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  • Wednesday,

    March 8, 2000

    Part II

    Department of theTreasuryOffice of the Comptroller of theCurrency

    Office of Thrift Supervision

    Federal ReserveSystem

    Federal DepositInsuranceCorporation12 CFR Parts 3, 208, 225, 325 and 567

    Risk-Based Capital Standards; Recourseand Direct Credit Substitutes; ProposedRule

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  • 12320 Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules


    Office of the Comptroller of theCurrency

    12 CFR Part 3

    [Docket No. 00–06]

    RIN 1557–AB14


    12 CFR Parts 208 and 225

    [Regulations H and Y; Docket No. R–1055]


    12 CFR Part 325

    RIN 3064–AB31


    Office of Thrift Supervision

    12 CFR Part 567

    [Docket No. 2000–15]

    RIN 1550–AB11

    Risk-Based Capital Standards;Recourse and Direct Credit Substitutes

    AGENCIES: Office of the Comptroller ofthe Currency, Treasury; Board ofGovernors of the Federal ReserveSystem; Federal Deposit InsuranceCorporation; and Office of ThriftSupervision, Treasury.ACTION: Joint notice of proposedrulemaking.

    SUMMARY: The Office of the Comptrollerof the Currency (OCC), the Board ofGovernors of the Federal ReserveSystem (Board), the Federal DepositInsurance Corporation (FDIC), and theOffice of Thrift Supervision (OTS)(collectively, the agencies) areproposing changes to their risk-basedcapital standards to address theregulatory capital treatment of recourseobligations and direct credit substitutesthat expose banks, bank holdingcompanies, and thrifts (collectively,banking organizations) to credit risk.The proposal treats recourse obligationsand direct credit substitutes moreconsistently than under the agencies’current risk-based capital standards. Inaddition, the agencies would use creditratings and certain alternativeapproaches to match the risk-basedcapital requirement more closely to abanking organization’s relative risk ofloss in asset securitizations. Theproposal also requires the sponsor of arevolving credit securitization thatinvolves an early amortization feature to

    hold capital against the amount of assetsunder management, i.e. the off-balancesheet securitized receivables.

    This proposal is intended to result inmore consistent treatment of recourseobligations and similar transactionsamong the agencies, more consistentrisk-based capital treatment for certaintypes of transactions involving similarrisk, and capital requirements that moreclosely reflect a banking organization’srelative exposure to credit risk.DATES: Your comments must be receivedby June 7, 2000.ADDRESSES: Comments should bedirected to:

    OCC: You may send commentselectronically to [email protected] or by mail to Docket No.00–06, Communications Division, ThirdFloor, Office of the Comptroller of theCurrency, 250 E Street, SW,Washington, DC 20219. In addition, youmay send comments by facsimiletransmission to (202) 874–5274. Youcan inspect and photocopy comments atthat address.

    Board: Comments, which should referto Docket No. R–1055, may be mailed toJennifer J. Johnson, Secretary, Board ofGovernors of the Federal ReserveSystem, 20th Street and ConstitutionAvenue, NW, Washington, DC 20551.Comments may also be delivered toRoom B–2222 of the Eccles Buildingbetween 8:45 a.m. and 5:15 p.m.weekdays, or to the guard station in theEccles Building courtyard on 20th Streetbetween Constitution Avenue and CStreet, NW, at any time. Comments maybe inspected in Room MP–500 of theMartin Building between 9 a.m. and 5p.m. weekdays, except as provided in 12CFR 261.8 of the Board’s RulesRegarding Availability of Information.

    FDIC: Written comments should beaddressed to Robert E. Feldman,Executive Secretary, Attention:Comments/OES, Federal DepositInsurance Corporation, 550 17th Street,NW, Washington, DC 20429. Commentsmay be hand delivered to the guardstation at the rear of the 550 17th StreetBuilding (located on F Street), onbusiness days between 7 a.m. and 5 p.m.(Fax number: (202) 898–3838; Internetaddress: [email protected]).Comments may be inspected andphotocopied in the FDIC PublicInformation Center, Room 100, 801 17thStreet, NW, Washington, DC, between 9a.m. and 4:30 p.m. on business days.

    OTS: Send comments to Manager,Dissemination Branch, RecordsManagement and Information Policy,Office of Thrift Supervision, 1700 GStreet, NW, Washington, DC 20552,Attention Docket No. 2000–15. These

    submissions may be hand-delivered to1700 G Street, NW, from 9 a.m. to 5 p.m.on business days or may be sent byfacsimile transmission to FAX number(202) 906–7755; or by e-mail:[email protected] Thosecommenting by e-mail should includetheir name and telephone number.Comments will be available forinspection at 1700 G Street, NW, from9 to 4 p.m. on business days.FOR FURTHER INFORMATION CONTACT:OCC: Roger Tufts, Senior EconomicAdvisor or Amrit Sekhon, RiskSpecialist, Capital Policy Division, (202)874–5070; Laura Goldman, SeniorAttorney, Legislative and RegulatoryActivities Division, (202) 874–5090,Office of the Comptroller of theCurrency, 250 E Street, SW,Washington, DC 20219.

    Board: Thomas R. Boemio, SeniorSupervisory Financial Analyst, (202)452–2982, or Norah Barger, AssistantDirector (202) 452–2402, Division ofBanking Supervision and Regulation.For the hearing impaired only,Telecommunication Device for the Deaf(TDD), Diane Jenkins, (202) 452–3544,Board of Governors of the FederalReserve System, 20th Street andConstitution Avenue, NW, Washington,DC 20551.

    FDIC: Robert F. Storch, Chief,Accounting Section, Division ofSupervision, (202) 898–8906; or JameyBasham, Counsel, Legal Division, (202)898–7265, Federal Deposit InsuranceCorporation, 550 17th Street, NW,Washington, DC 20429.

    OTS: Michael D. Solomon, SeniorProgram Manager for Capital Policy,Supervision Policy, (202) 906–5654; orKaren Osterloh, Assistant Chief Counsel(202) 906–6639, Office of ThriftSupervision, 1700 G Street, NW,Washington, DC 20552.SUPPLEMENTARY INFORMATION:

    I. Introduction

    The agencies are proposing to amendtheir risk-based capital standards tochange the treatment of certain recourseobligations, direct credit substitutes,and securitized transactions that exposebanking organizations to credit risk.This proposal amends the agencies’ risk-based capital standards to align moreclosely the risk-based capital treatmentof recourse obligations and direct creditsubstitutes and to vary the capitalrequirements for positions in securitizedtransactions (and certain other creditexposures) according to their relativerisk. The proposal also requires thesponsor of a revolving creditsecuritization that involves an earlyamortization feature to hold capital

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  • 12321Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules

    1 See 60 FR 17986 (April 10, 1995) (OCC); 60 FR8177 (February 13, 1995) (Board); 60 FR 15858(March 28, 1995) (FDIC).

    2 See 60 FR 45618 (August 31, 1995.)3 International Convergence of Capital

    Measurement and Capital Standards (July 1988).

    4 For purposes of this discussion, references to‘‘securitization’’ also include structured financetransactions or programs that generally createstratified credit risk positions, which may or maynot be in the form of a security, whose performanceis dependent upon a pool of loans or other creditexposures.

    5 As used in this proposal, the terms ‘‘creditenhancement’’ and ‘‘enhancement’’ refer to bothrecourse arrangements and direct credit substitutes.

    against the amount of assets undermanagement in that securitization.

    This proposal builds on the agencies’earlier work with respect to theappropriate risk-based capital treatmentfor recourse obligations and direct creditsubstitutes. On May 25, 1994, theagencies published in the FederalRegister a proposal to reduce the capitalrequirement for banks for low-levelrecourse transactions, to treat first-loss(but not second-loss) direct creditsubstitutes like recourse, and toimplement definitions of ‘‘recourse,’’‘‘direct credit substitute,’’ and relatedterms. 59 FR 27116 (May 25, 1994) (the1994 Notice). The 1994 Notice alsocontained, in an advance notice ofproposed rulemaking, a proposal to usecredit ratings to determine the capitaltreatment of certain recourse obligationsand direct credit substitutes. The OCC,the Board, and the FDIC subsequentlyimplemented the capital reduction forlow-level recourse transactions, therebysatisfying the requirements of section350 of the Riegle CommunityDevelopment and RegulatoryImprovement Act, Public Law 103–325,sec. 350, 108 Stat. 2160, 2242 (1994)(CDRI Act).1 The OTS risk-based capitalregulation already included the low-level recourse treatment required by thestatute.2 The agencies did not issue afinal regulation on the remainingelements of the 1994 Notice.

    On November 5, 1997, the agenciespublished another notice of proposedrulemaking. 62 FR 59943 (1997Proposal). In the 1997 Proposal, theagencies proposed to use credit ratingsfrom nationally recognized statisticalrating organizations to determine thecapital requirement for recourseobligations, direct credit substitutes,and senior asset-backed securities.Additionally, the 1997 Proposalrequested comment on a series ofoptions and alternatives to supplementor replace the ratings-based approach.

