in capital planning and provide account-ability for those responsible for the capital plan-ning process. A firm should also have anestablished process for policy exceptions. Suchexceptions should be approved by the appropri-ate level of management based upon the gravityof the exception. Policies and procedures shouldreflect the firm’s current practices, and be re-viewed and updated as appropriate, but at leastannually. A firm should maintain evidence thatmanagement and staff are adhering to policiesand procedures in practice.

A firm’s documentation should cover keyaspects of its capital planning process, includingits risk-identification, measurement and man-agement practices and infrastructure; methodsto estimate inputs to post-stress capital ratios;the process used to aggregate estimates andproject capital needs; the process for makingcapital decisions; and governance and internalcontrol practices. A firm’s capital planning docu-mentation should include detailed informationto enable independent review of key assump-tions, stress testing outputs, and capital actionrecommendations.

2. Model Validation and IndependentReview of Estimation Approaches

Models used in the capital planning processshould be reviewed for suitability for their in-tended uses. A firm should give particular con-sideration to the validity of models used for

17. See Instructions for the Capital Planning and StressTesting Information Collection (Reporting Form FR Y-14A),Appendix A (Supporting Documentation), available atwww.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDa2AwLR/gLe5DPhQFttuq/4.





calculating post-stress capital positions. In par-ticular, models designed for ongoing businessactivities may be inappropriate for estimatinglosses, revenue, and expenses under stressedconditions. If a firm identifies weaknesses oruncertainties in a model, the firm should makeadjustments to model output if the findingswould otherwise result in the material under-statement of capital needs (see Appendix B,“Model Overlays”). If the deficiencies are criti-cal, the firm should restrict the use of the model,apply overlays, or avoid using the model en-tirely.

A firm should independently validate or oth-erwise conduct effective challenge of modelsused in internal capital planning, consistent withsupervisory guidance on model risk manage-ment.18 The model review and validation pro-cess should include an evaluation of conceptualsoundness of models and ongoing monitoring ofthe model performance. The firm’s validationstaff should have the necessary technical compe-tencies, sufficient stature within the organiza-tion, and appropriate independence from modeldevelopers and business areas to provide a criti-cal and unbiased evaluation of the estimationapproaches.

A firm should maintain an inventory of allestimation approaches used in the capital plan-ning process, including models used to produceprojections or estimates used by the models thatgenerate final loss, revenue, expense, and capi-tal projections.19 Material models should receivegreater attention (see Appendix C, “Use ofBenchmark Models in the Capital Planning Pro-cess”).20 The intensity and frequency of valida-tion work should be a function of the impor-tance of those models in generating estimates ofpost-stress capital.

Not all models can be fully validated prior touse in capital planning. However, a firm shouldconduct a conceptual soundness review of allmodels prior to their use in capital planning. Ifsuch a conceptual soundness review is not pos-sible, the absence of that review should be madetransparent to users of model output and thefirm should determine whether the use of com-

pensating controls (such as conservative adjust-ments) are warranted.

Further, a firm should treat output from mod-els for which there are model risk managementshortcomings with caution. In addition, a firmshould have compensating controls for knownmodel uncertainties and apply well supportedconservative adjustments to model results, asappropriate.

A firm should ensure that benchmark or chal-lenger models that contribute to post-stress capi-tal estimates or are otherwise used explicitly inthe capital planning process are identified andsubject to validation (see Appendix C, “Use ofBenchmark Models in the Capital Planning Pro-cess”).

3. Management Information Systems andChange Control Processes

A firm should have internal controls that ensurethe integrity of reported results and that makecertain the firm is identifying, documenting,reviewing, and tracking all material changes tothe capital planning process and its components.The firm should ensure that such controls existat all levels of the capital planning process.Specific controls should ensure

• sufficiently sound management informationsystems to support the firm’s capital planningprocess;

• comprehensive reconciliation and data integ-rity processes for key reports;

• the accurate and complete presentation ofcapital planning process results, including adescription of adjustments made to compen-sate for identified weaknesses; and

• that information provided to senior manage-ment and the board is accurate and timely.

Many of the processes used to assess capitaladequacy, including models, data, and manage-ment information systems, are tightly integratedand interdependent. As a result, a firm shouldensure consistent change control oversight acrossthe entire firm, in line with existing supervisoryguidance.21 A firm should establish and main-tain a policy describing minimum internal con-

18. See SR-11-7, “Supervisory Guidance on Model RiskManagement.” The term “effective challenge” means criticalreview by objective, informed parties who have the properincentives, competence, and influence to challenge the modeland its results.

19. The definition of a model covers quantitative ap-proaches whose inputs are partially or wholly qualitative orbased on expert judgment, provided that the output is quanti-tative in nature.

20. Materiality of the model is a function of both theimportance of the business or portfolio assessed and theimpact of the model on the firm’s overall results.

21. Federal Financial Institutions Examination Council,“IT Examination Handbook—Operations Booklet,” availableat http://ithandbook.ffiec.gov/ITBooklets/FFIEC_ITBooklet_Operations.pdf. See also SR-15-3, “FFIEC Information Tech-nology Examination Handbook.”



http://ithandbook.ffiec.gov/ITBooklets/FFIEC_ITBooklet_Operations.pdf


trol standards for managing change in capitalplanning process policies and procedures, modeldevelopment, information technology, and data.Control standards for these areas should addressrisk, testing, authorization and approval, timingof implementation, post-installation verification,and recovery, as applicable.

4. Internal Audit Function

Internal audit should play a key role in evaluat-ing capital planning and the elements describedin this guidance to ensure that the entire processis functioning in accordance with supervisoryexpectations and the firm’s policies and proce-dures. Internal audit should review the mannerin which deficiencies are identified, tracked, andremediated. Furthermore, internal audit shouldensure appropriate independent review and chal-lenge is occurring at all key levels within thecapital planning process.

As discussed further in Appendix E, “Role ofthe Internal Audit Function in the Capital Plan-ning Process,” internal audit staff should havethe appropriate competence and influence toidentify and escalate key issues. All deficien-cies, limitations, weaknesses and uncertaintiesidentified by the internal audit function thatrelate to the firm’s capital planning processshould be reported to senior management, andmaterial deficiencies should be reported to theboard of directors (or the audit committee of theboard) in a timely manner.22

D. Capital Policy

A capital policy is a firm’s written assessmentof the principles and guidelines used for capitalplanning, issuance, usage, and distributions.23

This includes internal post-stress capital goals(as discussed in more detail below and in Appen-dix F, “Estimating Impact on Capital Positions”)and real-time targeted capital levels; guidelinesfor dividend payments and stock repurchases;strategies for addressing potential capital short-falls; and internal governance responsibilitiesand procedures for the capital policy. The capi-tal policy must be approved by the firm’s board

of directors or a designated committee of theboard.24

The capital policy should be reevaluated atleast annually and revised as necessary to ad-dress changes to the firm’s business strategy,risk appetite, organizational structure, gover-nance structure, post-stress capital goals, real-time targeted capital levels, regulatory environ-ment, and other factors potentially affecting thefirm’s capital adequacy.

A capital policy should describe the firm’scapital adequacy decision-making process,including the decision-making process for com-mon stock dividend payments or stock repur-chases.25 The policy should incorporate action-able protocols, including governance andescalation, in the event a post-stress capital goal,real-time targeted capital level, or other earlywarning metric is breached. The policy shouldalso include elements such as

• roles and responsibilities of key parties, includ-ing those responsible for producing analyticalmaterials, reviewing the analysis, and makingcapital distribution recommendations and de-cisions;

• factors and key metrics that influence the size,timing, and form of capital actions, and theanalytical materials used in making capitalaction decisions; and

• the frequency with which capital adequacywill be evaluated and the analysis that will beconsidered in the determination of capitaladequacy, including the specific circum-stances that activate the contingency plan.

1. Post-Stress Capital Goals

A firm should establish post-stress capital goalsthat are aligned with its risk appetite and riskprofile, its ability to act as a financial intermedi-ary in times of stress, and the expectations ofinternal and external stakeholders. Post-stresscapital goals should be calibrated based on thefirm’s own internal analysis, independent ofregulatory capital requirements, of the mini-mum level of post-stress capital the firm has

22. For additional information on supervisory expectationsfor internal audit, see SR-13-1, “Supplemental Policy State-ment on the Internal Audit Function and Its Outsourcing.”

23. 12 C.F.R. 225.8(d)(7).

24. 12 C.F.R. 225.8(e)(1)(iii).25. Consistent with the Board’s November 14, 1985, Pol-

icy Statement on the Payment of Cash Dividends, the prin-ciples of which are incorporated into this guidance, firmsshould have comprehensive policies on dividend paymentsthat clearly articulate the firm’s objectives and approaches formaintaining a strong capital position and achieving the objec-tives of the policy statement. See Bank Holding Company

Supervision Manual, section 2020.5.1.1, Intercompany Trans-

actions (Dividends), available at www.federalreserve.gov/boarddocs/supmanual/bhc/bhc.pdf.



http://www.federalreserve.gov/boarddocs/supmanual/bhc/bhc.pdf


deemed necessary to remain a going concernover the planning horizon. A firm should alsodetermine targets for real-time capital ratios andcapital levels that ensure that capital ratios andlevels would not fall below the firm’s internalpost-stress capital goals (including regulatoryminimums) under stressful conditions at anypoint over the planning horizon. For more de-tails, see Appendix F, “Capital Policy.”

E. Incorporating Stressful Conditionsand Events

As part of its capital planning process, a firmshould incorporate appropriately stressful condi-tions and events that could adversely affect thefirm’s capital adequacy into its capital planning.As part of its capital plan, a firm must use atleast one scenario that stresses the specific vul-nerabilities of the firm’s activities and associ-ated risks, including those related to the com-pany’s capital adequacy and financialcondition.26 More generally, as part of its ongo-ing capital adequacy assessment, a firm shoulduse multiple scenarios to assess a broad range ofrisks, stressful, conditions, or events that couldimpact the firm’s capital adequacy.

1. Scenario design

A firm should develop complete firm-specificscenarios that focus on the specific vulnerabili-ties of the firm’s risk profile and operations. Thescenario design process should be directly linkedto the firm’s risk identification process and asso-ciated risk assessment. For those aspects of risksnot well captured by scenario analysis, the firmshould clearly articulate how the risks are other-wise captured and addressed in the capital plan-ning process and factored into decisions aboutcapital needs and distributions.

In developing its scenarios, the firm shouldrecognize that multiple stressful conditions orevents can occur simultaneously or in rapidsuccession. The firm should also consider thecumulative effects of stressful conditions, includ-ing possible interactions among the conditionsand second-order or “knock-on” effects.

When identifying and developing the specificset of stressful conditions to capture in its stressscenarios, the firm should engage a broad rangeof internal stakeholders, such as risk experts,business managers, and senior management, toensure the process comprehensively takes into

account the full range of vulnerabilities specificto the firm.

2. Scenario narrative

A firm’s stress scenario should be supported bya detailed narrative describing how the scenarioaddresses the firm’s particular material risks andvulnerabilities, and how the paths of the sce-nario variables relate to each other. The narra-tive should describe the key attributes of thescenario, including any stress events in the sce-nario, such as counterparty defaults, large opera-tional risk related events, and ratings down-grades. For more details, see Appendix G,“Scenario Design.”

F. Estimating Impact on Capital Positions

A firm should employ estimation approachesthat allow it to project the impact on capitalpositions of various types of stressful conditionsand events. The firm’s stress testing practicesshould capture the potential increase in losses ordecrease in pre-provision net revenue (PPNR)that could result from the firm’s risks, expo-sures, and activities under stressful scenarios. Afirm should estimate losses, revenues, expenses,and capital using a sound method that relatesmacroeconomic and other risk drivers to itsestimates. The firm should be able to identifythe manner in which key variables, factors, andevents in a scenario affect losses, revenue, ex-penses, and capital over the planning horizon.Projections of losses and PPNR should be doneat a level of granularity that allows for theappropriate differentiation of risk drivers, whilebalancing practical constraints such as data limi-tations (see Appendix A, “Use of Models andOther Estimation Approaches” and AppendixD, “Sensitivity Analysis and Assumptions Man-agement”).

The balance sheet projection process shouldestablish and incorporate the relationships amongrevenue, expense, and on- and off-balance sheetexposures under stressful conditions, includingnew originations, purchases, sales, maturities,prepayments, defaults, and other borrower anddepositor behavior considerations. A firm shouldalso ensure that changes in its asset mix andresulting RWAs are consistent with PPNR andloss estimates. A firm should be able to identifykey risk drivers, variables or factors in the sce-

26. 12 C.F.R. 225.8(e)(2).



narios that generate increased losses, reducedrevenues, and changes to the balance sheet andRWAs over the planning horizon (see AppendixH, “Risk-weighted Asset (RWA) Projections”).

1. Loss estimation

A firm should estimate losses using a soundmethod that relates macroeconomic and otherrisk drivers to losses. A firm should empiricallydemonstrate that a strong relationship existsbetween the variables used in loss estimationand prior losses. When using supervisory sce-narios, a firm should project additional scenariovariables beyond those included in the supervi-sory scenarios if the additional variables wouldbe more directly linked to particular portfoliosor exposures. A firm should include a variety ofloss types in its stress tests based on the firm’sexposures and activities. Loss types shouldinclude retail and wholesale credit risk losses,credit and fair value losses on securities, marketand default risk on trading and counterpartyexposures, and operational-risk losses.

a. Credit risk losses on loans and securities

A firm should develop sound methods to esti-mate credit losses under stress that take intoaccount the type and size of portfolios, riskcharacteristics, and data availability. A firmshould understand the key characteristics of itsloss estimation approach. In addition, a firm’sreserves for each quarter of the planning hori-zon, including the last quarter, should be suffi-cient to cover estimated loan losses consistentwith generally accepted accounting standards. Afirm should account for the timing of loss recog-nition in setting the appropriate level of reservesat the end of each quarter of the planninghorizon.

A firm should test credit-sensitive securitiesfor potential other-than-temporary impairment(OTTI) regardless of current impairment status.The threshold for determining OTTI for struc-tured products should be based on cash-flowanalysis and credit analysis of underlying obli-gors.

b. Fair-value losses on loans and securities

As applicable, a firm should project changes in

the fair value of loans and available-for-salesecurities (and impaired held-to-maturity securi-ties). The projections should be based on rel-evant risk drivers, such as changes in creditspreads and interest rates. The firm should en-sure that the risk drivers appropriately captureunderlying risk characteristics of the loan orsecurity, including duration and the credit riskof the underlying collateral or issuer.

c. Market and default risks on trading andcounterparty exposures

A firm should project how the stress affectsmark-to-market values and the default risk of itstrading and counterparty exposures. A firm shouldcapture all of its trading positions and counter-party exposures, identify all relevant risk fac-tors, and employ sound revaluation methods. Aspart of its scenario analysis, as described ingreater detail in section III.E of this guidance“Incorporating Stressful Conditions,” a firmshould use scenarios that severely stress thefirm’s mark-to-market positions and account forthe firm’s idiosyncratic risks.

d. Operational-risk losses

A firm should maintain a sound process forestimating operational risk losses in its capitalplanning process. Operational losses can risefrom various sources, including inadequate orfailed internal processes, people, and systems,or from external events (see Appendix I, “Opera-tional Loss Projections”).

A firm should have a structured, transparent,and repeatable framework in place to developcredible loss projections under stress that takesinto account the differences in loss characteris-tics of different types of operational loss events.The approaches used to project operational lossesshould be well supported and include scenarioanalysis.

2. PPNR

In projecting PPNR, a firm should take intoaccount not only its current positions, but alsohow its activities, business strategy, and revenuedrivers may evolve over time under the varyingcircumstances and operating environments. Thefirm should ensure that the various PPNR com-ponents, including net interest income, non-interest income and non-interest expense, andother key items projected by the firm such as



balance sheet positions, RWA, and losses, areprojected in a manner that is internally con-sistent.

The ability to effectively project net interestincome is dependent upon the firm’s ability toidentify and aggregate current positions andtheir attributes; project future changes in accru-ing balances due to a variety of factors; andappropriately translate the impact of these fac-tors and relevant interest rates into net interestincome based on assumed conditions. Accord-ingly, a firm’s current portfolio of interest-bearing assets and liabilities should serve as thefoundation for its forward-looking estimates ofnet interest income. Beginning positions, posi-tions added during the planning horizon, and theexpected behavior of those positions are criticaldeterminants of net interest income. A firmshould have the ability to capture these dynamicrelationships under its stress scenarios, and shouldensure all related assumptions are well sup-ported (see Appendix D, “Sensitivity Analysisand Assumptions Management”).

Non-interest income is derived from a diverseset of sources, including fees, certain realizedgains and losses, and mark-to-market income.Non-interest income generally is more suscep-tible to rapid changes than net interest income,especially if certain market measures movesharply. A firm’s projections should incorporatematerial factors that could affect the generationof non-interest income under stress, includingthe firm’s business strategy, the competitivelandscape, and changing regulations.

Non-interest expenses include both expensesthat are likely to vary with certain stressfulconditions and those that are not. Projections ofexpenses that are closely linked to revenues orbalances should vary with projected changes inrevenue or balance sheet levels. Non-interestexpense should be projected using either quanti-tative estimation methods or well-supported judg-ment, depending on the underlying drivers ofthe expense item.

3. Aggregating Estimation Results

A firm should have well-documented processesfor projecting the size and composition of on-and off-balance sheet positions and RWAs overthe planning horizon that feed in to the widercapital planning process (see Appendix H, “Risk-weighted Asset (RWA) Projections”).

A firm should have a consistently executedprocess for aggregating enterprise-wide stresstest projections of losses, revenues, and ex-penses, including estimating on- and off-balance

sheet exposures, and RWAs, and for calculatingpost-stress capital positions and ratios. The ag-gregation system should be able to bring to-gether data and information across businesslines, portfolios, and risk types and should includethe data systems and sources, data reconciliationpoints, data quality checks, and appropriate in-ternal control points to ensure accurate and con-sistent projection of financial data withinenterprise-wide scenario analysis. Internal pro-cesses for aggregating projections from all rel-evant systems and regulatory templates shouldbe identified and documented. In addition, thebeginning points for projections and scenariovariables should align with the end of the his-torical reference period.

Appendix A: Use of Models and OtherEstimation Approaches

Projections of losses and PPNR under variousscenarios are key components of enterprise-wide stress testing and capital planning. Thefirm should ensure that its projection ap-proaches, including any specific processes ormethodologies employed, are well supported,transparent, and repeatable over time.

A firm should generally use models or otherquantitative methods, supported by expert judg-ment as appropriate, as the basis for generatingprojections. In limited instances, such as incases of new products or businesses, or whereinsufficient data are available to support mod-eled approaches, qualitative approaches may beappropriate in lieu of quantitative methods togenerate projections for those specific areas.

A firm should adhere to supervisory guidanceon model risk management (SR-11-7) whenusing models, and should have sound internalcontrols around both quantitative and qualitativeapproaches.

1. Quantitative Approaches

Firms use a range of quantitative approaches forcapital planning. The type and level of sophisti-cation of any quantitative approach should beappropriate for the type and materiality of theportfolio or activity for which it is used and thegranularity and length of available data. Thefirm should also ensure that the quantitativeapproach selected generates credible estimates



that are consistent with assumed scenario condi-tions.

A firm should separately estimate losses andPPNR for portfolios or business lines that areeither sensitive to different risk drivers or sensi-tive to risk drivers in a markedly different way,particularly during periods of stress. For instance,losses on commercial and industrial loans andcommercial real estate (CRE) loans are, in part,driven by different risk factors, with the path ofproperty values having a pronounced effect onCRE loan losses, but not necessarily on othercommercial loans. Similarly, although fallingproperty values affect both income-producingCRE loans and construction loans, the effectoften differs materially due to structural differ-ences between the two portfolios. Such differ-ences can become more pronounced duringperiods of stress.

A firm should have a well-supported variableselection process that is based on economicintuition, in addition to statistical significancewhere applicable. The firm should provide aclear rationale for the macroeconomic variablesor other risk drivers chosen for all quantitativeapproaches, including why certain variables orrisk drivers were not selected.

A firm should estimate losses and PPNR at asufficiently disaggregated level within a givenportfolio or business line to capture observedvariations in risk characteristics (for example,credit score or loan-to-value ratio ranges forloan portfolios) and performance across sub-portfolios or segments under changing condi-tions and environments. Loss and PPNR esti-mates should also be sufficiently granular tocapture changing exposure levels over the plan-ning horizon. However, in assessing the appro-priate level of granularity of segments, a firmshould factor in issues such as the availability ofdata or the costs and benefits of model complex-ity. For example, when projecting losses for amore diverse portfolio with a range of borrowerrisk characteristics and observed historical per-formance, firms should segment the portfoliomore finely based on key risk attributes unlessthe segments lack sufficient data observations toproduce reliable model estimates.

a. Use of Data

A firm should use internal data to estimatelosses and PPNR as part of its enterprise-wide

stress testing and capital planning practices.27

However, it may be appropriate for a firm to useexternal data if internal data limitations exist asa result of systems limitations, acquisitions, ornew products, or other factors that may causeinternal data to be less relevant for developingstressed estimates. If a firm uses external data toestimate its losses or PPNR, the firm shouldensure that the external data reasonably approxi-mate underlying risk characteristics of the firm’sportfolios or business lines. Further, the firmshould make adjustments to estimation methodsor outputs, as appropriate, to account for identi-fied differences in risk characteristics and per-formance reflected in internal and external data.In addition, firms should relate their projectionsunder stress scenarios to the characteristics oftheir assets and activities described in theirinternal data.

A firm should generally include all availabledata in its analysis, unless the firm no longerengages in a line of business or its activitieshave changed such that the firm is no longerexposed to a particular risk. The firm should notselectively exclude data based on the changingnature of the ongoing business or activity with-out strong empirical support. For example, ex-cluding certain loans only on the basis that theywere underwritten to standards that no longerapply or on the basis that the loans were ac-quired by the firm is not sound practice.

b. Use of Vendor Models28

A firm should have processes to confirm thatany vendor or other third-party models it usesare sound, appropriate for the given task, andimplemented properly. A firm should clearlyoutline limitations and uncertainties associatedwith vendor models.

Vendor model management includes havingan appropriate vendor selection process, assign-ing staff to oversee and maintain the vendorrelationships, and ensuring that there is suffi-cient documentation of vendor models. A firmshould also confirm that vendor models havebeen sufficiently tested and that data used by thevendor are appropriate for use at the firm. Thefirm should also establish key measures for

27. Firms are required to collect and report a substantialamount of risk information to the Federal Reserve on FR Y-14schedules. These data may help to support the firms’ enterprise-wide stress test. See Capital Assessments and Stress Testinginformation collection, Reporting Forms FR Y-14A, Q, andM.

