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Wednesday, March 8, 2000 Part II Department of the Treasury Office of the Comptroller of the Currency Office of Thrift Supervision Federal Reserve System Federal Deposit Insurance Corporation 12 CFR Parts 3, 208, 225, 325 and 567 Risk-Based Capital Standards; Recourse and Direct Credit Substitutes; Proposed Rule VerDate 07<MAR>2000 20:04 Mar 07, 2000 Jkt 190000 PO 00000 Frm 00001 Fmt 4717 Sfmt 4717 E:\FR\FM\08MRP2.SGM pfrm08 PsN: 08MRP2

Wednesday, March 8, 2000Wednesday, March 8, 2000 Part II Department of the Treasury Office of the Comptroller of the Currency Office of Thrift Supervision Federal Reserve System

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Page 1: Wednesday, March 8, 2000Wednesday, March 8, 2000 Part II Department of the Treasury Office of the Comptroller of the Currency Office of Thrift Supervision Federal Reserve System

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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Page 2: Wednesday, March 8, 2000Wednesday, March 8, 2000 Part II Department of the Treasury Office of the Comptroller of the Currency Office of Thrift Supervision Federal Reserve System

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

DEPARTMENT OF THE TREASURY

Office of the Comptroller of theCurrency

12 CFR Part 3

[Docket No. 00–06]

RIN 1557–AB14

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

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

FEDERAL DEPOSIT INSURANCECORPORATION

12 CFR Part 325

RIN 3064–AB31

DEPARTMENT OF THE TREASURY

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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12324 Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / Proposed Rules

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 $150million, this proposal will not affectsuch companies.

FDIC: Pursuant to section 605(b) ofthe Regulatory Flexibility Act (PublicLaw 96–354, 5 U.S.C. 601 et seq.), theFDIC certifies that the proposed rulewill not have a significant impact on asubstantial number of small entities.Comparison of Call Report data onFDIC-supervised banks to the itemscovered by the proposal that result inincreased capital requirements showsthat application of the proposal to smallentities will be the infrequent exception.

OTS: Pursuant to section 605(b) of theRegulatory Flexibility Act, the OTScertifies that this proposal will not havea significant impact on a substantialnumber of small entities. A comparisonof TFR data on OTS-supervised thriftsshows that the proposed rule wouldhave little impact on the overall level ofcapital required at small thrifts, sincecapital requirements (other than therisk-based capital standards) aretypically more binding on smallerthrifts. Moreover, the provisions of thisproposal that may increase capitalrequirements are unlikely to affect smallsavings associations. Small thrifts rarelyprovide direct credit substitutes in assetsecuritizations and do not serve assponsors of revolving securitizations.Accordingly, a regulatory flexibilityanalysis is not required.

VII. Paperwork Reduction ActThe Agencies have determined that

this proposal does not involve acollection of information pursuant tothe provisions of the PaperworkReduction Act of 1995 (44 U.S.C. 3501,et seq.).

VIII. Executive Order 12866OCC: The OCC has determined that

this proposal is not a significantregulatory action for purposes ofExecutive Order 12866. The OCCexpects that any increase in nationalbanks’ risk-based capital requirement,resulting from the proposed treatment ofdirect credit substitutes largely will beoffset by the ability of those banks toreduce their capital requirement inaccordance with the ratings-basedapproach. The managed assets positionof the proposal may require a limitednumber of national banks to raiseadditional capital in order to remain inthe category to which they are assignedcurrently under the OCC’s promptcorrective action framework. The OCCbelieves that the costs associated withraising this new capital are below thethresholds prescribed in the ExecutiveOrder. Nonetheless, the impact of anyfinal rule resulting from this proposalwill depend on factors for which theagencies do not currently collectindustry-wide information, such as the

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proportion of bank-provided directcredit substitutes that would be ratedbelow investment grade. The OCC,therefore, welcomes any quantitativeinformation national banks wish toprovide about the impact they expectthe various portions of this proposal tohave if issued in final form.

OTS: The Director of the OTS hasdetermined that this proposal does notconstitute a ‘‘significant regulatoryaction’’ under Executive Order 12866.Since OTS already applies a ‘‘gross up’’treatment for recourse obligations andfor most direct credit substitutes, theproposal generally is likely to reducethe risk-based capital requirements forthrifts. The proposed rule wouldincrease capital requirements only forcertain direct credit substitutes issuedin connection with asset securitizationsor for thrifts that may serve as sponsorsof revolving securitization programs.Currently, thrifts rarely participate insuch activities. As a result, OTS hasconcluded that the proposal will haveonly minor effects on the thrift industry.

IX. OCC and OTS—Unfunded MandatesReform Act of 1995

Section 202 of the UnfundedMandates Reform Act of 1995, PublicLaw 104–4, (Unfunded Mandates Act),requires that an agency prepare abudgetary impact statement beforepromulgating a rule that includes aFederal mandate that may result in theexpenditure by state, local, and tribalgovernments, in the aggregate, or by theprivate sector, of $100 million or morein any one year. If a budgetary impactstatement is required, section 205 of theUnfunded Mandates Act also requiresan agency to identify and consider areasonable number of regulatoryalternatives before promulgating a rule.The OCC and OTS have determined thatthis proposed rule will not result inexpenditures by state, local, and tribalgovernments, or by the private sector, ofmore than $100 million or more in anyone year. Therefore, the OCC and OTShave not prepared a budgetary impactstatement or specifically addressed theregulatory alternatives considered. Asdiscussed in the preamble, this proposalwill reduce inconsistencies in theagencies’ risk-based capital standardsand, in certain circumstances, willallow banking organizations to maintainlower amounts of capital against certainrated recourse obligations and directcredit substitutes.

X. Plain Language RequirementSection 722 of the Gramm-Leach-

Bliley Act of 1999 requires the federalbanking agencies to use ‘‘plainlanguage’’ in all proposed and final

rules published after January 1, 2000.We invite your comments on how tomake this proposal easier to understand.For example:

(1) Have we organized the material tosuit your needs?

(2) Are the requirements in the ruleclearly stated?

(3) Does the rule contain technicallanguage or jargon that isn’t clear?

(4) Would a different format (groupingand order of sections, use of headings,paragraphing) make the rule easier tounderstand?

(5) Would more (but shorter) sectionsbe better?

(6) What else could we do to make therule easier to understand?

XI. FDIC Assessment of Impact ofFederal Regulation on Families

The FDIC has determined that thisproposed rule will not affect familywell-being within the meaning ofsection 654 of the Treasury and GeneralGovernment Appropriations Act of 1999(Pub. Law 105–277).

List of Subjects

12 CFR Part 3

Administrative practice andprocedure, Capital, National banks,Reporting and recordkeepingrequirements, Risk.

12 CFR Part 208

Accounting, Agriculture, Banks,Banking, Confidential businessinformation, Crime, Currency, FederalReserve System, Mortgages, Reportingand recordkeeping requirements,Securities.

12 CFR Part 225

Administrative practice andprocedure, Banks, Banking, FederalReserve System, Holding companies,Reporting and recordkeepingrequirements, Securities.

12 CFR Part 325

Administrative practice andprocedure, Bank deposit insurance,Banks, Banking, Capital adequacy,Reporting and recordkeepingrequirements, Savings associations,State non-member banks.

12 CFR Part 567

Capital, Reporting and recordkeepingrequirements, Savings associations.

Department of the Treasury

Office of the Comptroller of theCurrency

12 CFR Chapter I

Authority and Issuance

For the reasons set out in thepreamble, part 3 of chapter I of title 12of the Code of Federal Regulations isproposed to be amended as follows:

PART 3—MINIMUM CAPITAL RATIOS;ISSUANCE OF DIRECTIVES

1. The authority citation for part 3continues to read as follows:

Authority: 12 U.S.C. 93a, 161, 1818,1828(n), 1828 note, 1831n note, 1835, 3907,and 3909.

§ 3.4 [Amended]

2. In § 3.4:A. The undesignated paragraph is

designated as paragraph (a);B. The second sentence in the newly

designated paragraph (a) is revised; andC. New paragraph (b) is added to read

as follows:

§ 3.4 Reservation of authority.

(a) * * * Similarly, the OCC may findthat a particular intangible asset neednot be deducted from Tier 1 or Tier 2capital. * * *

(b) Notwithstanding the riskcategories in section 3 of appendix A tothis part, the OCC may find that theassigned risk weight for any asset or thecredit equivalent amount or creditconversion factor for any off-balancesheet item does not appropriately reflectthe risks imposed on a bank and mayrequire another risk weight, creditequivalent amount, or credit conversionfactor that the OCC deems appropriate.Similarly, if no risk weight, creditequivalent amount, or credit conversionfactor is specifically assigned, the OCCmay assign any risk weight, creditequivalent amount, or credit conversionfactor that the OCC deems appropriate.In making its determination, the OCCconsiders risks associated with the assetor off-balance sheet item as well as otherrelevant factors.

Appendix A to Part 3—[Amended]

3. In section 3 of appendix A:A. Footnote 11a in paragraph (a)(3)(v) is

revised;B. Paragraph (b) introductory text is

amended by adding a new sentence at itsend;

C. Paragraph (b)(1)(i) and footnote 13 areremoved and reserved;

D. Paragraph (b)(1)(ii) is revised;E. Paragraph (b)(1)(iii) and footnote 14 are

removed and reserved;

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11a The portion of multifamily residentialproperty loans that is sold subject to a pro rata losssharing arrangement may be treated by the sellingbank as sold to the extent that the sales agreementprovides for the purchaser of the loan to share inany loss incurred on the loan on a pro rata basiswith the selling bank. The portion of multifamilyresidential property loans sold subject to any losssharing arrangement other than pro rata sharing ofthe loss shall be accorded the same treatment as anyother asset sold under an agreement to repurchaseor sold with recourse under section 3(d)(2) of thisappendix A.

16 Participations in performance-based standbyletters of credit are treated in accordance withsection 3(d) of this appendix A.

17 Participations in commitments are treated inaccordance with section 3(d) of this appendix A.

F. Footnotes 16 and 17 in paragraphs(b)(2)(i) and (ii), respectively, are revised; and

G. Paragraph (d) is revised to read asfollows:

Appendix A to Part 3—Risk-Based CapitalGuidelines

* * * * *

§ 3 Risk Categories/Weights for On-BalanceSheet Assets and Off-Balance Sheet Items

* * * * *(a) * * *(3) * * *(v) * * * 11a

* * * * *(b) * * * However, direct credit

substitutes, recourse obligations, andsecurities issued in connection with assetsecuritizations are treated as described insection 3(d) of this appendix A.

(1) * * *(ii) Risk participations purchased in

bankers’ acceptances.

* * * * *(2) * * *(i) * * * 16 * * *(ii) * * * 17 * * *

* * * * *(d) Recourse obligations, direct credit

substitutes, and asset-backed securities—(1)Definitions. For purposes of this section 3 ofthis appendix A:

(i) Covered representations and warrantiesmeans representations and warranties thatare made or assumed in connection with atransfer of assets (including loan servicingassets) and that obligate a bank to absorblosses arising from credit risk in the assetstransferred or the loans serviced. Coveredrepresentations and warranties includepromises to protect a party from lossesresulting from the default or nonperformanceof another party or from an insufficiency inthe value of the collateral.

(ii) Credit derivative means a contract thatallows one party (the beneficiary) to transferthe credit risk of an asset or off-balance sheetcredit exposure to another party (theguarantor). The value of a credit derivative isdependent, at least in part, on the creditperformance of a ‘‘reference asset.’’

(iii) Direct credit substitute means anarrangement in which a bank assumes creditrisk associated with an on-or off-balancesheet asset that was not previously owned bythe bank (third-party asset) and the riskassumed by the bank exceeds the pro ratashare of the bank’s interest in the third-partyasset. If a bank has no claim on the third-party asset, then the bank’s assumption ofany risk of credit loss is a direct creditsubstitute. Direct credit substitutes include:

(A) Financial guarantee-type standbyletters of credit that support financial claimson a third party that exceed a bank’s pro ratashare in the financial claim;

(B) Guarantees, surety arrangements, creditderivatives and similar instruments backingfinancial claims that exceed a bank’s pro ratashare in the financial claim;

(C) Purchased subordinated interests thatabsorb more than their pro rata share oflosses from the underlying assets;

(D) Entering into a credit derivativecontract under which the bank assumes morethan its pro rata share of credit risk on athird-party asset;

(E) Loans or lines of credit that providecredit enhancement for the securitizationactivities of a third party; and

(F) Purchased loan servicing assets if theservicer is responsible for credit losses or ifthe servicer makes or assumes coveredrepresentations and warranties with respectto the loans serviced. Cash advancesdescribed in section 4(d)(1)(vii) of thisappendix A are not direct credit substitutes.

(iv) Externally rated means that aninstrument or obligation has received a creditrating from at least one nationally recognizedstatistical rating organization.

(v) Face amount means the notionalprincipal, or face value, amount of an off-balance sheet item; the amortized cost of anasset not held for trading purposes; and thefair value of a trading asset.

(vi) Financial guarantee-type standby letterof credit means a letter of credit or similararrangement that represents an irrevocableobligation to a third-party beneficiary:

(A) To repay money borrowed by, oradvanced to, or for the account of, a secondparty (the account party); or

(B) To make payment on behalf of theaccount party, in the event that the accountparty fails to fulfill its obligation to thebeneficiary.

(vii) Mortgage servicer cash advance meansfunds that a mortgage servicer advances toensure an uninterrupted flow of payments,including advances made to coverforeclosure costs or other expenses tofacilitate the timely collection of the loan. Amortgage servicer cash advance is not arecourse obligation or a direct creditsubstitute if:

(A) The servicer is entitled to fullreimbursement and this right is notsubordinated to other claims on the cashflows from the underlying asset pool; or

(B) For any one loan, the servicer’sobligation to make nonreimbursableadvances is contractually limited to aninsignificant amount.

(viii) Nationally recognized statisticalrating organization (NRSRO) means an entityrecognized by the Division of MarketRegulation of the Securities and ExchangeCommission (or any successor Division)(Commission) as a nationally recognizedstatistical rating organization for variouspurposes, including the Commission’suniform net capital requirements for brokersand dealers.

(ix) Recourse means the retention, by abank, of any risk of credit loss directly orindirectly associated with a transferred assetthat exceeds a pro rata share of that bank’sclaim on the asset. If a bank has no claim ona transferred asset, then the retention of anyrisk of credit loss is recourse. A recourseobligation typically arises when a banktransfers assets and retains an explicitobligation to repurchase assets or to absorblosses due to a default on the payment ofprincipal or interest or any other deficiencyin the performance of the underlying obligoror some other party. Recourse may also existimplicitly if a bank provides creditenhancement beyond any contractualobligation to support assets it has sold. Thefollowing are examples of recoursearrangements:

(A) Making covered representations andwarranties on transferred assets;

(B) Retaining loan servicing assetspursuant to an agreement under which thebank will be responsible for losses associatedwith the loans serviced. Mortgage servicercash advances, as defined in section4(d)(1)(vii) of this appendix A, are notrecourse arrangements;

(C) Retaining a subordinated interest thatabsorbs more than its pro rata share of lossesfrom the underlying assets;

(D) Selling assets under an agreement torepurchase, if the assets are not alreadyincluded on the balance sheet; and

(E) Selling loan strips without contractualrecourse where the maturity

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24 Stripped mortgage-backed securities, such asinterest-only or principal-only strips, may beassigned only, at a minimum, to the 100% riskcategory.

of the transferred portion of the loan isshorter than the maturity of the whole loan.

(x) Risk participation means a participationin which the originating bank remains liableto the beneficiary for the full amount of anobligation (e.g. a direct credit substitute)notwithstanding that another party hasacquired a participation in that obligation.

(xi) Securitization means the pooling andrepackaging of assets or other creditexposures into securities that can be sold toinvestors, including transactions that createstratified credit risk positions.

(xii) Traded position means a recourseobligation, direct credit substitute or asset-backed security retained, assumed or issuedin connection with a securitization that isexternally rated, where there is anexpectation that, in the near future, the ratingwill be relied upon by:

(A) Investors to purchase the position; or(B) A third party to enter into a transaction

involving the position, such as a purchase,loan or repurchase agreement.

(2) Credit equivalent amounts and riskweights of recourse obligations and directcredit substitutes—(i) Credit-equivalentamount. Except as provided in sections3(d)(3) and (4) of this appendix A, the credit-equivalent amount for a recourse obligationor direct credit substitute is the full amountof the credit-enhanced assets for which thebank directly or indirectly retains or assumescredit risk multiplied by a 100% conversionfactor.

(ii) Risk-weight factor. To determine thebank’s risk-weighted assets for off-balancesheet recourse obligations and direct creditsubstitutes, the credit equivalent amount isassigned to the risk category appropriate tothe obligor in the underlying transaction,after considering any associated guaranteesor collateral. For a direct credit substitutethat is an on-balance sheet asset (e.g., apurchased subordinated security), a bankmust calculate risk-weighted assets using theamount of the direct credit substitute and thefull amount of the assets it supports, i.e., allthe more senior positions in the structure.