    In June 1999, the Basel Committee onBanking Supervision issued aconsultative paper, ‘‘A New CapitalAdequacy Framework, that sets forthpossible revisions to the 1988 BaselAccord.3 The Basel consultative paperdiscusses potential modifications to thecurrent capital standards, including thecapital treatment of securitizations. Thesuggested changes in the Baselconsultative paper move in the samedirection as this proposal by looking toexternal credit ratings issued by

    qualifying external credit assessmentinstitutions as a basis for determiningthe credit quality and the resultingcapital treatment of securitizations.

    II. Background

    A. Asset SecuritizationAsset securitization is the process by

    which loans or other credit exposuresare pooled and reconstituted intosecurities, with one or more classes orpositions, that may then be sold.Securitization 4 provides an efficientmechanism for banking organizations tobuy and sell loan assets or creditexposures and thereby to make themmore liquid.

    Securitizations typically carve up therisk of credit losses from the underlyingassets and distribute it to differentparties. The ‘‘first dollar,’’ orsubordinate, loss position is first toabsorb credit losses; the most ‘‘senior’’investor position is last; and there maybe one or more loss positions inbetween (‘‘second dollar’’ losspositions). Each loss position functionsas a credit enhancement for the moresenior loss positions in the structure.

    For residential mortgages soldthrough certain Federally-sponsoredmortgage programs, a Federalgovernment agency or Federalgovernment sponsored enterprise (GSE)guarantees the securities sold toinvestors. However, many of today’sasset securitization programs involvenonmortgage assets or are not Federallysupported in any way. Sellers of theseprivately securitized assets thereforeoften provide other forms of creditenhancement—first and second dollarloss positions—to reduce investors’ riskof credit loss.

    A seller may provide this creditenhancement itself through recoursearrangements. As defined in thisproposal, ‘‘recourse’’ refers to the risk ofcredit loss that a banking organizationretains in connection with the transferof its assets. Banking organizations havelong provided recourse in connectionwith sales of whole loans or loanparticipations; today, recoursearrangements frequently are associatedwith asset securitization programs.

    A seller may also arrange for a thirdparty to provide credit enhancement 5 inan asset securitization. If the third-party

    enhancement is provided by anotherbanking organization, that organizationassumes some portion of the assets’credit risk. In this proposal, all forms ofthird-party enhancements, i.e., allarrangements in which a bankingorganization assumes risk of credit lossfrom third-party assets or other claimsthat it has not transferred, are referredto as ‘‘direct credit substitutes.’’ Theeconomic substance of a bankingorganization’s risk of credit loss fromproviding a direct credit substitute canbe identical to its risk of credit loss fromtransferring an asset with recourse.

    Depending on the type ofsecuritization transaction, the sponsorof a securitization may provide aportion of the total credit enhancementinternally, as part of the securitizationstructure, through the use of spreadaccounts, overcollateralization, retainedsubordinated interests, or other similarforms of on-balance sheet assets. Whenthese or other types of internalenhancements are provided, theenhancements are considered a form ofrecourse for risk-based capital purposes.Many asset securitizations use acombination of internal enhancement,recourse, and third-party enhancementto protect investors from risk of creditloss.

    B. Risk Management of ExposuresArising From Securitization Activities

    While asset securitization canenhance both credit availability and abanking organization’s profitability,managing the risks associated with thisactivity can pose significant challenges.This is because the risks involved, whilenot new to banking organizations, maybe less obvious and more complex thanthe risks of traditional lending.Specifically, securitization can involvecredit, liquidity, operational, legal, andreputational risks in concentrations andforms that may not be fully recognizedby management or adequatelyincorporated into a bankingorganization’s risk managementsystems.

    The risk-based capital treatmentdescribed in this proposal provides oneimportant way of addressing the creditrisk presented by securitizationactivities, but a banking organization’scompliance with capital standardsshould be complemented by effectiverisk management strategies. Theagencies expect that bankingorganizations will identify, measure,monitor and control the risks of theirsecuritization activities (including

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  • 12322 Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules

    6 ‘‘Synthetic securitization’’ refers to the bundlingof credit risk associated with on-balance sheetassets and off-balance sheet items for subsequentsale into the market.

    7 In this regard, the agencies note that oneincreasingly important component of the systemsfor controlling credit risk at larger bankingorganizations is the identification of the gradationsin credit risk among their business loans and theassignment of internal credit risk ratings to loansthat correspond to these gradations. The agenciesbelieve that the use of such an internal ratingprocess is appropriate—indeed, necessary—forsound risk management at large bankingorganizations. In particular, those bankingorganizations with significant involvement insecuritization activities should have relatively

    elaborate and formal approaches for assessing andmanaging the associated credit risk.

    8 Stress testing usually involves identifyingpossible events or changes in market behavior thatcould have unfavorable effects on an bankingorganization and assessing the organization’s abilityto withstand them. Stress testing should not onlyconsider the probability of adverse events, but alsopotential ‘‘worst case’’ scenarios. Such an analysisshould be done on a consolidated basis andconsider, for example, the effect of higher thanexpected levels of delinquencies and defaults. Theanalysis should also consider the consequences ofearly amortization events that could raise concernsregarding a banking organization’s capital adequacyand its liquidity and funding capabilities. Stress testanalyses should also include contingency plansregarding the actions management might take givencertain situations.

    9 Assets transferred with any amount of recoursein a transaction reported as a financing inaccordance with generally accepted accountingprinciples (GAAP) remain on the balance sheet andare risk-weighted in the same manner as any otheron-balance sheet asset. Assets transferred withrecourse in a transaction that is reported as a saleunder GAAP are removed from the balance sheetand are treated as off-balance sheet exposures forrisk-based capital purposes.

    10 Consistent with statutory requirements, theagencies’ current rules also provide for specialtreatment of sales of small business loan obligationswith recourse. See 12 CFR Part 3, appendix A,Section 3(c) (OCC); 12 CFR parts 208 and 225,appendix A, II.B.5 (FRB); 12 CFR part 325,appendix A, II.B.6 (FDIC); 12 CFR 567.6(E)(3)(OTS).

    11 Section 350 of the CDRI Act required theagencies to prescribe regulations providing that therisk-based capital requirement for assets transferredwith recourse could not exceed a bankingorganization’s maximum contractual exposure. Theagencies may require a higher amount if necessaryfor safety and soundness reasons. See 12 U.S.C.4808.

    synthetic securitizations 6 using creditderivatives) and explicitly incorporatethe full range of risks into their riskmanagement systems. Management isresponsible for having adequate policiesand procedures in place to ensure thatthe economic substance of their risks isfully recognized and appropriatelymanaged. Banking organizations shouldbe able to measure and manage theirrisk exposure from risk positions in thesecuritizations, either retained oracquired, and should be able to assessthe credit quality of the retainedresidual portfolio after the transfer ofassets in a securitization transaction.The formality and sophistication withwhich the risks of these activities areincorporated into a bankingorganization’s risk management systemshould be commensurate with thenature and volume of its securitizationactivities. Banking organizations withsignificant securitization activities, nomatter what the size of their on-balancesheet assets, are expected to have moreelaborate and formal approaches tomanage the risks. Failure to understandthe risks inherent in securitizationactivities and to incorporate them intorisk management systems and internalcapital allocations may constitute anunsafe or unsound banking practice.

    Banking organizations must haveadequate systems that evaluate the effectof securitization transactions on thebanking organization’s risk profile andcapital adequacy. Based on thecomplexity of transactions, thesesystems should be capable ofdifferentiating between the nature andquality of the risk exposures transferredversus those that the bankingorganization retains. Adequatemanagement systems usually:

    • Have an internal system for gradingcredit risk exposures, including: (1)Adequate differentiation of risk amongrisk grades; (2) adequate controls toensure the objectivity and consistencyof the rating process; and (3) analysis orevidence supporting the accuracy orappropriateness of the risk-gradingsystem.7

    • Evaluate the effect of thetransaction on the nature anddistribution of the banking bookexposures that have not been transferredin connection with securitization. Thisanalysis should include a comparison ofthe banking book’s risk profile beforeand after the transaction, including themix of exposures by risk grade and bybusiness or economic sector. Theanalysis should also includeidentification of any concentrations ofcredit risk.

    • Perform rigorous, forward-lookingstress testing 8 on exposures that havenot been transferred (that is, loans andcommitments remaining in the bankingbook), transferred exposures, andexposures retained to facilitate transfers(that is, credit enhancements).

    • Have an internal economic capitalallocation methodology that providesthe banking organization will haveadequate capitalization to meet aspecific probability that it will notbecome insolvent if unexpected creditlosses occur and that readjusts, asnecessary, the sponsoring bank’sinternal economic capital requirementsto take into account the effect of thesecuritization transactions.

    Banking organizations should ensurethat their capital positions aresufficiently strong to support all of therisks associated with these activities ona fully consolidated basis and shouldmaintain adequate capital in allaffiliated entities engaged in theseactivities.