28. See SR-13-19/CA 13-21, “Guidance on Managing Out-sourcing Risk.” (Refer to this manual’s section 2124.3)



evaluating vendor model performance and track-ing those measures whenever those vendor mod-els are used, as well as assess vendor models(including to incorporate any relevant updatesor changes). Vendor models should be subject tovalidation processes similar to those employedfor models developed internally.

2. Assessing Model Performance

A firm should use measures to assess modelperformance that are appropriate for the type ofmodel being used. The firm should outline howeach performance measure is evaluated andused. A firm should also assess the sensitivity ofmaterial model estimates to key assumptionsand use benchmarking to assess reliability ofmodel estimates (see Appendix C, “Use of Bench-mark Models in the Capital Planning Process”and Appendix D, “Sensitivity Analysis and As-sumptions Management”).

A firm should employ multiple performancemeasures and tests, as generally no single mea-sure or test is sufficient to assess model perfor-mance. This is particularly the case when themodels are used to project outcomes in stressfulcircumstances. For example, assessing modelperformance through out-of-sample and out-of-time back testing may be challenging due to theshort length of observed data series or the pau-city of realized stressed outcomes against whichto measure the model performance. When usingmultiple approaches, the firm should have aconsistent framework for evaluating the resultsof different approaches and supporting rationalefor why it chose the methods and estimatesultimately used.

A firm should provide supporting informationabout models to users of the model output,including descriptions of known measurementproblems, simplifying assumptions, model limi-tations, or other ways in which the model exhib-its weaknesses in capturing the relationshipsbeing modeled. Providing such qualitative infor-mation is critical when certain quantitative crite-ria or tests measuring model performance arelacking.

3. Qualitative Approaches

A qualitative approach to project losses andPPNR may be appropriate in limited cases wheresevere data or other limitations preclude thedevelopment of reliable quantitative approaches.The firm should document why such an ap-proach is reliable for generating projections andis justified based on business need.

When using a qualitative approach, the firmshould substantiate assumptions and estimatesusing analysis of current and past risk driversand performance, internal risk identification,forward-looking risk assessments, external analy-sis or other available information. The firmshould conduct an initial and ongoing assess-ment of the performance and viability of thequalitative approach. The processes used inqualitative projection approaches should be trans-parent and repeatable. The firm should alsoclearly document qualitative approaches and keyassumptions used.

Qualitative approaches should be subject toindependent review, although the review maydiffer from the review of quantitative ap-proaches or models. The level of independentreview should be commensurate with the

• materiality of the portfolio or business line forwhich the qualitative approach is used;

• impact of the approach’s output on the overallcapital results; and

• complexity of the approach.

Firm staff conducting the independent reviewof the qualitative approaches should not beinvolved in developing, implementing or usingthe approach. However, this staff can be differ-ent than the staff that conducts validation ofquantitative approaches or models.

Appendix B: Model Overlays

A firm may need to rely on overrides or adjust-ments to model output (model overlay) to com-pensate for model, data, or other known limita-tions.29 If well-supported, use of a model overlaycan represent a sound practice.

A model overlay may be appropriate to ad-dress cases of identified weaknesses or limita-tions in the firm’s models that cannot be other-wise addressed, or for select portfolios that haveunique risks that are not well captured by themodel used for those exposures and activities.30

In contrast, a model overlay that functions as a

29. For the purposes of this appendix, the term “overlays”will be used to cover overrides, overlays, or other adjustmentsapplied to model output. Firms should follow expectations setforth in SR-11-7, “Supervisory Guidance on Model RiskManagement,” relating to overlays.

30. Expectations for the use of judgment within modeldevelopment is discussed in Appendix A, “Use of Models andOther Estimation Approaches.”



general “catch all” buffer on top of targetedcapital levels to account for model weaknessesgenerally would not represent sound practice.31

A firm should also avoid extensive relianceon model overlays throughout its capital plan-ning process, particularly for material portfoliosor where an overlay would have a large effecton projections. Further, a firm should reduce itsreliance on overlays by addressing the under-lying model issue over time. Firms should evalu-ate the reasons for overlays and track and ana-lyze overlay performance.

As part of its overall documentation of meth-odologies used in stress testing, a firm shoulddocument its use of model overlays. Firms mustbe able to identify the main factors necessitatingthe use of an overlay as well as how the selectedoverlay addresses those factors. Key assump-tions related to the overlay should be clearlyoutlined and consistent with assumed scenarioconditions.

1. Process for Applying Overlays

A firm should establish a consistent firm-wideprocess for applying model overlays and forcontrols around model overlays. The processcan vary by model type and portfolio, but shouldcontain some key elements, as described below.This process should be outlined in the firm’spolicies and procedures and include a specificexception process for the use of overlays that donot follow the firm’s standards. As part of modeldevelopment, implementation and use, overlaysshould be well documented, supported and com-municated to senior management. Model over-lays should be applied in an appropriate, system-atic, and transparent manner. Model results shouldalso be reported to senior management with andwithout overlay adjustments.

Model overlays (including those based solelyon expert or management judgment) should besubject to validation or some other type of effec-tive challenge.32 Consistent with the materiality

principle in SR-11-7, the intensity of model riskmanagement for overlays should be a functionof the materiality of the model and overlay.Effective challenge should occur before the modeloverlay is formally applied, not on an ex-postbasis.

Validation or other type of effective challengeof model overlays may differ from quantitativemodel validation. Staff responsible for effectivechallenge should not also be setting the overlayitself or providing significant input to the levelor type of overlay. For example, a committeethat develops an overlay should not also beresponsible for the effective challenge of theoverlay. In addition, staff engaging in the effec-tive challenge of model overlays should meetsupervisory expectations relating to incentives,competence, and influence (as outlined inSR-11-7). Staff conducting effective challengeshould confirm that model overlays are suffi-ciently conservative to compensate for modellimitations and associated uncertainties in modelestimates. Sensitivity analysis should be used tohelp quantify the overlay.

2. Governance of Overlays

Overlays and adjustments used by a firm shouldbe reviewed and approved at a level within theorganization commensurate with the materialityof that overlay or adjustment to overall proforma results. In general, the purpose and im-pact of overlays should be communicated tosenior management in a manner that facilitatesan understanding of the issues by the firm’ssenior management. Material overlays to themodel—either in isolation or in combination—should receive a heightened level of support andscrutiny, up to and including review by thefirm’s board of directors (or a designated com-mittee), in instances where the impact on proforma results is material.

Seniormanagement shouldperiodically receivea high-level description of the use of modeloverlays. This description should include thenumber of models having overlays, whethermore material models have overlays, whetheroverlays on the whole result in more or lessconservative projections, and the range of theeffect of overlays on the model output (espe-cially for those cases where the overlays pro-duce less conservative outcomes).

Senior management should be able to inde-pendently assess the reasonableness of using an

31. Firms may choose to apply overall capital buffers as anadditional conservative measure, beyond overlays applied atthe model level. Overall capital buffers should be subject tothe same governance processes applicable to model overlays,as described in section 2 of this appendix. However, supervi-sors emphasize that having such a buffer should not in anyway replace sound model risk management practices for over-lays at the individual model level or address the need for theoverlay at the individual model level.

32. The term “effective challenge” means critical reviewby objective, informed parties who have the proper incentives,

competence, and influence to challenge the model and itsresults.



overlay to capture a particular risk or compen-sate for a known limitation. Extensive use ofoverlays should trigger discussion as to whethernew or improved modeling approaches are neededto reduce overlay dependency. Signs that theunderlying model needs revision or redevelop-ment include a high rate of overrides or over-rides that consistently affect model performance.

Appendix C: Use of Benchmark Modelsin the Capital Planning Process

As noted in Appendix A, “Use of Models andOther Estimation Approaches,” a firm shoulduse a variety of methods, including benchmark-ing, to assess model performance and gain com-fort with model estimates. A firm should usebenchmark or challenger models to assess theperformance of its primary models for all mate-rial portfolios or to supplement, where appropri-ate, the primary models.33 Such models shouldbe used in conjunction with other aspects ofbenchmarking, such as comparing model resultsto actual market data, internal firm data, datafrom similar firms or portfolios, or judgmentalestimates by business line experts. A firm shouldalso use benchmark models during validation asan additional check on the primary model andits results.

Use of benchmark models is particularly im-portant when primary models have exhibitedsignificant deficiencies or are still under devel-opment. For instance, a firm’s primary modelmay use a preferred methodology, but lack arich data set to support modeled estimates. Inthese cases, the firm should use benchmarkmodels based on different data and modelingapproaches to provide additional checks on pri-mary model estimates. To the extent that abenchmark model highlights that a primary modelhas flaws (e.g., the model is producing outputthat is vastly different from experience duringprior periods of stress), a firm should analyzewhether it would be appropriate to adjust themodel specification, apply model overlays, ordevelop different estimation approaches.

Benchmark models that are developed andrun independently of primary models can beused to more effectively calibrate the firm’sfinal estimates. For example, a firm can usebenchmark model outputs to substantiate modeloverlays,givendifferences in riskcapturebetween

primary and benchmark models. This type of“triangulation” is especially suitable for thoseareas of modeling that present considerable un-certainty.

Benchmark models used to arrive at the firm’sfinal estimates should be subject to model riskmanagement. The intensity and frequency ofvalidation or other type of effective challenge ofbenchmark models of a firm should correspondto the importance of those models in generatingestimates. For example, if the output of a bench-mark model is averaged with primary modelresults to develop final estimates, or if the bench-mark model is used to develop overlays or over-rides for the primary model, that model shouldbe subject to more intensive validation.

Benchmark models that are used only duringthe validation process and do not contributedirectly to the firm’s estimates do not need to bevalidated. However, a firm should assess therigor of all benchmark models and benchmarkdata used to ensure they provide reasonablecomparisons.

Appendix D: Sensitivity Analysis andAssumptions Management

A firm should understand the sensitivity of itsstress testing estimates used in capital planningto the various inputs and assumptions. In addi-tion, sensitivity analysis should be used to testthe robustness of quantitative approaches andmodels and enhance reporting to the firm’ssenior management, board of directors, and su-pervisors. A firm should ensure that it identifies,documents, and manages the use of all keyassumptions used in capital planning.

1. Sensitivity Analysis

Understanding and documenting a range of po-tential outcomes provides insight into the inher-ent uncertainty and imprecision around pro formaresults. A firm should assess the sensitivity of itsestimates of capital ratios, losses, revenues, andRWAs to key assumptions and uncertainty acrossthe entire firm’s projections under stress. Throughthis assessment, a firm should calculate a rangeof potential estimates based on changes to as-sumptions and inputs. Examples of assumptionsthat generally should be subject to sensitivityanalysis include projected market share, size ofthe market, cost and flow of deposits, utilization

33. Note that the terms “benchmark model” and “chal-lenger model” are used interchangeably for purposes of thisappendix to mean a model to support or give additionalperspective to a primary model.



rate of credit lines, discount rates, or level andcomposition of trading assets and RWA.

A firm should also evaluate the sensitivity ofmodels to key assumptions to evaluate modelperformance, assess the appropriateness of as-sumptions, and understand uncertainty associ-ated with model output.

Sensitivity analysis for capital planning mod-els should be applied in a manner consistentwith the expectations outlined in the FederalReserve’s supervisory guidance on model riskmanagement (refer to SR-11-7). Sensitivity analy-sis should be conducted during model develop-ment and during model validation to provideinformation about how models respond to changesin key inputs and assumptions, and how thosemodels perform in stressful conditions. In addi-tion, sensitivity analysis should be applied tounderstand the range of possible results fromvendor-provided models and vendor-providedscenario forecasts that have opaque or propri-etary elements. Sensitivity analysis should beused to provide information to help users ofmodel output interpret results, but does not haveto result in changes to models or model outputs.Changes made based on sensitivity analysisshould be clearly documented and justified.

A firm should ensure that the key sensitivitiesare presented to senior management and theboard in advance of decision-making around thefirm’s capital plan and capital actions. Sensitiv-ity analysis should also be used to inform seniormanagement, and, as appropriate, the board ofdirectors about the potential uncertainty associ-ated with models employed of the firm’s projec-tions under stress.

2. Assumptions Management

A firm should clearly document assumptionswhen estimating losses, PPNR, and balancesheet, and RWA components. Documentationshould include the rationale and empirical sup-port for assumptions and specifically addresshow those assumptions are consistent with andappropriate under the firm’s scenario conditions.

A firm’s rationale for assumptions used incapital planning should be consistent with thedifferent effects of scenario conditions, shifts inportfolio mix, and growth or decline in balancesprojected over the planning horizon. For exam-ple, the firm should scrutinize and support anyassumptions about sizeable loan growth duringa severe economic downturn.

A firm should generally use conservativeassumptions, particularly in areas of high uncer-tainty. The firm should provide greater supportfor assumptions that appear optimistic or other-wise appear to benefit the firm (such as lossreduction or revenue enhancement). A firm shouldnot assume that senior management will be ableto realize favorable strategic actions that cannotbe reasonably assured in stress scenarios giventhe high level of uncertainty around market con-ditions. Further, a firm should not assume that itwould have the perfect foresight that wouldallow it, for example, to make significant ex-pense reductions in the first quarter of the fore-cast horizon in anticipation of the forthcomingeconomic deterioration described in the sce-nario.

A firm should not always assume that histori-cal patterns will repeat. For example, a firmshould not assume that if it has suffered no orminimal losses in a certain business line orproduct in the past, such a pattern will continue.In addition, a firm should carefully analyzeeffects of any structural changes in customerbase, product, and financial markets on its pro-jections, as these changes could significantlyaffect a firm’s performance under stress sce-narios. Furthermore, the firm should explore thepotential effects of changes in assumed interre-lationships among variables and the behavior ofexposures. The firm should also explicitly jus-tify, document, and appropriately challenge anyassumptions about diversification benefits.

A firm should confirm that key assumptionsused in vendor or other third-party products aretransparent and have sufficient support beforeusing the products in stress testing. The firmshould limit use of vendor products whose as-sumptions are not fully transparent or supportedor use those products only in conjunction withanother approach or compensating controls (e.g.,overlays).

Appendix E: Role of the Internal AuditFunction in the Capital Planning Process

A firm’s internal audit function should play akey role in evaluating the adequacy of the firm’scapital planning process and in assessing whetherthe risk management and internal control prac-tices supporting that process are comprehensiveand effective. A firm should establish an auditprogram around its capital planning process thatis consistent with SR-13-1, “Supplemental Pol-icy Statement on the Internal Audit Functionand its Outsourcing.”



1. Responsibilities of Audit Function

The internal audit function should identify allauditable processes related to capital planningand develop an associated audit plan. The auditfunction should also perform substantive testingto ascertain the effectiveness of the controlframework supporting the firm’s capital plan-ning process, communicate identified limita-tions and deficiencies to senior management,and communicate material limitations and defi-ciencies to the board of directors (or the auditcommittee of the board). The audit functionshould comprehensively cover the firm’s capitalplanning process.

The internal audit function should performperiodic reviews of all aspects of the internalcontrol framework supporting the capital plan-ning process to ensure that all individual compo-nents as well as the entire process are function-ing in accordance with supervisory expectationsand the firm’s policies and procedures. Theinternal audit function should also review themanner in which deficiencies are identified,tracked, and remediated. Furthermore, the inter-nal audit function should ensure appropriateindependent review is occurring at various lev-els within the capital planning process.

A firm’s internal audit staff should have theappropriate competence and stature to identifyand escalate key issues when necessary. Ad-equate quantitative expertise is needed to assessthe effectiveness of the capital planning pro-cesses and procedures. The role of audit staff isto evaluate whether the capital planning processis comprehensive, rigorous, and effective. Theinternal audit function may also rely on an inde-pendent third party external to the firm to com-plete some of the substantive testing as long asthe internal audit function can demonstrate properindependence of the third-party from the areabeing assessed and provide oversight over theexecution and quality of the work.

Other supervisory expectations for the inter-nal audit function relating to the capital ad-equacy process include

• verifying that acceptable policies are in placeand that staff comply with those policies;

• assessing accuracy and completeness of themodel inventory;

• evaluating procedures for updating processesand ensuring appropriate change/version con-trols;

• confirming that staff are meeting documenta-tion standards, including reporting;

• reviewing supporting operational systems andevaluating the reliability of data used in the

capital planning process; and• reviewing the quality of any work conducted

by external parties.

2. Development of Audit Plan

The internal audit function should have a docu-mented plan describing its strategy to assess theprocesses and controls supporting the firm’scapital planning process. When defining theannual audit universe and audit plan, the inter-nal audit function of a firm should focus on themost significant risks relating to the capital plan-ning process. The firm may leverage existing orregularly scheduled audits to ensure coverage ofall the capital planning process components;however, the findings and conclusions of theseaudits should be incorporated into the overallsummary of audit activities and conclusionsregarding the firm’s capital planning process.

The internal audit function should also estab-lish a process for reviewing and updating, asappropriate, its audit plan annually to accountfor material changes to the firm’s capital plan-ning process, internal control systems, infra-structure, work processes, business lines, orchanges to relevant laws and regulations. Thefirm should also ensure that the periodic assess-ment of the capital planning process is sup-ported by a reliable and current assessment ofthe individual components.

3. Briefings to Senior Managementand Board

On an annual basis, the internal audit functionshould report to senior management and theboard of directors on the capital planning pro-cess to inform recommendations and decisionson the firm’s capital plan. The report shouldprovide an opinion of the capital planning pro-cess, a statement of the effectiveness of thecontrols and processes employed, a status up-date on previously identified issues and reme-diation plans, and any open issues or uncertain-ties related to the firm’s capital plan. Any keyprocesses that are not comprehensively re-viewed and tested, due to timing or significantchanges in processes, should be clearly docu-mented and identified as areas with potentialheightened risk. In addition, a firm’s internalaudit function should brief the board of direc-tors (or a designated committee thereof) and



senior management at least quarterly on thestatus of key findings relating to the capitalplanning process.

The internal audit function should trackresponses to its findings and report to the boardany cases in which senior management is notimplementing required changes related to auditfindings or is doing so with insufficient inten-sity. In addition, the internal audit functionshould report any identified material deficien-cies, limitations, or weaknesses related to thefirm’s capital planning process to the board ofdirectors and senior management in a timelymanner.

Appendix F: Capital Policy

A firm’s capital policy should describe how thefirm manages, monitors, and makes decisionsregarding capital planning.34 The policy shouldinclude internal post-stress capital goals andreal-time targeted capital levels; guidelines fordividends and stock repurchases; and strategiesfor addressing potential capital shortfalls.

A firm’s capital policy should describe themanner in which consolidated estimates of capi-tal positions are presented to senior manage-ment and the board of directors. The capitalpolicy should require staff with responsibilityfor developing capital estimates to clearly iden-tify and communicate to senior managementand board of directors the key assumptionsaffecting various components that feed into theaggregate estimate of capital positions and ratios.The capital policy should require that aggre-gated results be directly compared against thefirm’s stated post-stress capital goals, and thatthose comparisons are included within the stan-dard reporting to senior management and theboard of directors.


Post-stress capital goals should provide specificminimum thresholds for the level and composi-tion of capital that the firm intends to maintainduring a stress period. Post-stress capital goalsshould include any capital measures that arerelevant to the firm. The firm should be able to

demonstrate through its own internal analysis,independently of regulatory capital require-ments, that remaining at or above its internalpost-stress capital goals will allow the firm tocontinue to operate. Capital goals should takeinto consideration the uncertainty inherent incapital planning, as well as the economic andmarket outlook.

The capital policy should describe how seniormanagement and the board concluded that thefirm’s post-stress capital goals are appropriate,sustainable in different conditions and environ-ments, and consistent with its strategic objec-tives, business model, and capital plan. In addi-tion, the capital policy should describe the processby which the firm establishes its post-stresscapital goals, and include the supporting analy-sis underpinning the goals chosen by the firm.

A firm should annually review its capitalgoals, evaluate whether its post-stress capitalgoals are still appropriate based on changes inoperating environment, business mix, or otherconditions, and adjust those goals as needed.

A firm should adjust its real-time capital tar-gets (that is the amount of current capital itholds above its post-stress capital goals to en-sure it does not fall below those goals understress) more frequently than it adjusts capitalgoals, based on changes in the business mix,operating environment, or other current condi-tions and circumstances.

2. Dividends and Stock Repurchases

A firm’s capital policy should describe the pro-cesses relating to common stock dividend andrepurchase decisions, including the processes todetermine the timing, form, and amount of allplanned distributions. The capital policy shouldalso specify the analysis and metrics that seniormanagement and the board use to make capitaldistributiondecisions.Theanalysis should includestrategic considerations such as new businessinitiatives, potential acquisitions, and the otherrelevant factors.

The capital policy should identify the types ofcalculations and analysis that support a firm’sproposedcapital actionsanddetermine theamountof capital available for distribution at any giventime. For example, a firm should develop anduse payout ratio limits in the decision makingprocess. While payout ratio limits or targetsshould not be the single determining factor, thecapital policy should describe how payout ratiolimits or targets are considered, including howthey are consistent with firm’s strategic goals,how they were derived, and what analysis was

34. A capital policy is a firm’s written assessment of theprinciples and guidelines used for capital planning, issuance,usage, and distributions. 12 C.F.R. 225.8(d)(7).



used to determine the appropriate amount ofcapital to distribute in a given period. Further, afirm should include in its capital policy thresh-old levels for payout ratios that trigger manage-ment action. Such action should include escala-tion to the board and potential suspension ofcapital distributions. Escalation protocols shouldbe clear, credible, and actionable in the event ofan actual or projected target is breached.

3. Contingency Plans forCapital Shortfalls

A firm’s capital policy should include specificcapital contingency actions the firm would taketo remedy any current or prospective deficien-cies in its capital position. The firm’s capitalcontingency plan should reflect strategies foridentifying and addressing potential capital short-falls and specify circumstances under which theboard of directors and senior management willrevisit planned capital actions or otherwise insti-tute contingency measures.35 A contingency planshould include a set of thresholds for metrics orevents that provide early warning signs of capi-tal deterioration and that trigger managementaction or scrutiny.36 Additionally, triggers formore severe levels of deterioration should belinked to escalation procedures for more imme-diate management action and should be consis-tent with triggers in the firm’s recovery plan.Triggers should reflect both point-in-time andforward-looking measures (both baseline andstress).

Capital contingency plans should includeoptions for actions that a firm would considertaking to remedy any current or prospectivedeficiencies in its capital position, such as reduc-ing or ceasing capital distributions, raising addi-tional capital, reducing risk, or employing othermeans to preserve existing capital. Contingencyoptions in the firm’s capital policy should beconsequential, realistic, actionable, and compre-hensive.