(3) Credit equivalent amount and riskweight of participations in, and syndicationsof, direct credit substitutes. The creditequivalent amount for a participation interestin, or syndication of, a direct credit substituteis calculated and risk weighted as follows:

(i) In the case of a direct credit substitutein which a bank has conveyed a riskparticipation, the full amount of the assetsthat are supported by the direct credit

substitute is converted to a credit equivalentamount using a 100% conversion factor. Thepro rata share of the credit equivalentamount that has been conveyed through arisk participation is then assigned towhichever risk-weight category is lower: Therisk-weight category appropriate to theobligor in the underlying transaction, afterconsidering any associated guarantees orcollateral, or the risk-weight categoryappropriate to the institution acquiring theparticipation. The pro rata share of the creditequivalent amount that has not beenparticipated out is assigned to the risk-weightcategory appropriate to the obligor,guarantor, or collateral.

(ii) In the case of a direct credit substitutein which the bank has acquired a riskparticipation, the acquiring bank’s percentageshare of the direct credit substitute ismultiplied by the full amount of the assetsthat are supported by the direct creditsubstitute and converted using a 100% creditconversion factor. The resulting creditequivalent amount is then assigned to therisk-weight category appropriate to theobligor in the underlying transaction, afterconsidering any associated guarantees orcollateral.

(iii) In the case of a direct credit substitutethat takes the form of a syndication whereeach bank is obligated only for its pro ratashare of the risk and there is no recourse tothe originating bank, each bank’s creditequivalent amount will be calculated bymultiplying only its pro rata share of theassets supported by the direct creditsubstitute by a 100% conversion factor. Theresulting credit equivalent amount is thenassigned to the risk-weight categoryappropriate to the obligor in the underlyingtransaction, after considering any associatedguarantees or collateral.

(4) Externally rated positions: Credit-equivalent amounts and risk weights.—(i)Traded positions. With respect to a recourseobligation, direct credit substitute, or asset-backed security that is a ‘‘traded position’’and that has received an external rating thatis one grade below investment grade orbetter, the bank shall multiply the faceamount of the position by the appropriaterisk weight, determined in accordance withTable B. 24

TABLE B

Rating category Examples Risk weight(percent)

Highest or secondhighest invest-ment grade.

AAA, AA .. 20

Third highest in-vestment grade.

A .............. 50

Lowest invest-ment grade.

BBB ......... 100

One categorybelow invest-ment grade.

BB ........... 200

(ii) Non-traded positions. A recourseobligation or direct credit substitute extendedin connection with a securitization that is nota ‘‘traded position’’ is assigned a risk weightin accordance with section 3(d)(4)(i) of thisappendix A if:

(A) It has been externally rated onecategory below investment grade or better bytwo NRSROs;

(B) The ratings are publicly available; and(C) The ratings are based on the same

criteria used to rate securities sold to thepublic. If the two ratings are different, thelower rating will determine the risk categoryto which the recourse obligation or directcredit substitute will be assigned.

(5) Senior positions not externally rated.For a recourse obligation, direct creditsubstitute, or asset-backed security that is notexternally rated but is senior in all credit-riskrelated features to a traded position(including collateralization), a bank mayapply a risk weight to the face amount of thesenior position in accordance with section3(d)(4)(i) of this appendix A, based upon thetraded position, subject to the bank satisfyingthe OCC that this treatment is appropriate.

(6) Direct credit substitutes that are notexternally rated. A direct credit substituteextended in connection with a securitizationthat is not externally rated may risk weightthe face amount of the direct credit substitutebased on the bank’s determination of thecredit rating of the position, as specified inTable C. In order to qualify for this treatment,the bank’s system for determining the creditrating of the direct credit substitute mustmeet one of the three alternative standardsset out in section 3(d)(6)(i) through (iii) ofthis appendix A.

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25 The adequacy of a bank’s use of its internalcredit risk rating system must be demonstrated tothe OCC considering the criteria listed in thissection and the size and complexity of the creditexposures assumed by the bank.

26 This requirement does not apply to intereststhat the seller has retained.

TABLE C

Rating category Examples Risk weight(percent)

Highest or secondhighest invest-ment grade.

AAA, AA .. 100

Third highest in-vestment grade.

A .............. 100

Lowest invest-ment grade.

BBB ......... 100

One categorybelow invest-ment grade.

BB ........... 200

(i) Internal risk rating used for asset-backed programs. The direct credit substituteis issued in connection with an asset-backedcommercial paper program sponsored by thebank and the bank’s internal credit risk ratingsystem is adequate. Adequate internal creditrisk rating systems usually contain thefollowing criteria: 25

(A) The internal credit risk system is anintegral part of the bank’s risk managementsystem that explicitly incorporates the fullrange of risks arising from a bank’sparticipation in securitization activities;

(B) Internal credit ratings are linked tomeasurable outcomes, such as the probabilitythat the position will experience any loss, theposition’s expected loss given default, andthe degree of variance in losses given defaulton that position;

(C) The bank’s internal credit risk systemmust separately consider the risk associatedwith the underlying loans or borrowers, andthe risk associated with the structure of aparticular securitization transaction;

(D) The bank’s internal credit risk systemmust identify gradations of risk among‘‘pass’’ assets and other risk positions;

(E) The bank must have clear, explicitcriteria that are used to classify assets intoeach internal risk grade, including subjectivefactors;

(F) The bank must have independent creditrisk management or loan review personnelassigning or reviewing the credit risk ratings;

(G) An internal audit procedure shouldperiodically verify that internal risk ratingsare assigned in accordance with the bankingorganization’s established criteria.

(H) The bank must monitor theperformance of the internal credit risk ratingsassigned to nonrated, nontraded direct creditsubstitutes over time to determine theappropriateness of the initial credit risk

rating assignment and adjust individualcredit risk ratings, or the overall internalcredit risk ratings system, as needed; and

(I) The internal credit risk system mustmake credit risk rating assumptions that areconsistent with, or more conservative than,the credit risk rating assumptions andmethodologies of NRSROs.

(ii) Program ratings. The direct creditsubstitute is issued in connection with asecuritization program and a NRSRO (orother entity satisfactory to the OCC) hasreviewed the terms of the securitization andstated a rating for positions associated withthe program. If the program has options fordifferent combinations of assets, standards,internal credit enhancements and otherrelevant factors, and the NRSRO or otherentity specifies ranges of rating categories tothem, the bank may apply the rating categoryapplicable to the option that corresponds tothe bank’s position. The bank mustdemonstrate to the OCC’s satisfaction that thecredit risk rating assigned to the programmeets the same standards generally used byNRSROs for rating traded positions. Inaddition, the bank must also demonstrate tothe OCC’s satisfaction that the criteriaunderlying the NRSRO’s assignment ofratings for the program are satisfied for theparticular direct credit substitute issued bythe bank. If a bank participates in asecuritization sponsored by another party,the OCC may authorize the bank to use thisapproach based on a program rating obtainedby the sponsor of the program.

(iii) Computer program. The bank is usingan acceptable credit assessment computerprogram to determine the rating of a directcredit substitute extended in connection witha securitization. A NRSRO (or another entityapproved by the OCC) must have developedthe computer program and the bank mustdemonstrate to the OCC’s satisfaction thatratings under the program correspondcredibly and reliably with the rating of tradedpositions.

(7) Off-balance sheet securitized assetssubject to early amortization. An asset that issold by a bank into a revolving securitizationsponsored by the bank, notwithstanding suchsale, shall be converted to an on-balancesheet credit equivalent using a 100%conversion factor, and assigned to the 20percent risk-weight category, if thesecuritization has an early amortizationfeature.26 The total capital requirement forthese assets, including capital charges arisingfrom any retained recourse or direct creditsubstitute, may not exceed 8% of the amountof the assets in the securitization.

(8) Limitations on risk-based capitalrequirements—(i) Low-level exposure rule. Ifthe maximum contractual liability orexposure to loss retained or assumed by abank is less than the effective risk-basedcapital requirement for the asset supportedby the bank’s position, the risk based capitalrequired under this appendix A is limited tothe bank’s contractual liability, less anyrecourse liability account established inaccordance with generally acceptedaccounting principles.

(ii) Related on-balance sheet assets. If anasset is included in the calculation of therisk-based capital requirement under thissection 3(d) of this appendix A and alsoappears as an asset on a bank’s balance sheet,the asset is risk-weighted only under thissection 3(d) of this appendix A, except in thecase of loan servicing assets and similararrangements with embedded recourseobligations or direct credit substitutes. In thatcase, both the on-balance sheet servicingassets and the related recourse obligations ordirect credit substitutes are incorporated intothe risk-based capital calculation.

* * * * *4. In appendix A, Table 2, ‘‘100 Percent

Conversion Factor,’’ Item 1 is revised to readas follows:

* * * * *

Table 2—Credit Conversion Factors for Off-Balance Sheet Items

100 Percent Conversion Factor

1. [Reserved]

* * * * *Dated: February 9, 2000.

John D. Hawke, Jr.,Comptroller of the Currency.

Federal Reserve System

12 CFR Chapter II

Authority and Issuance

For the reasons set forth in the jointpreamble, parts 208 and 225 of chapter II oftitle 12 of the Code of Federal Regulations areproposed to be amended as follows:

PART 208—MEMBERSHIP OF STATEBANKING INSTITUTIONS IN THEFEDERAL RESERVE SYSTEM(REGULATION H)

1. The authority citation for part 208continues to read as follows:

Authority: 12 U.S.C. 24, 36, 92(a), 93(a),248(a), 248(c), 321–338a, 371d, 461, 481–486,

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4 Consultation would not ordinarily be necessaryif an instrument were redeemed with the proceedsof, or replaced by, a like amount of a similar orhigher quality capital instrument and theorganization’s capital position is considered fullyadequate by the Federal Reserve.

601, 611, 1814, 1816, 1818, 1820(d)(9),1823(j), 1828(o), 1831, 1831o, 1831p–1,1831r–1, 1835(a), 1882, 2901–2907, 3105,3310, 3331–3351, and 3906–3909; 15 U.S.C.78b, 78l(b), 78l(g), 78l(i), 78o–4(c)(5), 78q,78q–1, and 78w; 31 U.S.C. 5318; 42 U.S.C.4012a, 4104a, 4104b, 4106, and 4128.

2. In appendix A to part 208:A. The three introductory paragraphs

to section II. are revised;B. A new undesignated fifth

paragraph is added at the end of sectionIII.A;

C. In section III.B., paragraph 3 isrevised and footnote 23 is removed, andin paragraph 4, footnote 24 is removed;

D. In section III.C., paragraphs 1through 3, footnotes 25 through 37 areredesignated as footnotes 23 through 35,and paragraph 4 is revised;

E. In section III.D., the introductoryparagraph and paragraph 1 are revised;

F. In sections III.D. and III.E., footnote46 is removed and footnotes 47 through51 are redesignated as footnotes 44through 48; and

G. In section IV.B., footnote 52 isremoved.

Appendix A to Part 208—Capital AdequacyGuidelines for State Member Banks: Risk-Based Measure

* * * * *

II. * * *

A bank’s qualifying total capital consists oftwo types of capital components: ‘‘corecapital elements’’ (comprising Tier 1 capital)and ‘‘supplementary capital elements’’(comprising Tier 2 capital). These capitalelements and the various limits, restrictions,and deductions to which they are subject, arediscussed below and are set forth inAttachment II.

The Federal Reserve will, on a case-by-casebasis, determine whether and, if so, howmuch of any liability that does not fit whollywithin the terms of one of the capitalcategories set forth below or that does nothave an ability to absorb lossescommensurate with the capital treatmentotherwise specified below will be counted asan element of Tier 1 or Tier 2 capital. Inmaking such a determination, the FederalReserve will consider the similarity of theliability to liabilities explicitly treated in theguidelines, the ability of the liability toabsorb losses while the bank operates as agoing concern, the maturity and redemptionfeatures of the liability, and other relevantterms and factors. To qualify as an elementof Tier 1 or Tier 2 capital, a capitalinstrument may not contain or be covered byany covenants, terms, or restrictions that areinconsistent with safe and sound bankingpractices.

Redemptions of permanent equity or othercapital instruments before stated maturitycould have a significant impact on a bank’soverall capital structure. Consequently, abank considering such a step should consultwith the Federal Reserve before redeemingany equity or debt capital instrument (priorto maturity) if such redemption could have

a material effect on the level or compositionof the institution’s capital base.4

* * * * *III. * * *A. * * *The Federal Reserve will, on a case-by-case

basis, determine the appropriate risk weightfor any asset or the credit equivalent amountof an off-balance sheet item that does not fitwholly within the terms of one of the riskweight categories set forth below or thatimposes risks on a bank that areincommensurate with the risk weightotherwise specified below for the asset or off-balance sheet item. In addition, the FederalReserve will, on a case-by-case basis,determine the appropriate credit conversionfactor for any off-balance sheet item that doesnot fit wholly within the terms of one of thecredit conversion factors set forth below orthat imposes risks on a bank that areincommensurate with the credit conversionfactors otherwise specified below for the off-balance sheet item. In making such adetermination, the Federal Reserve willconsider the similarity of the asset or off-balance sheet item to assets or off-balancesheet items explicitly treated in theguidelines, as well as other relevant factors.

* * * * *B. * * *3. Recourse obligations, direct credit

substitutes, and asset- and mortgage-backedsecurities. Direct credit substitutes, assetstransferred with recourse, and securitiesissued in connection with assetsecuritizations and structured financings aretreated as described below. Use of the term‘‘asset securitizations’’ or ‘‘securitizations’’ inthis rule includes structured financings, aswell as asset securitization transactions.

a. Definitions—(i) Credit derivatives are on-or off-balance sheet notes or contracts thatallow one party (the ‘‘beneficiary’’) to transferthe credit risk of a ‘‘reference asset,’’ whichit often owns, to another party (the‘‘guarantor’’). The value of a credit derivativeis dependent, at least in part, on the creditperformance of the reference asset, whichtypically is a publicly traded loan orcorporate bond.

(ii) Credit-enhancing representations andwarranties means representations andwarranties extended by a bank when ittransfers assets (including loan servicingassets) or assumed by the bank when itpurchases loan servicing assets that obligatethe bank to absorb credit losses ontransferred assets or serviced loans. Theserepresentations and warranties typically arisewhen the bank agrees to protect purchasersor some other party from losses due to thedefault or nonperformance of the obligor onthe transferred assets or serviced loans, orinsufficiency in the value of collateralsupporting the transferred assets or servicedloans.

(iii) Direct credit substitute means anarrangement in which a bank assumes, in

form or in substance, any risk of credit lossdirectly or indirectly associated with a third-party asset or other financial claim, thatexceeds the bank’s pro rata share of the assetor claim. If the bank has no claim on theasset, then the assumption of any risk of lossis a direct credit substitute. Direct creditsubstitutes include, but are not limited to:

(1) Financial guarantee-type standby lettersof credit that support financial claims on theaccount party;

(2) Guarantees, surety arrangements, creditderivatives, and irrevocable guarantee-typeinstruments backing financial claims such asoutstanding securities, loans, or otherfinancial liabilities, or that back off-balancesheet items against which risk-based capitalmust be maintained;

(3) Purchased subordinated interests orsecurities that absorb more than their prorata share of losses from the underlyingassets;

(4) Loans or lines of credit that providecredit enhancement for the financialobligations of an account party; and

(5) Purchased loan servicing assets if theservicer is responsible for credit lossesassociated with the loans being serviced(other than mortgage servicer cash advancesas defined in paragraph III.B.3.a.(vi) of thissection), or if the servicer makes or assumescredit-enhancing representations andwarranties with respect to the serviced loans.

(iv) Externally rated means, with respect toan instrument or obligation, that theinstrument or obligation has received a creditrating from a nationally-recognized statisticalrating organization.

(v) Financial guarantee-type standby letterof credit means any letter of credit or similararrangement, however named or described,that represents an irrevocable obligation tothe beneficiary on the part of the issuer:

(1) To repay money borrowed by, advancedto, or for the account of, the account party;or

(2) To make payment on account of anyindebtedness undertaken by the accountparty in the event that the account party failsto fulfill its obligation to the beneficiary.

(vi) Mortgage servicer cash advance meansfunds that a residential mortgage loanservicer advances to ensure an uninterruptedflow of payments or the timely collection ofresidential mortgage loans, includingdisbursements made to cover foreclosurecosts or other expenses arising from amortgage loan to facilitate its timelycollection. A mortgage servicer cash advanceis not a recourse obligation or a direct creditsubstitute if the mortgage servicer is entitledto full reimbursement or, for any oneresidential mortgage loan, nonreimbursableadvances are contractually limited to aninsignificant amount of the outstandingprincipal on that loan.

(vii) Nationally recognized statistical ratingorganization means an entity recognized bythe Division of Market Regulation of theSecurities and Exchange Commission as anationally recognized statistical ratingorganization for various purposes, includingthe Commission’s uniform net capitalrequirements for brokers and dealers (17 CFR240.15c3–1(c)(2)(vi)(E), (F), and (H)).

(viii) Recourse means an arrangement inwhich a bank retains, in form or in

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substance, any risk of credit loss directly orindirectly associated with a transferred assetthat exceeds a pro rata share of the bank’sclaim on the asset. If a bank has no claim ona transferred asset, then the retention of anyrisk of loss is recourse. A recourse obligationtypically arises when an institution transfersassets and retains an obligation to repurchasethe assets or absorb losses due to a defaultof principal or interest or any otherdeficiency in the performance of theunderlying obligor or some other party.Recourse may exist implicitly where a bankprovides credit enhancement beyond anycontractual obligation to support assets it hassold. Recourse obligations include, but arenot limited to:

(1) Credit-enhancing representations andwarranties on the transferred assets thatobligate the servicer to absorb credit losses,including early-default clauses;

(2) Retained loan servicing assets if theservicer is responsible for losses associatedwith the loans being serviced other thanmortgage servicer cash advances as definedin paragraph III.B.3.a.(vi) of this section.

