The FRB, OCC and FDIC (the "agencies") announced that they are seeking comment on a notice of proposed rulemaking that would revise the market risk capital rules for banking organizations with significant trading activity (the "NPR"). The Agencies believe that the proposed revisions would better capture positions for which the market risk capital rules are appropriate, reduce procyclicality in market risk capital requirements, enhance the rules’ sensitivity to risks that are not adequately captured by the current regulatory measurement methodologies, and increase market discipline through enhanced disclosures.
The NPR is based on a previous proposal (from September 2006) by the Agencies to revise the market risk rules as well as a series of publications by the Basel Committee on Banking Supervision (the “Basel Committee”) intended to enhance the market risk capital framework, particularly in light of the deficiencies revealed during the recent financial crisis. The Agencies are not currently proposing to use credit ratings for the assignment of standardized charges for securitization and re-securitization positions as published by the Basel Committee in July 2009; however, the NPR indicates that the Agencies intend to implement these standardized charges in a subsequent rulemaking in a way that achieves the results intended by the Basel Committee’s proposed revisions, and that appropriately reflects the requirements of Section 939A of the Dodd-Frank Act.
Similar to the Basel II capital framework for credit risk, the NPR is based on three pillars: minimum regulatory capital (Pillar 1), supervisory review (Pillar 2), and market discipline through enhanced public disclosure (Pillar 3). Below is a general description of the market risk capital rules, with special attention to the material proposed modifications.
Scope of the Market Risk Capital Rules
The market risk capital rules supplement and adjust the Agencies’ credit risk capital rules. The applicability of the NPR would remain unchanged from the existing market risk capital rule in that it would apply to banking organizations with aggregate trading assets and trading liabilities equal to at least 10% of total assets or $1 billion. The primary federal supervisor of a banking organization also may generally apply the market risk capital rule to a banking organization, or exempt a banking organization from application of the rule, if, consistent with safe and sound banking practices, the supervisor deems that it is appropriate based on the banking organization’s level of market risk. In addition, the NPR contains a reservation of authority provision permitting a banking organization’s primary federal supervisor to increase or decrease capital requirements as appropriate in specific circumstances. Furthermore, the NPR would authorize a regulator to include specific positions or portfolios in the market risk rules, or the credit risk rules, as applicable, to more appropriately reflect the risks of the positions.
Definition of Covered Position
The NPR requires banking organizations to maintain capital against the market risk of their “covered positions.” In order to address the concern that banking organizations can arbitrage the capital standards for market and credit risk by calculating capital for a given position under the framework that resulted in the lowest capital requirement, the NPR establishes more explicit eligibility criteria for which positions can be designated as covered positions.
The NPR modifies the definition of a covered position to include trading assets and trading liabilities that are “trading positions” (i.e., positions held for the purpose of short-term resale or with the intent of benefiting from actual or expected short-term price movements, or to lock in arbitrage profits). A banking organization’s covered positions also would include trading assets and trading liabilities that hedge covered positions, but only if those hedges are within the scope of the banking organization’s hedging strategy. The Agencies expressed concern in the NPR that a banking organization could craft its hedging strategies in order to bring non-trading positions that are more appropriately treated under the credit risk capital rules into a banking organization’s covered positions. Accordingly, the Agencies noted that they will scrutinize each banking organization’s hedging strategies to ensure that they are not being manipulated in this manner.
As under the existing market risk rule, the NPR also would include as a covered position any foreign exchange or commodity position regardless of whether it is a trading asset or trading liability. Also consistent with the current market risk rule, liquidity facilities for asset-backed commercial paper would be excluded from the definition of a covered position. In addition, the definition of covered position under the NPR would exclude all intangible assets, including servicing assets, because their risks are explicitly addressed in the credit risk capital rules, often through a deduction from capital.