Capital contingency plans should include a

detailed explanation of the circumstances inwhich the firm would consider implementingthese options, including when it would reduceor suspend a dividend or repurchase program ornot execute a previously planned capital action.The capital contingency plans should specifythe type of information that would be providedto decision makers when the firm’s current orprojected capital levels have deteriorated, includ-ing how management would present options toaddress the capital position and the long-termviability of the firm. Contingency options shouldbe ranked according to ease of execution andimpact and should incorporate an assessment ofstakeholder reactions. All options should beevaluated for their feasibility and the reason-ableness of underlying assumptions (such aswhether a firm would be able to raise capital ordraw on capital from another entity during aperiod of stressful market conditions).

Appendix G: Scenario Design

As part of its capital plan, a firm must use atleast one scenario that stresses the specific vul-nerabilities of the firm’s risk profile and opera-tions, including those related to the company’scapital adequacy and financial condition.37 Thefirm’s stress scenario should be at least as severeas the Federal Reserve’s severely adverse super-visory scenario, measured in terms of its effecton net income and other elements that affectcapital.38

As noted in the core document, a firm shoulddevelop at least one complete firm-specific sce-nario that focuses on the specific vulnerabilitiesof the firm’s risk profile and operations. Thefirm’s scenario should be carefully tailored tothe idiosyncratic risks of the firm, as definedthrough the firm’s internal material risk identifi-cation process, and should incorporate circum-stances that are particularly stressful to the firm,

35. Capital contingency planning should be closely inte-grated with the broader crisis management framework, includ-ing recovery and other contingency planning efforts focusedon ensuring sustainability under a broad range of internal orexternal stresses. See SR-14-1 “Heightened Supervisory Ex-pectations for Recovery and Resolution Preparedness for Cer-tain Large Bank Holding Companies,” and SR-14-8, “Con-solidated Recovery Planning for Certain Large DomesticBank Holding Companies.”

36. Capital contingency plans may include triggers forliquidity, earnings, debt and credit default swap spreads, rat-ings downgrades, stock performance, supervisory actions,general market stress, or other noncapital metrics.

37. 12 C.F.R. 225.8(e)(2). In addition, a firm is required toreport to the Federal Reserve its projections under a baselinescenario, which captures the firm’s view of the likely operat-ing environment over the planning horizon. A firm may usethe Board’s baseline scenario for its own baseline scenario ifthe firm can demonstrate that the Board’s baseline scenario isappropriate for the firm’s own risks, activities, and outlook;however, a firm cannot use the Board’s severely adversescenario for its own stress scenario.

38. For guidance on the severity of the scenarios, a firmshould review the Board’s “Policy Statement on the ScenarioDesign Framework for Stress Testing,” which sets forth theBoard’s approach to designing the severely adverse scenario.See 12 C.F.R. 252, appendix A.



given the firm’s idiosyncratic risks and key vul-nerabilities. Such circumstances include thoseaffecting the firm’s particular business model,revenue drivers, mix of assets and liabilities,geographic footprint, portfolio characteristics,and specific operational risk vulnerabilities. Thefirm can incorporate the idiosyncratic stress con-siderations in macroeconomic and financial mar-ket variables or a discrete stress event includedin the scenario. A firm-specific scenario wouldnot meet supervisory expectations if it is nottailored to the firm’s activities and risks. This isthe case even if the severity is generally equiva-lent to the supervisory stress scenarios or if thepost-stress capital ratios are lower than thoseunder the supervisory severely adverse scenario.

The stress scenario should include stressfulcircumstances and events that could, on a stand-alone basis or in combination, reduce the firm’scapital levels and ratios and potentially impedethe firm’s ability to operate as a going concern,and cover material risks to which the firm isexposed over the course of an annual planningcycle. A firm’s scenario should include factorsthat capture economy- or market-wide stressesand idiosyncratic risks that can put a strain onthe firm. A firm should also take into accountconditions and events that have not previouslyoccurred, but that may pose a significant threatto the firm given its exposures, risk profile, andbusiness strategy.

Use of Multiple Scenarios

In addition, a firm should use multiple scenariosas part of its ongoing capital adequacy assess-ment to assess a broad range of risks, stressfulconditions, or events that could impact the firm’scapital adequacy. This assessment should informdevelopment of the internal stress scenario(s)used in the firm’s plan, the firm’s post-stresscapital goals, and its current capital targets. Thefirm’s scenarios should collectively address allmaterial risks to which the firm is exposed overthe course of an annual planning cycle.

In designing its stress scenarios, a firm shouldincorporate risks and vulnerabilities that arisefrom multiple factors, sources and events. His-torical data may provide a starting point forscenarios, but a firm should also consider otherdata sources and challenge conventional assump-tions when identifying the stressful conditionsand events that could adversely affect the firm’scapital adequacy. In certain instances, scenarios

that include economic and financial market vari-ables that deviate from historical experience andcorrelations are appropriate if, for example, pre-viously unobserved vulnerabilities exist in cer-tain sectors of the economy or financial markets.In addition, the firm should not exclude experi-ences that have occurred outside its own historywhen designing stress scenarios, particularly ifthe firm has recently expanded its business toinclude new products, markets, or customers.

The macroeconomic variables used in a givenscenario should collectively describe the generaloperational environment considered in the sce-nario. A firm should ensure that the scenarioincludes sufficient macroeconomic variables tosupport its stress testing estimation methods.While a firm should assess the internal consis-tency of the scenario, the firm should evaluatewhether deviations from historically observedrelationships among macroeconomic variablesthat increase the degree of stress placed on thefirm may be appropriate.

Depending on the significance of market riskin a firm’s overall risk profile, the firm’s stressscenarios should include an adverse movementin financial market variables, such as asset prices,spreads, and rates, and related risk factors thatimpact a firm’s trading exposures. The firmshould base market risk factors in the scenarioon a thorough evaluation of the specific posi-tions of the firm and the material risks coinci-dent with those positions. A firm should limituse of past periods of financial market stressthat do not sufficiently stress the firm’s currentpositions.

Appendix H: Risk-weighted Asset (RWA)Projections

A firm should maintain a sound process forprojecting RWAs over the planning horizon.The firm’s initial RWA calculations should beconsistent with applicable regulatory capital re-quirements. In addition, the firm’s projections ofRWAs should be developed in a fashion consis-tent with the scenario conditions and in accor-dance with applicable regulatory capital require-ments.

1. Initial RWA Calculations

Starting balances for both on- and off-balancesheet exposures and applicable risk weightsform the foundation for estimates of post-stresscapital ratios. Therefore, firms should verifycarefully the accuracy of these starting balances.



Moreover, deficiencies in starting RWA calcula-tions are generally compounded in RWA projec-tions over the planning horizon. A firm shouldensure that it has sound controls around itsRWA calculation and regulatory reporting pro-cesses as part of the firm’s broader data gover-nance program.

2. RWA Projections

A firm should ensure that RWA projections areconsistent with a given scenario and incorporatethe impact of projected changes in exposureamounts and risk characteristics of on- and off-balance sheet exposures under the scenario. Afirm should demonstrate that assumptions asso-ciated with RWA projections are clearly condi-tioned on a given scenario and are consistentwith stated internal and external business strate-gies. In addition, firms should ensure that pro-jected market risk-weighted assets (marketRWAs) are consistent with market factors (e.g.,volatility levels, equity index levels, bondspreads)and assumptions around the size and composi-tion of their trading assets.

A firm should document assumptions for pro-jecting RWAs and their relationship to the RWAprojections. If the firm’s models for projectingRWAs rely upon historical relationships, thefirm should provide a description of the histori-cal data used and clearly describe why theserelationships are expected to be maintained un-der a given scenario. Further, a firm shouldanalyze the appropriateness of assumptions re-garding the following:

• any aggregation of balance projections byexposure type or characteristic (e.g., balancesfor exposures that do not distinguish betweenamounts that are considered past due andthose that are current) for purposes of apply-ing corresponding risk weights;

• any use of average or effective risk weightsbased on the firm’s as-of date portfolio com-position or historical trend; and

• any exposure types for which RWAs are heldconstant over the projection horizon.

For purposes of projecting RWAs under thestandardized approach, a firm should projectbalances, risk characteristics, and calculationparameters with appropriate consistency andgranularity to facilitate application of appropri-ate regulatory risk weights for its on- and off-balance sheet exposures.39 In particular, RWA

projections should include information suffi-cient to assess the impact of potential changes tothe following:

• counterparty mix, collateral mix, collateralhaircuts, and netting assumptions for deriva-tives and repo-style transactions;

• default fund assumptions for derivatives thatare centrally cleared;

• simplified supervisory formula approach(SSFA) input parameters for securitizationexposures;

• organization for Economic Cooperation andDevelopment (OECD) Country Risk Classifi-cations (CRCs) or default status relating toforeign exposures;

• the utilization rate of off-balance sheet linesof credit;

• the mix between unconditionally cancellableand conditionally cancellable off balance sheetexposures;

• the volume of residential mortgage exposuresthat qualify for 50 percent risk weight, and;

• the volume of past due exposures as definedunder Regulation Q.40

3. Market Risk-weighted AssetProjections

The methods and processes used to project mar-ket RWAs will differ across firms, in part as afunction of the combination of model and non-model based methods used to determine startingmarket RWAs. However, as a general matter,market RWAs are expected to be positively cor-related to volatility, spreads, or other relevantmarket factors, holding all things equal. If a firmprojects flat or declining market RWAs over theplanning horizon under the stress scenarios, thefirm should provide support for the reasonable-ness of these assumptions under stressful marketconditions. In addition, the firm should demon-strate that those assumptions are applied consis-tently across the enterprise-wide stress testingprocess, including for revenue projections.

If a firm that is not currently subject to themarket risk rule projects its trading assets andtrading liabilities to grow over the planninghorizon, it should assess whether the projectedgrowth would require the firm to calculate mar-ket RWA under the regulatory capital rule.41

39. 12 C.F.R. 217, subpart D.

40. 12 C.F.R. 217.32(k).41. 12 C.F.R. 217.201.



The firm should estimate the effect of marketRWAs, if applicable, on its projected capitalratios and document the process used to projectmarket RWAs in its capital plan.

4. Independent Review of RWA Reportingand Projections

A firm should implement and document an inde-pendent review of RWA regulatory reporting bythe firm’s internal audit function or anotherindependent control function. The independentreview should ensure point-in-time RWA calcu-lation processes appropriately capture all rel-evant on- and off-balance sheet exposures andare consistent with applicable risk-weightingmethodologies to which the firm is subject underRegulation Q. The independent review shouldbe conducted by a party with the necessaryexpertise to perform such reviews but with inde-pendence from the assignment of the risk weightsfor regulatory reporting purposes. The reviewshould provide reasonable assurance that theinitial RWAs are accurate and that the methodsused to project RWAs are sound. Documenta-tion of the independent review should clearlydescribe the scope of the review, outcomes andfindings of the review, and any associated reme-diation efforts. A firm should also ensure thatthe underlying data processes supporting RWAprojections include appropriate controls, recon-ciliations and attestations, and that data integritytesting is conducted by an independent party.

Appendix I: Operational Loss Projections

A firm faces a wide range of operational risk inconducting its business operations. Operationallosses can arise from various sources, includinginadequate or failed internal processes, people,and systems, or from external events, and candiffer in frequency and severity. For example,some operational loss events, such as credit cardfraud, are often more predictable as they occurat high frequency, but generally have low lossseverity. The outcome of other events, such asmajor litigation, are less certain and can result inoutsized losses.

1. Risk Identification Process

A firm should maintain a sound process for

estimating operational risk losses in its capitalplanning process, taking into account the differ-ences in loss characteristics of different opera-tional loss event types. A firm’s risk identifica-tion process should include the evaluation of thetype of operational risk loss events to which thefirm is exposed and the sensitivity of thoseevents to internal and external operating envi-ronments.

The firm-specific scenario submitted in a firm’scapital plan should capture the firm’s materialoperational risks, be designed with the firm’sparticular vulnerabilities in mind, and includepotential firm-specific events such as systemfailures, or litigation-related losses. The firmshould evaluate both the firm’s own loss historyand the large loss events experienced by indus-try peers with similar business mix and overalloperational risk profiles.

2. Approaches to Operational LossEstimation

The firm should have transparent and well-supported estimation approaches based on bothquantitative analysis and expert judgment, andshould not rely on unstable or unintuitive corre-lations to project operational losses. Scenarioanalysis should be a core component of thefirm’s operational loss projection approaches.

Certain operational risks, particularly thosemost likely to give rise to large losses, oftenmay not have measureable relationships to theoverall scenario conditions. In addition, largeoperational loss events are often idiosyncratic,limiting the relevance of historical data. Thefirm should also limit dependence on distribution-based approaches that rely on historical data andrequire significant assumptions when projectinglarge operational losses. The firm should evalu-ate a range of outcomes under various scenarios,and make generally conservative assumptions.

The firm should engage business line andsenior management to identify operational riskvulnerabilities and assess ways an operationalrisk event may unfold. The estimation ap-proaches should also be subject to an effectiveindependent review and challenge process.

3. Use of Data

The firm’s operational loss projection ap-proaches should make appropriate use of rel-evant reference data, including both internal andexternal data, evaluate all measurable linkagesto overall scenario conditions, and include all



potential sources of material operational risklosses across the firm. A firm’s internal loss datashould serve as both inputs to the firm’s opera-tional loss estimation approaches projectionsand a benchmark for operational loss estimatesin various scenarios. A firm should have soundand comprehensive internal data-collection pro-cesses that capture key operational elements.

The firm should include all relevant operationalloss data, including large operational loss eventssuch as legal settlements and tax and compli-ance penalties. If a firm’s internal data lacksufficient operational loss history or granularity,the firm should use relevant external data tosupplement its internal data.



Federal Reserve Supervisory Assessment of Capital Planningand Positions for Large and Noncomplex Firms Section 4065.0

The Federal Reserve is issuing this guidance toexplain its supervisory expectations for capitalplanning at large and noncomplex bank holdingcompanies and intermediate holding companiesof foreign banking organizations, consistent withthe broad supervisory expectations set forth inSR-12-17/CA-12-14, “Consolidated SupervisionFramework for Large Financial Institutions.”1

Capital is central to a firm’s ability to absorbunexpected losses and continue to lend to credit-worthy businesses and consumers. Therefore, afirm’s processes for managing and allocating itscapital resources are critical to its financialstrength and resiliency, and also to the stabilityand effective functioning of the U.S. financialsystem. The following guidance provides theFederal Reserve’s core capital planning expecta-tions for large and noncomplex firms, buildingupon the capital planning requirements in theFederal Reserve’s capital plan rule and stresstest rules.2,3

The guidance outlines capital planning expec-tations for

• Governance• Risk management• Internal controls• Capital policy• Scenario design, and• Projection methodologies.

Further, the guidance includes several appen-dices that detail supervisory expectations on afirm’s capital planning process. This guidancelargely consolidates the Federal Reserve’s exist-ing capital planning guidance, including:

• Capital Planning at Large Bank Holding Com-panies: Supervisory Expectations and Range

of Current Practice (August 2013)4

• Comprehensive Capital Analysis and Review2015 Summary Instructions and Guidance(October 2014)5

• Instructions for the Capital Assessments andStress Testing information collection (Report-ing Form FR Y-14A), (OMB No. 7100-0341)6

• SR-11-7, “Supervisory Guidance on ModelRisk Management” (Refer to section 2126.0of this manual.)

• SR-12-7, “Supervisory Guidance on StressTesting for Banking Organizations with MoreThan $10 Billion in Total Consolidated Assets”

• SR-12-17/CA-12-14, “Consolidated Supervi-sion Framework for Large Financial Institu-tions” (Refer to section 2124.05 of this manual.)

(Refer to SR-15-19 and its attachment.)

4065.0.1 FEDERAL RESERVEGUIDANCE ON SUPERVISORYASSESSMENT OF CAPITALPLANNING AND POSITIONS FORLARGE AND NONCOMPLEX FIRMS(OMB NO. 7100-0341 AND OMB NO.7100-0342)

I. Introduction

This guidance (the attachment to SR-15-19) pro-vides the Federal Reserve’s core capital plan-ning expectations for Large and NoncomplexFirms, building upon the capital planning require-ments included in the Board’s capital plan ruleand stress test rules. This guidance outlines capi-tal planning expectations7 for these firms in thefollowing areas:

1. The term “capital planning process,” as used herein,which aligns with terminology in SR-12-17/ CA-12-14, isequivalent to the term “capital adequacy process” used inother Federal Reserve documents.

2. For the capital plan rule, refer to section 225.8 ofRegulation Y (12 C.F.R. 225.8). Regulation Q (12 C.F.R. 217)establishes minimum capital requirements and overall capitaladequacy standards for Federal Reserve-regulated institutions.Regulation YY (12 C.F.R. 252) establishes capital stress test-ing requirements for bank holding companies with total con-solidated assets of $50 billion or more, including require-ments to participate in the Federal Reserve’s annual supervisorystress test and conduct their own internal capital stress tests.

3. With the issuance of this letter, SR-99-18, “AssessingCapital Adequacy in Relation to Risk at Large Banking Orga-nizations and Others with Complex Risk Profiles,” is super-seded. In addition, SR-09-4, “Applying Supervisory Guidanceand Regulations on the Payment of Dividends, Stock Redemp-tions, and Stock Repurchases at Bank Holding Companies,” issuperseded with respect to firms subject to this guidance.

4. Available at www.federalreserve.gov/bankinforeg/bcreg20130819a1.pdf.

5. Available at www.federalreserve.gov/newsevents/press/bcreg/bcreg20141017a1.pdf.

6. Available at www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDa2AwLR/gLe5DPhQFttuq/4.

7. Note that these expectations build upon the capital plan-ning requirements set forth in the Board’s capital plan ruleand stress test rules (12 C.F.R. 225.8; 12 C.F.R. 252, subpartsE and F). Other relevant rules pertaining to the Board’sregulatory regime for capital planning and positions aredescribed above in Section II, “Regulatory Requirements forCapital Positions and Planning.” The Federal Reserve maynot conduct or sponsor, and an organization (or a person) isnot required to respond to, a collection of information unlessit displays a currently valid OMB control number. The OMBcontrol numbers for this guidance are OMB No. 7100-0341and OMB No. 7100-0342.








• Governance• Risk management• Internal controls• Capital policy• Incorporating stressful conditions and events,

and• Estimating impact on capital positions.

Further, this guidance provides detailed super-visory expectations on a firm’s capital planningprocess in the following appendices:

A. Use of Models and Other EstimationApproaches

B. Model OverlaysC. Use of Benchmark Models in the Capital

Planning ProcessD. Sensitivity Analysis and Assumptions Man-

agementE. Role of the Internal Audit Function in the

Capital Planning ProcessF. Capital PolicyG. Scenario DesignH. Risk-weighted Asset (RWA) ProjectionsI. Operational Loss Projections

This guidance applies to U.S. bank holdingcompanies and intermediate holding companiesof foreign banking organizations that have totalconsolidated assets of at least $50 billion butless than $250 billion, have consolidated totalon-balance sheet foreign exposure of less than$10 billion, and are not otherwise subject to theFederal Reserve’s Large Institution SupervisionCoordinating Committee (LISCC) framework8

(referred to in this guidance as a “Large andNoncomplex Firm”).9,10 The guidance is effec-

tive immediately for bank holding companiesthat are subject to the capital plan rule as ofJanuary 1, 2016. The guidance will becomeeffective for intermediate holding companiesbeginning on January 1, 2017, which is the dateon which the capital plan rule applies to thesefirms.

The Federal Reserve has different expecta-tions for sound capital planning and capitaladequacy depending on the size, scope of opera-tions, activities, and systemic importance of afirm. Concurrently with issuance of this guid-ance, the Federal Reserve is issuing separateguidance for U.S. bank holding companies andintermediate holding companies that are subjectto the LISCC framework (referred to as a “LISCCFirm”) or that otherwise have total consolidatedassets of $250 billion or more or consolidatedtotal on-balance sheet foreign exposure of$10 billion or more (referred to as a “Large andComplex Firm”). This separate guidance clari-fies that expectations for LISCC Firms andLarge and Complex Firms are higher than theexpectations for Large and Noncomplex Firms.

II. Regulatory Requirements for CapitalPositions and Planning

Sound capital planning for any firm begins withadherence to all applicable rules and regulationsrelating to capital adequacy. Three FederalReserve regulations form the basis of the regula-tory framework for capital positions and capitalplanning:

(1) Regulation Q (12 C.F.R. 217), Capital Ad-equacy Requirements for Board-regulatedInstitutions;

(2) Regulation YY (12 C.F.R. 252), EnhancedPrudential Standards; and

(3) Section 225.8 of Regulation Y (12 C.F.R.225.8, also known as the capital plan rule).

Regulation Q establishes minimum capitalrequirements and overall capital adequacy stan-dards for Federal Reserve-regulated institutions.Among other things, Regulation YY establishescapital stress testing requirements for bank hold-ing companies with total consolidated assets of$50 billion or more, including requirements toparticipate in the Federal Reserve’s annual super-visory stress test and conduct their own internal

8. The LISCC framework is designed to materially increasethe financial and operational resiliency of systemically impor-tant financial institutions to reduce the probability of, and costassociated with, their material financial distress or failure. Seewww.federalreserve.gov/bankinforeg/large-institution-supervision.htm.

9. Total consolidated assets equals the amount of totalassets reported on the firm’s Consolidated Financial State-ments for Holding Companies (FR Y-9C), measured as anaverage over the preceding four quarters. If a firm has notfiled the FR Y-9C for each of the four most recent consecutivequarters, a firm’s total consolidated assets are measured as theaverage of its total consolidated assets, as reported on the FRY-9C, for the most recent quarter or consecutive quarters, asapplicable. Consolidated total on-balance sheet foreign expo-sure equals total cross-border claims less claims with headoffice or guarantor located in another country plus redistrib-uted guaranteed amounts to the country of head office orguarantor plus local country claims on local residents plusrevaluation gains on foreign exchange and derivative prod-ucts, calculated as of the most recent year-end in accordance

with the Federal Financial Institutions Examination Council(FFIEC) 009 Country Exposure Report.

10. This guidance does not apply to nonbank financialcompanies designated by the Financial Stability OversightCouncil for supervision by the Board of Governors.

Federal Reserve Supervisory Assessment of Capital Planning and Positions 4065.0




capital stress tests. The capital plan rule estab-lishes general capital planning requirements fora bank holding company with total consolidatedassets of $50 billion or more and requires a bankholding company to develop an annual capitalplan that is approved by its board of directors.

This guidance provides the Federal Reserve’score capital planning expectations for firms sub-ject to this guidance, building upon the capitalplanning requirements in the Federal Reserve’scapital plan rule and stress test rules.11

III. Capital Planning Expectations

Capital is central to a firm’s ability to absorbunexpected losses and continue to lend to credit-worthy businesses and consumers. A firm’s capi-tal planning processes are critical to its financialstrength and resiliency.