(3) Retained subordinated interests orsecurities or credit derivatives that absorbmore than their pro rata share of losses fromthe underlying assets;

(4) Assets sold under an agreement torepurchase if the assets are not alreadyincluded on the balance sheet; and

(5) Loan strips sold without direct recoursewhere the maturity of the transferred loanthat is drawn is shorter than the maturity ofthe commitment.

(ix) Securitization means the pooling andrepackaging of loans or other creditexposures into securities that can be sold toinvestors. For purposes of this appendix A,securitization also includes structuredfinance transactions or programs thatgenerally create stratified credit riskpositions whose performance is dependentupon an underlying pool of credit exposures,including loans and commitments.

(x) Traded position means a recourseobligation, direct credit substitute, or asset-ormortgage-backed security that is retained,assumed, or issued in connection with anasset securitization and that is rated with areasonable expectation that, in the nearfuture:

(1) The position would be sold to investorsrelying on the rating; or

(2) A third party would, in reliance on therating, enter into a transaction such as apurchase, loan, or repurchase agreementinvolving the position.

b. Amount of position to be included inrisk-weighted assets. Other types of recourseobligations or direct credit substitutes, otherthan those listed in section III.B.3.b.(i)(1)through (7) of this appendix A, should betreated in accordance with the principlescontained in section III.B.3. of this appendixA. The treatment of direct credit substitutesthat have been syndicated or in which riskparticipations have been conveyed oracquired is set forth in section III.D.1 of thisappendix A.

(i) General rule for determining the creditequivalent amount and risk weight ofrecourse obligations and direct creditsubstitutes. Except as otherwise provided in

section III of this appendix A, the riskweighted asset amount or the creditequivalent amount for a recourse obligationor direct credit substitute is the full amountof the credit enhanced assets from which riskof credit loss is directly or indirectly retainedor assumed. This credit equivalent amount isassigned to the risk weight categoryappropriate to the obligor or, if relevant, theguarantor or nature of any collateral. Thus, abank that extends a partial direct creditsubstitute, e.g., a financial standby letter ofcredit, that absorbs the first 10 percent of losson a transaction, must maintain capitalagainst the full amount of the assets beingsupported. Furthermore, for direct creditsubstitutes that are on-balance sheet assets,e.g., purchased subordinated securities,banks must maintain capital against theamount of the direct credit substitutes andthe full amount of the assets being supported,i.e., all more senior positions. This treatmentis subject to the low-level capital rulediscussed in section III.B.3.c.i. of thisappendix A. For purposes of this appendixA, the full amount of the credit enhancedassets from which risk of credit loss isdirectly or indirectly retained or assumedmeans for:

(1) A financial guarantee-type standbyletter of credit, surety arrangement, creditderivative, guarantee, or irrevocableguarantee-type instruments, the full amountof the assets that the direct credit substitutefully or partially supports;

(2) A subordinated interest or security, theamount of the subordinated interest orsecurity plus all more senior interests orsecurities;

(3) Mortgage servicing assets that arerecourse obligations or direct creditsubstitutes, the outstanding amount of theloans serviced;

(4) Credit-enhancing representations andwarranties, the amount of the assets subjectto the representations or warranties;

(5) Loans or lines of credit that providecredit enhancement for the financialobligations of an account party, the fullamount of the enhanced financialobligations;

(6) Loans strips, the amount of the loans;and

(7) For assets sold with recourse, theamount of assets for which risk of loss isdirectly or indirectly retained, less anyapplicable recourse liability accountestablished in accordance with generallyaccepted accounting principles.

(ii) Determining the credit risk weight ofrecourse obligations, direct credit substitutes,and asset- and mortgage-backed securitiesthat are rated within one of the five highestrating categories. (1) A traded position iseligible for the risk-based capital treatmentdescribed in this paragraph if its externalrating is within one of the five highest ratingcategories, e.g., AAA through BB, used by anationally-recognized statistical ratingorganization. A recourse obligation, directcredit substitute, or asset- or mortgage-backedsecurity which is not externally rated but issenior in all respects to a traded position thatis externally rated, including access to anycollateral, is also eligible for the risk-basedcapital treatment described in this paragraph

III.B.3.b.(ii) as if it had the same rating as thetraded position. This treatment for theunrated senior position is subject to currentand prospective supervisory guidance on acase-by-case basis.

(A) Two highest investment grades. Exceptas otherwise provided in section III. of thisappendix A, the face amount of a recourseobligation, direct credit substitute, or anasset- or mortgage-backed security that israted in either of the two highest investmentgrade categories, e.g., AAA or AA, is assignedto the 20 percent risk category.

(B) Third highest investment grade. Exceptas otherwise provided in this section III. ofthis appendix A, the face amount of arecourse obligation, direct credit substitute,or an asset-or mortgage-backed security thatis rated in the third highest investment gradecategory, e.g., A, is assigned to the 50 percentrisk category.

(C) Lowest investment grade. Except asotherwise provided in this section III. of thisappendix A, the face amount of a recourseobligation, direct credit substitute, or anasset-or mortgage-backed security that israted in the lowest investment gradecategory, e.g., BBB, is assigned to the 100percent risk category.

(D) One category below investment grade.Except as otherwise provided in this sectionIII. of this appendix A, the face amount of arecourse obligation, direct credit substitute,or an asset-or mortgage-backed security thatis rated in the next lower category below thelowest investment grade category, e.g., BB, isassigned a 200 percent risk weight.

(2) Nontraded recourse obligations, directcredit substitutes, or asset-or mortgage-backed securities that are retained, assumedor issued in connection with an assetsecuritization also are eligible for thetreatment described in this paragraphIII.B.3.b.(ii) if they are externally rated withinone of the five highest rating categories bytwo nationally-recognized statistical ratingorganizations, the ratings are publiclyavailable, and the ratings are based on thesame criteria used to rate securities sold tothe public.

(3) A direct credit substitute extended inconnection with an asset securitization thatis not a traded position and is not externallyrated by a nationally-recognized statisticalrating organization (such as a letter of credit)may be eligible for the treatment described insection III.B.3.b.(ii)(1)(C) and (D) of thisappendix A, i.e., a minimum risk weight of100 percent, if it satisfies the criteria of oneof the following approaches deemedappropriate for the institution by the FederalReserve:

(A) A bank, under its qualifying internalrisk rating system, assigns an internal ratingto a direct credit substitute extended to anasset-backed commercial paper program thatis equivalent to an external credit rating onecategory below investment grade or higherprovided by a nationally recognizedstatistical rating organization. A qualifyinginternal risk rating system must be reviewedand deemed appropriate by the FederalReserve and must satisfy the followingcriteria and any other prudential standardsthat the Federal Reserve determines arenecessary. Qualifying internal risk ratingsystems at a minimum must:

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36 Such assets include all nonlocal currencyclaims on, and the portions of claims that areguaranteed by, non-OECD central governments andthose portions of local currency claims on, orguaranteed by, non-OECD central governments thatexceed the local currency liabilities held bysubsidiary depository institutions.

37 Customer liabilities on acceptances outstandinginvolving nonstandard risk claims, such as claimson U.S. depository institutions, are assigned to therisk category appropriate to the identity of theobligor or, if relevant, the nature of the collateralor guarantees backing the claims. Portions ofacceptances conveyed as risk participations to U.S.depository institutions or foreign banks are assignedto the 20 percent risk category appropriate to short-term claims guaranteed by U.S. depositoryinstitutions and foreign banks.

(i) Be an integral part of an effective riskmanagement system that explicitlyincorporates the full range of risks arisingfrom a bank’s participation in securitizationactivities;

(ii) Link the internal ratings to measurableoutcomes, such as the probability that theposition will experience any loss, theposition’s expected loss given default, andthe degree of variance in losses given defaulton that position;

(iii) Separately consider the risk associatedwith the underlying loans or borrowers, andthe risk associated with the structure of aparticular securitization transaction;

(iv) Identify gradations of risk among‘‘pass’’ assets and other risk positions;

(v) Have clear, explicit criteria that areused to classify assets into each internal riskgrade, including subjective factors;

(vi) Have independent credit riskmanagement or loan review personnelassigning or reviewing the credit risk ratings;

(vii) Have an internal audit procedure thatperiodically verifies that the internal creditrisk ratings are assigned in accordance withthe established criteria;

(viii) Monitor the performance of theinternal ratings assigned to nonratednontraded direct credit substitutes over timeto determine the appropriateness of theinitial rating assignment and adjustindividual ratings accordingly; and

(ix) Be consistent with, or moreconservative than, the rating assumptionsand methodologies of nationally recognizedstatistical rating organizations.

(B) A bank’s direct credit substituteextended to a securitization or structuredfinance program is reviewed by a nationallyrecognized statistical rating organization, inconjunction with a review of the overallprogram, and is assigned a rating or itsequivalent. If the program has options fordifferent combinations of assets, standards,internal credit enhancements, and otherrelevant factors, the rating organization mayspecify ranges of rating categories that mayapply premised on which options are utilizedby the bank’s risk position. The bank mustdemonstrate to the Federal Reserve that thenationally recognized statistical ratingorganization’s programmatic rating for its riskposition generally meets the same standardsused by the rating organization for ratingtraded positions, and that the ratingorganization’s underlying premises aresatisfied for particular direct creditsubstitutes issued by the bank. If a bankparticipates in a securitization or structuredfinance program sponsored by another party,the Federal Reserve may authorize the bankto use this approach based on aprogrammatic rating obtained by the sponsorof the program.

(C) A bank may rate its credit risk exposureto direct credit substitutes by relying on aqualifying credit assessment computerprogram. A nationally recognized statisticalrating agency or other acceptable third partymust have developed such a creditassessment system for determining the creditrisk of direct credit substitutes and otherstratified credit positions. Banks mustdemonstrate to the Federal Reserve thatratings under such a credit assessment

computer program correspond credibly andreliably with the ratings assigned by therating agencies to publicly traded securities.

(iii) Determining the credit risk weight foroff-balance sheet securitized assets that aresubject to early amortization provisions. If abank securitizes revolving assets, such ascredit cards, home equity lines, orcommercial loans issued under lines ofcredit, in a securitization transaction that ithas sponsored and which includes earlyamortization provisions, then the sponsoringbank must maintain risk-based capital againstthe off-balance sheet securitized assets fromthe inception of the transaction. An earlyamortization feature is a provision that,under specified conditions, returns principalto investors prior to the expected paymentdates and generally is a result of adeteriorating portfolio. The securitized, off-balance sheet assets are to be converted to anon-balance sheet credit equivalent amountusing the 100 percent conversion factor andassigned to the 20 percent risk category.However, this capital requirement, whencombined with the capital requirements forany retained recourse or direct creditsubstitute associated with the securitizedassets, is limited to a total of 8 percent of theoff-balance sheet securitized assets.

c. Limitations on risk-based capitalrequirements. (i) Low-level exposure. If themaximum contractual liability or exposure toloss retained or assumed by a bank inconnection with a recourse obligation or adirect credit substitute is less than theeffective risk-based capital requirement forthe enhanced assets, the risk-based capitalrequirement is limited to the maximumcontractual liability or exposure to loss, lessany liability account established inaccordance with generally acceptedaccounting principles. This limitation doesnot apply to assets sold with implicitrecourse.

(ii) Mortgage-related securities orparticipation certificates retained in amortgage loan swap. If a bank holds amortgage-related security or a participationcertificate as a result of a mortgage loan swapwith recourse, capital is required to supportthe recourse obligation plus the percentage ofthe mortgage-related security or participationcertificate that is not covered by the recourseobligation. The total amount of capitalrequired for the on-balance sheet asset andthe recourse obligation, however, is limitedto the capital requirement for the underlyingloans, calculated as if the bank continued tohold these loans as an on-balance sheet asset.

(iii) Related on-balance sheet assets. If arecourse obligation or direct credit substitutesubject to section III.B.3. of this appendix Aalso appears as a balance sheet asset, thebalance sheet asset is not included in abank’s risk-weighted assets to the extent thevalue of the balance sheet asset is alreadyincluded in the off-balance sheet creditequivalent amount for the recourse obligationor direct credit substitute, except in the caseof loan servicing assets and similararrangements with embedded recourseobligations or direct credit substitutes. In thelatter cases, both the on-balance sheet assetsand the related recourse obligations and

direct credit substitutes are incorporated intothe risk-based capital calculation.

* * * * *C. * * *4. Category 4: 100 percent. a. All assets not

included in the categories above are assignedto this category, which comprises standardrisk assets. The bulk of the assets typicallyfound in a loan portfolio would be assignedto the 100 percent category.

b. This category includes long-term claimson, and the portions of long-term claims thatare guaranteed by, non-OECD banks, and allclaims on non-OECD central governmentsthat entail some degree of transfer risk.36 Thiscategory includes all claims on foreign anddomestic private-sector obligors not includedin the categories above (including loans tonondepository financial institutions andbank holding companies); claims oncommercial firms owned by the publicsector; customer liabilities to the bank onacceptances outstanding involving standardrisk claims; 37 investments in fixed assets,premises, and other real estate owned;common and preferred stock of corporations,including stock acquired for debts previouslycontracted; all stripped mortgage-backedsecurities and similar instruments; andcommercial and consumer loans (exceptthose assigned to lower risk categories due torecognized guarantees or collateral and loanssecured by residential property that qualifyfor a lower risk weight).

c. Also included in this category areindustrial-development bonds and similarobligations issued under the auspices of stateor political subdivisions of the OECD-basedgroup of countries for the benefit of a privateparty or enterprise where that party orenterprise, not the government entity, isobligated to pay the principal and interest,and all obligations of states or politicalsubdivisions of countries that do not belongto the OECD-based group.

d. The following assets also are assigned arisk weight of 100 percent if they have notbeen deducted from capital: Investments inunconsolidated companies, joint ventures, orassociated companies; instruments thatqualify as capital issued by other bankingorganizations; and any intangibles, includingthose that may have been grandfathered intocapital.

D. * * *The face amount of an off-balance sheet

item is generally incorporated into risk-weighted assets in two steps. The faceamount is first multiplied by a credit

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38 The sufficiency of collateral and guarantees foroff-balance-sheet items is determined by the marketvalue of the collateral or the amount of theguarantee in relation to the face amount of the item,except for derivative contracts, for which thisdetermination is generally made in relation to thecredit equivalent amount. Collateral and guaranteesare subject to the same provisions noted undersection III.B. of this appendix A.

39 Forward forward deposits accepted are treatedas interest rate contracts.

40 That is, a participation in which the originatingbank remains liable to the beneficiary for the fullamount of the direct credit substitute if the partythat has acquired the participation fails to pay whenthe instrument is drawn.

41 A risk participation in bankers acceptancesconveyed to other institutions is also assigned tothe risk category appropriate to the institutionacquiring the participation or, if relevant, theguarantor or nature of the collateral.

42 Risk participations with a remaining maturityof over one year that are conveyed to non-OECDbanks are to be assigned to the 100 percent riskcategory, unless a lower risk category is appropriateto the obligor, guarantor, or collateral.

43 For example, if a bank has a 10 percent shareof a $10 syndicated direct credit substitute thatprovides credit support to a $100 loan, then thebank’s $1 pro rata share in the enhancement meansthat a $10 pro rata share of the loan is included inrisk weighted assets.

5 Consultation would not ordinarily be necessaryif an instrument were redeemed with the proceedsof, or replaced by, a like amount of a similar orhigher quality capital instrument and theorganization’s capital position is considered fullyadequate by the Federal Reserve. In the case oflimited-life Tier 2 instruments, consultation wouldgenerally be obviated if the new security is of equalor greater maturity than the one it replaces.

conversion factor, except for direct creditsubstitutes and recourse obligations asdiscussed in section III.D.1. of this appendixA. The resultant credit equivalent amount isassigned to the appropriate risk categoryaccording to the obligor or, if relevant, theguarantor or the nature of the collateral.38

Attachment IV to this appendix A sets forththe conversion factors for various types ofoff-balance sheet items.