    C. Current Risk-Based CapitalTreatment of Recourse and Direct CreditSubstitutes

    Currently, the agencies’ risk-basedcapital standards apply differenttreatments to recourse arrangements anddirect credit substitutes. As a result,capital requirements applicable to creditenhancements do not consistentlyreflect credit risk. The current rules ofthe OCC, Board, and FDIC (the bankingagencies) are also not entirely consistentwith those of the OTS.

    1. RecourseThe agencies’ risk-based capital

    guidelines prescribe a single treatmentfor assets transferred with recourse,regardless of whether the transaction isreported as a financing or a sale of assetsin a bank’s Consolidated Reports ofCondition and Income (Call Report), abank holding company’s FR Y–9reports, or a thrift’s Thrift FinancialReport.9 For a transaction reported as afinancing, the transferred assets remainon the balance sheet and are risk-weighted. For a transaction reported asa sale, the entire outstanding amount ofthe assets sold (not just the contractualamount of the recourse obligation) isconverted into an on-balance sheetcredit equivalent amount using a 100%credit conversion factor. This creditequivalent amount (less any applicablerecourse liability account recorded onthe balance sheet) is then risk-weighted.10 If the seller’s balance sheetincludes as an asset any retainedinterest in the assets sold, the retainedinterest is not risk-weighted separately.Thus, regardless of the method used toaccount for the transfer, risk-basedcapital is held against the full, risk-weighted amount of the transferredassets, although the transaction issubject to the low-level recourse rule,which limits the maximum risk-basedcapital requirement to the bankingorganization’s maximum contractualexposure. 11

    For leverage capital ratio purposes, ifa transfer with recourse is reported as afinancing, the transferred assets remainon the transferring bankingorganization’s balance sheet and thebanking organization must hold leveragecapital against these assets. If a transferwith recourse is reported as a sale, theassets sold do not remain on the selling

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  • 12323Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules

    12 The OTS, which already defines the term‘‘recourse’’ in its rules, would revise its definitionso that it is consistent with the definition adoptedby the other agencies. The OTS is also adding adefinition of ‘‘financial guarantee-type letter ofcredit’’ to be consistent with the OCC and theBoard.

    13 ‘‘Nationally recognized statistical ratingorganization’’ means an entity recognized by theDivision of Market Regulation of the Securities andExchange Commission as a nationally recognizedstatistical rating organization for various purposes,

    including the capital rules for broker-dealers. SeeSEC Rule 15c3–1(c)(2)(vi)(E), (F) and (H), 17 CFR240.15c3–091(c)(2)(vi)(E), (F), and (H).

    14 For a description of these approaches, see 62FR 59944, 59952–59961 (November 5, 1997).

    banking organization’s balance sheetand the banking organization need nothold leverage capital against theseassets. However, if the seller’s balancesheet includes as an asset any retainedinterest in the assets sold, leveragecapital must be held against the retainedinterest.

    2. Direct Credit SubstitutesDirect credit substitutes are treated

    differently from recourse under thecurrent risk-based capital standards.Under the banking agencies’ currentstandards, off-balance sheet direct creditsubstitutes, such as financial standbyletters of credit provided for third-partyassets, carry a 100% credit conversionfactor. However, only the dollar amountof the direct credit substitute isconverted into an on-balance sheetcredit equivalent amount, so that capitalis held only against the face amount ofthe direct credit substitute. The capitalrequirement for a recourse arrangement,in contrast, generally is based on the fullamount of the assets enhanced.

    If a direct credit substitute covers lessthan 100% of the potential losses on theassets enhanced, the current capitaltreatment results in a lower capitalcharge for a direct credit substitute thanfor a comparable recourse arrangement.For example, if a direct credit substitutecovers losses up to the first 20% of theassets enhanced, then the on-balancesheet credit equivalent amount equalsthat 20% amount, and risk-based capitalis held against only the 20% amount. Incontrast, required capital for a first-loss20% recourse arrangement is higherbecause capital is held against the fulloutstanding amount of the assetsenhanced, subject to the low-levelrecourse rule.

    Currently, under the bankingagencies’ guidelines, purchasedsubordinated interests receive the samecapital treatment as off-balance sheetdirect credit substitutes. That is, theamount of the purchased subordinatedinterest is placed in the appropriaterisk-weight category. In contrast, abanking organization that retains asubordinated interest in connectionwith the transfer of its own assets isconsidered to have transferred the assetswith recourse. As a result, the bankingorganization must hold capital againstthe carrying amount of the retainedsubordinated interest as well as theoutstanding amount of all seniorinterests that it supports, subject to thelow-level recourse rule.

    The OTS risk-based capital regulationtreats some forms of direct creditsubstitutes (e.g., financial standbyletters of credit) in the same manner asthe banking agencies’ guidelines.

    However, unlike the banking agencies,the OTS treats purchased subordinatedinterests (except for certain high qualitysubordinated mortgage-relatedsecurities) under its general recourseprovisions. The risk-based capitalrequirement is based on the carryingamount of the subordinated interestplus all senior interests, as though thethrift owned the full outstandingamount of the assets enhanced.

    3. Concerns Raised by Current Risk-Based Capital Treatment

    The agencies’ current risk-basedcapital standards raise significantconcerns with respect to the treatmentof recourse and direct credit substitutes.First, banking organizations are oftenrequired to hold different amounts ofcapital for recourse arrangements anddirect credit substitutes that expose thebanking organization to equivalent riskof credit loss. Banking organizations aretaking advantage of this anomaly, forexample, by providing first-loss lettersof credit to asset-backed commercialpaper conduits that lend directly tocorporate customers. This results in asignificantly lower capital requirementthan if the loans had originally beencarried on the banking organizations’balance sheets and then were sold.Moreover, the current capital standardsdo not recognize differences in riskassociated with different loss positionsin asset securitizations, nor do theyprovide uniform definitions of recourse,direct credit substitute, and associatedterms.

    III. Description of the ProposalThis proposal would amend the

    agencies’ risk-based capital standards asfollows:

    • The proposal defines ‘‘recourse’’and revises the definition of ‘‘directcredit substitute’’; 12

    • It provides more consistent risk-based capital treatment for recourseobligations and direct credit substitutes;

    • It varies the capital requirements forpositions in securitized transactionsaccording to their relative risk exposure,using credit ratings from nationallyrecognized statistical ratingorganizations 13 (rating agencies) tomeasure the level of risk;

    • It permits the limited use of abanking organization’s qualifyinginternal risk rating system, a ratingagency’s or other appropriate thirdparty’s review of the credit risk ofpositions in structured programs, andqualifying software to determine thecapital requirement for certain unrateddirect credit substitutes; and

    • It requires the sponsor of arevolving credit securitization thatinvolves an early amortization feature tohold capital against the amount of assetsunder management in thatsecuritization.

    The use of credit ratings in thisproposal is similar to the 1997 Proposal.Although many commenters expressedconcerns about specific details in the1997 Proposal, commenters generallysupported the goal of making the capitalrequirements associated with assetsecuritizations more rational andefficient, and viewed the 1997 Proposalas a positive step toward achieving amore consistent, rational, and efficientregulatory capital framework. Theagencies have made several changes tothe 1997 Proposal in response tocommenters’ concerns and based onfurther agency consideration of theissues presented.

    Several options and alternatives in the1997 Proposal have been eliminated: themodified gross-up approach, the ratingsbenchmark approach, and the historicallosses approach.14 Commentersexpressed numerous concerns aboutthese approaches and the agencies agreethat better alternatives exist.

    Commenters responding to the 1997Proposal expressed a number ofconcerns about the use of ratings fromrating agencies to determine capitalrequirements, especially in the case ofunrated direct credit substitutes.Commenters noted that bankingorganizations actively involved in thesecuritization business have their owninternal risk rating systems, thatbanking organizations know their assetsbetter than third parties, and that arequirement that a banking organizationobtain a rating from a rating agencysolely for regulatory capital purposes isburdensome. Some commenters alsoexpressed skepticism about thesuitability of rating agency credit ratingsfor regulatory capital purposes.

    In the opinion of the agencies, ratingshave the advantages of being relativelyobjective, widely used, and relied uponby investors and other participants in

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    15 The OTS currently defines the term ‘‘recourse’’more broadly than the proposal to includearrangements involving credit risk that a thriftassumes or accepts from third-party assets as wellas risk that it retains in an asset transfer. Under theproposal, credit risk that a banking organization

    assumes from third-party assets falls under thedefinition of ‘‘direct credit substitute’’ rather than‘‘recourse.’’

    the financial markets. Ratings provide aflexible, efficient, market-oriented wayto measure credit risk. The agenciesrecognize, however, that there aredrawbacks to using credit ratings fromrating agencies to set capitalrequirements. Moreover, the agenciesagree with some commenters’observation that credit ratings are mostuseful with respect to publicly-tradedpositions that would be rated regardlessof the agencies’ risk-based capitalrequirements.