The NPR would require a banking organization to have clearly defined policies and procedures for determining which of its trading assets and trading liabilities are trading positions, as well as which of its trading positions are “correlation trading positions” (as defined below). These policies and procedures must take into account (i) the extent to which positions and their related hedges can be marked-to-market daily by references to a two-way market, and (ii) possible impairments to the liquidity of a position or its hedge.
In addition, the NPR requires a bank to have clearly defined policies and procedures for actively managing all covered positions, which policies and procedures must require, among other things, daily monitoring by senior management (including daily marking to market and daily risk assessment). Senior management also must reassess established limits on positions at least annually. Moreover, as a result of the Agencies’ concerns about deficiencies in banking organizations’ valuation of less liquid trading positions, the NPR introduces new requirements for the prudent valuation of covered positions that include maintaining policies and procedures for valuation, marking positions to market or to model, independent price verification, and valuation adjustments or reserves.
Internal Model Requirements
Unlike the existing market risk rule, the NPR proposes that a banking organization must receive the prior written approval of its primary federal supervisor before using any internal model to calculate its market risk capital requirement. The NPR also would require a banking organization to promptly notify such regulator when it plans to extend the use of such model to an additional business line or product type, or if it makes any change to the internal model that would result in a material change in the risk-weighted asset amount for a portfolio of covered positions. The banking organization also must notify its primary federal supervisor if it makes any material change to its modeling assumptions. Such primary federal supervisor may rescind its approval, in whole or in part, of the use of any internal model and determine an appropriate capital requirement for the applicable covered positions.
Under the NPR, a banking organization must incorporate its internal models into its risk management process and integrate the internal models used for calculating its VaR-based measure into its daily risk management process. The level of sophistication of a banking organization’s models must be commensurate with the complexity and amount of its covered positions. In addition, the NPR expands upon the current market risk rule’s stress-testing requirement by requiring a banking organization to stress test the market risk of its covered positions at a frequency appropriate to each portfolio, and in no case less frequently than quarterly.
Market Risk Capital Requirements
As under the existing market risk rule, the NPR would require a banking organization to calculate its risk-based capital ratio denominator as the sum of its adjusted risk-weighted assets and market risk equivalent assets. To calculate market risk equivalent assets, a banking organization must multiply its measure for market risk by 12.5.
The NPR would require a bank to capture a broader set of risks than under the current market risk rule. In addition to the VaR-based capital requirement, any specific risk add-ons, and any capital requirement for de minimis exposures, as required under the current market risk rule, the NPR would also require calculation of: (a) a stressed VaR-based capital requirement; (b) any incremental risk capital requirement; and (c) any comprehensive risk capital requirement. No adjustments would be permitted to address potential double counting among any of the components of a banking organization’s measure for market risk.
a. VaR-based Capital Requirement. Consistent with the current rule, the NPR requires a banking organization to use one or more internal models to calculate a daily VaR-based measure that reflects general market risk for all covered positions. The quantitative requirements for this VaR model remain consistent with those in the current rules: a one-tailed, 99.0% confidence level with a ten business day holding period, and a historical observation period of at least one year. The daily VaR-based measure may also reflect the banking organizations specific risk for one or more portfolios of debt or equity positions and must reflect the specific risk for any portfolios of correlation trading positions that are modeled as described below.
In addition to interest rate risk, equity price risk, foreign exchange rate risk, and commodity price risk, the NPR adds credit spread risk to the list of risk categories a banking organization must include in its VaR-based measure. Furthermore, the NPR would allow a banking organization to include certain term repo-style transactions in its VaR-based measure even though these positions may not meet the definition of a covered position, provided the banking organization includes all such term repo-style transactions consistently over time.