1. Items with a 100 percent conversionfactor. a. Except as otherwise provided insection III.B.3. of this appendix A, the fullamount of an asset or transaction supported,in whole or in part, by a direct creditsubstitute or a recourse obligation. Directcredit substitutes and recourse obligationsare defined in section III.B.3. of thisappendix A.

b. Sale and repurchase agreements andforward agreements. Forward agreements arelegally binding contractual obligations topurchase assets with certain drawdown at aspecified future date. Such obligationsinclude forward purchases, forward forwarddeposits placed,39 and partly-paid shares andsecurities; they do not include commitmentsto make residential mortgage loans orforward foreign exchange contracts.

c. Securities lent by a bank are treated inone of two ways, depending upon whetherthe lender is at risk of loss. If a bank, as agentfor a customer, lends the customer’ssecurities and does not indemnify thecustomer against loss, then the transaction isexcluded from the risk-based capitalcalculation. If, alternatively, a bank lends itsown securities or, acting as agent for acustomer, lends the customer’s securities andindemnifies the customer against loss, thetransaction is converted at 100 percent andassigned to the risk weight categoryappropriate to the obligor, or if applicable toany collateral delivered to the lending bank,or, the independent custodian acting on thelending bank’s behalf. Where a bank is actingas agent for a customer in a transactioninvolving the lending or sale of securitiesthat is collateralized by cash delivered to thebank, the transaction is deemed to becollateralized by cash on deposit in the bankfor purposes of determining the appropriaterisk-weight category, provided that anyindemnification is limited to no more thanthe difference between the market value ofthe securities and the cash collateral receivedand any reinvestment risk associated withthat cash collateral is borne by the customer.

d. In the case of direct credit substitutes inwhich a risk participation 40 has beenconveyed, the full amount of the assets that

are supported, in whole or in part, by thecredit enhancement are converted to a creditequivalent amount at 100 percent. However,the pro rata share of the credit equivalentamount that has been conveyed through arisk participation is assigned to whicheverrisk category is lower: the risk categoryappropriate to the obligor, after consideringany relevant guarantees or collateral, or therisk category appropriate to the institutionacquiring the participation.41 Any remainderis assigned to the risk category appropriate tothe obligor, guarantor, or collateral. Forexample, the pro rata share of the fullamount of the assets supported, in whole orin part, by a direct credit substitute conveyedas a risk participation to a U.S. domesticdepository institution or foreign bank isassigned to the 20 percent risk category.42

e. In the case of direct credit substitutes inwhich a risk participation has been acquired,the acquiring bank’s percentage share of thedirect credit substitute is multiplied by thefull amount of the assets that are supported,in whole or in part, by the creditenhancement and converted to a creditequivalent amount at 100 percent. The creditequivalent amount of an acquisition of a riskparticipation in a direct credit substitute isassigned to the risk category appropriate tothe account party obligor or, if relevant, thenature of the collateral or guarantees.

f. In the case of direct credit substitutesthat take the form of a syndication whereeach bank is obligated only for its pro ratashare of the risk and there is no recourse tothe originating bank, each bank will onlyinclude its pro rata share of the assetssupported, in whole or in part, by the directcredit substitute in its risk-based capitalcalculation.43

* * * * *

PART 225—BANK HOLDINGCOMPANIES AND CHANGE IN BANKCONTROL (REGULATION Y)

1. The authority citation for part 225continues to read as follows:

Authority: 12 U.S.C. 1817(j)(13), 1818,1828(o), 1831i, 1831p–1, 1843(c)(8), 1844(b),1972(1), 3106, 3108, 3310, 3331–3351, 3907,and 3909.

2. In appendix A to part 225:A. The three introductory paragraphs

to section II. are revised;B. A new fifth undesignated

paragraph is added to section III.A.;

C. In section III.B., paragraph 3 isrevised and footnote 26 is removed, andin paragraph 4 footnote 27 is removed;

D. In section III.C., paragraphs 1through 3, footnotes 28 through 40 areredesignated as footnotes 26 through 38,and paragraph 4 is revised;

E. In section III.D., the introductoryparagraph and paragraph 1 are revised;and

F. In section III.D. and III.E., footnote50 is removed and footnotes 51 through57 are redesignated as footnotes 47through 53.

Appendix A to Part 225—Capital AdequacyGuidelines for Bank Holding Companies:Risk-Based Measure

* * * * *II. * * *An institution’s qualifying total capital

consists of two types of capital components:‘‘core capital elements’’ (comprising Tier 1capital) and ‘‘supplementary capitalelements’’ (comprising Tier 2 capital). Thesecapital elements and the various limits,restrictions, and deductions to which theyare subject, are discussed below and are setforth in Attachment II.

The Federal Reserve will, on a case-by-casebasis, determine whether, and if so howmuch of, any liability that does not fit whollywithin the terms of one of the capitalcategories set forth below or that does nothave an ability to absorb lossescommensurate with the capital treatmentotherwise specified below will be counted asan element of Tier 1 or Tier 2 capital. Inmaking such a determination, the FederalReserve will consider the similarity of theliability to liabilities explicitly treated in theguidelines, the ability of the liability toabsorb losses while the institution operatesas a going concern, the maturity andredemption features of the liability, and otherrelevant terms and factors. To qualify as anelement of Tier 1 or Tier 2 capital, a capitalinstrument may not contain or be covered byany covenants, terms, or restrictions that areinconsistent with safe and sound bankingpractices.

Redemptions of permanent equity or othercapital instruments before stated maturitycould have a significant impact on aorganization’s overall capital structure.Consequently, an organization consideringsuch a step should consult with the FederalReserve before redeeming any equity or debtcapital instrument (prior to maturity) if suchredemption could have a material effect onthe level or composition of the organization’scapital base.5

* * * * *III. * * *A. * * *

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The Federal Reserve will, on a case-by-casebasis, determine the appropriate risk weightfor any asset or the credit equivalent amountof an off-balance sheet item that does not fitwholly within the terms of one of the riskweight categories set forth below or thatimposes risks on a bank that areincommensurate with the risk weightotherwise specified below for the asset or off-balance sheet item. In addition, the FederalReserve will, on a case-by-case basis,determine the appropriate credit conversionfactor for any off-balance sheet item that doesnot fit wholly within the terms of one of thecredit conversion factors set forth below orthat imposes risks on an institution that areincommensurate with the credit conversionfactors otherwise specified below for the off-balance sheet item. In making such adetermination, the Federal Reserve willconsider the similarity of the asset or off-balance sheet item to assets or off-balancesheet items explicitly treated in theguidelines, as well as other relevant factors.

B. * * *3. Recourse obligations, direct credit

substitutes, and asset-and mortgage-backedsecurities. Direct credit substitutes, assetstransferred with recourse, and securitiesissued in connection with assetsecuritizations and structured financings aretreated as described below. Use of the term‘‘asset securitizations’’ or ‘‘securitizations’’ inthis rule includes structured financings, aswell as asset securitization transactions.

a. Definitions. (i) Credit derivatives are on-or off-balance sheet notes or contracts thatallow one party (the ‘‘beneficiary’’) to transferthe credit risk of a ‘‘reference asset,’’ whichit often owns, to another party (the‘‘guarantor’’). The value of a credit derivativeis dependent, at least in part, on the creditperformance of the reference asset, whichtypically is a publicly traded loan orcorporate bond.

(ii) Credit-enhancing representations andwarranties means representations andwarranties extended by a bank when ittransfers assets (including loan servicingassets) or assumed by the bank when itpurchases loan servicing assets that obligatethe bank to absorb credit losses ontransferred assets or serviced loans. Theserepresentations and warranties typically arisewhen the bank agrees to protect purchasersor some other party from losses due to thedefault or nonperformance of the obligor onthe transferred assets or serviced loans, orinsufficiency in the value of collateralsupporting the transferred assets or servicedloans.

(iii) Direct credit substitute means anarrangement in which a banking organizationassumes, in form or in substance, any risk ofcredit loss directly or indirectly associatedwith a third-party asset or other financialclaim, that exceeds the bankingorganization’s pro rata share of the asset orclaim. If the banking organization has noclaim on the asset, then the assumption ofany risk of loss is a direct credit substitute.Direct credit substitutes include, but are notlimited to:

(1) Financial guarantee-type standby lettersof credit that support financial claims on theaccount party;

(2) Guarantees, surety arrangements, creditderivatives, and irrevocable guarantee-typeinstruments backing financial claims such asoutstanding securities, loans, or otherfinancial liabilities, or that back off-balancesheet items against which risk-based capitalmust be maintained;

(3) Purchased subordinated interests orsecurities that absorb more than their pro ratashare of losses from the underlying assets;

(4) Loans or lines of credit that providecredit enhancement for the financialobligations of an account party; and

(5) Purchased loan servicing assets if theservicer is responsible for credit lossesassociated with the loans being serviced(other than mortgage servicer cash advancesas defined in paragraph III.B.3.a.(vi) of thisappendix A), or if the servicer makes orassumes credit-enhancing representationsand warranties with respect to the servicedloans.

(iv) Externally rated means, with respect toan instrument or obligation, that theinstrument or obligation has received a creditrating from a nationally-recognized statisticalrating organization.

(v) Financial guarantee-type standby letterof credit means any letter of credit or similararrangement, however named or described,that represents an irrevocable obligation tothe beneficiary on the part of the issuer:

(1) To repay money borrowed by, advancedto, or for the account of, the account party;or

(2) To make payment on account of anyindebtedness undertaken by the accountparty in the event that the account party failsto fulfill its obligation to the beneficiary.

(vi) Mortgage servicer cash advance meansfunds that a residential mortgage loanservicer advances to ensure an uninterruptedflow of payments or the timely collection ofresidential mortgage loans, includingdisbursements made to cover foreclosurecosts or other expenses arising from amortgage loan to facilitate its timelycollection. A mortgage servicer cash advanceis not a recourse obligation or a direct creditsubstitute if the mortgage servicer is entitledto full reimbursement or, for any oneresidential mortgage loan, nonreimbursableadvances are contractually limited to aninsignificant amount of the outstandingprincipal on that loan.

(vii) Nationally recognized statistical ratingorganization means an entity recognized bythe Division of Market Regulation of theSecurities and Exchange Commission as anationally recognized statistical ratingorganization for various purposes, includingthe Commission’s uniform net capitalrequirements for brokers and dealers (17 CFR240.15c3–1(c)(2)(vi)(E), (F), and (H)).

(viii) Recourse means an arrangement inwhich a banking organization retains, in formor in substance, any risk of credit lossdirectly or indirectly associated with atransferred asset that exceeds a pro rata shareof the banking organization’s claim on theasset. If a banking organization has no claimon a transferred asset, then the retention ofany risk of loss is recourse. A recourseobligation typically arises when aninstitution transfers assets and retains anobligation to repurchase the assets or absorb

losses due to a default of principal or interestor any other deficiency in the performance ofthe underlying obligor or some other party.Recourse may exist implicitly where abanking organization provides creditenhancement beyond any contractualobligation to support assets it has sold.Recourse obligations include, but are notlimited to:

(1) Credit-enhancing representations andwarranties on the transferred assets thatobligate the servicer to absorb credit losses,including early-default clauses;

(2) Retained loan servicing assets if theservicer is responsible for losses associatedwith the loans being serviced other thanmortgage servicer cash advances as definedin paragraph III.B.3.a.(v) of this appendix A.

(3) Retained subordinated interests orsecurities or credit derivatives that absorbmore than their pro rata share of losses fromthe underlying assets;

(4) Assets sold under an agreement torepurchase if the assets are not alreadyincluded on the balance sheet; and

(5) Loan strips sold without direct recoursewhere the maturity of the transferred loanthat is drawn is shorter than the maturity ofthe commitment.

(ix) Securitization means the pooling andrepackaging of loans or other creditexposures into securities that can be sold toinvestors. For purposes of this appendix A,securitization also includes structuredfinance transactions or programs thatgenerally create stratified credit riskpositions, whether in the form of a securityor not, whose performance is dependentupon an underlying pool of credit exposures,including loans and commitments.

(x) Traded position means a recourseobligation, direct credit substitute, or asset-or mortgage-backed security that is retained,assumed, or issued in connection with anasset securitization and that is rated with areasonable expectation that, in the nearfuture:

(1) The position would be sold to investorsrelying on the rating; or

(2) A third party would, in reliance on therating, enter into a transaction such as apurchase, loan, or repurchase agreementinvolving the position.

b. Amount of position to be included inrisk-weighted assets. Types of recourseobligations or direct credit substitutes, otherthan those listed in section III.B.3.b.(i)(1)through (7) of this appendix A, should betreated in accordance with the principlescontained in section III.B.3 of this appendixA. The treatment of direct credit substitutesthat have been syndicated or in which riskparticipations have been conveyed oracquired is set forth in section III.D.1 of thisappendix A.

(i) General rule for determining the creditequivalent amount and risk weight ofrecourse obligations and direct creditsubstitutes. Except as otherwise provided insection III of this appendix A, the riskweighted asset amount or the creditequivalent amount for a recourse obligationor direct credit substitute is the full amountof the credit enhanced assets from which riskof credit loss is directly or indirectly retainedor assumed. This credit equivalent amount is

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assigned to the risk weight categoryappropriate to the obligor or, if relevant, theguarantor or nature of any collateral. Thus, abanking organization that extends a partialdirect credit substitute, e.g., a financialstandby letter of credit, that absorbs the first10 percent of loss on a transaction, mustmaintain capital against the full amount ofthe assets being supported. Furthermore, fordirect credit substitutes that are on-balancesheet assets, e.g., purchased subordinatedsecurities, banking organizations mustmaintain capital against the amount of thedirect credit substitutes and the full amountof the assets being supported, i.e., all moresenior positions. This treatment is subject tothe low-level capital rule discussed insection III.B.3.c.(i) of this appendix A. Forpurposes of this appendix A, the full amountof the credit enhanced assets from which riskof credit loss is directly or indirectly retainedor assumed means for:

(1) A financial guarantee-type standbyletter of credit, surety arrangement, creditderivative, guarantee, or irrevocableguarantee-type instruments, the full amountof the assets that the direct credit substitutefully or partially supports;

(2) A subordinated interest or security, theamount of the subordinated interest orsecurity plus all more senior interests orsecurities;

(3) Mortgage servicing assets that arerecourse obligations or direct creditsubstitutes, the outstanding amount of theloans serviced;

(4) Credit-enhancing representations andwarranties, the amount of the assets subjectto the representations or warranties;

(5) Loans or lines of credit that providecredit enhancement for the financialobligations of an account party, the fullamount of the enhanced financialobligations;

(6) Loans strips, the amount of the loans;and

(7) For assets sold with recourse, theamount of assets for which risk of loss isdirectly or indirectly retained, less anyapplicable recourse liability accountestablished in accordance with generallyaccepted accounting principles.

(ii) Determining the credit risk weight ofrecourse obligations, direct credit substitutes,and asset- and mortgage-backed securitiesthat are rated within one of the five highestrating categories. (1) A traded position iseligible for the risk-based capital treatmentdescribed in this paragraph if its externalrating is within one of the five highest ratingcategories, e.g. AAA through BB, used by anationally-recognized statistical ratingorganization. A recourse obligation, directcredit substitute, or asset- or mortgage-backedsecurity which is not externally rated but issenior in all respects to a traded position thatis externally rated, including access to anycollateral, is also eligible for the risk-basedcapital treatment described in this paragraphIII.B.3.b.(ii) as if it had the same rating as thetraded position. This treatment for theunrated senior position is subject to currentand prospective supervisory guidance on acase-by-case basis.

(A) Two highest investment grades. Exceptas otherwise provided in this section III. of

this appendix A, the face amount of arecourse obligation, direct credit substitute,or an asset- or mortgage-backed security thatis rated in either of two highest investmentgrade categories, e.g., AAA or AA, is assignedto the 20 percent risk category.

(B) Third highest investment grade. Exceptas otherwise provided in this section III. ofthis appendix A, the face amount of arecourse obligation, direct credit substitute,or an asset- or mortgage-backed security thatis rated in the third highest investment gradecategory, e.g., A, is assigned to the 50 percentrisk category.

(C) Lowest investment grade. Except asotherwise provided in this section III. of thisappendix A, the face amount of a recourseobligation, direct credit substitute, or anasset- or mortgage-backed security that israted in the lowest investment gradecategory, e.g., BBB, is assigned to the 100percent risk category.

(D) One category below investment grade.Except as otherwise provided in this sectionIII. of this appendix A, the face amount of arecourse obligation, direct credit substitute,or an asset- or mortgage-backed security thatis rated in the next lower category below thelowest investment grade category, e.g., BB, isassigned to the 200 percent risk category.

(2) Nontraded recourse obligations, directcredit substitutes, or asset- or mortgage-backed securities that are retained, assumed,or issued in connection with an assetsecuritization are also eligible for thetreatment described in this paragraphIII.B.3.b.(ii) if they are externally rated withinone of the five highest rating categories bytwo nationally-recognized statistical ratingorganizations, the ratings are publiclyavailable, and the ratings are based on thesame criteria used to rate securities sold tothe public.

(3) A direct credit substitute extended inconnection with an asset securitization thatis not a traded position and is not externallyrated by a nationally-recognized statisticalrating organization (such as a letter of credit)may be eligible for the treatment described inparagraph III.B.3.b.ii(1)(C) and (D), i.e., aminimum risk weight of 100 percent, if itsatisfies the criteria of one of the followingapproaches deemed appropriate for theorganization by the Federal Reserve:

(A) A banking organization, under itsqualifying internal risk rating system, assignsan internal rating to a direct credit substituteextended to an asset-backed commercialpaper program that is equivalent to anexternal credit rating one category belowinvestment grade or higher provided by anationally recognized statistical ratingorganization. A qualifying internal risk ratingsystem must be reviewed and deemedappropriate by the Federal Reserve and mustsatisfy the following criteria and any otherprudential standards that the Federal Reservedetermines are necessary. Qualifying internalrisk rating systems at a minimum must:

(i) Be an integral part of an effective riskmanagement system that explicitlyincorporates the full range of risks arisingfrom a banking organization’s participationin securitization activities;

(ii) Link the internal ratings to measurableoutcomes, such as the probability that the

position will experience any loss, theposition’s expected loss given default, andthe degree of variance in losses given defaulton that position;

(iii) Separately consider the risk associatedwith the underlying loans or borrowers, andthe risk associated with the structure of aparticular securitization transaction;

(iv) Identify gradations of risk among‘‘pass’’ assets and other risk positions;

(v) Have clear, explicit criteria that areused to classify assets into each internal riskgrade, including subjective factors;

(vi) Have independent credit riskmanagement or loan review personnelassigning or reviewing the credit risk ratings;

(vii) Have an internal audit procedure thatperiodically verifies that the internal creditrisk ratings are assigned in accordance withthe established criteria;

(viii) Monitor the performance of theinternal ratings assigned to nonratednontraded direct credit substitutes over timeto determine the appropriateness of theinitial rating assignment and adjustindividual ratings accordingly; and,

(ix) Be consistent with, or moreconservative than, the rating assumptionsand methodologies of nationally recognizedstatistical rating organizations.