    To minimize the need for bankingorganizations to obtain ratings onotherwise unrated enhancements thatare provided in asset-backedcommercial paper securitizations, theproposal permits banking organizationsto use their own qualifying internal riskrating systems in place of ratings fromrating agencies for risk weighting certaindirect credit substitutes. The use ofinternal risk ratings to assign directcredit substitutes in asset-backedcommercial paper programs to ratingcategories under the ratings-basedapproach is dependent upon theexistence of adequate internal risk ratingsystems. The adequacy of any internalrisk rating system will depend upon abanking organization’s incorporation ofthe prudential standards outlined in thisproposal, as well as other factorsrecommended through supervisoryguidance or on a case-by-case basis.

    Finally, the agencies are proposing anadditional measure to address the riskassociated with early amortizationfeatures in certain asset securitizations.The managed assets approach, describedin Section III.D., would apply a 20%risk weight to the amount of off-balancesheet securitized assets undermanagement in such transactions.

    A. Definitions and Scope of the Proposal

    1. Recourse

    The proposal defines the term‘‘recourse’’ to mean an arrangement inwhich a banking organization retainsrisk of credit loss in connection with anasset transfer, if the risk of credit lossexceeds a pro rata share of the bankingorganization’s claim on the assets. Theproposed definition of recourse isconsistent with the banking agencies’longstanding use of this term, andincorporates existing agency practicesregarding retention of risk in assettransfers into the risk-based capitalstandards.15

    Currently, the term ‘‘recourse’’ is notdefined explicitly in the bankingagencies’ risk-based capital guidelines.Instead, the guidelines use the term‘‘sale of assets with recourse,’’ which isdefined by reference to the Call ReportInstructions. See Call ReportInstructions, Glossary (entry for ‘‘Salesof Assets for Risk-Based CapitalPurposes’’). Once a definition ofrecourse is adopted in the risk-basedcapital guidelines, the banking agencieswould remove the cross-reference to theCall Report instructions from theguidelines. The OTS capital regulationcurrently provides a definition of theterm ‘‘recourse,’’ which would also bereplaced once a final definition ofrecourse is adopted.

    2. Direct Credit SubstituteThe proposed definition of ‘‘direct

    credit substitute’’ complements thedefinition of recourse. The term ‘‘directcredit substitute’’ would refer to anyarrangement in which a bankingorganization assumes risk of credit-related losses from assets or otherclaims it has not transferred, if the riskof credit loss exceeds the bankingorganization’s pro rata share of theassets or other claims. Currently, underthe banking agencies’ guidelines, thisterm covers guarantee-typearrangements. As revised, it would alsoinclude explicitly items such aspurchased subordinated interests,agreements to cover credit losses thatarise from purchased loan servicingrights, credit derivatives and lines ofcredit that provide credit enhancement.

    Some commenters responding to the1997 Proposal suggested that thedefinition of ‘‘direct credit substitute’’should exclude risk positions that arenot part of an asset securitization.Although direct credit substitutescommonly are used in assetsecuritizations, enhancements involvingsimilar credit risk exposure can arise inother contexts and should receive thesame capital treatment as enhancementsassociated with securitizations.

    Several commenters objected to the1997 Proposal’s treatment of directcredit substitutes as recourse.Commenters asserted that the businessof providing third-party creditenhancements has historically been safeand profitable for banks and objectedthat the proposed capital treatmentwould impair the competitive positionof U.S. banks and thrifts. As has beenpreviously described, however, thecurrent treatment of direct credit

    substitutes is not consistent with thetreatment of recourse obligations. Theagencies have concluded that thedifference in treatment between the twoforms of credit enhancement invitesbanking organizations to obtain directcredit substitutes in place of recourseobligations in order to avoid the capitalrequirement applicable to recourseobligations and on-balance-sheet assets.For this reason, the agencies are againproposing, as a general rule, to extendthe current risk-based capital treatmentof asset transfers with recourse,including the low-level recourse rule, todirect credit substitutes.

    In an effort to address competitiveinequities at the international level,however, the agencies have raised thisissue with the bank supervisoryauthorities from the other countriesrepresented on the Basel Committee onBanking Supervision. The BaselCommittee’s consultative paper, ‘‘ANew Capital Adequacy Framework,’’acknowledges that the current BaselCapital Accord, upon which theagencies’ risk-based capital standardsare based, lacks consistency in itstreatment of credit enhancements.

    3. Lines of Credit

    One commenter requestedclarification that a line of credit thatprovides credit enhancement for thefinancial obligations of an account partycould be a direct credit substitute onlyif it represented an irrevocableobligation to the beneficiary. Arevocable line of credit would not be adirect credit substitute because theissuer could protect itself against creditlosses at any time prior to a draw on theline of credit. However, an irrevocableline of credit could expose the issuer tocredit losses and would constitute adirect credit substitute, if it met thecriteria in the definitions. Also, anyconditions attached to the issuer’sability to revoke the undrawn portion ofa line of credit, or that interfere with theissuer’s ability to protect itself againstcredit loss prior to a draw, will causethe line of credit to constitute a directcredit substitute.

    4. Credit Derivatives

    The proposed definitions of‘‘recourse’’ and ‘‘direct creditsubstitute’’ cover credit derivatives tothe extent that a banking organization’scredit risk exposure exceeds its pro ratainterest in the underlying obligation.The ratings-based approach thereforeapplies to rated instruments such ascredit-linked notes issued as part of a

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    16 ‘‘Synthetic securitization’’ refers to thebundling of credit risk associated with on-balancesheet assets and off-balance sheet items forsubsequent sale into the market. Credit derivatives,and in particular credit-linked notes, are used tostructure a synthetic securitization. For moreinformation on synthetic securitizations see, JointOCC and Federal Reserve Board Issuance on CreditDerivatives, ‘‘Capital Interpretations—SyntheticCollateralized Loan Obligations,’’ dated November15, 1999.

    17 Current OTS risk-based capital guidelinesexclude certain high-quality subordinatedmortgage-related securities from treatment asrecourse arrangements due to their credit quality.

    synthetic securitization. 16 The agenciesrequest comment on the inclusion ofcredit derivatives in the definitions of‘‘recourse’’ and ‘‘direct creditsubstitute,’’ as well as on the definitionof ‘‘credit derivative’’ contained in theproposal.

    5. Risks Other Than Credit RisksA capital charge would be assessed

    only against arrangements that createexposure to credit or credit-related risks.This continues the agencies’ currentpractice and is consistent with the risk-based capital standards’ traditionalfocus on credit risk. The agencies haveundertaken other initiatives to ensurethat the risk-based capital standardstake interest rate risk and other non-credit related market risks into account.

    6. Implicit RecourseThe definitions cover all

    arrangements that are recourse or directcredit substitutes in form or insubstance. Recourse may also existwhen a banking organization assumesrisk of loss without an explicitcontractual agreement or, if there is acontractual limit, when the bankingorganization assumes risk of loss in anamount exceeding the limit. Theexistence of implicit recourse is often acomplex and fact-specific issue, usuallydemonstrated by a bankingorganization’s actions to support asecuritization beyond any contractualobligation. Actions that may constituteimplicit recourse include: providingvoluntary support for a securitization byselling assets to a trust at a discountfrom book value; exchanging performingfor non-performing assets; or otheractions that result in a significanttransfer of value in response todeterioration in the credit quality of asecuritized asset pool.

    To date, the agencies have taken theposition that when a bankingorganization provides implicit recourse,it generally should hold capital in thesame amount as for assets sold withrecourse. However, the complexity ofmany implicit recourse arrangementsand the variety of circumstances underwhich implicit recourse may beprovided raise issues about whetherrecourse treatment is always the mostappropriate way to address the level of

    risk that a banking organization haseffectively retained or whether adifferent capital requirement would bewarranted in some circumstances.Accordingly, the 1997 Proposalrequested comment on the types ofactions that should be consideredimplicit recourse and how the agenciesshould treat those actions for regulatorycapital purposes.

    Commenters responding to the 1997Proposal generally supported the viewthat implicit recourse is best handled ona case-by-case basis, guided by thegeneral rule that actions thatdemonstrate retention of risk will triggerrecourse treatment of affectedtransactions. The agencies intend tocontinue to address implicit recoursecase-by-case, but may issue additionalguidance if needed to clarify further thecircumstances in which a bankingorganization will be considered to haveprovided implicit recourse.