Consistent with the current rule, a banking organization’s VaR-based capital requirement under the NPR would equal the greater of (i) the previous day’s VaR-based measure, or (ii) the average of the daily VaR-based measures for each of the preceding 60 business days multiplied by three, or such higher multiplication factor required based on backtesting results.
b. Stressed VaR-based Capital Requirement. Pursuant to the NPR, a banking organization would have to calculate at least weekly a stressed VaR-based measure using the same internal model(s) used to calculate its VaR-based measure, but with model inputs calibrated to reflect historical data from a continuous 12-month period that reflects a period of significant financial stress appropriate to the banking organization’s current portfolio. The stressed VaR-based measure, which is intended to reduce the procyclicality of the minimum capital requirements for market risk and ensure banks hold enough capital to survive a period of financial distress, would equal the greater of (i) the most recent stressed VaR-based measure; or (ii) the average of the weekly VaR-based measures for each of the preceding 12 weeks multiplied by three, or a higher multiplication factor based on backtesting results.
c. Revised Modeling Standards for Specific Risk. Compared to the current market risk rule, the NPR more clearly specifies the modeling standards for specific risk and eliminates the current option for a bank to model some but not all material aspects of specific risk for an individual portfolio of debt or equity positions. Under the current market risk rule, if a banking organization incorporates specific risk in its internal model but fails to demonstrate to its primary federal supervisor that its internal model adequately measures all aspects of specific risk for a portfolio of debt or equity positions, the banking organization is subject to an internal models-based specific risk add-on for that portfolio. In contrast, the NPR, in order to create an incentive for more robust risk modeling, requires a banking organization that does not have an approved internal model that captures all material aspects of specific risk for a particular portfolio of debt, equity, or correlation trading positions to use the standardized measurement method described below to calculate a specific risk add-on for that portfolio.
d. Standardized Specific Risk Capital Requirement. The NPR would require a banking organization to calculate a total specific risk add-on for each portfolio of debt and equity positions for which the bank’s VaR-based measure does not capture all material aspects of specific risk and for each of its securitization positions that are not modeled with respect to the comprehensive risk capital requirement described below. The standardized specific risk capital requirements for securitization positions are left unchanged from the current market risk rule due to the Dodd-Frank Act’s prohibition on the Agencies’ requiring the use of external credit ratings to compute capital requirements. The Agencies noted that they plan to develop an alternative treatment for securitizations that does not require reliance on external ratings at a later date and request comment on alternative creditworthiness standards for purposes of the market risk capital rules.
e. Incremental Risk Capital Requirement. As a result of banking organizations including certain types of positions in the market risk capital framework that contain significant levels of credit risk, which was not envisioned when the market risk rule was first implemented, the NPR establishes a new capital requirement: the incremental risk charge. Pursuant to the NPR, a banking organization that measures the specific risk of a portfolio of debt positions using internal models would calculate an incremental risk measure for that portfolio using an internal model (an “incremental risk model”). As stated in the NPR, incremental risk “consists of the default risk of a position (that is, the risk of loss on the position upon an event of default (for example, the failure of the obligor to make timely payments of principal or interest), including bankruptcy, insolvency, or similar proceeding) and the credit migration risk of a position (that is, price risk that arises from significant changes in the underlying credit quality of the position).”
The NPR also allows a banking organization, with the prior approval of its primary federal supervisor, to include portfolios of equity positions in its incremental risk model, provided that it consistently includes such equity positions in a manner that is consistent with how the bank internally measures and manages the incremental risk for such positions at the portfolio level. A banking organization may not include correlation trading positions or securitization positions in its incremental risk model. With respect to the applicable quantitative requirements, the NPR would require an incremental risk model to measure incremental risk over a one-year time horizon and at a one-tail, 99.9% confidence level, either under the assumption of a constant level of risk, or under the assumption of constant positions.
A banking organization that calculates an incremental risk measure would be required to do so at least weekly, with the capital requirement being the greater of: (i) the average of the incremental risk measures over the previous 12 weeks; or (ii) the most recent incremental risk measure.
f. Comprehensive Risk Capital Requirement. The NPR would permit a banking organization, with the approval of its primary federal supervisor, to measure all material price risk of one or more portfolios of correlation trading positions using an internal model (a “comprehensive risk model”). A correlation trading position is defined as (i) a securitization position for which all or substantially all of the value of the underlying exposures is based on the credit quality of a single company for which a two-way market exists, or on commonly traded indices based on such exposures for which a two-way market exists on the indices; or (ii) a position that is not a securitization position and that hedges a position described in clause (i).