SR-12-17/CA-12-14, “Consolidated Supervi-sion Framework for Large Financial Institu-tions,” outlines core expectations for sound capi-tal planning for bank holding companies withtotal consolidated assets of $50 billion or more.This capital planning and positions guidanceprovides additional details around the FederalReserve’s core capital planning expectations forLarge and Noncomplex Firms, building on thecapital planning requirements included in thecapital plan rule and the Board’s stress testrules.12 A firm should maintain a sound capitalplanning process on an ongoing basis, includingin between submissions of its annual capitalplan.13

A. Governance

The Federal Reserve expects a firm to havesound governance over its capital planning pro-cess. In general, senior management shouldestablish the capital planning process and theboard of directors should review and periodi-cally approve that process.

1. Board of Directors

A firm’s board of directors is ultimately respon-sible and accountable for the firm’s capital-related decisions and for capital planning. Thefirm’s capital planning should be consistent withthe strategy and risk appetite set by the boardand with the firm’s risk levels, including howrisks at the firm may emerge and evolve understress. The board must annually review andapprove the firm’s capital plan.14

The board should direct senior managementto provide a briefing on their assessment of thefirm’s capital adequacy at least quarterly, andwhenever economic, financial, or firm-specificconditions warrant a more frequent update. Thebriefing should describe whether current capitallevels and planned capital distributions remainappropriate and consistent with capital goals(see Section III.D, “Capital Policy”). In theirbriefing, senior management should also high-light for the board any problem areas related tocapital planning identified by senior manage-ment, internal audit, or supervisors.

The board should hold senior managementaccountable for providing sufficient informationon the firm’s material risks and exposures toinform board decisions on capital adequacy andactions, including capital distributions. Informa-tion provided to the board should be clear, accu-rate, and timely. The board should direct seniormanagement to provide this information at leastquarterly and whenever economic, financial, orfirm-specific conditions warrant a more frequentupdate. The information presented to the boardshould include consideration of a number offactors, such as

• macro-economic conditions and relevant mar-ket events;

• current capital levels relative to budgets andforecasts;

• post-stress capital goals and targeted real timecapital levels (see section III.D, “Capital Pol-icy”);

• enterprise-wide and line-of-business perfor-mance;

• expectations from stakeholders (includingshareholders, regulators, investors, lenders,counterparties, and rating agencies);

• potential sources of stress to the firm’s operat-ing performance; and

11. Refer to footnote 3.12. The capital planning process described in this guidance

is broadly equivalent to an internal capital adequacy assess-ment process (ICAAP) under the Federal Reserve’s advancedapproaches capital guidelines. The expectations articulated inthis document are consistent with the U.S. federal bankingagencies’ supervisory guidance relating to the ICAAP (see 73FR 44620 (July 31, 2008)).

13. The term “capital planning process” used in this docu-ment, which aligns with terminology in SR-12-17/CA-12-14,is equivalent to the term “capital adequacy process” used inother Federal Reserve documents.

14. 12 C.F.R. 225.8(e)(1)(iii).



• risks that may emerge only under stressfulconditions.

After receiving the information, the boardshould be in a position to understand the majordrivers of the firm’s projections under a range ofconditions, including baseline and stress sce-narios.

The board should direct senior managementto provide information about the firm’s estima-tion approaches, model overlays, and assess-ments of model performance (see Appendix A,“Use of Models and Other Estimation Ap-proaches” and Appendix B, “Model Overlays”).The board should also receive information aboutuncertainties around projections of capital needsor limitations within the firm’s capital planningprocess to understand the impact of these weak-nesses on the process. This information shouldinclude key assumptions and the analysis ofsensitivity of a firm’s projections to changes inthe assumptions (see Appendix D, “SensitivityAnalysis and Assumptions Management”). Theboard should incorporate uncertainties in projec-tions and limitations in the firm’s capital plan-ning process into its decisions on capital ad-equacy and capital actions. It should also reviewand approve mitigating steps to address capitalplanning process weaknesses.

The board should direct senior managementto establish sound controls for the entire capitalplanning process. The board should approvepolicies related to capital planning, and reviewthem annually. The board should also approvecapital planning activities and strategies. Theboard of directors should maintain an accuraterecord of its meetings pertaining to the firm’scapital planning process.

2. Senior Management

Senior management should direct staff to imple-ment board-approved capital policies, capitalplanning activities, and strategies in an effectivemanner. Senior management should make in-formed recommendations to the board regardingthe firm’s capital planning and capital adequacy,including post-stress capital goals and capitaldistribution decisions. Senior management’s pro-posed capital goals and capital distributionsshould have analytical support and take intoaccount the expectations of important stakehold-ers, including shareholders, rating agencies, coun-terparties, depositors, creditors, and supervisors.

Senior management should design and over-see the implementation of the firm’s capitalplanning process; identify and assess materialrisks and use appropriate firm-specific scenariosin the firm’s stress test; monitor and assesscapital planning practices to identify limitationsand uncertainties and develop remediation plans;understand key assumptions used throughout afirm’s capital planning process and assess thesensitivity of the firm’s projections to thoseassumptions (see Appendix D, “SensitivityAnalysis and Assumptions Management”); andreview the capital planning process at leastsemi-annually.

Senior management should establish a pro-cess for independent review of the firm’s capitalplanning process, including the elements out-lined in this guidance. The independent reviewprocess should be designed to identify the weak-nesses and limitations of the capital planningprocess and the potential impact of those weak-nesses on the process. Senior management shouldalso develop remediation plans for any identi-fied weaknesses affecting the reliability of capi-tal planning results. Both the specific identifiedweaknesses and the remediation plans should bereported to the board of directors in a timelymanner.

B. Risk Management

A firm should have a risk management infra-structure that appropriately identifies, measures,and assesses material risks and provides a strongfoundation for capital planning.15 This risk man-agement infrastructure should be supported bycomprehensive policies and procedures, clearand well-established roles and responsibilities,and strong and independent internal controls. Inaddition, the risk management infrastructureshould be built upon sound information technol-ogy and management information systems. TheFederal Reserve’s supervisory assessment of thesufficiency of a firm’s capital planning processwill depend in large part on the effectiveness ofthe firm’s risk management infrastructure andthe strength of its process to identify uniquerisks under normal and stressful conditions, aswell as on the strength of its overall governanceand internal control processes.

15. 12 C.F.R. 225.8(e)(2).



1. Risk Identification andAssessment Process

A firm’s risk identification process should includea comprehensive assessment of risks stemmingfrom its unique business activities and associ-ated exposures. The assessment should includeon-balance sheet assets and liabilities, off-balance sheet exposures, vulnerability of thefirm’s earnings, and other major firm-specificdeterminants of capital adequacy under normaland stressed conditions. This assessment shouldalso capture those risks that only materialize orbecome apparent under stressful conditions.

The specifics of the risk identification processwill differ across firms given differences in orga-nizational structure, business activities, and sizeand complexity of operations. However, the riskidentification process at all firms subject to thisguidance should be dynamic, inclusive, andcomprehensive, and drive the firm’s capital ad-equacy analysis. A firm should

• evaluate material risks across the enterprise toensure comprehensive risk capture on an on-going basis;

• actively monitor its material risks; and• use identified material risks to inform key

aspects of the firm’s capital planning, includ-ing the development of stress scenarios, theassessment of the adequacy of post-stresscapital levels, and the appropriateness of po-tential capital actions in light of the firm’scapital objectives.

A firm should be able to demonstrate howmaterial risks are accounted for in its capitalplanning process. For risks not well captured byscenario analysis, the firm should clearly articu-late how the risks are otherwise captured andaddressed in the capital planning process andfactored into decisions about capital needs anddistributions.

2. Risk Measurement andRisk Materiality

A firm should have a sound risk measurementprocess that informs senior management aboutthe size and risk characteristics of exposuresand business activities under both normal andstressful operating conditions. A firm shouldemploy risk measurement approaches that areappropriate for its size, complexity and riskprofile.

Identified weaknesses, limitations, biases, andassumptions in the firm’s risk measurement pro-

cesses should be assessed for their potentialimpact on the integrity of a firm’s capital plan-ningprocess (seeAppendixD,”SensitivityAnaly-sis and Assumptions Management“). A firmshould have a process in place for determiningmateriality in the context of material risk identi-fication and capital planning. This process shouldinclude a sound analysis of relevant quantitativeand qualitative considerations, including, but notlimited to, the firm’s risk profile, size, and com-plexity, and their effects on the firm’s projectedregulatory capital ratios in stressed scenarios.16

A firm should identify how and where itsmaterial risks are accounted for within the capi-tal planning process. The firm should be able tospecify material risks that are captured in itsscenario design, the approaches used to estimatethe impact on capital, and the risk drivers asso-ciated with each material risk.

C. Internal Controls

A firm should have a sound internal controlframework that helps ensure that all aspects ofthe capital planning process are functioning asdesigned and result in sound assessments of thefirm’s capital needs. The framework shouldinclude

• an independent internal audit function;• independent review and validation practices;

and• integrated management information systems,

effective reporting, and change control pro-cesses.

A firm’s internal control framework shouldsupport its entire capital planning process, includ-ing the sufficiency of and adherence to policiesand procedures; risk identification, measure-ment, and management practices and systemsused to produce input data; and the models,management overlays, and other methods usedto generate inputs to post-stress capital esti-mates. Any part of the capital planning processthat relies on manual procedures should receiveheightened attention. The internal control frame-work should also assess the aggregation andreporting process used to produce reports to

16. For simplicity, the terms “quantitative” and “qualita-tive” are used to describe two different types of approaches,with the recognition that all quantitative estimation ap-proaches involve some qualitative/judgmental aspects, andqualitative estimation approaches produce quantitative output.



senior management and to the board of directorsand the process used to support capital adequacyrecommendations to the board.

1. Comprehensive Policies, Procedures,and Documentation for Capital Planning

A firm should have policies and procedures thatsupport consistent and repeatable capital plan-ning processes.17 Policies and procedures shoulddescribe the capital planning process in a man-ner that informs internal and external stakehold-ers of the firm’s expectations for internal prac-tices, documentation, and business line controls.The firm’s documentation should be sufficientto provide relevant information to those makingdecisions about capital actions. The documenta-tion should also allow parties unfamiliar with aprocess or model to understand generally how itoperates, as well as its main limitations, keyassumptions, and uncertainties.

Policies and procedures should also clearlyidentify roles and responsibilities of staff in-volved in capital planning and provide account-ability for those responsible for the capital plan-ning process. A firm should also have anestablished process for policy exceptions. Suchexceptions should be approved by the appropri-ate level of management based upon the gravityof the exception. Policies and procedures shouldreflect the firm’s current practices, and be re-viewed and updated as appropriate, but at leastannually.

2. Model Validation and IndependentReview of Estimation Approaches

Models used in the capital planning processshould be reviewed for suitability for their in-tended uses. A firm should give particular con-sideration to the validity of models used forcalculating post-stress capital positions. In par-ticular, models designed for ongoing businessactivities may be inappropriate for estimatinglosses, revenue, and expenses under stressedconditions. If a firm identifies weaknesses oruncertainties in a material model, the firm shouldmake adjustments to model output if the find-

ings would otherwise result in the material un-derstatement of capital needs (see Appendix B,“Model Overlays”). If the deficiencies are criti-cal, the firm should restrict the use of the model,apply overlays, or avoid using the model en-tirely.

A firm should independently validate or oth-erwise conduct effective challenge of modelsused in internal capital planning, consistent withsupervisory guidance on model risk manage-ment, with priority given to more material mod-els.18 The model review and validation processshould include an evaluation of conceptual sound-ness of models and ongoing monitoring of themodel performance. The firm’s validation staffshould have the necessary technical competen-cies, sufficient stature within the organization,and appropriate independence from model devel-opers and business areas to provide a criticaland unbiased evaluation of the estimation ap-proaches.

A firm should maintain an inventory of allestimation approaches used in the capital plan-ning process, including models used to produceprojections or estimates used by the models thatgenerate final loss, revenue, expense, and capi-tal projections.19 Material models should receivegreater attention.20 The intensity and frequencyof validation work should be a function of theimportance of those models in generating esti-mates of post-stress capital.

Not all models can be fully validated prior touse in capital planning. However, a firm shouldmake efforts to conduct a conceptual soundnessreview of its material models prior to their usein capital planning. If such a conceptual sound-ness review is not possible, the absence of thatreview should be made transparent to users ofmodel output and the firm should determinewhether the use of compensating controls (suchas conservative adjustments) are warranted.

Further, a firm should treat output from mate-rial models for which there are model risk man-agement shortcomings with caution.

17. See Instructions for the Capital Planning and StressTesting Information Collection (Reporting Form FR Y-14A),Appendix A (Supporting Documentation), available atwww.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDa2AwLR/gLe5DPhQFttuq/4.

18. See SR-11-7, “Supervisory Guidance on Model RiskManagement” (SR-11-7.) The term “effective challenge” meanscritical review by objective, informed parties who have theproper incentives, competence, and influence to challenge themodel and its results.

19. The definition of a model covers quantitative ap-proaches whose inputs are partially or wholly qualitative orbased on expert judgment, provided that the output is quanti-tative in nature.

20. Materiality of the model is a function of both theimportance of the business or portfolio assessed and theimpact of the model on the firm’s overall results.





3. Management Information Systems andChange Control Processes

A firm should have internal controls that ensurethe integrity of reported results and that makecertain the firm is identifying, documenting,reviewing, and tracking all material changes tothe capital planning process and its components.The firm should ensure that such controls existat all levels of the capital planning process.Specific controls should ensure

• sufficiently sound management informationsystems to support the firm’s capital planningprocess;

• comprehensive reconciliation and data integ-rity processes for key reports;

• the accurate and complete presentation ofcapital planning process results, including adescription of adjustments made to compen-sate for identified weaknesses; and

• that information provided to senior manage-ment and the board is accurate and timely.

Many of the processes used to assess capitaladequacy, including models, data, and manage-ment information systems, are tightly integratedand interdependent. As a result, a firm shouldensure consistent change control oversight acrossthe entire firm, in line with existing supervisoryguidance.21 A firm should establish and main-tain a policy describing minimum internal con-trol standards for managing change in capitalplanning process policies and procedures, modeldevelopment, information technology, and data.Control standards for these areas should addressrisk, testing, authorization and approval, timingof implementation, and post-installation verifi-cation.

4. Internal Audit Function

Internal audit should play a key role in evaluat-ing capital planning and the elements describedin this guidance to ensure that the entire processis functioning in accordance with supervisoryexpectations and the firm’s policies and proce-dures. Internal audit should review the mannerin which deficiencies are identified, tracked, andremediated. Furthermore, internal audit shouldensure appropriate independent review and chal-lenge is occurring at all key levels within thecapital planning process.

As discussed further in Appendix E, “Role ofthe Internal Audit Function in the Capital Plan-ning Process,” internal audit staff should havethe appropriate competence and influence toidentify and escalate key issues. All deficien-cies, limitations, weaknesses and uncertaintiesidentified by the internal audit function thatrelate to the firm’s capital planning processshould be reported to senior management, andmaterial deficiencies should be reported to theboard of directors (or the audit committee of theboard) in a timely manner.22

D. Capital Policy

A capital policy is a firm’s written assessmentof the principles and guidelines used for capitalplanning, issuance, usage, and distributions.23

This includes internal post-stress capital goals(as discussed in more detail below and in Appen-dix F, “Estimating Impact on Capital Positions”)and real-time targeted capital levels; guidelinesfor dividend payments and stock repurchases;strategies for addressing potential capital short-falls; and internal governance responsibilitiesand procedures for the capital policy. The capi-tal policy must be approved by the firm’s boardof directors or a designated committee of theboard.24

The capital policy should be reevaluated atleast annually and revised as necessary to ad-dress changes to the firm’s business strategy,risk appetite, organizational structure, gover-nance structure, post-stress capital goals, real-time targeted capital levels, regulatory environ-ment, and other factors potentially affecting thefirm’s capital adequacy.

A capital policy should describe the firm’scapital adequacy decision-making process,including the decision-making process for com-mon stock dividend payments or stock repur-chases.25 The policy should incorporate action-

21. Federal Financial Institutions Examination Council,“IT Examination Handbook—Operations Booklet,” availableat http://ithandbook.ffiec.gov/ITBooklets/FFIEC_ITBooklet_Operations.pdf. See also SR-15-3, “FFIEC Information Tech-nology Examination Handbook.”

22. For additional information on supervisory expectationsfor internal audit see SR-13-1, “Supplemental Policy State-ment on the Internal Audit Function and Its Outsourcing.”

23. 12 C.F.R. 225.8(d)(7).24. 12 C.F.R. 225.8(e)(1)(iii).25. Consistent with the Board’s November 14, 1985, Pol-

icy Statement on the Payment of Cash Dividends, the prin-ciples of which are incorporated into this guidance, firmsshould have comprehensive policies on dividend paymentsthat clearly articulate the firm’s objectives and approaches formaintaining a strong capital position and achieving the objec-tives of the policy statement. See Bank Holding Company

Supervision Manual, section 2020.5.1.1, Intercompany Trans-





able protocols, including governance andescalation, in the event a post-stress capital goal,real-time targeted capital level, or other earlywarning metric is breached.

Post-Stress Capital Goals

A firm should establish post-stress capital goalsthat are aligned with its risk appetite and riskprofile, its ability to act as a financial intermedi-ary in times of stress, and the expectations ofinternal and external stakeholders. Post-stresscapital goals should be calibrated based on thefirm’s own internal analysis, independent ofregulatory capital requirements, of the mini-mum level of post-stress capital the firm hasdeemed necessary to remain a going concernover the planning horizon. A firm should alsodetermine targets for real-time capital ratios andcapital levels that ensure that capital ratios andlevels would not fall below the firm’s internalpost-stress capital goals (including regulatoryminimums) under stressful conditions at anypoint over the planning horizon. For more de-tails, see Appendix F, “Capital Policy.”

E. Incorporating Stressful Conditionsand Events

As part of its capital planning process, a firmshould incorporate appropriately stressful condi-tions and events that could adversely affect thefirm’s capital adequacy into its capital planning.As part of its capital plan, a firm must use atleast one scenario that stresses the specific vul-nerabilities of the firm’s activities and associ-ated risks, including those related to the com-pany’s capital adequacy and financialcondition.26

1. Scenario design

A firm should either develop a complete internalscenario or adjust the Federal Reserve’s supervi-sory scenarios for the specific vulnerabilities ofthe firm’s risk profile and operations, as needed,to appropriately capture the firm’s risks (seeAppendix G, “Scenario Design”).

2. Scenario narrative

A firm’s stress scenario should be supported bya brief narrative describing how the scenarioaddresses the firm’s particular material risks andvulnerabilities, and how the paths of the sce-nario variables relate to each other.

F. Estimating Impact on Capital Positions

A firm should employ estimation approachesthat allow it to project the impact on capitalpositions of various types of stressful conditionsand events. The firm’s stress testing practicesshould capture the potential increase in losses ordecrease in pre-provision net revenue (PPNR)that could result from the firm’s risks, expo-sures, and activities under stressful scenarios. Afirm should estimate losses, revenues, expenses,and capital using a sound method that relatesmacroeconomic and other risk drivers to itsestimates. The firm should be able to identifythe manner in which key variables, factors, andevents in a scenario affect losses, revenue, ex-penses, and capital over the planning horizon.The firm may use simple approaches for theirnon-material portfolios or business lines, suchas application of loss or revenue rates during theprior stress periods or other conservative assump-tions.

1. Loss estimation

A firm should provide support for the assumedrelationship between risk drivers and losses. Afirm is expected to estimate losses by type ofbusiness activity.

a. Credit risk losses on loans and securities

A firm should develop sound methods to esti-mate credit losses under stress that take intoaccount the type and size of portfolios, riskcharacteristics, and data availability. A firmshould understand the key characteristics of itsloss estimation approach. In addition, a firm’sreserves for each quarter of the planning hori-zon, including the last quarter, should be suffi-cient to cover estimated loan losses consistentwith generally accepted accounting standards.

A firm should test credit-sensitive securitiesfor potential other-than-temporary impairment(OTTI) regardless of current impairment status.The threshold for determining OTTI for struc-tured products should be based on cash-flow

actions (Dividends), available at www.federalreserve.gov/boarddocs/supmanual/bhc/bhc.pdf.

26. 12 C.F.R. 225.8(e)(2).





analysis and credit analysis of underlying ob-ligors.

b. Operational-risk losses

A firm should maintain a sound process forestimating operational risk losses in its capitalplanning process. Operational losses can risefrom various sources, including inadequate orfailed internal processes, people, and systems,or from external events (see Appendix I, “Opera-tional Loss Projections”).

2. PPNR

In projecting PPNR, a firm should take intoaccount not only its current positions, but alsohow its activities, business strategy, and revenuedrivers may evolve over time under the varyingcircumstances and operating environments. Thefirm should ensure that the various PPNR com-ponents, including net interest income, non-interest income and non-interest expense, andother key items projected by the firm such asbalance sheet positions, RWA, and losses, areprojected in a manner that is internally consis-tent.

The ability to effectively project net interestincome is dependent upon the firm’s ability toidentify and aggregate current positions andtheir attributes; project future changes in accru-ing balances due to a variety of factors; andappropriately translate the impact of these fac-tors and relevant interest rates into net interestincome based on assumed conditions. Accord-ingly, a firm’s current portfolio of interest-bearing assets and liabilities should serve as thefoundation for its forward-looking estimates ofnet interest income.

Non-interest income is derived from a diverseset of sources, including fees and certain real-ized gains and losses. Non-interest income gen-erally is more susceptible to rapid changes thannet interest income, especially if certain marketmeasures move sharply. A firm’s projectionsshould incorporate material factors that couldaffect the generation of non-interest incomeunder stress, including the firm’s business strat-egy, the competitive landscape, and changingregulations.

Non-interest expenses include both expensesthat are likely to vary with certain stressfulconditions and those that are not. Projections ofexpenses that are closely linked to revenues orbalances should vary with projected changes inrevenue or balance sheet levels.

3. Aggregating Estimation Results

A firm should have well-documented processesfor projecting the size and composition of on-and off-balance sheet positions and RWAs overthe planning horizon that feed in to the widercapital planning process (see Appendix H, “Risk-weighted Asset (RWA) Projections”).

A firm should have a consistently executedprocess for aggregating enterprise-wide stresstest projections of losses, revenues, and ex-penses, including estimating on- and off-balancesheet exposures, and RWAs, and for calculatingpost-stress capital positions and ratios. The ag-gregation system should be able to bring to-gether data and information across businesslines, portfolios, and risk types and should includethe data systems and sources, data reconciliationpoints, data quality checks, and appropriate in-ternal control points to ensure accurate and con-sistent projection of financial data withinenterprise-wide scenario analysis. Internal pro-cesses for aggregating projections from all rel-evant systems and regulatory templates shouldbe identified and documented. In addition, thebeginning points for projections and scenariovariables should align with the end of the his-torical reference period.

Appendix A: Use of Models and OtherEstimation Approaches

Projections of losses and PPNR under variousscenarios are key components of enterprise-wide stress testing and capital planning. Thefirm should ensure that its material projectionapproaches, including any specific processes ormethodologies employed, are well supported,transparent, and repeatable over time.