(B) A banking organization’s direct creditsubstitute extended to a securitization orstructured finance program is reviewed by anationally recognized statistical ratingorganization, in conjunction with a review ofthe overall program, and is assigned a ratingor its equivalent. If the program has optionsfor different combinations of assets,standards, internal credit enhancements, andother relevant factors, the rating organizationmay specify ranges of rating categories thatmay apply premised on which options areutilized by the bank’s risk position. Thebanking organization must demonstrate tothe Federal Reserve that the nationallyrecognized statistical rating organization’sprogrammatic rating for its risk positiongenerally meets the same standards used bythe rating organization for rating tradedpositions, and that the rating organization’sunderlying premises are satisfied forparticular direct credit substitutes issued bythe institution. If a banking organizationparticipates in a securitization or structuredfinance program sponsored by another party,the Federal Reserve may authorize theinstitution to use this approach based on aprogrammatic rating obtained by the sponsorof the program.

(C) An institution may rate its credit riskexposure to direct credit substitutes byrelying on a qualifying credit assessmentcomputer program. A nationally recognizedstatistical rating agency or other acceptablethird party must have developed such acredit assessment system for determining thecredit risk of direct credit substitutes andother stratified credit positions. Institutionsmust demonstrate to the Federal Reserve thatratings under such a credit assessmentcomputer program correspond credibly andreliably with the ratings assigned by therating agencies to publicly traded securities.

(iii) Determining the credit risk weight foroff-balance sheet securitized assets that aresubject to early amortization provisions. If a

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39 Such assets include all nonlocal currencyclaims on, and the portions of claims that areguaranteed by, non-OECD central governments andthose portions of local currency claims on, orguaranteed by, non-OECD central governments thatexceed the local currency liabilities held bysubsidiary depository institutions.

40 Customer liabilities on acceptances outstandinginvolving nonstandard risk claims, such as claimson U.S. depository institutions, are assigned to therisk category appropriate to the identity of theobligor or, if relevant, the nature of the collateralor guarantees backing the claims. Portions ofacceptances conveyed as risk participations to U.S.depository institutions or foreign banks are assignedto the 20 percent risk category appropriate to short-term claims guaranteed by U.S. depositoryinstitutions and foreign banks.

41 The sufficiency of collateral and guarantees foroff-balance-sheet items is determined by the marketvalue of the collateral of the amount of theguarantee in relation to the face amount of the item,except for derivative contracts, for which thisdetermination is generally made in relation to thecredit equivalent amount. Collateral and guaranteesare subject to the same provisions noted undersection III.B. of this appendix A.

42 Forward forward deposits accepted are treatedas interest rate contracts.

43 That is, a participation in which the originatingbanking organization remains liable to thebeneficiary for the full amount of the direct creditsubstitute if the party that has acquired theparticipation fails to pay when the instrument isdrawn.

bank securitizes revolving assets, such ascredit cards, home equity lines, orcommercial loans issued under lines ofcredit, in a securitization transaction that ithas sponsored and which includes earlyamortization provisions, then the sponsoringbank must maintain risk-based capital againstthe off-balance sheet securitized assets fromthe inception of the transaction. An earlyamortization feature is a provision that,under specified conditions, returns principalto investors prior to the expected paymentdates and generally is a result of adeteriorating portfolio. The securitized, off-balance sheet assets are to be converted to anon-balance sheet credit equivalent amountusing the 100 percent conversion factor andassigned to the 20 percent risk category.However, this capital requirement, whenconbined with the capital requirements forany retained recourse or direct creditsubstitute associated with the securitizedassets, is limited to a toal of 8 percent of theoff-balance sheet securitized assets.

c. Limitations on risk-based capitalrequirements. (i) Low-level exposure. If themaximum contractual liability or exposure toloss retained or assumed by a bankingorganization in connection with a recourseobligation or a direct credit substitute is lessthan the effective risk-based capitalrequirement for the enhanced assets, the risk-based capital requirement is limited to themaximum contractual liability or exposure toloss, less any recourse liability accountestablished in accordance with generallyaccepted accounting principles. Thislimitation does not apply to assets sold withimplicit recourse.

(ii) Mortgage-related securities orparticipation certificates retained in amortgage loan swap. If a bankingorganization holds a mortgage-relatedsecurity or a participation certificate as aresult of a mortgage loan swap with recourse,capital is required to support the recourseobligation plus the percentage of themortgage-related security or participationcertificate that is not covered by the recourseobligation. The total amount of capitalrequired for the on-balance sheet asset andthe recourse obligation, however, is limitedto the capital requirement for the underlyingloans, calculated as if the bankingorganization continued to hold these loans asan on-balance sheet asset.

(iii) Related on-balance sheet assets. If arecourse obligation or direct credit substitutesubject to section III.B.3. of this appendix Aalso appears as a balance sheet asset, thebalance sheet asset is not included in abanking organization’s risk-weighted assetsto the extent the value of the balance sheetasset is already included in the off-balancesheet credit equivalent amount for therecourse obligation or direct credit substitute,except in the case of loan servicing assets andsimilar arrangements with embeddedrecourse obligations or direct creditsubstitutes. In the latter cases, both the on-balance sheet assets and the related recourseobligations and direct credit substitutes areincorporated into the risk-based capitalcalculation.

* * * * *C. * * *

4. Category 4: 100 percent. a. All assets notincluded in the categories above are assignedto this category, which comprises standardrisk assets. The bulk of the assets typicallyfound in a loan portfolio would be assignedto the 100 percent category.

b. This category includes long-term claimson, and the portions of long-term claims thatare guaranteed by, non-OECD banks, and allclaims on non-OECD central governmentsthat entail some degree of transfer risk.39 Thiscategory includes all claims on foreign anddomestic private-sector obligors not includedin the categories above (including loans tonondepository financial institutions andbank holding companies); claims oncommercial firms owned by the publicsector; customer liabilities to the bank onacceptances outstanding involving standardrisk claims; 40 investments in fixed assets,premises, and other real estate owned;common and preferred stock of corporations,including stock acquired for debts previouslycontracted; all stripped mortgage-backedsecurities and similar instruments; andcommercial and consumer loans (exceptthose assigned to lower risk categories due torecognized guarantees or collateral and loanssecured by residential property that qualifyfor a lower risk weight).

c. Also included in this category areindustrial-development bonds and similarobligations issued under the auspices of stateor political subdivisions of the OECD-basedgroup of countries for the benefit of a privateparty or enterprise where that party orenterprise, not the government entity, isobligated to pay the principal and interest,and all obligations of states or politicalsubdivisions of countries that do not belongto the OECD-based group.

d. The following assets also are assigned arisk weight of 100 percent if they have notbeen deducted from capital: investments inunconsolidated companies, joint ventures, orassociated companies; instruments thatqualify as capital issued by other bankingorganizations; and any intangibles, includingthose that may have been grandfathered intocapital.

D. * * *The face amount of an off-balance sheet

item is generally incorporated into risk-weighted assets in two steps. The faceamount is first multiplied by a creditconversion factor, except for direct creditsubstitutes and recourse obligations asdiscussed in section III.D.1. of this appendixA. The resultant credit equivalent amount is

assigned to the appropriate risk categoryaccording to the obligor or, if relevant, theguarantor or the nature of the collateral.41

Attachment IV to this appendix A sets forththe conversion factors for various types ofoff-balance sheet items.

1. Items with a 100 percent conversionfactor. a. Except as otherwise provided insection III.B.3. of this appendix A, the fullamount of an asset or transaction supported,in whole or in part, by a direct creditsubstitute or a recourse obligation. Directcredit substitutes and recourse obligationsare defined in section III.B.3. of thisappendix A. b. Sale and repurchaseagreements and forward agreements. Forwardagreements are legally binding contractualobligations to purchase assets with certaindrawdown at a specified future date. Suchobligations include forward purchases,forward forward deposits placed,42 andpartly-paid shares and securities; they do notinclude commitments to make residentialmortgage loans or forward foreign exchangecontracts.

c. Securities lent by a banking organizationare treated in one of two ways, dependingupon whether the lender is at risk of loss. Ifa banking organization, as agent for acustomer, lends the customer’s securities anddoes not indemnify the customer against loss,then the transaction is excluded from therisk-based capital calculation. If,alternatively, a banking organization lends itsown securities or, acting as agent for acustomer, lends the customer’s securities andindemnifies the customer against loss, thetransaction is converted at 100 percent andassigned to the risk weight categoryappropriate to the obligor, or if applicable toany collateral delivered to the lending bank,or, the independent custodian acting on thelending banking organization’s behalf. Wherea banking organization is acting as agent fora customer in a transaction involving thelending or sale of securities that iscollateralized by cash delivered to thebanking organization, the transaction isdeemed to be collateralized by cash ondeposit in the banking organization forpurposes of determining the appropriate risk-weight category, provided that anyindemnification is limited to no more thanthe difference between the market value ofthe securities and the cash collateral receivedand any reinvestment risk associated withthat cash collateral is borne by the customer.

d. In the case of direct credit substitutes inwhich a risk participation 43 has beenconveyed, the full amount of the assets that

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44 A risk participation in bankers acceptancesconveyed to other institutions is also assigned tothe risk category appropriate to the institutionacquiring the participation or, if relevant, theguarantor or nature of the collateral.

45 Risk participations with a remaining maturityof over one year that are conveyed to non-OECDbanks are to be assigned to the 100 percent riskcategory, unless a lower risk category is appropriateto the obligor, guarantor, or collateral.

46 For example, if a banking organization has a 10percent share of a $10 syndicated direct creditsubstitute that provides credit support to a $100loan, then the banking organization’s $1 pro ratashare in the enhancement means that a $10 pro ratashare of the loan is included in risk weighted assets.

are supported, in whole or in part, by thecredit enhancement are converted to a creditequivalent amount at 100 percent. However,the pro rata share of the credit equivalentamount that has been conveyed through arisk participation is assigned to whicheverrisk category is lower: the risk categoryappropriate to the obligor, after consideringany relevant guarantees or collateral, or therisk category appropriate to the institutionacquiring the participation.44 Any remainderis assigned to the risk category appropriate tothe obligor, guarantor, or collateral. Forexample, the pro rata share of the fullamount of the assets supported, in whole orin part, by a direct credit substitute conveyedas a risk participation to a U.S. domesticdepository institution or foreign bank isassigned to the 20 percent risk category.45

e. In the case of direct credit substitutes inwhich a risk participation has been acquired,the acquiring banking organization’spercentage share of the direct creditsubstitute is multiplied by the full amount ofthe assets that are supported, in whole or inpart, by the credit enhancement andconverted to a credit equivalent amount at100 percent. The credit equivalent amount ofan acquisition of a risk participation in adirect credit substitute is assigned to the riskcategory appropriate to the account partyobligor or, if relevant, the nature of thecollateral or guarantees.

f. In the case of direct credit substitutesthat take the form of a syndication whereeach banking organization is obligated onlyfor its pro rata share of the risk and there isno recourse to the originating bankingorganization, each banking organization willonly include its pro rata share of the assetssupported, in whole or in part, by the directcredit substitute in its risk-based capitalcalculation.46

* * * * *By order of the Board of Governors of the

Federal Reserve System, February 10, 2000.Jennifer J. Johnson,Secretary of the Board.

Federal Deposit Insurance Corporation

12 CFR Chapter III

Authority and Issuance

For the reasons set forth in the jointpreamble, part 325 of chapter III of title12 of the Code of Federal Regulations isproposed to be amended as follows:

PART 325—CAPITAL MAINTENANCE

1. The authority citation for part 325continues to read as follows:

Authority: 12 U.S.C. 1815(a), 1815(b),1816, 1818(a), 1818(b), 1818(c), 1818(t),1819(Tenth), 1828(c), 1828(d), 1828(i),1828(n), 1828(o), 1831o, 1835, 3907, 3909,4808; Pub. L. 102–233, 105 Stat. 1761, 1789,1790 (12 U.S.C. 1831n note); Pub. L. 102–242, 105 Stat. 2236, 2355, as amended byPub. L. 103–325, 108 Stat. 2160, 2233 (12U.S.C. 1828 note); Pub. L. 102–242, 105 Stat.2236, 2386, as amended by Pub. L. 102–550,106 Stat. 3672, 4089 (12 U.S.C. 1828 note).

2. In appendix A to part 325, sectionII:

A. In paragraph A., the first twoundesignated paragraphs are designated1. and 2. respectively;

B. A new paragraph A.3. is added;C. Paragraph B. is amended by

revising paragraph B.5.;D. In paragraph C., Category 1—Zero

Percent Risk Weight through Category3—50 Percent Risk Weight, footnotes 15through 31 are redesignated as footnotes19 through 34;

E. In paragraph C., Category 2—20Percent Risk Weight, the threeundesignated paragraphs are designatedas paragraphs a. through c., respectively,and a new paragraph d. is added;

F. In paragraph C., Category 3—50Percent Risk Weight, the thirdundesignated paragraph is removed andthe remaining three undesignatedparagraphs are designated as paragraphsa. through c., respectively;

G. In paragraph C., Category 3—50Percent Risk Weight, newly designatedfootnote 32 is revised;

H. In paragraph C., Category 4—100Percent Risk Weight is revised;

I. In paragraph C., following theparagraph titled Category 4—100Percent Risk Weight, a new paragraphtitled Category 5—200 Percent RiskWeight is added;

J. In paragraph D., the undesignatedintroductory paragraph is revised;

K. Paragraph D.1. is revised;L. In paragraph D.2., footnote 38 is

removed; andM. In paragraphs D.2. and E.,

footnotes 39 through 42 are redisignatedas footnotes 38 through 41.

Appendix A to Part 325—Statement of Policyon Risk-Based Capital

* * * * *

II. * * *

A. * * *3. The Director of the Division of

Supervision may, on a case-by-case basis,determine the appropriate risk weight for anyasset or credit equivalent amount that doesnot fit wholly within one of the riskcategories set forth below or that imposesrisks on a bank that are not commensurate

with the risk weight otherwise specifiedbelow for the asset or credit equivalentamount. In addition, the Director of theDivision of Supervision may, on a case-by-case basis, determine the appropriate creditconversion factor for any off-balance sheetitem that does not fit wholly within one ofthe credit conversion factors set forth belowor that imposes risks on a bank that are notcommensurate with the credit conversionfactor otherwise specified below for the off-balance sheet item. In making such adetermination, the Director of the Division ofSupervision will consider the similarity ofthe asset or off-balance sheet item to assetsor off-balance sheet items explicitly treatedin the guidelines, as well as other relevantfactors.

B. * * *5. Recourse obligations, direct credit

substitutes, and asset-and mortgage-backedsecurities. Direct credit substitutes, assetssold with recourse, and securities issued inconnection with asset securitizations aretreated as described below.

(a) Definitions. (i) Credit derivative meansan on-or off-balance sheet note or contractthat allows one party (the ‘‘beneficiary’’) totransfer the credit risk of a ‘‘reference asset,’’which the beneficiary often owns, to anotherparty (the ‘‘guarantor’’). The value of a creditderivative is dependent, at least in part, onthe credit performance of the reference asset,which typically is a publicly traded loan orcorporate bond.

(ii) Credit-enhancing representations andwarranties means representations andwarranties, extended by a bank when ittransfers assets (including loan servicingassets) or assumed by the bank when itpurchases loan servicing assets, that obligatethe bank to protect another party from lossesdue to credit risk in the transferred assets orserviced loans. These representations andwarranties typically arise when the bankagrees to protect purchasers or some otherparty from losses due to:

(1) The default or nonperformance of theobligor on the transferred assets or servicedloans; or

(2) Insufficiency in the value of collateralsupporting the transferred assets or servicedloans.

(iii) Direct credit substitute means anarrangement in which a bank assumes, inform or in substance, any risk of credit lossdirectly or indirectly associated with a third-party asset or other financial claim, thatexceeds the bank’s pro rata share of the assetor claim. If the bank has no claim on theasset, then the assumption of any risk of lossis a direct credit substitute. Direct creditsubstitutes include, but are not limited to:

(1) Financial standby letters of credit,which includes any letter of credit or similararrangement, however named or described,that represents an irrevocable obligation tothe beneficiary on the part of the issuer:

(a) To repay money borrowed by, advancedto, or for the account of, the account party,or

(b) To make payment on account of anyindebtedness undertaken by the accountparty in the event that the account party failsto fulfill its obligation to the beneficiary.

(2) Guarantees, surety arrangements, creditderivatives, and irrevocable guarantee-type

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14 That is, a participation in which the originatingbank remains liable to the beneficiary for the fullamount of the direct credit substitute if the partythat has acquired the participation fails to pay whenthe instrument is drawn.

15 A risk participation in a bankers acceptanceconveyed to another institution is also assigned tothe risk category appropriate to the institutionacquiring the participation or, if relevant, theguarantor or nature of the collateral.