    7. Subordinated Interests in Loans orPools of Loans

    The definitions of recourse and directcredit substitute explicitly cover abanking organization’s ownership ofsubordinated interests in loans or poolsof loans. This continues the bankingagencies’ longstanding treatment ofretained subordinated interests asrecourse and recognizes that purchasedsubordinated interests can also functionas credit enhancements. (The OTScurrently treats both retained andpurchased subordinated securities asrecourse obligations.) Subordinatedinterests generally absorb more thantheir pro rata share of losses (principaland interest) from the underlying assetsin the event of default. For example, amulti-class asset securitization mayhave several classes of subordinatedsecurities, each of which provides creditenhancement for the more seniorclasses. Generally, the holder of anyclass that absorbs more than its pro ratashare of losses from the total underlyingassets is providing credit protection forall of the more senior classes. 17

    Some commenters questioned thetreatment of purchased subordinatedinterests as recourse. Subordinatedinterests expose holders to comparablerisk regardless of whether the interestsare retained or purchased. If purchasedsubordinated interests were not treatedas recourse, banking organizations couldavoid recourse treatment by swappingretained subordinated interests withother banking organizations or by

    purchasing subordinated interests inassets originated by a conduit. Theproposal would mitigate the effect oftreating purchased subordinatedinterests as recourse by reducing thecapital requirement on interests thatqualify under the multi-level approachdescribed in section III.B.

    8. Representations and WarrantiesWhen a banking organization transfers

    assets, including servicing rights, itcustomarily makes representations andwarranties concerning those assets.When a banking organization purchasesloan servicing rights, it may also assumerepresentations and warranties made bythe seller or a prior servicer. Theserepresentations and warranties givecertain rights to other parties andimpose obligations upon the seller orservicer of the assets. The proposaladdresses those particularrepresentations and warranties thatfunction as credit enhancements, i.e.those where, typically, a bankingorganization agrees to protectpurchasers or some other party fromlosses due to the default or non-performance of the obligor orinsufficiency in the value of collateral.Therefore, to the extent a bankingorganization’s representations andwarranties function as creditenhancements to protect assetpurchasers or investors from credit riskby obligating the banking organizationto protect another party from losses dueto credit risk in the transferred assets,the proposal treats them as recourse ordirect credit substitutes.

    The 1997 Proposal treated as recourseor a direct credit substitute anyrepresentation or warranty other than astandard representation or warranty.Standard representations and warrantieswere those referring to facts verified bythe seller or servicer with reasonabledue diligence or conditions within thecontrol of the seller or servicer andthose providing for the return of assetsin the event of fraud or documentationdeficiencies. Some commenters objectedthat the 1997 Proposal would treat asrecourse many industry-standardwarranties that impose only minoroperational risk instead of true creditrisk. Other commenters objected that thedue diligence requirement wasburdensome, and that it would imposecompliance costs on bankingorganizations disproportionate to therisk assumed.

    The current proposal focuses onwhether a warranty allocates credit riskto the banking organization, rather thanwhether the warranty is somehowstandard or customary within theindustry. Several commenters suggested

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    18 Servicer cash advances include disbursementsmade to cover foreclosure costs or other expensesarising from a loan in order to facilitate its timelycollection (but not to protect investors fromincurring these expenses).

    that the agencies expressly takeaccepted mortgage banking industrypractice into account in determiningwhether a warranty should receiverecourse treatment. However, theagencies are aware of warrantiessometimes characterized as ‘‘standard’’that effectively function as creditenhancements. These includewarranties that transferred loans willremain of investment quality, or that nocircumstances exist involving the loancollateral or borrower’s credit standingthat could cause the loan to becomedelinquent. They may also includewarranties that, for seasoned mortgages,the value of the loan collateral stillequals the original appraised value andthe borrower’s ability to pay has notchanged adversely.

    The proposal is consistent with theagencies’ longstanding recoursetreatment of representations andwarranties that effectively guarantyperformance or credit quality oftransferred loans. However, the proposaland the agencies’ longstanding practicealso recognize that bankingorganizations typically make a numberof factual warranties unrelated toongoing performance or credit quality.These warranties entail operational risk,as opposed to the open-ended credit riskinherent in a financial guaranty.Warranties that create operational riskinclude: warranties that assets havebeen underwritten or collateralappraised in conformity with identifiedstandards, and warranties that providefor the return of assets in instances ofincomplete documentation or fraud.

    Warranties can impose varyingdegrees of operational risk. For example,a warranty that asset collateral has notsuffered damage from hazard entails riskthat is offset to some extent by prudentunderwriting practices requiring theborrower to provide hazard insurance tothe banking organization. A warrantythat asset collateral is free ofenvironmental hazards may presentacceptable operational risk for certaintypes of properties that have beensubject to environmental assessment,depending on the circumstances. Theagencies address appropriate limits forthese operational risks throughsupervision of a banking organization’sloan underwriting, sale, and servicingpractices. Also, a banking organizationthat provides warranties to loanpurchasers and investors must includeassociated operational risks in its riskmanagement of exposures arising fromloan sale or securitization-relatedactivities. Banking organizations shouldbe prepared to demonstrate toexaminers that the operational risks areeffectively managed.

    The proposal continues the agencies’current practice of imposing recoursetreatment on ‘‘early-default’’ clauses.Early-default clauses typically warrantthat transferred loans will not becomemore than 30 days delinquent within astated period, such as four months.Once the stated period has run, theearly-default clause will no longertrigger recourse treatment, provided thatthere is no other provision thatconstitutes recourse. One commenter tothe 1997 Proposal stated that early-default clauses carry minimal risk, andare intended to deal with inadvertenttransfers of loans that are already 30-daydelinquencies, or to guard againstunsound originations by the loan seller.Another commenter found recoursetreatment of early-default clauses to bean appropriate response to the transferof credit risk that takes place underthese clauses.

    The agencies find that early-defaultclauses are often drafted so broadly thatthey are indistinguishable from aguaranty of financial assets. Theagencies have even found recentexamples in which early-default clauseshave been expanded to cover the firstyear after loan transfer. Industryconcerns about assets delinquent at thetime of transfer or unsound originationscould be dealt with by warrantiesdirectly addressing the condition of theasset at the time of transfer andcompliance with stated underwritingstandards or, failing that, exposure capspermitting the banking organization totake advantage of the low-level recourserule. The proposal also requiresrecourse treatment for warrantiesproviding assurances about the actualvalue of asset collateral, including thatthe market value corresponds to itsappraised value or that the appraisedvalue will be realized in the event offoreclosure and sale.

    The agencies invite further commenton these issues. The agencies also invitecomment on whether ‘‘premiumrefund’’ clauses should receive recoursetreatment under any final rule. Theseclauses require the seller to refund thepremium paid by the investor for anyloan that prepays within a stated periodafter the loan is transferred. Theagencies are aware of premium refundclauses with terms ranging from 90 daysto 36 months.

    9. Loan Servicing ArrangementsThe proposed definitions of

    ‘‘recourse’’ and ‘‘direct creditsubstitute’’ cover loan servicingarrangements if the servicer isresponsible for credit losses associatedwith the loans being serviced. However,cash advances made by residential

    mortgage servicers to ensure anuninterrupted flow of payments toinvestors or the timely collection of themortgage loans are specifically excludedfrom the definitions of recourse anddirect credit substitute, provided thatthe residential mortgage servicer isentitled to reimbursement for anysignificant advances.18 This type ofadvance is assessed risk-based capitalonly against the amount of the cashadvance, and is assigned to the risk-weight category appropriate to the partyobligated to reimburse the servicer.

    If a residential mortgage servicer isnot entitled to full reimbursement, thenthe maximum possible amount of anynonreimbursed advances on any oneloan must be contractually limited to aninsignificant amount of the outstandingprincipal on that loan in order for theservicer’s obligation to make cashadvances to be excluded from thedefinitions of recourse and direct creditsubstitute. This treatment reflects theagencies’ traditional view that servicercash advances meeting these criteria arepart of the normal mortgage servicingfunction and do not constitute creditenhancements.

    Commenters responding to the 1997Proposal generally supported theproposed definition of servicer cashadvances. Some commenters asked forclarification of the term ‘‘insignificant’’and whether ‘‘reimbursement’’ includesreimbursement payable out ofsubsequent collections orreimbursement in the form of a generalclaim on the party obligated toreimburse the servicer. Nonreimbursedadvances on any one loan that aregenerally contractually limited to nomore than one percent of the amount ofthe outstanding principal on that loanwould be considered insignificant.Reimbursement includes reimbursementpayable from subsequent collectionsand reimbursement in the form of ageneral claim on the party obligated toreimburse the servicer, provided thatthe claim is not subordinated to otherclaims on the cash flows from theunderlying asset pool.

    Some commenters responding to the1997 Proposal suggested that theagencies treat servicer cash advances asany advances that the servicerreasonably expects will be repaid. Theagencies believe that a clear, specificstandard is needed to prevent the use ofservicer cash advances to circumventthe proposed risk-based capital

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    19 The OTS does not have a market risk rule.

    20 The Board is also proposing to add language toits risk-based capital standards that would permitthe Board to adjust the treatment of a capitalinstrument that does not fit into the existing capitalcategories or that provides capital to a bankingorganization at levels that are not commensurate

    with the nominal capital treatment of theinstrument. The other agencies already have thisflexibility under their existing rules.

    treatment of recourse obligations anddirect credit substitutes.