A firm may use either quantitative methods orqualitative approaches for generating projec-tions. A firm is not expected to employ a sophis-ticated modeled approach, particularly if thefirm can demonstrate that a simpler approach,combined with well-supported expert judgment,produces credible and transparent output. A firmcan apply simple assumptions to generate lossesor PPNR for its non-material portfolios or busi-ness lines.

A firm should adhere to supervisory guidanceon model risk management (SR-11-7) whenusing models, and should have sound internalcontrols around both quantitative and qualitativeapproaches.



1. Quantitative Approaches

If a firm decides to employ quantitative ap-proaches, it is not expected to use any specificquantitative estimation method. Any quantita-tive approach should be appropriate for the typeand materiality of the portfolio or activity forwhich it is used and the granularity and lengthof available data. The firm should also ensurethat the quantitative approach selected generatescredible estimates that are consistent with as-sumed scenario conditions. A firm should sepa-rately estimate losses and PPNR for portfoliosor business lines that are either sensitive todifferent risk drivers or sensitive to risk driversin a markedly different way, particularly duringperiods of stress.

a. Use of Data

A firm may use either internal or external datato estimate losses and PPNR as part of itsenterprise-wide stress testing and capital plan-ning practices.27 If a firm uses external data toestimate its losses or PPNR, the firm shouldensure that the external data reasonably approxi-mate underlying risk characteristics of the firm’sportfolios or business lines. Further, the firmshould make adjustments to estimation methodsor outputs, as appropriate, to account for identi-fied differences in risk characteristics and per-formance reflected in internal and external data.If internal data are not available, a firm shouldstrive to collect internal data over time to aug-ment its projections.

For material portfolios and business lines, afirm should generally include all available datain its analysis, unless the firm no longer engagesin a line of business or its activities have changedsuch that the firm is no longer exposed to aparticular risk. The firm should not selectivelyexclude data for material portfolios and businesslines based on the changing nature of the ongo-ing business or activity without strong empiricalsupport. For example, excluding certain loansonly on the basis that they were underwritten tostandards that no longer apply or on the basisthat the loans were acquired by the firm is notsound practice.

b. Use of Vendor Models28

A firm should have processes to confirm thatany vendor or other third-party models it usesare sound, appropriate for the given task, andimplemented properly. A firm should clearlyoutline limitations and uncertainties associatedwith vendor models.

2. Assessing Model Performance

A firm should use measures to assess modelperformance that are appropriate for the type ofmodel being used. The firm should outline howeach performance measure is evaluated andused. A firm should also assess the sensitivity ofmaterial model estimates to key assumptions(see Appendix D, “Sensitivity Analysis andAssumptions Management”).

For models used for material portfolios andbusiness lines, a firm should provide supportinginformation about the models to users of theiroutput, including descriptions of known mea-surement problems, simplifying assumptions,model limitations, or other ways in which themodel exhibits weaknesses in capturing the rela-tionships being modeled. Providing such quali-tative information is critical when certain quan-titative criteria or tests measuring modelperformance are lacking.

3. Qualitative Approaches

A firm may use a qualitative approach to projectlosses and PPNR. When using a qualitativeapproach for material portfolios and businesslines, the firm should substantiate assumptionsand estimates using analysis of current and pastrisk drivers and performance, internal risk iden-tification, forward-looking risk assessments, ex-ternal analysis or other available information.The firm should conduct an initial and ongoingassessment of the performance and viability ofthe qualitative approach. The processes used inqualitative projection approaches should be trans-parent and repeatable. The firm should alsoclearly document material qualitative ap-proaches and key assumptions used.

Qualitative approaches should be subject toindependent review, although the review maydiffer from the review of quantitative ap-proaches or models. The level of independentreview should be commensurate with the

27. Firms are required to collect and report a substantialamount of risk information to the Federal Reserve on FRY-14 schedules. These data may help to support the firms’enterprise-wide stress test. See Capital Assessments and StressTesting information collection, Reporting Forms FR Y-14A,Q, and M.

28. See SR-13-19/CA-13-21, “Guidance on Managing Out-sourcing Risk.”



• materiality of the portfolio or business line forwhich the qualitative approach is used;

• impact of the approach’s output on the overallcapital results; and

• complexity of the approach.

Firm staff conducting the independent reviewof the qualitative approaches should not beinvolved in developing, implementing or usingthe approach. However, this staff can be differ-ent than the staff that conducts validation ofquantitative approaches or models.

Appendix B: Model Overlays

A firm may need to rely on overrides or adjust-ments to model output (model overlay) to com-pensate for model, data, or other known limita-tions.29 If well-supported, use of a model overlaycan represent a sound practice.

A model overlay may be appropriate to ad-dress cases of identified weaknesses or limita-tions in the firm’s models that cannot be other-wise addressed, or for select portfolios that haveunique risks that are not well captured by themodel used for those exposures and activities.30

In contrast, a model overlay that functions as ageneral “catch all” buffer on top of targetedcapital levels to account for model weaknessesgenerally would not represent sound practice.31

As part of its overall documentation of meth-odologies used in stress testing, a firm shoulddocument its use of model overlays.

1. Process for Applying Overlays

A firm should establish a consistent firm-wideprocess for applying model overlays and forcontrols around model overlays. The processcan vary by model type and portfolio, but shouldcontain some key elements, as described below.This process should be outlined in the firm’s

policies and procedures and include a specificexception process for the use of overlays that donot follow the firm’s standards. As part of modeldevelopment, implementation and use, overlaysfor material portfolios and business lines shouldbe well documented, supported and communi-cated to senior management. Model overlaysshould be applied in an appropriate, systematic,and transparent manner. Model results shouldalso be reported to senior management with andwithout overlay adjustments.

Model overlays (including those based solelyon expert or management judgment) should besubject to validation or some other type of effec-tive challenge.32 Consistent with the materialityprinciple in SR-11-7, the intensity of model riskmanagement for overlays should be a functionof the materiality of the model and overlay. Afirm should make efforts to conduct effectivechallenge of its material overlays prior to theiruse in capital planning. If such validation oreffective challenge is not possible, those instancesshould be made transparent to users of themodel and overlay.

Validation or other type of effective challengeof model overlays may differ from quantitativemodel validation. Staff responsible for effectivechallenge should not also be setting the overlayitself or providing significant input to the levelor type of overlay. For example, a committeethat develops an overlay should not also beresponsible for the effective challenge of theoverlay. In addition, staff engaging in the effec-tive challenge of model overlays should meetsupervisory expectations relating to incentives,competence, and influence (as outlined inSR-11-7).

2. Governance of Overlays

Overlays and adjustments used by a firm shouldbe reviewed and approved at a level within theorganization commensurate with the materialityof that overlay or adjustment to overall proforma results. In general, the purpose and im-pact of material overlays should be communi-cated to senior management in a manner thatfacilitates an understanding of the issues by thefirm’s senior management. Material overlays tothe model—either in isolation or in

29. For the purposes of this appendix, the term “overlays”will be used to cover overrides, overlays, or other adjustmentsapplied to model output. Firms should follow expectations setforth in SR-11-7, “Supervisory Guidance on Model RiskManagement,” relating to overlays.

30. Expectations for the use of judgment within modeldevelopment is discussed in Appendix A, “Use of Models andOther Estimation Approaches.”

31. Firms may choose to apply overall capital buffers as anadditional conservative measure, beyond overlays applied atthe model level. Overall capital buffers should be subject tothe same governance processes applicable to model overlays,as described in section 2 of this appendix. However, supervi-sors emphasize that having such a buffer should not in anyway replace sound model risk management practices for over-lays at the individual model level or address the need for theoverlay at the individual model level.

32. The term “effective challenge” means critical reviewby objective, informed parties who have the proper incentives,competence, and influence to challenge the model and itsresults.



combination—should receive a heightened levelof support and scrutiny, up to and includingreview by the firm’s board of directors (or adesignated committee), in instances where theimpact on pro forma results is material.

Appendix C: Use of Benchmark Modelsin the Capital Planning Process

As noted in Appendix A, “Use of Models andOther Estimation Approaches,” a firm shoulduse a variety of methods to assess performanceof material models and gain comfort with mate-rial model estimates. However, a firm is notexpected to use benchmark models in its capitalplanning process.

Appendix D: Sensitivity Analysis andAssumptions Management

A firm should understand the sensitivity of itsstress testing estimates used in capital planningto the various inputs and assumptions. In addi-tion, sensitivity analysis should be used to testthe robustness of material quantitative ap-proaches and models and enhance reporting tothe firm’s senior management, board of direc-tors, and supervisors. A firm should ensure thatit identifies, documents, and manages the use ofall key assumptions used in capital planning.

1. Sensitivity Analysis

Understanding and documenting a range of po-tential outcomes provides insight into the inher-ent uncertainty and imprecision around pro formaresults. A firm should assess the sensitivity of itsestimates of capital ratios, losses, revenues, andRWAs to key assumptions and uncertainty acrossthe entire firm’s projections under stress. Throughthis assessment, a firm should calculate a rangeof potential estimates based on changes to as-sumptions and inputs.

A firm should also evaluate the sensitivity ofmaterial models to key assumptions to evaluatemodel performance, assess the appropriatenessof assumptions, and understand uncertainty asso-ciated with model output.

Sensitivity analysis for capital planning mod-els should be applied in a manner consistentwith the expectations outlined in the FederalReserve’s supervisory guidance on model risk

management (refer to SR-11-7). Sensitivityanalysis should be conducted during modeldevelopment and during model validation toprovide information about how models respondto changes in key inputs and assumptions, andhow those models perform in stressful condi-tions. In addition, sensitivity analysis should beapplied to understand the range of possibleresults from material vendor-provided modelsand vendor-provided scenario forecasts that haveopaque or proprietary elements. Sensitivity analy-sis should be used to provide information tohelp users of model output interpret results, butdoes not have to result in changes to models ormodel outputs. Changes made based on sensitiv-ity analysis should be clearly documented andjustified.

A firm should ensure that the key sensitivitiesare presented to senior management and theboard in advance of decision-making around thefirm’s capital plan and capital actions. Sensitiv-ity analysis should also be used to inform seniormanagement, and, as appropriate, the board ofdirectors about the potential uncertainty associ-ated with models employed of the firm’s projec-tions under stress.

2. Assumptions Management

A firm should clearly document assumptionswhen estimating losses, PPNR, and balancesheet, and RWA components. Documentationshould include the rationale and empirical sup-port for assumptions and specifically addresshow those assumptions are consistent with andappropriate under the firm’s scenario condi-tions.

A firm’s rationale for assumptions used incapital planning should be consistent with thedifferent effects of scenario conditions, shifts inportfolio mix, and growth or decline in balancesprojected over the planning horizon. For exam-ple, the firm should scrutinize and support anyassumptions about sizeable loan growth duringa severe economic downturn.

A firm should generally use conservativeassumptions, particularly in areas of high uncer-tainty. The firm should provide greater supportfor assumptions that appear optimistic or other-wise appear to benefit the firm (such as lossreduction or revenue enhancement). A firm shouldnot assume that senior management will be ableto realize favorable strategic actions that cannotbe reasonably assured in stress scenarios giventhe high level of uncertainty around market con-ditions. Further, a firm should not assume that itwould have the perfect foresight that would



allow it, for example, to make significant ex-pense reductions in the first quarter of the fore-cast horizon in anticipation of the forthcomingeconomic deterioration described in the sce-nario.

A firm should confirm that key assumptionsused in material vendor or other third-partyproducts are transparent and have sufficient sup-port before using the products in stress testing.The firm should limit use of material vendorproducts whose assumptions are not fully trans-parent or supported or use those products onlyin conjunction with another approach or com-pensating controls (e.g., overlays).

Appendix E: Role of the Internal AuditFunction in the Capital Planning Process

A firm’s internal audit function should play akey role in evaluating the adequacy of the firm’scapital planning process and in assessing whetherthe risk management and internal control prac-tices supporting that process are comprehensiveand effective. A firm should establish an auditprogram around its capital planning process thatis consistent with SR-13-1, “Supplemental Pol-icy Statement on the Internal Audit Functionand its Outsourcing.”

1. Responsibilities of Audit Function

The internal audit function should identify allauditable processes related to capital planningand develop an associated audit plan. The auditfunction should also perform substantive testingto ascertain the effectiveness of the controlframework supporting the firm’s capital plan-ning process, communicate identified limita-tions and deficiencies to senior management,and communicate material limitations and defi-ciencies to the board of directors (or the auditcommittee of the board). The audit functionshould comprehensively cover the firm’s capitalplanning process.

The internal audit function should performperiodic reviews of all aspects of the internalcontrol framework supporting the capital plan-ning process to ensure that all individual compo-nents as well as the entire process are function-ing in accordance with supervisory expectationsand the firm’s policies and procedures. Theinternal audit function should also review themanner in which deficiencies are identified,tracked, and remediated. Furthermore, the inter-nal audit function should ensure appropriateindependent review is occurring at various lev-els within the capital planning process.

A firm’s internal audit staff should have theappropriate competence and stature to identifyand escalate key issues when necessary. Theinternal audit function may also rely on an inde-pendent third party external to the firm to com-plete some of the substantive testing as long asthe internal audit function can demonstrateproper independence of the third-party fromthe area being assessed and provide oversightover the execution and quality of the work.

2. Development of Audit Plan

The internal audit function should have a docu-mented plan describing its strategy to assess theprocesses and controls supporting the firm’scapital planning process. When defining theannual audit universe and audit plan, the inter-nal audit function of a firm should focus on themost significant risks relating to the capital plan-ning process. The firm may leverage existing orregularly scheduled audits to ensure coverage ofall the capital planning process components;however, the findings and conclusions of theseaudits should be incorporated into the overallsummary of audit activities and conclusionsregarding the firm’s capital planning process.

3. Briefings to Senior Managementand Board

On an annual basis, the internal audit functionshould report to senior management and theboard of directors on the capital planning pro-cess to inform recommendations and decisionson the firm’s capital plan. The report shouldprovide an opinion of the capital planning pro-cess, a statement of the effectiveness of thecontrols and processes employed, a status up-date on previously identified issues and reme-diation plans, and any open issues or uncertain-ties related to the firm’s capital plan. Any keyprocesses that are not comprehensively re-viewed and tested, due to timing or significantchanges in processes, should be clearly docu-mented and identified as areas with potentialheightened risk.

The internal audit function should trackresponses to its material findings and report tothe board any cases in which senior manage-ment is not implementing required changes re-lated to audit findings or is doing so with insuf-ficient intensity.



Appendix F: Capital Policy

A firm’s capital policy should describe how thefirm manages, monitors, and makes decisionsregarding capital planning.33 The policy shouldinclude internal post-stress capital goals andreal-time targeted capital levels; guidelines fordividends and stock repurchases; and strategiesfor addressing potential capital shortfalls.

A firm’s capital policy should describe themanner in which consolidated estimates of capi-tal positions are presented to senior manage-ment and the board of directors. The capitalpolicy should require staff with responsibilityfor developing capital estimates to clearly iden-tify and communicate to senior managementand board of directors the key assumptionsaffecting various components that feed into theaggregate estimate of capital positions and ratios.The capital policy should require that aggre-gated results be directly compared against thefirm’s stated post-stress capital goals, and thatthose comparisons are included within the stan-dard reporting to senior management and theboard of directors.


Post-stress capital goals should provide specificminimum thresholds for the level and composi-tion of capital that the firm intends to maintainduring a stress period. Post-stress capital goalsshould include any capital measures that arerelevant to the firm.

The firm should be able to demonstrate throughits own internal analysis, independently of regu-latory capital requirements, that remaining at orabove its internal post-stress capital goals willallow the firm to continue to operate.

The capital policy should describe how seniormanagement and the board concluded that thefirm’s post-stress capital goals are appropriate,sustainable in different conditions and environ-ments, and consistent with its strategic objec-tives, business model, and capital plan. In addi-tion, the capital policy should describe theprocess by which the firm establishes its post-stress capital goals, and include the supportinganalysis underpinning the goals chosen by thefirm.

A firm should annually review its capitalgoals, evaluate whether its post-stress capitalgoals are still appropriate based on changes inoperating environment, business mix, or otherconditions, and adjust those goals as needed.

A firm should adjust its real-time capital tar-gets (that is the amount of current capital itholds above its post-stress capital goals to en-sure it does not fall below those goals understress) more frequently than it adjusts capitalgoals, based on changes in the business mix,operating environment or other current condi-tions and circumstances.

2. Dividends and Stock Repurchases

A firm’s capital policy should describe the pro-cesses relating to common stock dividend andrepurchase decisions, including the processes todetermine the timing, form, and amount of allplanned distributions. The capital policy shouldalso specify the analysis and metrics that seniormanagement and the board use to make capitaldistribution decisions. The analysis should in-clude strategic considerations such as new busi-ness initiatives, potential acquisitions, and theother relevant factors.

3. Contingency Plans forCapital Shortfalls

A firm’s capital policy should include specificcapital contingency actions the firm would taketo remedy any current or prospective deficien-cies in its capital position. The firm’s capitalcontingency plan should reflect strategies foridentifying and addressing potential capitalshortfalls and specify circumstances under whichthe board of directors and senior managementwill revisit planned capital actions or otherwiseinstitute contingency measures. A contingencyplan should include a set of thresholds for met-rics or events that provide early warning signsof capital deterioration and that trigger manage-ment action or scrutiny.34

Capital contingency plans should include optionsfor actions that a firm would consider taking toremedy any current or prospective deficienciesin its capital position, such as reducing or ceas-ing capital distributions, raising additional capi-

33. A capital policy is a firm’s written assessment of theprinciples and guidelines used for capital planning, issuance,usage, and distributions. 12 C.F.R. 225.8(d)(7).

34. Capital contingency plans may include triggers forliquidity, earnings, debt and credit default swap spreads, rat-ings downgrades, stock performance, supervisory actions,general market stress, or other noncapital metrics.



tal, reducing risk, or employing other means topreserve existing capital. Contingency optionsin the firm’s capital policy should be consequen-tial, realistic, actionable, and comprehensive.

Appendix G: Scenario Design

As part of its capital plan, a firm must use atleast one scenario that stresses the specific vul-nerabilities of the firm’s risk profile and opera-tions, including those related to the company’scapital adequacy and financial condition.35 Thefirm’s stress scenario should be at least as severeas the Federal Reserve’s severely adverse super-visory scenario, measured in terms of its effecton net income and other elements that affectcapital.36

As noted in the core document, a firm shouldcreate its stress scenario, either by developing acomplete internal scenario, or using the FederalReserve’s supervisory scenarios, adjusted forthe firm’s idiosyncratic risk profile.

The stress scenario should include stressfulcircumstances and events that could, on a stand-alone basis or in combination, reduce the firm’scapital levels and ratios and potentially impedethe firm’s ability to operate as a going concern,and cover material risks to which the firm isexposed over the course of an annual planningcycle. A firm’s scenario should include factorsthat capture economy- or market-wide stressesand idiosyncratic risks that can put a strain onthe firm. A firm should also take into accountconditions and events that have not previouslyoccurred, but that may pose a significant threatto the firm given its exposures, risk profile, andbusiness strategy.

Appendix H: Risk-weighted Asset (RWA)Projections

A firm should maintain a sound process forprojecting RWAs over the planning horizon.

The firm’s initial and projected RWA calcula-tions should be consistent with applicable regu-latory capital requirements.

Starting balances for both on- and off-balancesheet exposures and applicable risk weightsform the foundation for estimates of post-stresscapital ratios. Therefore, firms should verifycarefully the accuracy of these starting balances.Moreover, deficiencies in starting RWA calcula-tions are generally compounded in RWA projec-tions over the planning horizon. A firm shouldensure that it has sound controls around itsRWA calculation and regulatory reporting pro-cesses as part of the firm’s broader data gover-nance program.

A firm should ensure that RWA projectionsare consistent with a given scenario and incor-porate the impact of projected changes in expo-sure amounts and risk characteristics of on- andoff-balance sheet exposures under the scenario.A firm should demonstrate that assumptionsassociated with RWA projections are clearlyconditioned on a given scenario and are consis-tent with stated internal and external businessstrategies. For example, the firm should demon-strate how projected credit RWAs over the plan-ning horizon are related to projected loan growthunder the scenario. A firm should provide docu-mented evidence for the appropriateness of keyassumptions used to project RWAs.

Appendix I: Operational Loss Projections

A firm faces a wide range of operational risk inconducting its business operations. Operationallosses can arise from various sources, includinginadequate or failed internal processes, people,and systems, or from external events, and candiffer in frequency and severity. For example,some operational loss events, such as credit cardfraud, are often more predictable as they occurat high frequency, but generally have low lossseverity. The outcome of other events, such asmajor litigation, are less certain and can result inoutsized losses.

1. Risk Identification Process

A firm should maintain a sound process forestimating operational risk losses in its capitalplanning process, taking into account the differ-ences in loss characteristics of different opera-tional loss event types. A firm’s risk identifica-

35. 12 C.F.R. 225.8(e)(2). In addition, a firm is required toreport to the Federal Reserve its projections under a baselinescenario, which captures the firm’s view of the likely operat-ing environment over the planning horizon. A firm may usethe Board’s baseline scenario for its own baseline scenario ifthe firm can demonstrate that the Board’s baseline scenario isappropriate for the firm’s own risks, activities, and outlook;however, a firm cannot use the Board’s severely adversescenario for its own stress scenario.

36. For guidance on the severity of the scenarios, a firmshould review the Board’s “Policy Statement on the ScenarioDesign Framework for Stress Testing,” which sets forth theBoard’s approach to designing the severely adverse scenario.See 12 C.F.R. 252, appendix A.



tion process should include the evaluation of thetype of operational risk loss events to which thefirm is exposed and the sensitivity of thoseevents to internal and external operating envi-ronments. The firm-specific scenario submittedin a firm’s capital plan should capture the firm’smaterial operational risks.

2. Approaches to Operational LossEstimation

A firm can use a variety of estimation ap-proaches to project operational losses for itsenterprise-wide stress testing program, but shouldnot rely on unstable or unintuitive correlationsto project operational losses. The firm can use asimple, conservative approach based on histori-cal loss data, such as applying average historical

losses, or maximum historical losses, to projectoperational losses. A firm should also considerthe use of scenario analysis to evaluate theeffect of material operational risk events, espe-cially those which are less certain or can resultin outsized losses.

3. Use of Data

The firm’s operational loss projection ap-proaches should make appropriate use of rel-evant reference data. The firm should supple-ment its internal data with relevant external dataif the internal data lacks sufficient operationalloss history or granularity.