16 A risk participation with a remaining maturityof one year or less that is conveyed to a non-OECDbank is also assigned to the 20 percent risk category.

instruments backing financial claims such asoutstanding securities, loans, or otherfinancial claims, or that back off-balance-sheet items against which risk-based capitalmust be maintained;

(3) Purchased subordinated interests orsecurities that absorb more than their pro ratashare of credit losses from the underlyingassets;

(4) Loans or lines of credit that providecredit enhancement for the financialobligations of an account party; and

(5) Purchased loan servicing assets if theservicer is responsible for credit lossesassociated with the loans being serviced(other than mortgage servicer cash advancesas defined in paragraph B.5(a)(vi) of thissection), or if the servicer makes or assumescredit-enhancing representations andwarranties on the serviced loans.

(iv) Externally rated means, with respect toan instrument or obligation, that theinstrument or obligation has received a creditrating from a nationally-recognized statisticalrating organization.

(v) Face amount means the notionalprincipal, or face value, amount of an off-balance sheet item; the amortized cost of anasset not held for trading purposes; and thefair value of a trading asset.

(vi) Mortgage servicer cash advance meansfunds that a residential mortgage loanservicer advances to ensure an uninterruptedflow of payments or the timely collection ofresidential mortgage loans, includingdisbursements made to cover foreclosurecosts or other expenses arising from amortgage loan to facilitate its timelycollection, so long as the mortgage servicer isentitled to full reimbursement ornonreimbursable advances are contractuallylimited to an insignificant amount of theoutstanding principal for any one residentialmortgage loan, and the servicer’s entitlementto reimbursement is not subordinated.

(vii) Nationally recognized statistical ratingorganization means an entity recognized bythe Division of Market Regulation of theSecurities and Exchange Commission as anationally recognized statistical ratingorganization for various purposes, includingthe Commission’s uniform net capitalrequirements for brokers and dealers (17 CFR240.15c3–1(c)(2)(vi)(E), (F), and (H)).

(viii) Recourse means an arrangement inwhich a bank retains, in form or insubstance, any risk of credit loss directly orindirectly associated with an asset it hastransferred and sold that exceeds a pro ratashare of the bank’s claim on the asset. If abank has no claim on an asset it hastransferred and sold, then the retention ofany risk of credit loss is recourse. A recourseobligation typically arises when aninstitution transfers assets in a sale andretains an obligation to repurchase the assetsor absorb losses due to a default of principalor interest or any other deficiency in theperformance of the underlying obligor orsome other party. Recourse may existimplicitly where a bank provides creditenhancement beyond any contractualobligation to support assets it has sold.Recourse obligations include, but are notlimited to:

(1) Credit-enhancing representations andwarranties on the transferred assets;

(2) Retained loan servicing assets if theservicer is responsible for credit lossesassociated with the loans being serviced(including credit-enhancing representationsand warranties), other than mortgage servicercash advances as defined in paragraphB.5(a)(vi) of this section;

(3) Retained subordinated interests orsecurities, or credit derivatives that absorbmore than their pro rata share of credit lossesfrom the underlying assets;

(4) Assets sold under an agreement torepurchase, if the assets are not alreadyincluded on the balance sheet; and

(5) Loan strips sold without direct recoursewhere the maturity of the transferred loanthat is drawn is shorter than the maturity ofthe commitment.

(ix) Securitization means the pooling andrepackaging of loans or other creditexposures into securities that can be sold toinvestors. For purposes of this section II.B.5,securitization also includes transactions orprograms that generally create stratifiedcredit risk positions, whether in the form ofa security or not, whose performance isdependent upon an underlying pool of loansor other credit exposures.

(x) Traded position means a recourseobligation, direct credit substitute, or asset-ormortgage-backed security that is retained,assumed, or issued in connection with anasset securitization and that is externallyrated with a reasonable expectation that, inthe near future:

(1) The position would be sold to investorsrelying on the external rating; or

(2) A third party would, in reliance on theexternal rating, enter into a transaction suchas a purchase, loan, or repurchase agreementinvolving the position.

(b) Amount of position to be included inrisk-weighted assets—(i) General rule fordetermining the credit equivalent amountand risk weight of recourse obligations anddirect credit substitutes. Except as otherwiseprovided in this section II.B. of this appendixA, the credit equivalent amount for arecourse obligation or direct credit substituteis the full amount of the credit enhancedassets from which risk of credit loss isdirectly or indirectly retained or assumed bythe bank. This credit equivalent amount isassigned to the risk category appropriate tothe obligor, or if relevant, the guarantor ornature of any collateral. Thus, a bank thatextends a partial direct credit substitute, e.g.,a financial standby letter of credit thatabsorbs the first 10 percent of loss on atransaction, must maintain capital against thefull amount of the assets being supported.Furthermore, for a direct credit substitutethat is an on-balance sheet asset, e.g., apurchased subordinated security, a bankmust maintain capital against the amount ofthe direct credit substitute and the fullamount of the assets being supported, i.e., allmore senior positions. This treatment issubject to the low-level exposure rulediscussed in section II.B.5(c)(i) of thisappendix A. For purposes of this appendixA, the full amount of the credit enhancedassets from which risk of credit loss isdirectly or indirectly retained or assumedmeans for:

(1) A financial standby letter of credit,surety arrangement, credit derivative,

guarantee, or irrevocable guarantee-typeinstrument, the full amount of the assets thatthe direct credit substitute fully or partiallysupports;

(2) A subordinated interest or security, theamount of the subordinated interest orsecurity plus all more senior interests orsecurities;

(3) Loan servicing assets that are recourseobligations or direct credit substitutes, theoutstanding amount of the loans serviced;

(4) Credit-enhancing representations andwarranties, the amount of the assets subjectto the representations or warranties;

(5) Loans or lines of credit that providecredit enhancement for the financialobligations of an account party, the fullamount of the enhanced financialobligations;

(6) Loans strips, the amount of the loanssold; and

(7) Assets sold with recourse, the fullamount of the assets from which risk ofcredit loss is directly or indirectly retained,less any applicable recourse liability accountestablished in accordance with generallyaccepted accounting principles.

(ii) Participations in and syndications ofdirect credit substitutes. Subject to the low-level exposure rule discussed in sectionII.B.5(c)(i) of this appendix A:

(1) In the case of a direct credit substitutein which the bank has conveyed a riskparticipation,14 the full amount of the assetsthat are supported, in whole or in part, by thedirect credit substitute are converted to acredit equivalent amount at 100 percent.However, the pro rata share of the creditequivalent amount that has been conveyedthrough a risk participation is assigned towhichever risk category is lower: The riskcategory appropriate to the obligor, afterconsidering any relevant guarantees orcollateral, or the risk category appropriate tothe institution acquiring the participation.15

Any remainder is assigned to the riskcategory appropriate to the obligor,guarantor, or collateral. For example, the prorata share of the full amount of the assetssupported, in whole or in part, by a directcredit substitute conveyed as a riskparticipation to a U.S. domestic depositoryinstitution or an OECD bank is assigned tothe 20 percent risk category.16

(2) In the case of a direct credit substitutein which the bank has acquired a riskparticipation, the acquiring bank’s percentageshare of the direct credit substitute ismultiplied by the full amount of the assetsthat are supported, in whole or in part, by thedirect credit substitute and converted to acredit equivalent amount at 100 percent. Theresulting credit equivalent amount is

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17 For example, if a bank has a 10 percent shareof a $10 syndicated direct credit substitute thatprovides credit support to a $100 loan to a privateobligor, then the bank’s $1 pro rata share in theenhancement means that a $10 pro rata share of theloan is included in the bank’s risk weighted assets.

18 The bank must demonstrate to the FDIC’ssatisfaction that the ratings are based on the samecriteria that the ratings organizations use to ratetraded positions.

assigned to the risk category appropriate tothe account party obligor, guarantor, orcollateral.

(3) In the case of a direct credit substitutethat takes the form of a syndication whereeach bank is obligated only for its pro ratashare of the risk and there is no recourse tothe originating bank, each bank’s creditequivalent amount will be only its pro ratashare of the assets supported, in whole or inpart, by the direct credit substitute. Theresulting credit equivalent amount isassigned to the risk category appropriate tothe obligor, guarantor, or collateral. 17

(iii) Face-amount treatment for externallyrated recourse obligations, direct creditsubstitutes, and asset-and mortgage-backedsecurities. (1) A traded position is eligible forthe risk-based capital treatment described inthis paragraph II.B.5(b)(iii) if its externalrating is within one of the five highest ratingcategories, e.g., AAA through BB, used by anationally-recognized statistical ratingorganization.

(a) Two highest investment grades. Theface amount of a recourse obligation, directcredit substitute, or an asset-or mortgage-backed security that is rated in either of thetwo highest investment grade categories, e.g.,AAA or AA, is assigned to the 20 percent riskcategory.

(b) Third highest investment grade. Theface amount of a recourse obligation, directcredit substitute, or an asset-or mortgage-backed security that is rated in the thirdhighest investment grade category, e.g., A, isassigned to the 50 percent risk category.

(c) Lowest investment grade. The faceamount of a recourse obligation, direct creditsubstitute, or an asset-or mortgage-backedsecurity that is rated in the lowest investmentgrade category, e.g., BBB, is assigned to the100 percent risk category.

(d) One category below investment grade.The face amount of a recourse obligation,direct credit substitute, or an asset- ormortgage-backed security that is rated in thenext lower category below the lowestinvestment grade category, e.g., BB, isassigned to the 200 percent risk category.

(2) Other recourse obligations and directcredit substitutes that are retained, assumed,or issued in connection with an assetsecuritization are also eligible for the risk-based capital treatment described in thisparagraph II.B.5(b)(iii) if they are externallyrated by two nationally-rated statistical ratingorganizations as falling within one of the fivehighest rating categories used by theorganizations, the ratings are publiclyavailable, and the ratings are based on thesame criteria used to rate traded positions.18

If the two ratings differ, the lower rating willdetermine the risk category to which the

recourse obligation or direct credit substitutewill be assigned.

(3) Stripped mortgage-backed securities(such as interest-only or principal-onlystrips) may not be assigned to the 20 percentor 50 percent risk category under sectionII.B.5(b)(iii)(1)(a)–(b) of this appendix A.

(4) A position which is not externally ratedbut is senior in all respects to a tradedposition eligible for the risk-based capitaltreatment described in section II.B.5(b)(iii)(1)of this appendix A, including access to anycollateral, will be eligible for the risk-basedcapital treatment described in this paragraphII.B.5(b)(iii) as if it had the same rating as thetraded position, if the bank can demonstrateto the FDIC’s satisfaction that such treatmentis appropriate.

(iv) Face-amount treatment for direct creditsubstitutes which are not externally rated. Adirect credit substitute assumed or issued inconnection with an asset securitizationwhich does not qualify for face amounttreatment under section II.B.5(b)(iii) of thisappendix A because it is not externally ratedmay still qualify for face amount treatment,if the bank determines that the credit risk ofthe direct credit substitute is equivalent to orbetter than the external rating category setout at section II.B.5(b)(iii)(1)(d) of thisappendix A (e.g., BB). The face amount of aposition which the bank determines isequivalent to or better than the externalrating category set out at sectionII.B.5(b)(iii)(1)(c) of this appendix A (e.g.,BBB) must be assigned to the 100 percent riskcategory, and a position equivalent to theexternal rating category set out in sectionII.B.5(b)(iii)(1)(d) of this appendix A (e.g.,BB) must be assigned to the 200 percent riskcategory. The bank’s determination may onlybe made pursuant to the following threeapproaches, the use of which must besatisfactory to the FDIC:

(1) Internal risk ratings for asset-backedcommercial paper programs. A bank, underits internal risk rating system, assigns aninternal rating to a direct credit substitute thebank extends to the asset-backed commercialpaper program it sponsors, and the rating isequivalent to or better than the ratingcategory set out at section B.5(b)(iii)(1)(d) ofthis appendix A (e.g., BB). The internal riskrating system must be satisfactory to the FDICand must be prudent and appropriate for thesize and complexity of the bank’s program.Adequate internal risk rating systemstypically:

(a) are an integral part of an effective riskmanagement system that explicitlyincorporates the full range of risks arisingfrom a bank’s participation in securitizationactivities;

(b) link the internal ratings to measurableoutcomes, such as the probability that theposition will experience any loss, theposition’s expected loss given default, andthe degree of variance in losses given defaulton that position;

(c) separately consider the risk associatedwith the underlying loans or borrowers andthe risk associated with the structure of aparticular securitization transaction;

(d) identify gradations of risk among‘‘pass’’ assets and other risk positions;

(e) have clear, explicit criteria that are usedto classify assets into each internal risk grade,including criteria for subjective factors;

(f) have independent credit riskmanagement or loan review personnel withadequate training assigning or reviewing thecredit risk ratings, subject to internal auditreview to verify that ratings are assigned inaccordance with the bank’s criteria;

(g) track the performance of the internalratings over time and make adjustments tothe ratings system when the performance ofrated positions has a tendency to divergefrom assigned ratings, and adjust individualratings accordingly; and,

(h) are consistent with, or moreconservative than, the rating assumptionsand methodologies of nationally recognizedstatistical rating organizations.

(2) Program ratings. If a nationallyrecognized statistical rating organization orother entity satisfactory to the FDIC hasreviewed the terms of a securitizationprogram and stated a rating for direct creditsubstitutes to be issued under the programequivalent to or better than the externalrating category set out at sectionII.B.5(b)(iii)(1)(d) of this appendix A (e.g.,BB), a bank may use such a rating for a directcredit substitute the bank issues under theprogram. If the program has options fordifferent combinations of assets, standards,internal credit enhancements, and otherrelevant factors, the rating organization orother entity may specify ranges of ratingcategories that will apply premised on whichoptions correspond to the bank’s position.The bank must demonstrate to the FDIC’ssatisfaction that the program rating meets thesame standards generally used by nationallyrecognized statistical rating organizations forrating traded positions, and that the ratingorganization’s or other entity’s underlyingpremises are satisfied for the particular directcredit substitute issued by the bank.

(3) Credit assessment computer program. Abank may use an acceptable creditassessment computer program to determinethat a direct credit substitute is equivalent toor better than the external rating category setout at section II.B.5(b)(iii)(1)(d) of thisappendix A (e.g., BB). A nationallyrecognized statistical rating organization orother party satisfactory to the FDIC musthave developed the credit assessment systemfor determining the credit risk of direct creditsubstitutes and other stratified creditpositions. The bank must demonstrate to theFDIC’s satisfaction that ratings under such acredit assessment computer programcorrespond credibly and reliably with therating of traded positions.

(v) Determining the credit risk weight foroff-balance sheet securitized assets that aresubject to early amortization provisions. If abank securitizes revolving assets, such ascredit cards, home equity lines, orcommercial lines of credit, in a transactionthat it has sponsored and which includesearly amortization provisions, then the bankmust maintain risk-based capital against theoff-balance sheet securitized assets from theinception of the transaction. An earlyamortization feature is a provision that,under specified conditions, returns principalto investors prior to the expected payment

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32 The types of loans that qualify as loans securedby multifamily residential properties are listed in

the instructions for preparation of the ConsolidatedReports of Condition and Income. In addition, fromthe standpoint of the selling bank, when amultifamily residential property loan is sold subjectto a pro rata loss sharing arrangement whichprovides for the purchaser of the loan to share inany loss incurred on the loan on a pro rata basiswith the selling bank, that portion of the loan is notsubject to the risk-based capital standards. Inconnection with sales of multifamily residentialproperty loans in which the purchaser of the loanshares in any loss incurred on the loan with theselling institution on other than a pro rata basis, theselling bank must treat these other loss sharingarrangements in accordance with section II.B.5. ofthis appendix A.

35 Such assets include all nonlocal currencyclaims on, and the portions of claims that areguaranteed by, non-OECD central governments andthose portions of local currency claims on, orguaranteed by, non-OECD central governments thatexceed the local currency liabilities held by thebank.

36 Customer liabilities on acceptances outstandinginvolving nonstandard risk claims, such as claimson U.S. depository institutions, are assigned to therisk category appropriate to the identity of theobligor or, if relevant, the nature of the collateralor guarantees backing the claims. Portions ofacceptances conveyed as risk participations to U.S.depository institutions or foreign banks are assignedto the 20 percent risk category appropriate to short-term claims guaranteed by U.S. depositoryinstitutions and foreign banks.

37 The sufficiency of collateral and guarantees foroff-balance-sheet items is determined by the marketvalue of the collateral or the amount of theguarantee in relation to the face amount of the item,except for derivative contracts, for which thisdetermination is generally made in relation to thecredit equivalent amount. Collateral and guaranteesare subject to the same provisions noted undersection II.B. of this appendix A.

38 Forward forward deposits accepted are treatedas interest rate contracts.

dates, generally as a result of a deteriorationin the portfolio of securitized revolvingassets. The securitized, off-balance sheetassets are to be converted to an on-balancesheet credit equivalent amount using the 100percent conversion factor and the resultingamount is to be assigned to the 20 percentrisk category. However, this capitalrequirement, when combined with thecapital requirements for any retainedrecourse or direct credit substitute associatedwith the securitized assets, is limited to atotal of 8 percent of the managed assets.

(c) Limitations on risk-based capitalrequirements—(i) Low-level exposure. If themaximum contractual liability or exposure toloss retained or assumed by a bank inconnection with a recourse obligation or adirect credit substitute is less than theeffective risk-based capital requirement forthe enhanced assets, the risk-based capitalrequirement is limited to the maximumcontractual liability or exposure to loss, lessany recourse liability account established inaccordance with generally acceptedaccounting principles. This limitation doesnot apply to assets sold with implicitrecourse.