    10. Spread Accounts andOvercollateralization

    Several commenters requested thatthe agencies state in their rules thatspread accounts andovercollateralization do not impose arisk of loss on a banking organizationand are, therefore, not recourse. By itsterms, the definition of recourse coversonly the retention of risk in a sale ofassets. Overcollateralization does notordinarily impose a risk of loss on abanking organization, so it normallywould not fall within the proposeddefinition of recourse. However, aretained interest in a spread accountthat is reflected as an asset on a sellingbanking organization’s balance sheet(directly as an asset or indirectly as areceivable) is a form of recourse and istreated accordingly for risk-basedcapital purposes.

    11. Interaction With Market Risk Rule

    Some commenters responding to the1997 Proposal asked for clarification ofthe treatment of a transaction coveredby both the market risk rule and therecourse rule. Under the market riskrule,19 a position properly located in thetrading account is excluded from risk-weighted assets. The banking agenciesare not proposing to modify thistreatment, so a position that is properlyheld in the trading account would notbe included in risk-weighted assets,even if the position otherwise met thecriteria for a recourse obligation or adirect credit substitute.

    12. Participations in Direct CreditSubstitutes

    If a direct credit substitute isoriginated by a banking organizationwhich then sells a participation in thatdirect credit substitute to another entity,the originating banking organizationmust apply a 100% conversion factor tothe full amount of the assets supportedby the direct credit substitute. Theoriginating banking organization wouldthen risk weight the credit equivalentamount of the participant’s pro ratashare of the direct credit substitute atthe lower of the risk categoryappropriate to the obligor in theunderlying transaction, afterconsidering any relevant guaranties orcollateral, or the risk categoryappropriate to the participant entity.The remaining pro rata share of thecredit equivalent amount is assigned tothe risk-weight category appropriate to

    the obligor in the underlyingtransaction, guarantor or collateral.

    A banking organization that acquiresa risk participation in a direct creditsubstitute must apply a 100%conversion factor to its percentage shareof the direct credit substitute multipliedby the full amount of the assetssupported by the credit enhancement.The credit equivalent amount is thenassigned to the risk category appropriateto the obligor or, if relevant, the natureof the collateral or guaranty.

    Finally, in the case of the syndicationof a direct credit substitute where eachbanking organization is obligated onlyfor its pro rata share of the risk andthere is no recourse to the originatingbanking organization, each bankingorganization must hold risk-basedcapital against its pro rata share of theassets supported by the direct creditsubstitute.

    13. Reservation of AuthorityThe agencies are proposing to add

    language to the risk-based capitalstandards that will provide greaterflexibility in administering thestandards. Banking organizations aredeveloping novel transactions that donot fit well into the risk-weightcategories and credit conversion factorsset forth in the standards. Bankingorganizations also are devising novelinstruments that nominally fit into aparticular risk-weight category or creditconversion factor, but that impose riskson the banking organization at levelsthat are not commensurate with thenominal risk-weight or creditconversion factor for the asset, exposureor instrument. Accordingly, the agenciesare proposing to add language to thestandards to clarify their authority, on acase-by-case basis, to determine theappropriate risk-weight for assets andcredit equivalent amounts and theappropriate credit conversion factor foroff-balance sheet items in thesecircumstances. Exercise of this authorityby the agencies may result in a higheror lower risk weight for an asset orcredit equivalent amount or a higher orlower credit conversion factor for an off-balance sheet item. This reservation ofauthority explicitly recognizes theagencies retention of sufficientdiscretion to ensure that bankingorganizations, as they develop novelfinancial assets, will be treatedappropriately under the risk-basedcapital standards.20 In addition, the

    agencies reserve the right to assign riskpositions in securitizations toappropriate risk categories if the creditrating of the risk position is deemed tobe inappropriate.

    14. Privately-Issued Mortgage-BackedSecurities

    Currently, the agencies assignprivately-issued mortgage-backedsecurities to the 20% risk-weightcategory if the underlying pool iscomposed entirely of mortgage-relatedsecurities issued by the Federal NationalMortgage Association (Fannie Mae),Federal Loan Mortgage Corporation(Freddie Mac), or Government NationalMortgage Association (Ginnie Mae).Privately-issued mortgage-backedsecurities backed by whole residentialmortgages are now assigned to the 50%risk-weight category. The agenciespropose to eliminate this ‘‘pass-through’’ treatment in favor of a ratingsbased approach. Because mostmortgage-backed securities usually alsoreceive the highest or second highestcredit rating, the agencies believe that‘‘pass-through’’ treatment will beredundant once the ratings-basedapproach is implemented and, therefore,propose to eliminate it.

    B. Proposed Treatment for RatedPositions

    As described in section II.A., eachloss position in an asset securitizationstructure functions as a creditenhancement for the more senior losspositions in the structure. Currently, therisk-based capital standards do not varythe rate of capital requirement fordifferent credit enhancements or losspositions to reflect differences in therelative risk of credit loss represented bythe positions.

    To address this issue, the agencies areproposing a multi-level, ratings-basedapproach to assess capital requirementson recourse obligations, direct creditsubstitutes, and senior and subordinatedsecurities in asset securitizations basedon their relative exposure to credit risk.The approach uses credit ratings fromthe rating agencies and, to a limitedextent, banking organization’s internalrisk ratings and other alternatives, tomeasure relative exposure to credit riskand to determine the associated risk-based capital requirement. The use ofcredit ratings provides a way for theagencies to use determinations of creditquality relied upon by investors andother market participants to differentiatethe regulatory capital treatment for loss

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    21 The example rating designations (‘‘AAA,’’‘‘BBB,’’ etc.) are illustrative and do not indicate anypreference for, or endorsement of, any particularrating agency designation system.

    22 Similar to the current approach under which‘‘stripped’’ mortgage-backed securities are noteligible for risk weighting at 50% on a ‘‘pass-through’’ basis, stripped mortgage-backed securitiesare ineligible for the 20% or 50% risk categoriesunder the ratings based approach.

    23 ‘‘Gross-up’’ treatment means that a position iscombined with all more senior positions in thetransaction. The result is then risk-weighted basedon the nature of the underlying assets. For example,if a banking organization retains a first-loss positionin a pool of mortgage loans that qualify for a 50%risk weight, the banking organization wouldinclude the full amount of the assets in the pool,risk-weighted at 50% in its risk-weighted assets forpurposes of determining its risk-based capital ratio.

    The low level recourse rule provides that the dollaramount of risk-based capital required for assetstransferred with recourse should not exceed themaximum dollar amount for which a bankingorganization is contractually liable. See, 12 CFRpart 3, appendix A, Section 3(d) (OCC); 12 CFR 208and 225, appendix A, III.D.1(g) (FRB); 12 CFR part325, appendix A, II.D.1 (FDIC); 12 CFR567.6(a)(2)(i)(C) (OTS).

    positions representing differentgradations of risk. This use permits theagencies to give more equitabletreatment to a wide variety oftransactions and structures inadministering the risk-based capitalsystem.

    The fact that investors rely on theseratings to make investment decisionsexerts market discipline on the rating

    agencies and gives their ratings marketcredibility. The market’s reliance onratings, in turn, gives the agenciesconfidence that it is appropriate toconsider ratings as a major factor in therisk weighting of assets for regulatorycapital purposes. The agencies,however, would retain their authority tooverride the use of certain ratings or theratings on certain instruments, either on

    a case-by-case basis or through broadersupervisory policy, if necessary orappropriate to address the risk tobanking organizations.

    Under the ratings-based approach, thecapital requirement for a recourseobligation, direct credit substitute, ortraded asset-backed security would bedetermined as follows: 21

    Rating category Examples Risk weight

    Highest or second highest investment grade ......................................... AAA or AA ..................................... 20%.Third highest investment grade ............................................................... A .................................................... 50%.Lowest investment grade ........................................................................ BBB ................................................ 100%.One category below investment grade ................................................... BB .................................................. 200%.More than one category below investment grade, or unrated ................ B or unrated ................................... ’’Gross-up’’ treatment.

    Many commenters expressedconcerns about the so-called ‘‘cliffeffect’’ that would arise because of thesmall number of rating categories—three—contained in the 1997 Proposal.To reduce the cliff effect, which causesrelatively small differences in risk toresult in disproportionately largedifferences in the capital requirementfor a risk position, the agencies areproposing to add two additional ratingcategories, for a total of five.

    Under the proposal, the ratings-basedapproach is available for traded asset-backed securities 22 and for traded andnon-traded recourse obligations anddirect credit substitutes. A position isconsidered ‘‘traded’’ if, at the time it israted by an external rating agency, thereis a reasonable expectation that in thenear future: (1) The position may besold to investors relying on the rating;or (2) a third party may enter into atransaction (e.g., a loan or repurchaseagreement) involving the position inwhich the third party relies on therating of the position. If external ratingagencies rate a traded positiondifferently, the single highest ratingapplies.

    An unrated position that is senior (inall respects, including access tocollateral) to a rated position that istraded is treated as if it had the ratinggiven the rated position, subject to thebanking organization satisfying itssupervisory agency that such treatmentis appropriate.