Consolidated(Funding and Liquidity Risk Management) Section 4066.0


This section is being revised to include theMarch 1, 2016, “Interagency Guidance on FundsTransfer Pricing Related to Funding Contin-gency Risks.” The guidance was issued to ad-dress weaknesses observed in large financialinstitutions’ funds transfer pricing (FTP) prac-tices related to funding risk (including interestrate and liquidity components) and contingentliquidity risk. The interagency guidance buildson the principles of sound liquidity risk manage-ment that are described below. FTP is an impor-tant tool for managing a firm’s balance sheetstructure and measuring risk-adjusted profit-ability. By allocating funding and contingentliquidity risks to business lines, products, andactivities within a firm, FTP influences the vol-ume and terms of new business and ongoingportfolio composition. If done effectively, FTPpromotes more resilient, sustainable businessmodels. (Refer to SR-16-03.)

The March 17, 2010, interagency policy state-ment on “Funding and Liquidity Risk Manage-ment” targets funding and risk-management prin-ciples for insured depository institutions,including state member banks. The basic prin-ciples presented in this policy statement alsoapply to bank holding companies (BHCs). TheFederal Reserve expects supervised financialinstitutions and BHCs to manage liquidity riskusing processes and systems that are commensu-rate with their complexity, risk profile, andscope of operations. Liquidity risk-managementprocesses and plans should be well documentedand available for supervisory review. (SeeSR-10-6 and its attachment.)

BHCs are expected to manage and controlaggregate risk exposures on a consolidated basis,while recognizing legal distinctions and pos-sible obstacles to cash movements among sub-sidiaries. Appropriate liquidity risk manage-ment is especially important for BHCs sinceliquidity difficulties can easily spread to bothdepository and non-depository subsidiaries, par-ticularly in cases of similarly named companieswhere customers may not always understand thelegal distinctions between the holding companyand subsidiaries. For this reason, BHCs shouldensure that liquidity is sufficient at all levels ofthe organization to fully accommodate fundingneeds during periods of stress.

Liquidity risk-management processes andfunding programs should take into full account

the institution’s lending, investment, and otheractivities and should ensure that adequate liquid-ity is maintained at the parent holding companyand each of its subsidiaries. These processes andprograms should fully incorporate real andpotential constraints, including legal and regula-tory restrictions, on the transfer of funds amongsubsidiaries and between subsidiaries and theparent holding company. BHC liquidity shouldbe maintained at levels sufficient to fund hold-ing company and affiliate operations for anextended period of time in a stressed environ-ment when access to normal funding sources aredisrupted, without having a negative impact oninsured depository institution subsidiaries.

Material nonbank subsidiaries, such as broker-dealers, are expected to have liquidity-management processes and funding programsthat reflect the principles outlined in the inter-agency policy statement guidance below (sec-tion 4066.0.1) and are consistent with the sub-sidiaries’ complexity, risk profile, and scope ofoperations. A nonbank subsidiary that directlyaccesses market sources of funding and/or man-ages specific funding programs should pay par-ticular attention to

• maintaining sufficient liquidity, cash flow, andcapital strength to service its debt obligationsand cover fixed charges;

• assessing the potential that funding strategiescould undermine public confidence in theliquidity or stability of subsidiary depositoryinstitutions; and

• ensuring the adequacy of policies and prac-tices that address the stability of funding andintegrity of the institution’s liquidity risk pro-file as evidenced by funding mismatches andthe degree of dependence on potentially vola-tile sources of short-term funding.

For guidance on liquidity risk-measurementtechniques, see section 4020.1, Appendix 1, ofthe Commercial Bank Examination Manual. Forthe supervisory plans (areas of focus) for BHCsthat are designed to help ensure that the fundingand liquidity practices of the parent companyand its nonbank subsidiaries do not have anadverse impact on the organization’s depositoryinstitution subsidiaries, see SR-08-8 and section1050.1.3.3.2 for large complex banking organi-zations. For the similar supervisory plans forregional banking organizations, see SR-08-9 and


section 1050.2.3.3.2. Both manual sections aretitled “Parent Company and Nonbank Fundingand Liquidity.”

4066.0.1 APPENDIX A—INTERAGENCY POLICY STATEMENTON FUNDING AND LIQUIDITY RISKMANAGEMENT

The Board of Governors of the Federal ReserveSystem (FRB)1 issued this guidance to provideconsistent interagency expectations on soundpractices for managing funding and liquidityrisk. The guidance summarizes the principles ofsound liquidity risk management that the agen-cies have issued in the past2 and, where appro-priate, harmonizes these principles with theinternational statement recently issued by theBasel Committee on Banking Supervision titled‘‘Principles for Sound Liquidity Risk Manage-ment and Supervision.’’3

Recent events illustrate that liquidity riskmanagement at many financial institutions is inneed of improvement. Deficiencies includeinsufficient holdings of liquid assets, fundingrisky or illiquid asset portfolios with potentiallyvolatile short-term liabilities, and a lack ofmeaningful cash flow projections and liquiditycontingency plans.

The following guidance reiterates the processthat institutions should follow to appropriatelyidentify, measure, monitor, and control theirfunding and liquidity risk. In particular, theguidance re-emphasizes the importance of cashflow projections, diversified funding sources,stress testing, a cushion of liquid assets, and aformal well-developed contingency funding plan(CFP) as primary tools for measuring and man-aging liquidity risk. The agencies expect everydepository financial institutions4 to manageliquidity risk using processes and systems thatare commensurate with the institution’s com-plexity, risk profile, and scope of operations.Liquidity risk management processes and plansshould be well documented and available forsupervisory review. Failure to maintain anadequate liquidity risk management process willbe considered an unsafe and unsound practice.

Liquidity and Liquidity Risk

Liquidity is a financial institution’s capacity tomeet its cash and collateral obligations at areasonable cost. Maintaining an adequate levelof liquidity depends on the institution’s abilityto efficiently meet both expected and unex-pected cash flows and collateral needs withoutadversely affecting either daily operations or thefinancial condition of the institution.

Liquidity risk is the risk that an institution’sfinancial condition or overall safety and sound-ness is adversely affected by an inability (orperceived inability) to meet its obligations. Aninstitution’s obligations, and the funding sourcesused to meet them, depend significantly on itsbusiness mix, balance-sheet structure, and thecash flow profiles of its on- and off-balance-sheet obligations. In managing their cash flows,institutions confront various situations that cangive rise to increased liquidity risk. These includefunding mismatches, market constraints on theability to convert assets into cash or in accessingsources of funds (i.e., market liquidity), andcontingent liquidity events. Changes in eco-nomic conditions or exposure to credit, market,operation, legal, and reputation risks also canaffect an institution’s liquidity risk profile andshould be considered in the assessment of liquid-ity and asset/liability management.

1. The policy statement in section 4066.0.1 is slightlyamended to address those institutions supervised by the Fed-eral Reserve. The interagency policy statement was alsoissued by the Office of the Comptroller of the Currency(OCC), the Federal Deposit Insurance Corporation (FDIC),and the National Credit Union Administration (NCUA) (col-lectively, the agencies)—and the depository institutions thoseagencies supervise—in conjunction with the Conference ofState Bank Supervisors (CSBS). For the complete text of theinteragency policy statement see 75 Fed. Reg.13656. Thevarious state banking supervisors may implement this policystatement through their individual supervisory process.

2. For national banks, see the Comptroller’s Handbook on

Liquidity. For state member banks and bank holding compa-nies, see the Federal Reserve’s Commercial Bank Examina-

tion Manual (section 4020), Bank Holding Company Supervi-

sion Manual (section 4010), and Trading and Capital Markets

Activities Manual (section 2030). For state non-member banks,see the FDIC’s Revised Examination Guidance for Liquidity

and Funds Management (Trans. No. 2002-01) (Nov. 19, 2001)as well as Financial Institution Letter 84-2008, Liquidity Risk

Management (August 2008). Also see Basel Committee onBanking Supervision, “Principles for Sound Liquidity RiskManagement and Supervision,” (September 2008).

3. Basel Committee on Banking Supervision, “Principlesfor Sound Liquidity Risk Management and Supervision,”September 2008. See www.bis.org/publ/bcbs144.htm.

4. Unless otherwise indicated, this interagency guidanceuses the term “depository financial institutions” or “institu-tions” to include banks and saving associations.

Consolidated (Funding and Liquidity Risk Management) 4066.0


Sound Practices of Liquidity RiskManagement

An institution’s liquidity management processshould be sufficient to meet its daily fundingneeds and cover both expected and unexpecteddeviations from normal operations. Accordingly,institutions should have a comprehensive man-agement process for identifying, measuring,monitoring, andcontrolling liquidity risk.Becauseof the critical importance to the viability of theinstitution, liquidity risk management should befully integrated into the institution’s risk man-agement processes. Critical elements of soundliquidity risk management include:

1. Effective corporate governance consisting ofoversight by the board of directors and activeinvolvement by management in an institu-tion’s control of liquidity risk.

2. Appropriate strategies, policies, procedures,and limits used to manage and mitigate liquid-ity risk.

3. Comprehensive liquidity risk measurementand monitoring systems (including assess-ments of the current and prospective cashflows or sources and uses of funds) that arecommensurate with the complexity and busi-ness activities of the institution.

4. Active management of intraday liquidity andcollateral.

5. An appropriately diverse mix of existing andpotential future funding sources.

6. Adequate levels of highly liquid marketablesecurities, which are free of legal, regulatory,or operational impediments, that can be usedto meet liquidity needs in stressful situations.

7. Comprehensive contingency funding plans(CFPs) that sufficiently address potentialadverse liquidity events and emergency cashflow requirements.

8. Internal controls and internal audit processessufficient to determine the adequacy of theinstitution’s liquidity risk managementprocess.

Supervisors will assess these critical elementsin their reviews of an institution’s liquidity riskmanagement process in relation to its size, com-plexity, and scope of operations.

Corporate Governance

The board of directors is ultimately responsiblefor the liquidity risk assumed by the institution.As a result, the board should ensure that theinstitution’s liquidity risk tolerance is estab-

lished and communicated in such a manner thatall levels of management clearly understand theinstitution’s approach to managing the trade-offs between liquidity risk and short-term prof-its. The board of directors or its delegated com-mittee of board members should oversee theestablishment and approval of liquidity manage-ment strategies, policies and procedures, andreview them at least annually. In addition, theboard should ensure that it:

• Understands the nature of the liquidity risksof its institution and periodically reviews infor-mation necessary to maintain this understand-ing.

• Establishes executive-level lines of authorityand responsibility for managing the institu-tion’s liquidity risk.

• Enforces management’s duties to identify,measure, monitor, and control liquidity risk.

• Understands and periodically reviews the insti-tution’s CFPs for handling potential adverseliquidity events.

• Understands the liquidity risk profiles of im-portant subsidiaries andaffiliatesasappropriate.

Senior management is responsible for ensur-ing that board-approved strategies, policies, andprocedures for managing liquidity (on both along-term and day-to-day basis) are appropri-ately executed within the lines of authority andresponsibility designated for managing and con-trolling liquidity risk. This includes overseeingthe development and implementation of appro-priate risk measurement and reporting systems,liquid buffers (e.g., cash, unencumbered market-able securities, and market instruments), CFPs,and an adequate internal control infrastructure.Senior management is also responsible for regu-larly reporting to the board of directors on theliquidity risk profile of the institution.

Seniormanagement shoulddetermine thestruc-ture, responsibilities, and controls for managingliquidity risk and for overseeing the liquiditypositions of the institution. These elements shouldbe clearly documented in liquidity risk policiesand procedures. For institutions comprised ofmultiple entities, such elements should be fullyspecified and documented in policies for eachmaterial legal entity and subsidiary. Senior man-agement should be able to monitor liquidityrisks for each entity across the institution on anongoing basis. Processes should be in place toensure that the group’s senior management isactively monitoring and quickly responding to



all material developments and reporting to theboards of directors as appropriate.

Institutions should clearly identify the indi-viduals or committees responsible for imple-menting and making liquidity risk decisions.When an institution uses an asset/liability com-mittee (ALCO) or other similar senior manage-ment committee, the committee should activelymonitor the institution’s liquidity profile andshould have sufficiently broad representationacross major institutional functions that candirectly or indirectly influence the institution’sliquidity risk profile (e.g., lending, investmentsecurities, and wholesale and retail funding).Committee members should include senior man-agers with authority over the units responsiblefor executing liquidity-related transactions andother activities within the liquidity risk manage-ment process. In addition, the committee shouldensure that the risk measurement system ad-equately identifies and quantifies risk exposure.The committee also should ensure that the report-ing process communicates accurate, timely, andrelevant information about the level and sourcesof risk exposure.

Strategies, Policies, Procedures, and RiskTolerances

Institutions should have documented strategiesfor managing liquidity risk and clear policiesand procedures for limiting and controlling riskexposures that appropriately reflect the institu-tion’s risk tolerances. Strategies should identifyprimary sources of funding for meeting dailyoperating cash outflows, as well as seasonal andcyclical cash flow fluctuations. Strategies shouldalso address alternative responses to variousadverse business scenarios.5 Policies and proce-dures should provide for the formulation ofplans and courses of actions for dealing withpotential temporary, intermediate-term, and long-term liquidity disruptions. Policies, procedures,and limits also should address liquidity sepa-rately for individual currencies, legal entities,and business lines, when appropriate and mate-rial, and should allow for legal, regulatory, andoperational limits for the transferability of liquid-ity as well. Senior management should coordi-

nate the institution’s liquidity risk managementwith disaster, contingency, and strategic plan-ning efforts, as well as with business line andrisk management objectives, strategies, andtactics.

Policies should clearly articulate a liquidityrisk tolerance that is appropriate for the businessstrategy of the institution, considering its com-plexity, business mix, liquidity risk profile, andits role in the financial system. Policies shouldalso contain provisions for documenting andperiodically reviewing assumptions used in li-quidity projections. Policy guidelines shouldemploy both quantitative targets and qualitativeguidelines. For example, these measurements,limits, and guidelines may be specified in termsof the following measures and conditions, asapplicable:

1. Cash flow projections that include discreteand cumulative cash flow mismatches orgaps over specified future time horizons underbothexpectedandadversebusinessconditions.

2. Target amounts of unencumbered liquid assetreserves.

3. Measures used to identify unstable liabilitiesand liquid asset coverage ratios. For exam-ple, these may include ratios of wholesalefunding to total liabilities, potentially volatileretail (e.g., high-cost or out-of-market) depos-its to total deposits, and other liability depen-dency measures, such as short-term borrow-ings as a percent of total funding.

4. Asset concentrations that could increaseliquidity risk through a limited ability toconvert to cash (e.g., complex financialinstruments,6 bank-owned (corporate-owned) life insurance, and less marketableloan portfolios).

5. Funding concentrations that address diversi-fication of funding sources and types, such aslarge liability and borrowed funds depen-dency, secured versus unsecured fundingsources, exposures to single providers offunds, exposures to funds providers by mar-ket segments, and different types of brokereddeposits or wholesale funding.

6. Funding concentrations that address the term,re-pricing, and market characteristics of fund-ing sources with consideration given to thenature of the assets they fund. This mayinclude diversification targets for short-,medium-, and long-term funding; instrumenttype and securitization vehicles; and guid-

5. In formulating liquidity management strategies, mem-bers of complex banking groups should take into consider-ation their legal structures (e.g., branches versus separatelegal entities and operating subsidiaries), key business lines,markets, products, and jurisdictions in which they operate.

6. Financial instruments that are illiquid, difficult to value,or marked by the presence of cash flows that are irregular,uncertain, or difficult to model.



ance on concentrations for currencies andgeographical markets.

7. Contingent liability exposures such asunfunded loan commitments, lines of creditsupporting asset sales or securitizations, andcollateral requirements for derivatives trans-actions and various types of secured lending.

8. Exposures of material activities, such as secu-ritization, derivatives, trading, transaction pro-cessing, and international activities, to broadsystemic and adverse financial market events.This is most applicable to institutions withcomplex and sophisticated liquidity riskprofiles.

9. Alternative measures and conditions that maybe appropriate for certain institutions.

Policies also should specify the nature andfrequency of management reporting. In normalbusiness environments, senior managers shouldreceive liquidity risk reports at least monthly,while the board of directors should receiveliquidity risk reports at least quarterly. Depend-ing upon the complexity of the institution’sbusiness mix and liquidity risk profile, manage-ment reporting may need to be more frequent.Regardless of an institution’s complexity, itshould have the ability to increase the frequencyof reporting on short notice, if the need arises.Liquidity risk reports should impart to seniormanagement and the board a clear understand-ing of the institution’s liquidity risk exposure,compliance with risk limits, consistency betweenmanagement’s strategies and tactics, and consis-tency between these strategies and the board’sexpressed risk tolerance.

Institutions should consider liquidity costs,benefits, and risks in strategic planning and bud-geting processes. Significant business activitiesshould be evaluated for both liquidity risk expo-sure and profitability. More complex and sophis-ticated institutions should incorporate liquiditycosts, benefits, and risks in the internal productpricing, performance measurement, and newproduct approval process for all material busi-ness lines, products, and activities. Incorporat-ing the cost of liquidity into these functionsshould align the risk-taking incentives of indi-vidual business lines with the liquidity riskexposure their activities create for the institutionas a whole. The quantification and attribution ofliquidity risks should be explicit and transparentat the line management level and should includeconsideration of how liquidity would be affectedunder stressed conditions.

Liquidity Risk Measurement, Monitoring,and Reporting

The process of measuring liquidity risk shouldinclude robust methods for comprehensivelyprojecting cash flows arising from assets, li-abilities, and off-balance-sheet items over an ap-propriate set of time horizons. For example,time buckets may be daily for very shorttimeframes or extend out to weekly, monthly,and quarterly for longer time frames. Pro formacash flow statements are a critical tool foradequately managing liquidity risk. Cash flowprojections can range from simple spreadsheetsto very detailed reports depending upon thecomplexity and sophistication of the institutionand its liquidity risk profile under alternativescenarios. Given the critical importance that as-sumptions play in constructing measures ofliquidity risk and projections of cash flows,institutions should ensure that the assumptionsused are reasonable, appropriate, and adequatelydocumented. Institutions should periodicallyreview and formally approve these assumptions.Institutions should focus particular attention onthe assumptions used in assessing the liquidityrisk of complex assets, liabilities, and off-balance-sheet positions. Assumptions applied topositions with uncertain cash flows, includingthe stability of retail and brokered deposits andsecondary market issuances and borrowings, areespecially important when they are used toevaluate the availability of alternative sourcesof funds under adverse contingent liquidityscenarios. Such scenarios include, but are notlimited to, deterioration in the institution’s assetquality or capital adequacy.

Institutions should ensure that assets are prop-erly valued according to relevant financial report-ing and supervisory standards. An institutionshould fully factor into its risk managementpractices the consideration that valuations maydeteriorate under market stress and take this intoaccount in assessing the feasibility and impactof asset sales on its liquidity position duringstress events.

Institutions should ensure that their vulner-abilities to changing liquidity needs and liquid-ity capacities are appropriately assessed withinmeaningful time horizons, including intraday,day-to-day, short-term weekly and monthlyhorizons, medium-term horizons of up to oneyear, and longer-term liquidity needs of oneyear or more. These assessments should includevulnerabilities to events, activities, and strate-



gies that can significantly strain the capability togenerate internal cash.

Stress Testing

Institutions should conduct stress tests regu-larly for a variety of institution-specific andmarketwide events across multiple time hori-zons. The magnitude and frequency of stresstesting should be commensurate with the com-plexity of the financial institution and the levelof its risk exposures. Stress test outcomesshould be used to identify and quantify sourcesof potential liquidity strain and to analyze pos-sible impacts on the institution’s cash flows,liquidity position, profitability, and solvency.Stress tests should also be used to ensure thatcurrent exposures are consistent with the finan-cial institution’s established liquidity risk toler-ance. Management’s active involvement andsupport is critical to the effectiveness of thestress testing process. Management should dis-cuss the results of stress tests and take remedialor mitigating actions to limit the institution’sexposures, build up a liquidity cushion, andadjust its liquidity profile to fit its risk toler-ance. The results of stress tests should alsoplay a key role in shaping the institution’s con-tingency planning. As such, stress testing andcontingency planning are closely intertwined.

Collateral Position Management

An institution should have the ability to calcu-late all of its collateral positions in a timelymanner, including the value of assets currentlypledged relative to the amount of security requiredand unencumbered assets available to be pledged.An institution’s level of available collateralshould be monitored by legal entity, jurisdic-tion, and currency exposure, and systems shouldbe capable of monitoring shifts between intra-day and overnight or term collateral usage. Aninstitution should be aware of the operationaland timing requirements associated with access-ing the collateral given its physical location(i.e., the custodian institution or securities settle-ment system with which the collateral is held).Institutions should also fully understand thepotential demand on required and available col-lateral arising from various types of contractualcontingencies during periods of both mar-ketwide and institution-specific stress.

Management Reporting

Liquidity risk reports should provide aggregateinformation with sufficient supporting detail toenable management to assess the sensitivity ofthe institution to changes in market conditions,its own financial performance, and other impor-tant risk factors. The types of reports or informa-tion and their timing will vary according to thecomplexity of the institution’s operations andrisk profile. Reportable items may include butare not limited to cash flow gaps, cash flowprojections, asset and funding concentrations,critical assumptions used in cash flow projec-tions, key early warning or risk indicators, fund-ing availability, status of contingent fundingsources, or collateral usage. Institutions shouldalso report on the use of and availability ofgovernment support, such as lending and guar-antee programs, and implications on liquiditypositions, particularly since these programs aregenerally temporary or reserved as a source forcontingent funding.

Liquidity across Currencies, LegalEntities, and Business Lines

A depository institution should actively monitorand control liquidity risk exposures and fundingneeds within and across currencies, legal enti-ties, and business lines. Also, depository institu-tions should take into account operational limi-tations to the transferability of liquidity, andshould maintain sufficient liquidity to ensurecompliance during economically stressed periodswith applicable legal and regulatory restrictionson the transfer of liquidity among regulatedentities. The degree of centralization in manag-ing liquidity should be appropriate for the deposi-tory institution’s business mix and liquidity riskprofile.7 The agencies expect depository institu-tions to maintain adequate liquidity both at theconsolidated level and at significant legal entities.

Regardless of its organizational structure, it isimportant that an institution actively monitorand control liquidity risks at the level of indi-vidual legal entities, and the group as a whole,incorporating processes that aggregate data acrossmultiple systems in order to develop a group-wide view of liquidity risk exposures. It is alsoimportant that the institution identify constraintson the transfer of liquidity within the group.

7. Institutions subject to multiple regulatory jurisdictionsshould have management strategies and processes that recog-nize the potential limitations of liquidity transferability, aswell as the need to meet the liquidity requirements of foreignjurisdictions.



Assumptions regarding the transferability offunds and collateral should be described inliquidity risk management plans.