(ii) Mortgage-related securities orparticipation certificates retained in amortgage loan swap. If a bank holds amortgage-related security or a participationcertificate as a result of a mortgage loan swapwith recourse, capital is required to supportthe recourse obligation plus the percentage ofthe mortgage-related security or participationcertificate that is not covered by the recourseobligation. The total amount of capitalrequired for the on-balance sheet asset andthe recourse obligation, however, is limitedto the capital requirement for the underlyingloans, calculated as if the bank continued tohold these loans as an on-balance sheet asset.

(iii) Related on-balance sheet assets. If arecourse obligation or direct credit substitutesubject to paragraph B.5. of this section alsoappears as a balance sheet asset, the balancesheet asset is not included in a bank’s risk-weighted assets to the extent the value of thebalance-sheet asset is already included in thecredit equivalent amount for the recourseobligation or direct credit substitute, exceptin the case of loan servicing assets andsimilar arrangements with embeddedrecourse obligations or direct creditsubstitutes. In such a case, both the on-balance sheet servicing assets and the relatedrecourse obligations or direct creditsubstitutes are incorporated into the risk-based capital calculation.

* * * * *C. * * *Category 2—20 Percent Risk Weight.

* * * * *d. This category also includes the credit

equivalent amount of off-balance sheetsecuritized revolving assets in transactionswhich include early amortization provisionsthat were sponsored by the bank.

Category 3—50 Percent Risk Weight.

* * * * *b. * * * 32 * * *

* * * * *

Category 4—100 Percent Risk Weight. (a)All assets not included in the categoriesabove, except the assets specifically includedin the 200 percent category below, areassigned to this category, which comprisesstandard risk assets. The bulk of the assetstypically found in a loan portfolio would beassigned to the 100 percent category.

(b) This category includes:(1) Long-term claims on, and the portions

of long-term claims that are guaranteed by,non-OECD banks, and all claims on non-OECD central governments that entail somedegree of transfer risk; 35

(2) All claims on foreign and domesticprivate-sector obligors not included in thecategories above (including loans tonondepository financial institutions andbank holding companies);

(3) Claims on commercial firms owned bythe public sector;

(4) Customer liabilities to the bank onacceptances outstanding involving standardrisk claims; 36

(5) Investments in fixed assets, premises,and other real estate owned;

(6) Common and preferred stock ofcorporations, including stock acquired fordebts previously contracted;

(7) Commercial and consumer loans(except those assigned to lower riskcategories due to recognized guarantees orcollateral and loans secured by residentialproperty that qualify for a lower risk weight);

(8) Mortgage- and asset-backed securitiesthat do not meet the criteria for assignmentto a lower risk category;

(9) Industrial-development bonds andsimilar obligations issued under the auspicesof states or political subdivisions of theOECD-based group of countries for thebenefit of a private party or enterprise wherethat party or enterprise, not the governmententity, is obligated to pay the principal andinterest; and

(10) All obligations of states or politicalsubdivisions of countries that do not belongto the OECD-based group.

(c) The following assets also are assigneda risk weight of 100 percent if they have notalready been deducted from capital:investments in unconsolidated companies,joint ventures, or associated companies;instruments that qualify as capital issued byother banks; deferred tax assets; andmortgage servicing assets, nonmortgageservicing assets, and other allowedintangibles.

Category 5—200 Percent Risk Weight. Thiscategory includes:

(a) The face amount of externally ratedrecourse obligations, direct credit substitutes,and asset- and mortgage-backed securitiesthat are rated in the next lower categorybelow the lowest investment grade category,e.g., BB, to the extent permitted in sectionII.B.5(b)(iii) of this appendix A; and

(b) The face amount of direct creditsubstitutes for which the bank determinesthat the credit risk is equivalent to onecategory below investment grade, e.g., BB, tothe extent permitted in section II.B.5.(b)(iii)of this appendix A.

D. * * *The face amount of an off-balance sheet

item is generally incorporated into the risk-weighted assets in two steps. The faceamount is first multiplied by a creditconversion factor, except for direct creditsubstitutes and recourse obligations asdiscussed in section II.B.5. of this appendixA. The resultant credit equivalent amount isassigned to the appropriate risk categoryaccording to the obligor or, if relevant, theguarantor or the nature of the collateral.37

Table III to this appendix A sets forth theconversion factors for various types of off-balance-sheet items.

1. Items with a 100 percent conversionfactor. (a) Except as otherwise provided insection II.B.5. of this appendix A, the fullamount of an asset or transaction supported,in whole or in part, by a direct creditsubstitute or a recourse obligation. Directcredit substitutes and recourse obligationsare defined in section II.B.5. of this appendixA.

(b) Sale and repurchase agreements, if notalready included on the balance sheet, andforward agreements. Forward agreements arelegally binding contractual obligations topurchase assets with drawdown which iscertain at a specified future date. Suchobligations include forward purchases,forward forward deposits placed,38 andpartly-paid shares and securities; they do notinclude commitments to make residentialmortgage loans or forward foreign exchangecontracts.

(c) Securities lent by a bank are treated inone of two ways, depending upon whether

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4 For each off-balance sheet item, a conversionfactor (see Table III) must be applied to determinethe ‘‘credit equivalent amount’’ prior to assigningthe off-balance sheet time to a risk weight category.

the lender is exposed to risk of loss. If a bank,as agent for a customer, lends the customer’ssecurities and does not indemnify thecustomer against loss, then the securitiestransaction is excluded from the risk-basedcapital calculation. On the other hand, if abank lends its own securities or, acting asagent for a customer, lends the customer’ssecurities and indemnifies the customeragainst loss, the transaction is converted at100 percent and assigned to the risk weightcategory appropriate to the obligor or, ifapplicable, to the collateral delivered to thelending bank or the independent custodianacting on the lending bank’s behalf.

* * * * *3. In the tables at the end of appendix

A to part 325, Table II.—Summary ofRisk Weights and Risk Categories:

A. In Category 2—20 Percent RiskWeight, paragraph (11) is removed,paragraph (12) is redesignated asparagraph (11), and new paragraphs (12)and (13) are added;

B. In Category 3—50 Percent RiskWeight, paragraph (3) is revised;

C. In Category 4—100 Percent RiskWeight, paragraph (9) is revised and anew paragraph (10) is added; and

D. Following the paragraph titledCategory 4—100 Percent Risk Weight, anew paragraph titled, Category 5—200Percent Risk Weight, is added to read asfollows:* * * * *

Table II.—Summary of Risk Weights andRisk Categories.

* * * * *Category 2—20 Percent Risk Weight.

* * * * *(12) Asset- or mortgage-backed securities

(or recourse obligations or direct creditsubstitutes issued in connection with suchsecuritizations) rated in either of the twohighest investment grade categories, e.g.,AAA or AA.

(13) The credit equivalent amount of off-balance sheet revolving assets insecuritization transactions featuring earlyamortization provisions sponsored by thebank.

Category 3—50 Percent Risk Weight.

* * * * *(3) Asset- or mortgage-backed securities (or

recourse obligations or direct creditsubstitutes issued in connection with suchsecuritizations) rated in the third-highestinvestment grade category, e.g., A.

* * * * *Category 4—100 Percent Risk Weight.

* * * * *(9) Asset- or mortgage-backed securities (or

recourse obligations or direct creditsubstitutes issued in connection with suchsecuritizations) rated in the lowestinvestment grade category, e.g., BBB, as wellas certain direct credit substitutes which thebank rates as the equivalent of the lowestinvestment grade category, e.g., BBB, orabove through an internal assessmentsatisfactory to the FDIC.

(10) All other assets, including anyintangible assets that are not deducted from

capital, and the credit equivalent amounts 4

of off-balance sheet items not assigned to adifferent risk category.

Category 5—200 Percent Risk Weight.Asset- or mortgage-backed securities (or

recourse obligations or direct creditsubstitutes issued in connection with suchsecuritizations) rated one category belowinvestment grade, e.g., BB, as well as certaindirect credit substitutes which the bank ratesas the equivalent of one category belowinvestment grade, e.g., BB, through aninternal assessment satisfactory to the FDIC.

4. In the tables at the end of appendixA to part 325, Table III.—CreditConversion Factors for Off-BalanceSheet Items:

A. In this table, references to footnote1 are removed each time they appearand footnote 1 is removed.

B. In 100 Percent Conversion Factor,paragraphs (1) through (3) are revised,and a new paragraph (6) is added, toread as follows:

Table III.—Credit Conversion Factors forOff-Balance Sheet Items.

100 Percent Conversion Factor.(1) The full amount of assets supported by

direct credit substitutes or recourseobligations (unless a different treatment isotherwise specified). For risk participationsin such arrangements and acquired by thebank, the full amount of assets supported bythe main obligation multiplied by theacquiring bank’s percentage share of the riskparticipation.

(2) Acquisitions of risk participations inbankers acceptances.

(3) Sale and repurchase agreements, if notalready included on the balance sheet.

* * * * *(6) Off-balance sheet revolving assets in

securitization transactions featuring earlyamortization provisions sponsored by thebank.

* * * * *By Order of the Board of Directors.Dated at Washington, DC this 9th day of

February, 2000.Federal Deposit Insurance Corporation.Robert E. Feldman,Executive Secretary.

Department of the Treasury

Office of Thrift Supervision

12 CFR Chapter V

Authority and IssuanceFor the reasons set out in the

preamble, part 567 of chapter V of title12 of the Code of Federal Regulations isproposed to be amended as follows:

PART 567—CAPITAL

1. The authority citation for part 567continues to read as follows:

Authority: 12 U.S.C. 1462, 1462a, 1463,1464, 1467a, 1828 (note).

2. Section 567.1 is amended byrevising the definitions of direct creditsubstitute and recourse and addingdefinitions of covered representationsand warranties, credit derivative,financial guarantee-type standby letterof credit, nationally recognizedstatistical rating organization,performance-based standby letter ofcredit, rated, securitization, servicercash advance, standby letter of creditand traded position, to read as follows:

§ 567.1 Definitions.

* * * * *Covered representations and

warranties. The term coveredrepresentations and warranties meansrepresentations and warranties extendedby a savings association when ittransfers assets (including loan servicingassets) or assumed by a savingsassociation when it purchases loanservicing assets, that obligate thesavings association to protect anotherparty from losses due to credit risk inthe transferred assets or serviced loans.

Credit derivative. The term creditderivative means on- or off-balancesheet notes or contracts that allow oneparty to transfer the credit risk of areferenced asset, that it may own, toanother party. The value of a creditderivative is dependent, at least in part,on the credit performance of thereferenced asset.* * * * *

Direct credit substitute. The termdirect credit substitute means anarrangement in which a savingsassociation assumes, in form or insubstance, any risk of credit lossdirectly or indirectly associated with anasset or other financial claim owned inwhole or in part by another party, thatexceeds the association’s pro rata shareof the asset or claim. If the savingsassociation has no claim on the asset,then the assumption of any risk of lossis a direct credit substitute. Direct creditsubstitutes include:

(1) Financial guarantee-type standbyletters of credit that support financialclaims on the account party;

(2) Guarantees, surety arrangements,credit derivatives, and irrevocableguarantee-type instruments backingfinancial claims;

(3) Purchased subordinated interestsor securities that absorb more than theirpro rata share of losses from theunderlying assets;

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(4) Loans or lines of credit thatprovide credit enhancement for thefinancial obligations of an accountparty; and

(5) Purchased loan servicing assets ifthe servicer is responsible for creditlosses associated with the loans beingserviced (other than a servicer cashadvance), or if the servicer makes orassumes covered representations andwarranties with respect to such loans.* * * * *

Financial guarantee-type standbyletter of credit. The term financialguarantee-type standby letter of creditmeans any letter of credit or similararrangement, however named ordescribed, that represents an irrevocableobligation to the beneficiary on the partof the issuer:

(1) To repay money borrowed by,advanced to, or for the account of, theaccount party; or

(2) To make payment on account ofany indebtedness undertaken by theaccount party in the event that theaccount party fails to fulfill itsobligation to the beneficiary.* * * * *

Nationally recognized statisticalrating organization. The term nationallyrecognized statistical ratingorganization means an entity recognizedby the Division of Market Regulation ofthe Securities and ExchangeCommission as a nationally recognizedstatistical rating organization for variouspurposes, including the uniform netcapital regulations for broker-dealers.* * * * *

Performance-based standby letter ofcredit. The term performance-basedstandby letter of credit means any letterof credit, or similar arrangement,however named or described, whichrepresents an irrevocable obligation tothe beneficiary on the part of the issuerto make payment on account of anydefault by a third party in theperformance of a nonfinancial orcommercial obligation. Such letters ofcredit include arrangements backingsubcontractors’ and suppliers’performance, labor and materialscontracts, and construction bids.* * * * *

Rated. The term rated means, withrespect to an instrument or obligation,that the instrument or obligation hasreceived a credit rating from anationally recognized statistical ratingorganization. An instrument orobligation is rated investment grade if ithas received a credit rating that fallswithin one of the four highest ratingcategories used by the organization. Aninstrument or obligation is rated in thehighest investment grade if it has

received a credit rating that falls withinthe highest rating category used by theorganization.* * * * *

Recourse. The term recourse means anarrangement in which a savingsassociation retains, in form or insubstance, any risk of credit lossdirectly or indirectly associated with atransferred asset that exceeds the prorata share of the association’s claim onthe asset. If a savings association has noclaim on a transferred asset, then theretention of any risk of loss is recourse.A recourse obligation typically ariseswhen an institution transfers assets andretains an obligation to repurchase theassets or to absorb losses due to adefault of principal or interest or anyother deficiency in the performance ofthe underlying obligor or some otherparty. Recourse may exist implicitlywhere a savings association providescredit enhancement beyond anycontractual obligation to support assetsit has sold. Recourse obligationsinclude:

(1) Covered representations andwarranties on transferred assets;

(2) Retained loan servicing assets ifthe servicer is responsible for lossesassociated with the loans being serviced(other than a servicer cash advance);

(3) Retained subordinated interests orsecurities, or credit derivatives thatabsorb more than their pro rata share oflosses from the underlying assets;

(4) Assets sold under an agreement torepurchase; and

(5) Loan strips sold without directrecourse where the maturity of thetransferred loan is shorter than thematurity of the commitment.* * * * *

Securitization. The termsecuritization means the pooling andrepackaging of loans or other creditexposures into securities that can besold to investors. For purposes of§ 567.6(b) of this part, the termsecuritization also includes transactionsor programs that generally createstratified credit risk positions, whetherin the form of a security or not, whoseperformance is dependent upon anunderlying pool of loans or other creditexposures.

Servicer cash advance. The termservicer cash advance means funds thata residential mortgage loan serviceradvances to ensure an uninterruptedflow of payments or the timelycollection of residential mortgage loans,including disbursements made to coverforeclosure costs or other expensesarising from a mortgage loan to facilitateits timely collection. A servicer cashadvance is not a recourse obligation or

a direct credit substitute if the serviceris entitled to full reimbursement or, forany single residential mortgage loan,nonreimbursable advances arecontractually limited to an insignificantamount of the outstanding principal onthat loan.

Standby letter of credit. The termstandby letter of credit means anyfinancial guarantee-type standby letterof credit or performance-based standbyletter of credit.* * * * *

Traded position. The term tradedposition means a recourse obligation,direct credit substitute, or asset- ormortgage-backed security that isretained, assumed, or issued inconnection with an asset securitizationand that is rated with a reasonableexpectation that, in the near future:

(1) The position would be sold toinvestors relying on the rating; or

(2) A third party would, in reliance onthe rating, enter into a transaction suchas a purchase, loan, or repurchaseagreement involving the position.* * * * *

3. Section 567.2 is amended byrevising paragraph (a)(1)(i) to read asfollows:

§ 567.2 Minimum regulatory capitalrequirement.

(a) * * *(1) Risk-based capital requirement. (i)

A savings associations’ minimum risk-based capital requirement shall be anamount equal to 8% of its risk-weightedassets as measured under § 567.6 of thispart.* * * * *

4. Section 567.6 is amended by:A. Revising paragraph (a) introductory

text;B. Revising paragraph (a)(1)

introductory text;C. Revising paragraph (a)(2)

introductory text;D. Removing and reserving

paragraphs (a)(2)(i)(A) and (C);E. Revising paragraph (a)(2)(i)(B);F. Revising paragraph (a)(2)(ii)(A);G. Removing paragraph (a)(3); andH. Adding paragraph (b) to read as

follows:

§ 567.6 Risk-based capital credit risk-weight categories.

(a) Risk-weighted assets. Risk-weighted assets equal risk-weighted on-balance-sheet assets (as computed underparagraph (a)(1) of this section), plusrisk-weighted off-balance-sheetactivities (as computed under paragraph(a)(2) of this section), plus risk-weightedrecourse obligations, direct creditsubstitutes and asset- and mortgage-backed securities (as computed under

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paragraph (b) of this section). Assets notincluded for purposes of calculatingcapital under § 567.5 are not included incalculating risk-weighted assets.