    Recourse obligations and direct creditsubstitutes not qualifying for a reduced

    capital charge and positions rated morethan one category below investmentgrade receive ‘‘gross-up’’ treatment, thatis, the banking organization holding theposition would hold capital against theamount of the position plus all moresenior positions, subject to the low-levelrecourse rule.23 This grossed-up amountis placed into risk-weight categoriesaccording to the obligor and collateral.

    The ratings-based approach is basedon current ratings, so that a ratingdowngrade or withdrawal of a ratingcould change the treatment of a positionunder the proposal. However, adowngrade of a position by a singlerating agency would not affect thecapital treatment of a position if theposition still qualified for the previouscapital treatment under one or moreratings from a different rating agency.

    C. Proposed Treatment for Non-Tradedand Unrated Positions

    1. Ratings on Non-Traded Positions

    In the 1994 Notice, the agenciesproposed to permit a bankingorganization to obtain a rating for a non-traded recourse obligation or directcredit substitute in order to permit thatposition to qualify for a favorable risk-weight. In response to the 1994 Notice,one rating agency expressed concernthat use of ratings by the agencies forregulatory purposes could underminethe integrity of the rating process.Ordinarily, according to the commenter,there is a tension between the interestsof the investors who rely on ratings and

    the interests of the issuers who payrating agencies to generate ratings.Under the ratings-based approach in the1994 Notice, however, the holder of arecourse obligation or direct creditsubstitute that was not traded or soldcould, in some cases, seek a rating forthe sole purposes of permitting thecredit enhancement to qualify for afavorable risk weight. The rating agencyexpressed a strong concern that, withoutthe counterbalancing interest ofinvestors to rely on ratings, ratingagencies may have an incentive to issueinflated ratings.

    In response to this concern, the 1997Proposal included criteria to reduce thepossibility of inflated ratings andinappropriate risk weights if ratings areused for a position that is not traded. Anon-traded position could qualify forthe ratings-based approach only if: (1) Itqualified under ratings obtained fromtwo different rating agencies; (2) theratings were publicly available; (3) theratings were based on the same criteriaused to rate securities sold to the public;and (4) at least one position in thesecuritization was traded. In commentsresponding to the 1997 Proposal,banking organizations expressedconcern about the cost and delayassociated with obtaining ratings,particularly for direct credit substitutes,that they would not need absent theagencies’ adoption of a ratings-basedapproach for risk-based capitalpurposes.

    In this proposal, the agenciescontinue to permit a non-traded

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    recourse obligation or direct creditsubstitute to qualify for the ratings-based approach if the bankingorganization obtains ratings for theposition. The agencies have retained thefirst three of the 1997 Proposal’s fourcriteria for non-traded positions, buthave eliminated the fourth criterion, i.e.,the requirement that one position in thesecuritization be traded.

    To address concerns expressed bycommenters on the 1997 Proposal,however, the agencies have developed,and are also proposing, alternativeapproaches for determining the capitalrequirements for unrated direct creditsubstitutes, which are discussed in thefollowing sections. Under each of theseapproaches, the banking organizationmust satisfy its supervisory agency thatuse of the approach is appropriate forthe particular banking organization.

    2. Use of Banking Organizations’Internal Risk Ratings

    The proposal would permit a bankingorganization with a qualifying internalrisk rating system to use that system toapply the ratings-based approach to thebanking organization’s unrated directcredit substitutes in asset-backedcommercial paper programs. Internalrisk ratings could be used to qualify acredit enhancement (other than aretained recourse position) for a riskweight of 100% or 200% under theratings-based approach, but not for arisk weight of less than 100%. Thisrelatively limited use of internal riskratings for risk-based capital purposes isa step towards potential adoption ofbroader use of internal risk ratings asdiscussed in the Basel Committee’s June1999 Consultative Paper. Limiting theapproach to these types of creditenhancements reflects the agencies’view, based on industry research andempirical evidence, that these positionsare more likely than recourse positionsto be of investment-grade credit quality,and that the banking organizationsproviding them are more likely to haveinternal risk rating systems for thesecredit enhancements that aresufficiently accurate to be relied on forrisk-based capital calculations.

    Most sophisticated bankingorganizations that participateextensively in the asset securitizationbusiness assign internal risk ratings totheir credit exposures, regardless of theform of the exposure. Usually, internalrisk ratings more finely differentiate thecredit quality of a bankingorganization’s exposures than thecategories that the agencies use toevaluate credit risk during examinationsof banking organizations (pass,substandard, doubtful, loss). Individual

    banking organizations’ internal riskratings may be associated with a certainprobability of default, loss in the eventof default, and loss volatility.

    The credit enhancements thatsponsors obtain for their commercialpaper conduits are rarely rated. If aninternal risk ratings approach were notavailable for these unrated creditenhancements, the provider of theenhancement would have to obtain tworatings solely to avoid the gross-uptreatment that would otherwise apply tounrated positions in assetsecuritizations for risk-based capitalpurposes. However, before a provider ofan enhancement decides whether toprovide a credit enhancement for aparticular transaction (and at whatprice), the provider will generallyperform its own analysis of thetransaction to evaluate the amount ofrisk associated with the enhancement.

    Allowing banking organizations to useinternal credit ratings harnessesinformation and analyses that theyalready generate rather than requiringthem to obtain independent butredundant ratings from outside ratingagencies. An internal risk ratingsapproach therefore has the potential tobe less costly than a ratings-basedapproach that relies exclusively onratings by the rating agencies for therisk-weighting of these positions.

    Internal risk ratings that correspond tothe rating categories of the ratingagencies could be mapped to riskweights under the agencies’ capitalstandards in a way that would make itpossible to differentiate the riskiness ofvarious unrated direct credit substitutesbased on credit risk. However, the useof internal risk ratings raises concernsabout the accuracy and consistency ofthe ratings, especially because themapping of ratings to risk-weightcategories will give bankingorganizations an incentive to rate theirrisk exposures in a way that minimizesthe effective capital requirement.Banking organizations engaged insecuritization activities that wish to usethe internal risk ratings approach mustensure that their internal risk ratingsystems are adequate. Adequate internalrisk rating systems usually:

    (1) Are an integral part of an effectiverisk management system that explicitlyincorporates the full range of risksarising from an organization’sparticipation in securitization activities.The system must also fully take intoaccount the effect of such activities onthe organization’s risk profile andcapital adequacy as discussed in SectionII.B.

    (2) Link their ratings to measurableoutcomes, such as the probability that a

    position will experience any losses, theexpected losses on that position in theevent of default, and the degree ofvariance in losses given default on thatposition.

    (3) Separately consider the riskassociated with the underlying loansand borrowers and the risk associatedwith the specific positions in asecuritization transaction.

    (4) Identify gradations of risk among‘‘pass’’ assets, not just among assets thathave deteriorated to the point that theyfall into ‘‘watch’’ grades. Although it isnot necessary for a banking organizationto use the same categories as the ratingagencies, its internal ratings mustcorrespond to the ratings of the ratingagencies so that agencies can determinewhich internal risk rating correspondsto each rating category of the ratingagencies. A banking organization wouldhave the responsibility to demonstrateto the satisfaction of its primaryregulator how these ratings correspondwith the rating agency standards used asthe framework for this proposal. This isnecessary so that the mapping of creditratings to risk weight categories in theratings-based approach can be appliedto internal ratings.

    (5) Classify assets into each risk grade,using clear, explicit criteria, even forsubjective factors.

    (6) Have independent credit riskmanagement or loan review personnelassign or review credit risk ratings.These personnel should have adequatetraining and experience to ensure thatthey are fully qualified to perform thisfunction.

    (7) Periodically verify, through aninternal audit procedure, that internalrisk ratings are assigned in accordancewith the banking organization’sestablished criteria.

    (8) Track the performance of itsinternal ratings over time to evaluatehow well risk grades are being assigned,make adjustments to its rating systemwhen the performance of its ratedpositions diverges from assigned ratings,and adjust individual ratingsaccordingly.

    (9) Make credit risk ratingassumptions that are consistent with, ormore conservative than, the credit riskrating assumptions and methodologiesof the rating agencies.

    The agencies also are consideringwhether to develop review and approvalprocedures governing their respectivedeterminations of whether a particularbanking organization may use theinternal risk rating process. Theagencies request comment on theappropriate scope and nature of thatprocess.

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    If a banking organization’s ratingsystem is found to no longer beadequate, the banking organization’sprimary regulator may preclude it fromapplying the internal risk ratingsapproach to new transactions for risk-based capital purposes until it hasremedied the deficiencies. Additionally,depending on the severity of theproblems identified, the primaryregulator may also decline to rely on theinternal risk ratings that the bankingorganization has applied to previoustransactions that remain outstanding forpurposes of determining the bankingorganization’s regulatory capitalrequirements.