Intraday Liquidity Position Management

Intraday liquidity monitoring is an importantcomponent of the liquidity risk managementprocess for institutions engaged in significantpayment, settlement, and clearing activities. Aninstitution’s failure to manage intraday liquidityeffectively, under normal and stressed condi-tions, could leave it unable to meet payment andsettlement obligations in a timely manner,adversely affecting its own liquidity positionand that of its counterparties. Among large,complex organizations, the interdependenciesthat exist among payment systems and the inabil-ity to meet certain critical payments has thepotential to lead to systemic disruptions that canprevent the smooth functioning of all paymentsystems and money markets. Therefore, institu-tions with material payment, settlement andclearing activities should actively manage theirintraday liquidity positions and risks to meetpayment and settlement obligations on a timelybasis under both normal and stressed conditions.Senior management should develop and adoptan intraday liquidity strategy that allows theinstitution to:

1. Monitor and measure expected daily grossliquidity inflows and outflows.

2. Manage and mobilize collateral when neces-sary to obtain intraday credit.

3. Identify and prioritize time-specific and othercritical obligations in order to meet themwhen expected.

4. Settle other less critical obligations as soonas possible.

5. Control credit to customers when necessary.6. Ensure that liquidity planners understand the

amounts of collateral and liquidity needed toperform payment-system obligations whenassessing the organization’s overall liquidityneeds.

Diversified Funding

An institution should establish a funding strat-egy that provides effective diversification in thesources and tenor of funding. It should maintainan ongoing presence in its chosen funding mar-kets and strong relationships with funds provid-ers to promote effective diversification of fund-ing sources. An institution should regularly gauge

its capacity to raise funds quickly from eachsource. It should identify the main factors thataffect its ability to raise funds and monitor thosefactors closely to ensure that estimates of fundraising capacity remain valid.

An institution should diversify available fund-ing sources in the short-, medium-, and long-term. Diversification targets should be part ofthe medium- to long-term funding plans andshould be aligned with the budgeting and busi-ness planning process. Funding plans shouldtake into account correlations between sourcesof funds and market conditions. Funding shouldalso be diversified across a full range of retail aswell as secured and unsecured wholesale sourcesof funds, consistent with the institution’s sophis-tication and complexity. Management shouldalso consider the funding implications of anygovernment programs or guarantees it uses. Aswith wholesale funding, the potential unavail-ability of government programs over theintermediate- and long-term should be fully con-sidered in the development of liquidity riskmanagement strategies, tactics, and risk toler-ances. Funding diversification should be imple-mented using limits addressing counterparties,secured versus unsecured market funding, instru-ment type, securitization vehicle, and geo-graphic market. In general, funding concentra-tions should be avoided. Undue over-reliance onany one source of funding is considered anunsafe and unsound practice.

An essential component of ensuring fundingdiversity is maintaining market access. Marketaccess is critical for effective liquidity risk man-agement as it affects both the ability to raisenew funds and to liquidate assets. Senior man-agement should ensure that market access isbeing actively managed, monitored, and testedby the appropriate staff. Such efforts should beconsistent with the institution’s liquidity riskprofile and sources of funding. For example,access to the capital markets is an importantconsideration for most large complex institu-tions, whereas the availability of correspondentlines of credit and other sources of wholesalefunds are critical for smaller, less complex insti-tutions.

An institution should identify alternativesources of funding that strengthen its capacity towithstand a variety of severe institution-specificand marketwide liquidity shocks. Dependingupon the nature, severity, and duration of theliquidity shock, potential sources of fundinginclude, but are not limited to, the following:



1. Deposit growth.

2. Lengthening maturities of liabilities.

3. Issuance of debt instruments.

4. Sale of subsidiaries or lines of business.

5. Asset securitization.

6. Sale (either outright or through repurchaseagreements) or pledging of liquid assets.

7. Drawing down committed facilities.

8. Borrowing.

Cushion of Liquid Assets

Liquid assets are an important source of bothprimary (operating liquidity) and secondary (con-tingent liquidity) funding at many institutions.Indeed, a critical component of an institution’sability to effectively respond to potential liquid-ity stress is the availability of a cushion ofhighly liquid assets without legal, regulatory, oroperational impediments (i.e., unencumbered)that can be sold or pledged to obtain funds in arange of stress scenarios. These assets should beheld as insurance against a range of liquiditystress scenarios including those that involve theloss or impairment of typically available unse-cured and/or secured funding sources. The sizeof the cushion of such high-quality liquid assetsshould be supported by estimates of liquidityneeds performed under an institution’s stresstesting as well as aligned with the risk toleranceand risk profile of the institution. Managementestimates of liquidity needs during periods ofstress should incorporate both contractual andnoncontractual cash flows, including the possi-bility of funds being withdrawn. Such estimatesshould also assume the inability to obtain unse-cured and uninsured funding as well as the lossor impairment of access to funds secured byassets other than the safest, most liquid assets.

Management should ensure that unencum-bered, highly liquid assets are readily availableand are not pledged to payment systems orclearing houses. The quality of unencumberedliquid assets is important as it will ensure acces-sibility during the time of most need. An institu-tion could use its holdings of high-quality secu-rities, for example, U.S. Treasury securities,securities issued by U.S. government-sponsoredagencies, excess reserves at the central bank orsimilar instruments, and enter into repurchaseagreements in response to the most severe stressscenarios.

Contingency Funding Plan8

All financial institutions, regardless of size andcomplexity, should have a formal CFP thatclearly sets out the strategies for addressingliquidity shortfalls in emergency situations. ACFP should delineate policies to manage a rangeof stress environments, establish clear lines ofresponsibility, and articulate clear implementa-tion and escalation procedures. It should beregularly tested and updated to ensure that it isoperationally sound. For certain components ofthe CFP, affirmative testing (e.g., liquidation ofassets) may be impractical. In these instances,institutions should be sure to test operationalcomponents of the CFP. For example, ensuringthat roles and responsibilities are up-to-date andappropriate; ensuring that legal and operationaldocuments are up-to-date and appropriate; ensur-ing that cash and collateral can be moved whereand when needed; and ensuring that contingentliquidity lines can be drawn when needed.

Contingent liquidity events are unexpectedsituations or business conditions that may increaseliquidity risk. The events may be institution-specific or arise from external factors and mayinclude:

1. The institution’s inability to fund asset growth.2. The institution’s inability to renew or replace

maturing funding liabilities.3. Customers unexpectedly exercising options

to withdraw deposits or exercise off-balance-sheet commitments.

4. Changes in market value and price volatilityof various asset types.

5. Changes in economic conditions, market per-ception, or dislocations in the financial mar-kets.

6. Disturbances in payment and settlement sys-tems due to operational or local disasters.

Insured institutions should be prepared for thespecific contingencies that will be applicable tothem if they become less than Well Capitalizedpursuant to Prompt Correction Action (PCA)provisions under the Federal Deposit InsuranceCorporation Improvement Act.9 Contingenciesmay include restricted rates paid for deposits,the need to seek approval from the FDIC/NCUAto accept brokered deposits, and the inability to

8. Financial institutions that have had their liquidity sup-ported by temporary government programs administered bythe Department of the Treasury, Federal Reserve, and/or FDICshould not base their liquidity strategies on the belief thatsuch programs will remain in place indefinitely.

9. See 12 USC 1831o, 12 CFR 6 (OCC), 12 CFR 208.40(FRB), and 12 CFR 325.101 (FDIC).



accept any brokered deposits.10

A CFP provides a documented framework formanaging unexpected liquidity situations. Theobjective of the CFP is to ensure that the institu-tion’s sources of liquidity are sufficient to fundnormal operating requirements under contingentevents. A CFP also identifies alternative contin-gent liquidity resources11 that can be employedunder adverse liquidity circumstances. An insti-tution’s CFP should be commensurate with itscomplexity, risk profile, and scope of opera-tions. As macroeconomic and institution-specific conditions change, CFPs should berevised to reflect these changes.

Contingent liquidity events can range fromhigh-probability/low-impact events to low-probability/high-impact events. Institutionsshould incorporate planning for high-probability/low-impact liquidity risks into the day-to-daymanagement of sources and uses of funds. Insti-tutions can generally accomplish this by assess-ing possible variations around expected cashflow projections and providing for adequateliquidity reserves and other means of raisingfunds in the normal course of business. In con-trast, all financial institution CFPs will typicallyfocus on events that, while relatively infrequent,could significantly impact the institution’s opera-tions. A CFP should:

1. Identify Stress Events. Stress events are thosethat may have a significant impact on theinstitution’s liquidity given its specificbalance-sheet structure, business lines, orga-nizational structure, and other characteris-tics. Possible stress events may include dete-rioration in asset quality, changes in agencycredit ratings, PCA capital categories andCAMELS ratings downgrades, widening ofcredit default spreads, operating losses, declin-ing financial institution equity prices, nega-tive press coverage, or other events that maycall into question an institution’s ability tomeet its obligations.

2. Assess Levels of Severity and Timing. TheCFP should delineate the various levels ofstress severity that can occur during a contin-gent liquidity event and identify the differentstages for each type of event. The events,

stages, and severity levels identified shouldinclude temporary disruptions as well as thosethat might be more intermediate term orlonger-term. Institutions can use the differentstages or levels of severity identified to de-sign early-warning indicators, assess poten-tial funding needs at various points in adeveloping crisis, and specify comprehen-sive action plans. The length of the scenariowill be determined by the type of stress eventbeing modeled and should encompass theduration of the event.

3. Assess Funding Sources and Needs. A criti-cal element of the CFP is the quantitativeprojection and evaluation of expected fund-ing needs and funding capacity during thestress event. This entails an analysis of thepotential erosion in funding at alternativestages or severity levels of the stress eventand the potential cash flow mismatches thatmay occur during the various stress levels.Management should base such analysis onrealistic assessments of the behavior of fundsproviders during the event and incorporatealternative contingency funding sources. Theanalysis also should includeallmaterialon-andoff-balance-sheet cash flows and their relatedeffects. The result should be a realistic analy-sis of cash inflows, outflows, and funds avail-ability at different time intervals during thepotential liquidity stress event in order tomeasure the institution’s ability to fund opera-tions. Common tools to assess funding mis-matches include:a. Liquidity gap analysis—A cash flow report

that essentially represents a base case esti-mate of where funding surpluses and short-falls will occur over various future timeframes.

b. Stress tests—A pro forma cash flowreport with the ability to estimate futurefunding surpluses and shortfalls undervarious liquidity stress scenarios and theinstitution’s ability to fund expectedasset growth projections or sustain anorderly liquidation of assets under vari-ous stress events.

4. Identify Potential Funding Sources. Becauseliquidity pressures may spread from one fund-ing source to another during a significantliquidity event, institutions should identifyalternative sources of liquidity, and ensureready access to contingent funding sources.In some cases, these funding sources mayrarely be used in the normal course of busi-

10. Section 38 of the FDI Act (12 USC 1831o) requiresinsured depository institutions that are not well capitalized toreceive approval prior to engaging in certain activities. Sec-tion 38 restricts or prohibits certain activities and requires aninsured depository institution to submit a capital restorationplan when it becomes undercapitalized.

11. There may be time constraints, sometimes lastingweeks, encountered in initially establishing lines with FRBand/or FHLB. As a result, financial institutions should plan tohave these lines set up well in advance.



ness. Therefore, institutions should conductadvance planning and periodic testing toensure that contingent funding sources arereadily available when needed.

5. Establish Liquidity Event Management Pro-cesses. The CFP should provide for a reliablecrisis management team and administrativestructure, including realistic action plans usedto execute the various elements of the planfor given levels of stress. Frequent communi-cation and reporting among team members,the board of directors, and other affectedmanagers optimize the effectiveness of a con-tingency plan during an adverse liquidityevent by ensuring that business decisions arecoordinated to minimize further disruptionsto liquidity. Such events may also require thedaily computation of regular liquidity riskreports and supplemental information. TheCFP should provide for more frequent andmore detailed reporting as the stress situationintensifies.

6. Establish a Monitoring Framework forContingent Events. Institution managementshould monitor for potential liquidity stressevents by using early-warning indicators andevent triggers. The institution should tailorthese indicators to its specific liquidity riskprofile. The early recognition of potentialevents allows the institution to position itselfinto progressive states of readiness as theevent evolves, while providing a frameworkto report or communicate within the institu-tion and to outside parties. Early-warningsignals may include, but are not limited to,negative publicity concerning an asset classowned by the institution, increased potentialfor deterioration in the institution’s finan-cial condition, widening debt or creditdefault swap spreads, and increased concernsover the funding of off-balance-sheet items.

To mitigate the potential for reputation conta-gion, effective communication with counterpar-ties, credit-rating agencies, and other stakehold-ers when liquidity problems arise is of vitalimportance. Smaller institutions that rarely inter-act with the media should have plans in placefor how they will manage press inquiries thatmay arise during a liquidity event. In addition,groupwide contingency funding plans, liquiditycushions, and multiple sources of funding aremechanisms that may mitigate reputationconcerns.

In addition to early-warning indicators,

institutions that issue public debt, use warehousefinancing, securitize assets, or engage in materialover-the-counter derivative transactions typi-cally have exposure to event triggers embeddedin the legal documentation governing thesetransactions. Institutions that rely upon brokereddeposits should also incorporate PCA-relateddowngrade triggers into their CFPs since achange in PCA status could have a materialbearing on the availability of this funding source.Contingent event triggers should be an integralpart of the liquidity risk monitoring system.Institutions that originate and/or purchase loansfor asset securitization programs pose heightenedliquidity risk concerns due to the unexpectedfunding needs associated with an early amorti-zation event or disruption of warehouse funding.Institutions that securitize assets should haveliquidity contingency plans that address theserisks.

Institutions that rely upon secured fundingsources also are subject to potentially highermargin or collateral requirements that may betriggered upon the deterioration of a specificportfolio of exposures or the overall financialcondition of the institution. The ability of afinancially stressed institution to meet calls foradditional collateral should be considered in theCFP. Potential collateral values also should besubject to stress tests since devaluations or mar-ket uncertainty could reduce the amount of con-tingent funding that can be obtained from pledg-ing a given asset. Additionally, triggering eventsshould be understood and monitored by liquid-ity managers.

Institutions should test various elements ofthe CFP to assess their reliability under times ofstress. Institutions that rarely use the type offunds they identify as standby sources of liquid-ity in a stress situation, such as the sale orsecuritization of loans, securities repurchaseagreements, Federal Reserve discount windowborrowing, or other sources of funds, shouldperiodically test the operational elements ofthese sources to ensure that they work asanticipated. However, institutions should beaware that during real stress events, priormarket access testing does not guarantee thatthese funding sources will remain availablewithin the same time frames and/or on the sameterms.

Larger, more complex institutions can benefitby employing operational simulations to testcommunications, coordination, anddecisionmak-ing involving managers with different responsi-bilities, in different geographic locations, or atdifferent operating subsidiaries. Simulations ortests run late in the day can highlight specific



problems, such as difficulty in selling assets orborrowing new funds at a time when business inthe capital markets may be less active.

Internal Controls

An institution’s internal controls consist of pro-cedures, approval processes, reconciliations,reviews, and other mechanisms designed to pro-vide assurance that the institution manages liquid-ity risk consistent with board-approved policy.Appropriate internal controls should address rel-evant elements of the risk management process,including adherence to policies and procedures,the adequacy of risk identification, risk measure-ment, reporting, and compliance with applicablerules and regulations.

Management should ensure that an indepen-dent party regularly reviews and evaluates thevarious components of the institution’s liquidityrisk management process. These reviews shouldassess the extent to which the institution’s liquid-ity risk management complies with both super-visory guidance and industry sound practices,taking into account the level of sophisticationand complexity of the institution’s liquidity riskprofile.12 Smaller, less-complex institutions mayachieve independence by assigning this respon-sibility to the audit function or other qualifiedindividuals independent of the risk managementprocess. The independent review process shouldreport key issues requiring attention, includinginstances of noncompliance, to the appropriatelevel of management for prompt corrective actionconsistent with approved policy.

4066.0.2 APPENDIX B—INTERAGENCY GUIDANCE ONFUNDS TRANSFER PRICINGRELATED TO FUNDING ANDCONTINGENT LIQUIDITY RISKS

The Board of Governors of the Federal ReserveSystem (FRB), the Federal Deposit InsuranceCorporation (FDIC), and the Office of the Comp-troller of the Currency (OCC) issued this guid-ance on funds transfer pricing (FTP) practicesrelated to funding risk (including interest rateand liquidity components) and contingent liquid-ity risk at large financial institutions (hereafter

referred to as “firms”) to address weaknessesobserved in some firms’ FTP practices.13 Theguidance builds on the principles of sound liquid-ity risk management described in the “Inter-agency Policy Statement on Funding and Liquid-ity Risk Management,”14 and incorporateselements of the international statement issuedby the Basel Committee on Banking Supervi-sion titled “Principles for Sound Liquidity RiskManagement and Supervision.”15 Refer toSR-16-03.

Background

For purposes of this guidance, FTP refers to aprocess performed by a firm’s central manage-ment function that allocates costs and benefitsassociated with funding and contingent liquidityrisks (FTP costs and benefits), as measured attransaction or trade inception, to a firm’s busi-ness lines, products, and activities. While thisguidance specifically addresses FTP practicesrelated to funding and contingent liquidity risks,firms may incorporate other risks in their overallFTP frameworks.

FTP is an important tool for managing afirm’s balance sheet structure and measuringrisk-adjusted profitability. By allocating fundingand contingent liquidity risks to business lines,products, and activities within a firm, FTP influ-ences the volume and terms of new business andongoing portfolio composition. This processhelps align a firm’s funding and contingentliquidity risk profile and risk appetite and comple-ments, but does not replace, broader liquidityand interest rate risk management programs (forexample, stress testing) that a firm uses to cap-ture certain risks (for example, basis risk). If

12. This includes the standards established in this inter-agency guidance as well as the supporting material eachagency provides in its examination manuals and handbooksdirected at their supervised institutions. Industry standardsinclude those advanced by recognized industry associationsand groups.

13. For purposes of this guidance, large financial institu-tions include: national banks, federal savings associations andstate-chartered banks with consolidated assets of $250 billionor more, domestic bank and savings and loan holding compa-nies with consolidated assets of $250 billion or more orforeign exposure of $10 billion or more, and foreign bankingorganizations with combined U.S. assets of $250 billion ormore.

14. Refer to: FRB’s SR-10-6, “Interagency Policy State-ment on Funding and Liquidity Risk Management”; FDIC’sFIL-13-2010, “Funding and Liquidity Risk Management Inter-agency Guidance”; and OCC Bulletin 2010-13, “Final PolicyStatement: Interagency Policy Statement on Funding andLiquidity Management.”

15. The Basel Committee on Banking Supervision state-ment on “Principles for Sound Liquidity Risk Managementand Supervision” (September 2008) is available at www.bis.org/publ/bcbs144.htm.



done effectively, FTP promotes more resilient,sustainable business models. FTP is also animportant tool for centralizing the managementof funding and contingent liquidity risks for allexposures. Through FTP, a firm can transferthese risks to a central management functionthat can take advantage of natural offsets, cen-tralized hedging activities, and a broader viewof the firm.

Failure to consistently and effectively applyFTP can misalign the risk-taking incentives ofindividual business lines with the firm’s riskappetite, resulting in a misallocation of financialresources. This misallocation can arise in newbusinessandongoingportfoliocompositionwherethe business metrics do not reflect risks taken,thereby undermining the business model. Ex-amples include entering into excessive off-balance sheet commitments and on-balance sheetasset growth because of mispriced funding andcontingent liquidity risks.

The 2008 financial crisis exposed weak riskmanagement practices for allocating liquiditycosts and benefits across business lines. Severalfirms “acknowledged that if robust FTP prac-tices had been in place earlier, and if the sys-tems had charged not just for funding but forliquidity risks, they would not have carried thesignificant levels of illiquid assets and the sig-nificant risks that were held off-balance sheetthat ultimately led to sizable losses.”16

Funds Transfer Pricing Principles

A firm should have an FTP framework to sup-port its broader risk management and gover-nance processes that incorporates the generalprinciples described in this section and is com-mensurate with its size, complexity, businessactivities, and overall risk profile. The frame-work should incorporate FTP costs and benefitsinto product pricing, business metrics, and newproduct approval for all material business lines,products, and activities to align risk-taking incen-tives with the firm’s risk appetite.

Principle 1: A firm should allocate FTP costsand benefits based on funding risk and contin-gent liquidity risk.

A firm should have an FTP framework thatallocates costs and benefits based on the follow-ing risks.

• Funding risk, measured as the cost or benefit(including liquidity and interest rate compo-nents) of raising funds to finance ongoingbusiness operations, should be allocated basedon the characteristics of the business lines,products, and activities that give rise to thosecosts or benefits (for example, higher costsallocated to assets that will be held over alonger time horizon and greater benefits allo-cated to stable sources of funding).

• Contingent liquidity risk, measured as the costof holding standby liquidity composed of un-encumbered, highly liquid assets, should beallocated to the business lines, products, andactivities that pose risk of contingent fundingneeds during a stress event (for example,draws on credit commitments, collateral calls,deposit run-off, and increasing haircuts onsecured funding).

Principle 2: A firm should have a consistent andtransparent FTP framework for identifying andallocating FTP costs and benefits on a timelybasis and at a sufficiently granular level, com-mensurate with the firm’s size, complexity, busi-ness activities, and overall risk profile.

FTP costs and benefits should be allocated basedon methodologies that are set forth by a firm’sFTP framework. The methodologies should betransparent, repeatable, and sufficiently granularsuch that they align business decisions with thefirm’s desired funding and contingent liquidityrisk appetite. To the extent a firm applies FTP atan aggregated level to similar products andactivities, the firm should include the aggregat-ing criteria in the report on FTP.17 Additionally,the senior management group that oversees FTPshould review the basis for the FTP methodolo-gies. The attachment to this interagency guid-ance describes illustrative FTP methodologiesthat a firm may consider when implementing itsFTP framework.18

A firm should allocate FTP costs and benefits,as measured at transaction or trade inception, tothe appropriate business line, product, or activ-ity. If a firm retains any FTP costs or benefits ina centrally managed pool pursuant to its FTPframework, it should analyze the implications of

16. Senior Supervisors Group report on “Risk Manage-ment Lessons from the Global Financial Crisis of 2008”(October 21, 2009) is available at https://www.newyorkfed.org/medialibrary/media/newsevents/news/banking/2009/SSG_report.pdf.

17. See Principle 3 for a discussion of the report on FTP.18. The FRB, the FDIC, and the OCC will monitor evolv-

ing FTP practices in the market and may update or add to theillustrative methodologies in the interagency guidance attach-ment.



https://www.newyorkfed.org/medialibrary/media/newsevents/news/banking/2009/SSG_report.pdf



such decisions on business line incentives andthe firm’s overall risk profile. The firm custom-arily would include its findings in the report onFTP.