(1) On-balance-sheet assets. Except asprovided in paragraph (b) of thissection, risk-weighted on-balance-sheetassets are computed by multiplying theon-balance-sheet asset amounts timesthe appropriate risk weight categories.The risk weight categories for on-balance-sheet assets are:* * * * *

(2) Off-balance-sheet activities. Exceptas provided in paragraph (b) of thissection, risk-weighted off-balance-sheetitems are determined by the followingtwo-step process. First, the face amountof the off-balance-sheet item must bemultiplied by the appropriate creditconversion factor listed in thisparagraph (a)(2). This calculationtranslates the face amount of an off-balance-sheet exposure into an on-balance-sheet credit-equivalent amount.Second, the credit-equivalent amountmust be assigned to the appropriate riskweight category using the criteriaregarding obligors, guarantors, andcollateral listed in paragraph (a)(1) ofthis section, provided that the maximumrisk weight assigned to the credit-equivalent amount of an interest-rate orexchange-rate contract is 50 percent.The following are the credit conversionfactors and the off-balance-sheet itemsto which they apply.

(i) * * *

(B) Risk participations purchased inbank acceptances.* * * * *

(ii) * * *(A) Transaction-related contingencies,

including, among other things,performance bonds and performance-based standby letters of credit related toa particular transaction;* * * * *

(b) Recourse obligations, direct creditsubstitutes, and asset-and mortgage-backed securities—(1) In general. Exceptas otherwise provided in this paragraph(b), to calculate the risk-weighted assetamount for a recourse obligation, directcredit substitute, or asset- or mortgage-backed security, multiply the amount ofassets from which risk of credit loss isdirectly or indirectly retained orassumed, by the appropriate risk weightusing the criteria regarding obligors,guarantors, and collateral listed inparagraph (a)(1) of this section. Forpurposes of this paragraph (b), theamount of assets from which risk ofcredit loss is directly or indirectlyretained or assumed means:

(i) For a financial guarantee-typestandby letter of credit, suretyarrangement, credit derivative,guarantee, or irrevocable guarantee-typeinstruments, the amount of the assetsthat the direct credit substitute fully orpartially supports;

(ii) For a subordinated interest orsecurity, the amount of the subordinatedinterest or security plus all more seniorinterests or securities;

(iii) For mortgage servicing assets thatare recourse obligations or direct creditsubstitutes, the outstanding amount ofunpaid principal of the loans serviced;

(iv) For covered representations andwarranties, the amount of the assetssubject to the representations orwarranties;

(v) For loans or lines of credit thatprovide credit enhancement for thefinancial obligations of an accountparty, the amount of the enhancedfinancial obligations;

(vi) For loans strips, the amount of theloans;

(vii) For assets sold with recourse, theamount of assets from which risk of lossis directly or indirectly retained, lessany applicable recourse liability accountestablished in accordance withgenerally accepted accountingprinciples; and

(viii) Other types of recourseobligations and direct credit substitutesshould be treated in accordance withthe principles contained in thisparagraph (b).

(2) Ratings-based approach—(i)Calculation. As an alternative to thecalculation described in paragraph (b)(1)of this section, a savings associationmay calculate the risk-weighted assetamount for eligible recourse obligations,direct credit substitutes, or asset- ormortgage-backed securities described inparagraph (b)(2)(ii) of this section bymultiplying the face amount of theposition by the risk-weight associatedwith the applicable rating under thefollowing chart.

Rating category Risk weight

Highest or second highest investment grade ................................................................................. 20%.Third highest investment grade ...................................................................................................... 50%.Fourth highest investment grade .................................................................................................... 100%.One grade below investment grade ................................................................................................ 200%.More than one grade below investment grade or not rated ........................................................... Risk weight the asset under paragraph (b)(1)

of this section.

(ii) Eligibility. To be eligible for thetreatment described in this paragraph(b)(2), a recourse obligation, directcredit substitute, or asset- or mortgage-backed security must meet one of thefollowing criteria:

(A) Traded position rated by a ratingorganization. (1) A traded position iseligible for the risk-based capitaltreatment described in this paragraph(b)(2), if a nationally recognizedstatistical rating organization rates theposition in one of its five highest grades.If two or more nationally recognizedstatistical rating organizations assigndifferent ratings to a position, thesavings association may use the highestrating as the rating of the position for

the purposes of this paragraph (b)(2). Ifa rating changes, the savings associationmust use the new rating.

(2) If a recourse obligation, directcredit substitute, or asset- or mortgage-backed security or other credit riskposition is not rated but is senior in allcredit risk related features (includingaccess to any collateral) to a rated,traded position, the savings associationmay risk weight the position under thisparagraph (b)(2) using the rating of thetraded position. The savings associationmust satisfy OTS that this treatment isappropriate.

(B) Non-traded position rated by tworating organizations. (1) A recourseobligation or direct credit substitute that

is not a traded position is eligible for thetreatment described in this paragraph(b)(2), if two nationally recognizedstatistical rating organizations rate therecourse obligation or direct creditsubstitute in one of their five highestgrades. The organizations must applythe same criteria that they use to ratesecurities that are traded positions andmust make the rating publicly available.

(2) If two or more national recognizedstatistical rating organizations assigndifferent ratings to the recourseobligation or direct credit substitute, thesavings association must use the secondhighest rating as the rating of theposition for the purposes of thisparagraph (b)(2). If a rating changes, the

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savings association must use the newrating.

(3) Internal ratings, qualifiedstructured transactions, and creditassessment computer programs—(i)Calculation. As an alternative to the

calculation described in paragraph (b)(1)of this section, a savings associationmay calculate the risk-weighted assetamount for eligible direct creditsubstitutes described in paragraph

(b)(3)(ii) of this section by multiplyingthe face amount of the position by therisk-weight associated with theapplicable rating under the followingchart:

Rating category Risk weight

Investment grade ............................................................................................................................ 100%.One grade below investment grade ................................................................................................ 200%.More than one grade below investment grade or not rated ........................................................... Risk weight the asset under paragraph (b)(1)

of this section.

(ii) Eligibility. To be eligible for thetreatment described in this paragraph(b)(3), a direct credit substitute mustmeet one of the following criteria.

(A) Non-traded position ratedinternally. A direct credit substituteassumed or issued in connection withan asset-backed commercial paperprogram and that is not a tradedposition is eligible for the treatmentdescribed in this paragraph (b)(3), if asavings association that is the sponsor ofthe program rates the direct creditsubstitute as investment grade or onecategory immediately below investmentgrade. The savings association must usean internal risk weighting system that issatisfactory to OTS. Adequate internalrisk rating systems typically:

(1) Are an integral part of an effectiverisk management system that explicitlyincorporates the full range of risksarising from the institution’ssecuritization activities.

(2) Link ratings to measurableoutcomes, such as the probability thatthe position will experience loss, theexpected loss on the position in theevent of default, and variance of lossesin the event of default on that position;

(3) Separately consider the riskassociated with the underlying loans orborrowers, and the risk associated withthe structure of the particularsecuritization transaction;

(4) Identify gradations of risk evenamong those assets where no loss islikely as well as other risk positions;

(5) Use clear, explicit criteria toclassify assets into each internal ratingcategory;

(6) Employ independent credit riskmanagement or loan review personnelto assign or review the internal ratings;

(7) Include an internal auditprocedure to periodically verify thatinternal risk ratings are assigned inaccordance with the savingsassociation’s established criteria;

(8) Monitor the performance of theassigned internal ratings to determine ifthe system correctly identifiedindividual ratings and, if appropriate,

adjust the rating system and individualratings; and

(9) Use assumptions andmethodologies that are consistent with,or more conservative than, the ratingassumptions and methodologies used bynationally recognized statistical ratingorganizations.

(B) Non-traded positions in approvedsecuritization or structured financingprograms. A direct credit substitute thatis not a traded position is eligible for thetreatment described in this paragraph(b)(3), if the position is generatedthrough a securitization or structuredfinancing program that is approved byOTS. OTS will not approve the use ofa securitization or structured financingprogram unless the program meets thefollowing minimum criteria and otherappropriate prudential standards:

(1) A nationally recognized statisticalrating organization (or other entityapproved by OTS) must review theterms of the program, and state a ratingfor the direct credit substitutes to beissued under the program. If theprogram has options for differentcombinations of assets, standards,internal or external credit enhancementsand other relevant factors, the ratingorganization or other approved entitymay specify ranges of rating categoriesthat will be applied based on theoptions that are utilized in the position.

(2) The savings association mustdemonstrate to OTS’ satisfaction thatthe rating corresponds credibly andreliably with the ratings issued bynationally recognized statistical ratingorganizations for traded positions, andthat the rating organization’s or otherentity’s underlying premises aresatisfied by the direct credit substitute.

(3) If a savings association participatesin a securitization or structuredfinancing program sponsored by anotherparty, OTS may authorize the savingsassociation to use this approach basedon the program rating obtained by thesponsor of the program.

(C) Non-traded position in astructured financing program rated byusing qualifying credit assessment

computer software. A direct creditsubstitute that is not a traded positionis eligible for the treatment described inthis paragraph (b)(3), if the position isgenerated through a structuredfinancing program and the position israted using credit assessment computersoftware that has been approved byOTS. OTS will not approve the use ofcredit assessment computer softwareunless the software meets the followingminimum criteria and other appropriateprudential standards:

(1) A nationally recognized statisticalrating organization (or other entityapproved by OTS) developed thecomputer software for determining thecredit ratings of direct credit substitutesand other stratified positions; and

(2) The savings association mustdemonstrate that the ratings generatedusing the computer software correspondcredibly and reliably with the ratingsissued by nationally recognizedstatistical rating organizations for tradedpositions.

(4) Alternative capital computationfor small business obligations—(i)Definitions. For the purposes of thisparagraph (b)(4):

(A) Qualified savings associationmeans a savings association that:

(1) Is well capitalized as defined in§ 565.4 of this chapter without applyingthe capital treatment described inparagraph (b)(4)(ii) of this section; or

(2) Is adequately capitalized asdefined in § 565.4 of this chapterwithout applying the capital treatmentdescribed in paragraph (b)(4)(ii) of thissection and has received writtenpermission from the OTS to apply thatcapital calculation.

(B) Small business means a businessthat meets the criteria for a smallbusiness concern established by theSmall Business Administration in 13CFR part 121 pursuant to 15 U.S.C. 632.

(ii) Capital requirement. With respectto a transfer of a small business loan orlease of personal property with recoursethat is a sale under generally acceptedaccounting principles, a qualifiedsavings association may elect to include

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only the amount of its retained recoursein its risk-weighted assets for thepurposes of paragraph (b)(1) of thissection. To qualify for this election, thesavings association must establish andmaintain a reserve under generallyaccepted accounting principlessufficient to meet the reasonableestimated liability of the savingsassociation under the recourseobligation.

(iii) Aggregate amount of recourse.The total outstanding amount ofrecourse retained by a qualified savingsassociation with respect to transfers ofsmall business loans and leases ofpersonal property and included in therisk-weighted assets of the savingsassociation as described in paragraph(b)(4)(ii) of this section, may not exceed15 percent of the association’s totalcapital computed under § 567.5(c)(4).

(iv) Savings association that ceases tobe a qualified savings association orthat exceeds aggregate limits. If asavings association ceases to be aqualified savings association or exceedsthe aggregate limit described inparagraph (b)(4)(iii) of this section, thesavings association may continue toapply the capital treatment described inparagraph (b)(4)(ii) of this section totransfers of small business loans andleases of personal property thatoccurred when the association was aqualified savings association and didnot exceed the limit.

(v) Prompt corrective action notaffected. (A) A savings association shallcompute its capital without regard tothis paragraph (b)(4) of this section forpurposes of prompt corrective action (12U.S.C. 1831o), unless the savingsassociation is adequately or wellcapitalized without applying the capitaltreatment described in this paragraph(b)(4) and would be well capitalizedafter applying that capital treatment.

(B) A savings association shallcompute its capital requirement withoutregard to this paragraph (b)(4) for thepurposes of applying 12 U.S.C.1381o(g), regardless of the association’scapital level.

(5) Risk participations andsyndications of direct credit substitutes.Except as otherwise provided in thisparagraph (b) and subject to the lowlevel recourse rule, a savings associationmust calculate the risk-weighted assetamount for a risk participation in, orsyndication of, a direct credit substituteas described below. For the purposes ofthis paragraph (b)(5), in a riskparticipation the originator of theparticipation remains liable to thebeneficiary for the full amount of thedirect credit substitute, even though

another party may have acquired aparticipation in the obligation:

(i) Where a savings associationconveys a risk participation, the savingsassociation must risk weight the fullamount the assets supported, in wholeor in part, by the direct credit substitute.The savings association must assign apercentage share (i.e., the percentage ofthe direct credit substitute that isconveyed) of these assets to the lowerof: the risk-weight category appropriateto the obligor in the underlyingtransaction, after considering anyassociated guarantees or collateral; orthe risk-weight category appropriate tothe entity acquiring the participation.The remainder of the assets supported,in whole or in part, by the direct creditsubstitute, must be assigned to the risk-weight category appropriate to theobligor, guarantor or collateral.

(ii) If a savings association acquires arisk participation in a direct creditsubstitute, the savings association mustmultiply a percentage share (i.e. thepercentage of the direct credit substitutethat is acquired) by the full amount theassets supported, in whole or in part, bythe direct credit substitute. The savingsassociation must assign this amount tothe risk-weight category appropriate tothe account party obligor, guarantor orcollateral.

(iii) If the savings association holds adirect credit substitute as a part of asyndication and it is obligated only forits pro rata share of the risk of loss onthe direct credit substitute and there isno recourse to the originating entity, thesavings association must assign its shareof the assets supported, in whole or inpart, by the direct credit substitute tothe risk-weight category appropriate tothe obligor, guarantor or collateral.

(6) Limitations on risk-based capitalrequirements—(i) Low-level recourse. Ifthe maximum contractual liability orexposure to credit loss retained orassumed by a savings association inconnection with a recourse obligation ora direct credit substitute calculatedunder paragraphs (b)(1) through (5) ofthis section is less than the effectiverisk-based capital requirement for theenhanced assets, the risk-based capitalrequirement is limited to the maximumcontractual liability or exposure to loss,less any recourse liability accountestablished in accordance withgenerally accepted accountingprinciples. This limitation does notapply to assets sold with implicitrecourse.

(ii) Mortgage-related securities orparticipation certificates retained in amortgage loan swap. If a savingsassociation holds a mortgage-relatedsecurity or a participation certificate as

a result of a mortgage loan swap withrecourse, capital is required to supportthe recourse obligation plus thepercentage of the mortgage-relatedsecurity or participation certificate thatis not covered by the recourseobligation. The total amount of capitalrequired for the on-balance-sheet assetand the recourse obligation, however, islimited to the capital requirement forthe underlying loans, calculated as if thesavings association continued to holdthese loans as an on-balance-sheet asset.

(iii) Related on-balance-sheet assets.To the extent that an asset may beincluded in the calculation of risk-weighted on-balance-sheet assets underparagraph (a)(1) of this section and mayalso be included in the calculation ofrisk-weighted assets under thisparagraph (b), the savings associationshould risk-weight the asset only underthis paragraph (b), except mortgageservicing assets and similararrangements with embedded recourseobligations or direct credit substitutes.In such cases, the mortgage servicingasset is risk weighted as an on-balance-sheet asset under paragraph (a)(1) of thissection and the related recourseobligations and direct credit substitutesare risk-weighted under this paragraph(b).

(7) Obligations of subsidiaries. If asavings association retains a recourseobligation or assumes a direct creditsubstitute on the obligation of asubsidiary that is not an includablesubsidiary, and the recourse obligationor direct credit substitute is an equity ordebt investment in that subsidiaryunder generally accepted accountingprinciples, the face amount of therecourse obligation or direct creditsubstitute is deducted for capital under§§ 567.5(a)(2) and 567.9(c). All otherrecourse obligations and direct creditsubstitutes retained or assumed by asavings association on the obligations ofan entity in which the savingsassociation has an equity investment arerisk-weighted in accordance with thisparagraph (b).

(8) Addition to risk-weighted assets—managed assets. (i) A savingsassociation must include an additionalamount in the risk-weighted assetamount calculated under this paragraph(b), if:

(A) The savings association sellsassets to a revolving securitization (e.g.,credit card receivables or home equityline securitizations) with an earlyamortization feature. An earlyamortization feature is a provision that,under specified conditions, terminatesthe ability of the savings association toadd new receivables or debt to thesecuritization, and requires the savings

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association to use any paymentsreceived from the debtors to pay downthe receivables or debts previouslyincluded in the securitization; and

(B) The savings association is thesponsor of the revolving securitization.

(ii) The additional amount is equal tothe face amount of the assets that thesavings association sells to the revolvingsecuritization less the face amount ofany recourse obligation or direct creditsubstitute that the savings associationretains or assumes in connection withthe sale of the asset, multiplied by a 20percent risk weight.

5. Section 567.11 is amended byredesignating paragraph (c) as paragraph(c)(1) and adding a new paragraph (c)(2)to read as follows:

§ 567.11 Reservations of authority.

* * * * *(c) * * *(2) If a savings association has

calculated the risk-weighted assetamount for a recourse obligation, adirect credit substitute or an asset under§ 567.6(b), OTS may determine that risk-weighted asset amount does notadequately reflect the credit risk that the

savings association assumed or retainedin the transaction and require theinstitution to revise the risk-weightedasset amount to reflect the risk of, andother relevant factors associated with,the recourse obligation, direct creditsubstitute or asset.

Dated: February 9, 2000.By the Office of Thrift Supervision.

Ellen Seidman,Director.[FR Doc. 00–4211 Filed 3–7–00; 8:45 am]BILLING CODE 4810–33–P, 6210–01–P, 6714–01–P,6720–01–P

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