    3. Ratings of Specific Positions inStructured Financing Programs

    The agencies also propose toauthorize a banking organization to usea rating obtained from a rating agency orother appropriate third party of unrateddirect credit substitutes insecuritizations that satisfy specificationsset by the rating agency. The bankingorganization would need to demonstratethat the rating meets the same ratingstandards generally used by the ratingagency for rating publicly-issuedsecurities. In addition, the bankingorganization must also demonstrate toits primary regulator’s satisfaction thatthe criteria underlying the ratingagency’s assignment of ratings for theprogram are satisfied for the particulardirect credit substitute issued by thebanking organization.

    The proposal would also allowbanking organizations to demonstrate tothe agencies that it is reasonable andconsistent with the standards of thisproposal to rely on the rating ofpositions in a securitization structureunder a program in which the bankingorganization participates if the sponsorof that program has obtained a rating.This aspect of the proposal is mostlikely to be useful to bankingorganizations with limited involvementin securitization activities. In addition,some banking organizations extensivelyinvolved in securitization activitiesalready rely on ratings of the credit riskpositions under their securitizationprograms as part of their riskmanagement practices. Such bankingorganizations also could rely on suchratings under this proposal if the ratingsare part of a sound overall riskmanagement process and the ratingsreflect the risk of non-traded positionsto the banking organizations.

    This approach could be used toqualify a direct credit substitute (but nota retained recourse position) for a riskweight of 100% or 200% of the facevalue of the position under the ratings-

    based approach, but not for a riskweight of less than 100%.

    4. Use of Qualifying Rating SoftwareMapped to Public Rating Standards

    The agencies are also proposing toallow banking organizations,particularly those with limitedinvolvement in securitization activities,to rely on qualifying credit assessmentcomputer programs that the ratingagencies or other appropriate thirdparties have developed for ratingotherwise unrated direct creditsubstitutes in asset securitizations. Toqualify for use by banking organizationsfor risk-based capital purposes, thecomputer programs must be tracked tothe rating standards of the ratingagencies. Banking organizations mustdemonstrate the credibility of theseprograms in the financial markets,which would generally be shown by thesignificant use of the computer programby investors and market participants forrisk assessment purposes. Bankingorganizations also would need todemonstrate the reliability of theprograms in assessing credit risk.Banking organizations may use theseprograms for purposes of applying theratings-based approach under thisproposal only if the bankingorganization satisfies its primaryregulator that the programs result incredit assessments that credibly andreliably correspond with the rating ofpublicly issued securities by the ratingagencies. Sophisticated bankingorganizations with extensivesecuritization activities generally shoulduse this approach only if it is an integralpart of their risk management systemsand their systems fully capture the risksfrom the banking organizations’securitization activities.

    This approach could be used toqualify a direct credit substitute (but nota retained recourse position) for a riskweight of 100% or 200% of the facevalue of the position under the ratings-based approach, but not for a riskweight of less than 100%.

    D. Managed Assets ApproachWhen assets are securitized, the

    extent to which the selling orsponsoring entity transfers the risksassociated with the assets depends onthe structure of the securitization andthe revolving nature of the assetsinvolved. To the extent the sponsoringinstitution is dependent on futuresecuritizations as a funding source, as apractical matter, the amount of risktransferred often will be limited.Revolving credits include credit cardand home equity line securitizations aswell as commercial loans drawn down

    under long-term commitments that aresecuritized as collateralized loanobligations (CLOs).

    The early amortization feature presentin some revolving credit securitizationsensures that investors will be repaidbefore being subject to any risk ofsignificant credit losses. For example, ifa securitized asset pool begins toexperience credit deterioration to thepoint where the early amortizationfeature is triggered, then the asset-backed securities held by investorsbegin to rapidly pay down. This occursbecause, after an early amortizationfeature is triggered, new receivables thatare generated from the accountsdesignated to the securitization trust areno longer sold to investors, but areinstead retained on the sponsoringbanking organization’s balance sheet.

    Early amortization features raiseseveral distinct concerns about risks tothe seller. First, the seller’s interest inthe securitized assets is effectivelysubordinated to the interests of theinvestors by the payment allocationformula applied during earlyamortization. Investors effectively getpaid first, and the seller’s residualinterest will therefore absorb adisproportionate share of credit losses.

    Second, early amortization can createliquidity problems for the seller. Forexample, a credit card issuer must funda steady stream of new credit cardreceivables. When a securitization trustis no longer able to purchase newreceivables due to early amortization,the seller must either find an alternativebuyer for the receivables or else thereceivables will accumulate on theseller’s balance sheet, creating the needfor another source of funding.

    Third, the first two risks to the sellercan create an incentive for the seller toprovide implicit recourse—creditenhancement beyond any pre-existingcontractual obligation—to prevent earlyamortization. Incentives to provideimplicit recourse are to some extentpresent in other securitizations, becauseof concerns about damage to the seller’sreputation and its ability to securitizeassets going forward if one of itssecuritizations performs poorly.However, the early amortization featurecreates additional and more directfinancial incentives to prevent earlyamortization through implicit recourse.

    Because of their concerns about theserisks, the agencies are proposing toapply a managed assets approach tosecuritization transactions thatincorporate early amortizationprovisions. The approach would requirea sponsoring banking organization’ssecuritized (off-balance sheet)receivables to be included in risk-

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    weighted assets when determining itsrisk-based capital requirements. Thesecuritized, off-balance sheet assetswould be assigned to the 20 percent riskcategory, thereby effectively applying a1.6% risk-based capital charge to thoseassets.

    The 1.6% capital charge againstsecuritized assets could be limited incertain cases. If the sponsoring bankingorganization in a revolving creditsecuritization provides credit protectionto investors, either in the form ofretained recourse or a direct creditsubstitute, the sum of the regulatorycapital requirements for the creditprotection and the 1.6% charge on theoff-balance sheet securitized assets maynot exceed 8% of securitized assets forthat particular securitizationtransaction.

    A managed assets approach wouldrequire a banking organization to holdadditional capital against the potentialcredit and liquidity risks stemming fromthe early amortization provisions ofrevolving credit securitizationstructures. This proposed capital chargewould ensure that a bankingorganization maintain at least aminimum level of capital against therisks that arise when early amortizationprovisions are present in securitizationsof revolving credits.

    The agencies request comment on thepurpose of early amortizationprovisions, the proposed managedassets approach, and on any potentialeffects that the approach will have oncurrent industry practices involvingrevolving credit securitizations. Theagencies also recognize that there maybe concerns that the managed assetsapproach may not produce safety andsoundness benefits commensurate withthe additional regulatory burden thatwould result from a 20% risk weight onmanaged assets, and they requestcomment on possible alternativemeasures that would address moreeffectively the risks arising from earlyamortization provisions in revolvingsecuritizations. For example, onealternative to the managed assetsapproach described here would be torequire greater public disclosure ofsecuritization performance. Thisadditional information could allowmarket participants and regulators tobetter assess the risks inherent inrevolving securitizations with earlyamortization provisions and the capitallevel appropriate for those risks. Theagencies also request comment onwhether the benefits of greater publicdisclosure outweigh the costs associatedwith increased reporting.

    IV. Effective Date of a Final RuleResulting From This Proposal

    The agencies intend that any finalrules adopted as a result of this proposalthat result in increased risk-basedcapital requirements for bankingorganizations will apply only tosecuritization activities (as defined inthe proposal) entered into or acquiredafter the effective date of those finalrules. Conversely, any final rules thatresult in reduced risk-based capitalrequirements for banking organizationsmay be applied to all transactionsoutstanding as of the effective date ofthose final rules and to all subsequenttransactions. Because some ongoingsecuritization conduits may needadditional time to adapt to any newcapital treatments, the agencies intendto permit banking organizations to applythe existing capital rules to assetsecuritizations with no fixed term, e.g.,asset-backed commercial paperconduits, for up to two years after theeffective date of any final rule.

    V. Request for Comment

    The agencies request comment on allaspects of this proposal, as well as onthe specific issues described in thepreamble.

    VI. Regulatory Flexibility Act

    OCC: Pursuant to section 605(b) of theRegulatory Flexibility Act, the OCCcertifies that this proposal will not havea significant impact on a substantialnumber of small entities. 5 U.S.C. 601et seq. The provisions of this proposalthat increase capital requirements arelikely to affect large national banksalmost exclusively. Small nationalbanks rarely sponsor or provide directcredit substitutes in assetsecuritizations. Accordingly, aregulatory flexibility analysis is notrequired.

    Board: Pursuant to section 605(b) ofthe Regulatory Flexibility Act, the Boardhas determined that this proposal willnot have a significant impact on asubstantial number of small businessentities within the meaning of theRegulatory Flexibility Act (5 U.S.C. 601et seq.). The Board’s comparison of theapplicability section of this proposalwith Call Report Data on all existingbanks shows that application of theproposal to small entities will be therare exception. Accordingly, aregulatory flexibility analysis is notrequired. In addition, because the risk-based capital standards generally do notapply to bank holding companies withconsolidated assets of less than