The FTP framework should be implementedconsistently across the firm to appropriatelyalign risk-taking incentives. While it is possibleto apply different FTP methodologies within afirm due to, among other things, legal entitytype or specific jurisdictional circumstances, afirm should generally implement the FTP frame-work in a consistent manner across its corporatestructure to reduce the likelihood of misalignedincentives. If there are implementation differ-ences across the firm, management should ana-lyze the implications of such differences onbusiness line incentives and the firm’s overallfunding and contingent liquidity risk profile.The firm customarily would include its findingsin the report on FTP.

A firm should allocate, report, and updatedata on FTP costs and benefits at a frequencythat is appropriate for the business line, product,or activity. Allocating, reporting, and updatingof data should occur more frequently for tradingexposures (for example, on a daily basis). Infre-quent allocation, reporting, or updating of datafor trading exposures (for example, based onmonth-end positions) may not fully capture afirm’s day-to-day funding and contingent liquid-ity risks. For example, a firm should monitor theage of its trading exposures, and those heldlonger than originally intended should be reas-sessed and FTP costs and benefits should bereallocated based on the modified holding period.

A firm’s FTP framework should address de-rivative activities commensurate with the sizeand complexity of those activities. The FTPframework may consider the fair value of cur-rent positions, the rights of rehypothecation forcollateral received, and contingent outflows thatmay occur during a stress event.

To avoid a misalignment of risk-taking incen-tives, a firm should adjust its FTP costs andbenefits as appropriate based on both market-wide and idiosyncratic conditions, such as trappedliquidity, reserve requirements, regulatory re-quirements, illiquid currencies, and settlementor clearing costs. These idiosyncratic conditionsshould be contemplated in the FTP framework,and the firm customarily would include a discus-sion of the implications in the report on FTP.

Principle 3: A firm should have a robust gover-nance structure for FTP, including the produc-tion of a report on FTP and oversight from asenior management group and central manage-ment function.

A firm should have a senior management groupthat oversees FTP, which should include a broadrange of stakeholders, such as representativesfrom the firm’s asset-liability committee (if sepa-rate from the senior management group), thetreasury function, and business line and riskmanagement functions. This group should de-velop the policy underlying the FTP framework,which should identify assumptions, responsibili-ties, procedures, and authorities for FTP. Thepolicy should be reviewed and updated on aregular basis or when the firm’s asset-liabilitystructure or scope of activities undergoes amaterial change. Further, senior managementwith oversight responsibility for FTP shouldperiodically, but no less frequently than quar-terly, review the report on FTP to ensure that theestablished FTP framework is being properlyimplemented.

A firm should also establish a central manage-ment function tasked with implementing theFTP framework. The central management func-tion should have visibility over the entire firm’son- and off-balance sheet exposures. Among itsresponsibilities, the central management func-tion should regularly produce and analyze areport on FTP generated from accurate and reli-able management information systems. The re-port on FTP should be at a sufficiently granularlevel to enable the senior management groupand central management function to effectivelymonitor the FTP framework (for example, at thebusiness line, product, or activity level, as appro-priate). Among other items, all material approv-als, such as those related to any exception to theFTP framework, including the reason for theexception, would customarily be documented inthe report on FTP. The report on FTP may bestandalone or included within a broader riskmanagement report.

Independent risk and control functions andinternal audit should provide oversight of theFTP process and assess the report on FTP, whichshould be reviewed as appropriate to reflectchanging business and financial market condi-tions and to maintain the appropriate alignmentof incentives. Lastly, consistent with existingsupervisory guidance on model risk manage-ment,19 models used in FTP implementationshould be independently validated and regularlyreviewed to ensure that the models continue to

19. Refer to: FRB’s SR-11-7, “Guidance on Model RiskManagement”; OCC Bulletin 2011-12, “Supervisory Guid-ance on Model Risk Management.” Refer to section 2126.0 ofthis manual.



perform as expected, that all assumptions remainappropriate, and that limitations are understoodand appropriately mitigated.

Principle 4: A firm should align business incen-tives with risk management and strategic objec-tives by incorporating FTP costs and benefitsinto product pricing, business metrics, and newproduct approval.

Through its FTP framework, a firm should incor-porate FTP costs and benefits into product pric-ing, business metrics, and new product approvalfor all material business lines, products, andactivities (both on- and off-balance sheet). Theframework, the report on FTP, and any associ-ated management information systems shouldbe designed to provide decision makers suffi-cient and timely information about FTP costsand benefits so that risk-taking incentives alignwith the firm’s strategic objectives.

The information may be either at the transac-tion level or, if the transactions have homog-enous funding and contingent liquidity risk char-acteristics, at an aggregated level. In decidingwhether to allocate FTP costs and benefits at thetransaction or aggregated level, firms shouldconsider advantages and disadvantages of bothapproaches when developing the FTP frame-work. Although transaction-level FTP alloca-tions may add complexity and involve higherimplementation and maintenance costs, suchallocations may provide a more accurate mea-sure of risk-adjusted profitability. A firm assign-ing FTP allocations at an aggregated level shouldhave aggregation criteria based on funding andcontingent liquidity risk characteristics that aretransparent.

There should be ongoing dialogue betweenthe business lines and the central function respon-sible for allocating FTP costs and benefits toensure that funding and contingent liquidityrisks are being captured and are well-understoodfor product pricing, business metrics, and newproduct approval. The business lines shouldunderstand the rationale for the FTP costs andbenefits, and the central function should under-stand the funding and contingent liquidity risksimplicated by the business lines’ transactions.Decisions by senior management to incentivizecertain behaviors through FTP costs and bene-fits customarily would be documented andincluded in the report on FTP.

Conclusion

A firm should use the principles laid out in thisguidance to develop, implement, and maintainan effective FTP framework. In doing so, afirm’s risk-taking incentives should better alignwith its risk management and strategic objec-tives. The framework should be adequately tai-lored to a firm’s size, complexity, businessactivities, and overall risk profile.

Interagency Guidance AttachmentIllustrative Funds Transfer Pricing

Methodologies

March 1, 2016

The Funds Transfer Pricing (FTP) methodolo-gies described below are intended for illustra-tive purposes only and provide examples foraddressing principles set forth in the guidance.A firm’s FTP framework should be commensu-rate with its size, complexity, business activi-ties, and overall risk profile. In designing itsFTP framework, a firm may utilize other meth-odologies that are consistent with the principlesset forth in the guidance. Therefore, these illus-trative methodologies should not be interpretedas directives for implementing any particularFTP methodology.

Non-Trading Exposures

For non-trading exposures, a firm’s FTP meth-odology may vary based on its business activi-ties and specific exposures. For example, certainfirms may have higher concentrations of expo-sures that have less predictable time horizons,such as non-maturity loans and non-maturitydeposits.

Matched-Maturity Marginal Cost ofFunding

Matched-maturity marginal cost of funding is acommonly used methodology for non-tradingexposures. Under this methodology, FTP costsand benefits are based on a firm’s market cost offunds across the term structure (for example,wholesale long-term debt curve adjusted basedon the composition of the firm’s alternate sourcesof funding such as Federal Home Loan Bankadvances and customer deposits). This method-ology incentivizes business lines to generatestable funding (for example, core deposits) by



crediting them the benefit or premium associ-ated with such funding. It also ensures thatbusiness lines are appropriately charged the costof funding for the life of longer-dated assets (forexample, a five-year commercial loan). Giventhat funding costs can change over time, themarket cost of funds across the term structureshould be derived from reliable and readilyavailable data sources and be well understoodby FTP users.

FTP rates should, as closely as possible, matchthe characteristics of the transaction or the aggre-gated transactions to which they are applied. Indetermining the appropriate point on the derivedFTP curve for a transaction or pool of transac-tions, a firm could consider a variety of charac-teristics, including the holding period, cash flow,re-pricing, prepayments, and expected life of thetransaction or pool. For example, for a five-yearcommercial loan that has a rate that resets everythree months and will be held to maturity, theinterest rate component of the funding risk couldbe based on a three-month horizon for determin-ing the FTP cost, and the liquidity component ofthe funding risk could be based on a five-yearhorizon for determining the FTP cost. Thus, thetotal FTP cost for holding the five-year commer-cial loan would be the combination of these twocomponents.

Contingent Liquidity Risk

A firm may calculate the FTP cost related tonon-trading exposure contingent liquidity riskusing models based on behavioral assumptions.For example, charges for contingent commit-ments could be based on their modeled likeli-hood of drawdown, considering customer draw-down history, credit quality, and other factors;whereas, credits applied to deposits could bebased on volatility and modeled behavioral ma-turity. A firm should document and include allmodeling analyses and assumptions in the reporton FTP. If behavioral assumptions used in afirm’s FTP framework do not align with behav-ioral assumptions used in its internal stress testfor similar types of non-trading exposures, thefirm should document and include in the reporton FTP these inconsistencies.

Trading Exposures

For trading exposures, a firm could consider avariety of factors, including the type of fundingsource (for example, secured or unsecured), themarket liquidity of the exposure (for example,

the size of the haircut relative to the overallexposure), the holding period of the position,the prevailing market conditions, and any poten-tial impact the chosen approach could have onfirm incentives and overall risk profile. If afirm’s trading activities are not material, its FTPframework may require a less complex method-ology for trading exposures. The following FTPmethodologies have been observed for allocat-ing FTP costs for trading exposures.

Weighted Average Cost of Debt (WACD)

WACD is the weighted average cost of outstand-ing firm debt, usually expressed as a spread overan index. Some firms’ practices apply this rateto the amount of an asset expected to be fundedunsecured (repurchase agreement market hair-cuts may be used to delineate between theamount being funded secured and the amountbeing funded unsecured). A firm using WACDshould analyze whether the methodology mis-aligns risk-taking incentives and document suchanalyses in the report on FTP.

Marginal Cost of Funding

Marginal cost of funding sets the FTP costs atthe appropriate incremental borrowing rate of afirm. Some firms’ practices apply a marginalsecured borrowing rate to the amount of an assetexpected to be funded secured and a marginalunsecured borrowing rate to the amount of anasset expected to be funded unsecured (repur-chase agreement market haircuts may be used todelineate between the amount being fundedsecured and the amount being funded unse-cured). A firm using marginal cost of fundingshould analyze whether the methodology mis-aligns risk-taking incentives, considering cur-rent market rates compared to historical rates,and document such analyses in the report onFTP.

Contingent Liquidity Risk

A firm may calculate the FTP costs related tocontingent liquidity risk from trading exposuresby considering the unencumbered liquid assetsthat are held to cover the potential for wideninghaircuts of trading exposures that are fundedsecured. If haircuts used in a firm’s FTP frame-



work do not align with haircuts used in itsinternal stress test for similar types of tradingexposures, the firm should document and includein the report on FTP these inconsistencies. Hair-cuts should be updated at a frequency that isappropriate for a firm’s trading activities andmarket conditions.

A firm may also include the FTP costs relatedto contingent liquidity risk from potential deriva-tive outflows in stressed market conditions, whichmay be due to, for example, credit rating down-grades, additional termination rights, or marketshocks and volatility.



Dodd-Frank Act Company-Run Stress Testing for Banking Organizationswith Total Consolidated Assets of $10–50 Billion Section 4069.0

The federal banking agencies1 issued Supervi-sory Guidance on Implementing Dodd-FrankAct2 Company-Run Stress Tests for BankingOrganizations with Total Consolidated Assets ofMore Than $10 Billion but Less than $50 Billion(see the Fed. Reg. 14153, March 13, 2014)($10-50 billion companies) and offers additionaldetails about methodologies that should be em-ployed by these companies. The term “com-pany” refers to state member banks, bank hold-ing companies, and savings and loan holdingcompanies. This guidance builds upon the inter-agency stress testing guidance that was issued inMay 2012 for companies with more than $10billion in total consolidated assets that set forthgeneral principles for a satisfactory stress test-ing framework.3 This guidance discusses super-visory expectations for the Dodd-Frank WallStreet Reform and Consumer Protection Act(Dodd-Frank Act) stress test practices for thesecompanies. The agencies determined that pro-viding the supervisory guidance would be help-ful to the $10–50 billion companies in carryingout their tests that are appropriate for their riskprofile, size, complexity, business mix, and mar-ket footprint.4

The Dodd-Frank Act stress tests may notnecessarily capture a company’s full range ofrisks, exposures, activities, and vulnerabilitiesthat have a potential effect on capital adequacy.Additionally, the Dodd-Frank Act stress testsassess the impact of stressful outcomes on capi-tal adequacy and are not intended to measurethe adequacy of a company’s liquidity in thestress scenarios. Companies to which this guid-ance applies are not subject to the FederalReserve’s capital plan rule, the Federal Reserv-e’s annual Comprehensive Capital Analysis andReview (CCAR), supervisory stress tests forcapital adequacy, or the related data collectionssupporting the supervisory stress test. Refer toSR-14-3 and its attachments 1 and 2.

4069.0.1 EXPECTATIONS FORDODD-FRANK ACT STRESS TESTS

The supervisory expectations contained in theguidance follow the specific rule requirementscontained in the final Dodd-Frank Act stress testrules for $10–50 billion companies and are orga-nized in a similar manner. The guidance coversseveral categories, outlined below.

4069.0.1.1 Dodd-Frank Act Stress TestTimelines

Under the Dodd-Frank Act stress test rules,stress test projections are based on exposureswith the as-of-date of September 30 and extendover a nine-quarter planning horizon that beginsin the quarter ending December 31 of the sameyear and ends December 31 two years later.

4069.0.1.2 Scenarios for Dodd-Frank ActStress Tests

Under the stress test rules implementing theDodd-Frank Act requirements, $10–50 billioncompanies must assess the potential impact oncapital of a minimum of three macroeconomicscenarios (that is, baseline, adverse, and severelyadverse scenarios) provided by their primarysupervisor on their consolidated losses, rev-enues, balance sheet (including risk-weightedassets), and capital. A company is not requiredto use all of the variables provided in the sce-nario, if those variables are not relevant orappropriate to the company’s line of business.In addition, a company may, but is not requiredto, use additional variables beyond those pro-vided by the agencies. When using additionalvariables, companies should ensure that thepaths of such variables (including their timing)are consistent with the general economic envi-ronment assumed in the supervisory scenarios.

4069.0.1.3 Dodd-Frank Act Stress TestMethodologies and Practices

The agencies expect that the specific method-ological practices used by companies to producethe estimates of the impact on capital and that

1. The Federal Reserve, the Office of the Comptroller of

the Currency, and the Federal Deposit Insurance Corporation

(the agencies)

2. Pub. L. 111–203, 124 Stat. 1376 (2010).

3. See 77 Fed. Reg. 29458, ‘‘Supervisory Guidance on

Stress Testing for Banking Organizations With More Than

$10 Billion in Total Consolidated Assets,’’ (May 17, 2012).

The Federal Reserve’s rule for ‘‘Annual Company-Run Stress

Test Requirements for Banking Organizations with Total Con-

solidated Assets over $10 Billion Other than Covered Compa-

nies’’ was issued by the Board on October 12, 2012 (77 Fed.Reg. 62396).

4. The Dodd-Frank Act stress tests produce projections of

hypothetical results and are not intended to be forecasts of

expected or most likely outcomes.


other measures may vary across organizations.5

In addition, Dodd-Frank Act stress testing prac-tices for $10–50 billon companies should becommensurate with each company’s size, com-plexity, and sophistication. This means that,generally, larger or more sophisticated compa-nies should consider employing not just theminimum expectations, but the more advancedpractices described in the supervisory guidance.In addition, $10–50 billion companies shouldconsider using more than just the minimumexpectations for the exposures and activities ofhighest impact and that present the highest risk.

• Data sources. Companies are expected tohave appropriate management information sys-tems and data processes that enable them tocollect, sort, aggregate, and update data andother information efficiently and reliably withinbusiness lines and across the company for usein Dodd-Frank Act stress tests. In some cases,proxy data may be used. Companies shouldchallenge conventional assumptions to ensurethat a company’s stress test is not constrainedby its own past experience.

• Data segmentation. To account for differencesin risk profiles across various exposures andactivities, companies should segment theirportfolios and business activities into catego-ries based on common or related risk charac-teristics. The company should select the appro-priate level of segmentation based on the size,materiality, and risk of a given portfolio, pro-vided there are sufficiently granular historicaldata available to allow for the desired segmen-tation. The minimum expectation is that com-panies will segment their portfolios and busi-ness activities using the categories listed inthe $10–50 billion reporting form.6

• Model risk management. Companies shouldhave in place effective model risk-

management practices, including validation,for all models used in Dodd-Frank Act stresstests, consistent with existing supervisory guid-ance.7 Companies should ensure an effectivechallenge process by unbiased, competent,and qualified parties is in place for all models.There should also be sufficient documentationof all models, including model assumptions,limitations, and uncertainties. Companiesshould ensure that their model risk-management policies and practices generallyapply to the use of vendor and third-partyproducts as well. Qualitative elements of mod-els should also be subject to model risk man-agement.

• Loss estimation. For their Dodd-Frank Actstress tests, companies are expected to havecredible loss estimation practices that capturethe risks associated with their portfolios, busi-ness lines, and activities. Credit losses associ-ated with loan portfolios and securities hold-ings should be estimated directly and separately,whereas other types of losses should be incor-porated into estimated pre-provision net rev-enue (PPNR).8 Each company’s loss estima-tion practices should be commensurate withthe materiality of the risks measured and wellsupported by sound, empirical analysis. Lossestimates should include projections of other-than-temporary impairments (OTTI) for secu-rities both held for sale and held to maturity.

• Pre-provision net revenue estimation. For theDodd-Frank Act stress test, companies arerequired to project PPNR over the planninghorizon for each supervisory scenario. Com-panies should estimate PPNR at a level atleast as granular as the components outlinedin the $10–50 billion reporting form. Compa-nies should ensure that PPNR projections aregenerally consistent with projections of losses,the balance sheet, and risk-weighted assets. Acompany may estimate the stressed compo-nents of PPNR based on its own or industry-wide historical income and expense experi-ence. Other types of losses that could ariseunder the supervisory scenarios should beincluded in projections of PPNR to the extentthey would arise under the specified scenarioconditions.

• Balance sheet and risk-weighted asset projec-tions. A company is expected to project itsbalance sheet and risk-weighted assets for

5. In making projections, companies should make conser-

vative assumptions about management responses in the stress

tests, and should include only those responses for which there

is substantial support. For example, companies may account

for hedges that are already in place as potential mitigating

factors against losses, but should be conservative in making

assumptions about potential future hedging activities and not

necessarily anticipate that actions taken in the past could be

taken under the supervisory scenarios.

6. For purposes of the supervisory guidance, the term

‘‘$10–50 billion reporting form’’ generally refers to the FR

Y-16. However, for subsidiary banks and thrifts of $10–50

billion holding companies, it could be the relevant reporting

form the subsidiary will use to report the results of its Dodd-

Frank Act stress tests to its primary federal financial regula-

tory agency.

7. Refer to SR-11-7, ‘‘Guidance on Model Risk Manage-

ment.’’

8. The Dodd-Frank Act stress test rules define PPNR as net

interest income plus non-interest income less non-interest

expense. Non-operational or non-recurring income and ex-

pense items should be excluded.

Dodd-Frank Act Company-Run Stress Testing 4069.0


each of the supervisory scenarios. In doing so,these projections should be consistent withscenario conditions and the company’s priorhistory of managing through the different busi-ness environments, especially stressful ones.The projections of the balance sheet and risk-weighted assets should be consistent withother aspects of stress test projections, such aslosses and PPNR.

• Projections for quarterly provisions and allow-ance for loan and lease losses (ALLL). TheDodd-Frank Act stress test rules require com-panies to project quarterly provisions for loanand lease losses (PLLL). Companies areexpected to project PLLL for each scenariobased on projections of quarterly loan andlease losses and while maintaining an appro-priate ALLL balance at the end of each quar-ter of the planning horizon, including the lastquarter.

• Projections for quarterly net income. Underthe Dodd-Frank Act stress test rules, compa-nies must estimate projected quarterly netincome for each scenario. Net income projec-tions should be based on loss, revenue, andexpense projections.

4069.0.1.4 Estimating the PotentialImpact on Regulatory Capital Levels andCapital Ratios

Companies must estimate projected quarterlyregulatory capital levels and regulatory capitalratios for each scenario. Any rare cases in whichratios are higher under the adverse and severelyadverse scenarios should be very well supportedby analysis and documentation. Projected capi-tal levels and ratios should reflect applicableregulations and accounting standards for eachquarter of the planning horizon. In their Dodd-Frank Act stress tests, bank holding companiesand savings and loan holding companies arerequired to calculate pro forma capital ratiosusing a set of capital action assumptions basedon historical distributions, contracted payments,and a general assumption of no redemptions,repurchases, or issuances of capital instruments.There are no specified capital actions for statemember banks.

4069.0.1.5 Controls, Oversight, andDocumentation

A company must establish and maintain a sys-tem of controls, oversight, and documentation,including policies and procedures that apply to

all of its Dodd-Frank Act stress test compo-nents. Senior management and the board ofdirectors have specific responsibilities relatingto Dodd-Frank Act stress testing. The board ofdirectors should ensure it remains informedabout critical reviews of elements of the Dodd-Frank Act stress tests, especially regarding keyassumptions, uncertainties, and limitations. Inaddition, the board of directors and senior man-agement of a $10–50 billion company mustconsider the role of stress testing results innormal business, including in the company’scapital planning, assessment of capital adequacy,and risk-management practices. A companyshould appropriately document the manner inwhich Dodd-Frank Act stress tests are used forkey decisions about capital adequacy, includingcapital actions and capital contingency plans.The company should indicate the extent to whichDodd-Frank Act stress tests are used in conjunc-tion with other capital assessment tools.

4069.0.1.6 Report to Supervisors

A $10–50 billion company must report the resultsof its Dodd-Frank Act company-run stress testson the $10–50 billion annual reporting form (FRY-16). This report will include a company’squantitative projections of losses, PPNR, bal-ance sheet, risk-weighted assets, ALLL, andcapital on a quarterly basis over the duration ofthe scenario and planning horizon. In addition tothe quantitative projections, companies arerequired to submit qualitative information sup-porting their projections.9

4069.0.1.7 Public Disclosure ofDodd-Frank Act Test Results

Under the Dodd-Frank Act stress test rules, a$10–50 billion company must publicly discloseDodd-Frank Act stress test results between June15 and June 30, with the first disclosure in 2015.The summary of the results of the stress test,including both quantitative and qualitative infor-mation, should be included in a single release on

9. These companies should look to the $10–50 billion

consolidated assets reporting instructions for the supervisory

expectations as to what information should be included in the

report on the company’s Dodd-Frank Act stress test. See the

FR Y-16 instructions: www.federalreserve.gov/apps/

reportforms/reportdetail.aspx?sOoYJ+5BzDbzK2O0R3zNJ

w==



www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDbzK2O0R3zNJw==



a company’s website, or in any other forum thatis reasonably accessible to the public. A com-pany is required to publish results for the severelyadverse scenario only.



Documents

BHC Supervision Manual