Similar to the incremental risk model, a banking organization’s comprehensive risk model would be required to measure comprehensive risk consistent with a one-year time horizon and at a one-tail, 99.9% confidence level, under the assumption of either a constant level of risk or constant positions. A banking organization approved to measure comprehensive risk for one or more portfolios of correlation trading positions must calculate at least weekly a comprehensive risk measure, which equals the sum of the output from the bank’s approved comprehensive risk model plus a surcharge on the modeled correlation trading positions.
The Agencies are proposing an initial capital surcharge of 15.0% of the total specific risk add-on that would apply to the banking organization’s modeled correlation trading positions under the standardized measurement method for specific risk. Over time, however, with approval from its primary federal supervisor, a banking organization may be permitted to use a floor approach to calculate its capital requirement for correlation trading positions. This floor would be the higher of (i) the output of the banking organization’s approved comprehensive risk model, or (2) 8.0% of the total specific risk add-on for such positions.
The comprehensive risk capital requirement would be the greater of (i) the average of the comprehensive risk measures over the previous 12 weeks; or (ii) the most recent comprehensive risk measure.
If a banking organization does not use a comprehensive risk model to calculate the price risk of a portfolio of correlation trading positions, it must calculate the specific risk add-on for the portfolio using the standardized measurement method, which is the higher of (i) the standardized specific risk charges for all long correlation trading positions and (ii) the standardized specific risk charges for all short correlation trading positions.
Supervisory Review Process
The proposed supervisory review process stresses the need for banking organizations to assess their capital adequacy positions relative to risk, and for primary federal supervisors to take appropriate actions in response to those assessments. The NPR would require banking organizations to have an internal capital adequacy program to address their capital needs for market risk and capture these and all material risks. The NPR also provides requirements for the control, oversight, validation mechanisms, and documentation of internal models. In addition, the NPR requires a banking organization’s primary federal supervisor to evaluate the robustness and appropriateness of its stress tests through the supervisory review process.
With respect to Pillar 3 adjustments to the market risk rule, the NPR would impose quantitative and qualitative disclosure requirements designed to increase transparency and improve market discipline on the top-tier consolidated legal entity that is subject to the market risk capital rule. Under the NPR, a banking organization would have to disclose certain components of its market risk capital requirement, information on its modeling approaches, and information relating to its securitization activities.
More specifically, the NPR would require a banking organization, at least quarterly, to disclose publicly for each portfolio of covered positions the high, low, median, and mean: (i) VaR-based measures over the reporting period and the measure at period-end; (ii) stressed VaR-based measures over the reporting period and the measure at period-end; (iii) incremental risk capital requirements over the reporting period and at period-end; and (iv) comprehensive risk capital requirements over the reporting period and at period-end. Banking organizations would also have to disclose at least quarterly separate measures for interest rate risk, credit spread risk, equity price risk, foreign exchange rate risk, and commodity price risk used to calculate the VaR-based measure, and a comparison of VaR-based measures with actual results and an analysis of important outliers. In addition, banking organizations would have to publicly disclose at least quarterly: (a) the aggregate amount of on-balance sheet and off-balance sheet securitization positions, by exposure type; and (b) the aggregate amount of correlation trading positions.
Furthermore, a top-level banking organization would have to make certain qualitative disclosures at least annually, or more frequently in the event of material changes, on each portfolio of covered positions. These qualitative disclosures would include, among other things, information on: (i) portfolio composition; (ii) valuation policies, procedures and methodologies; (iii) internal model characteristics; (iv) model validation approaches; and (v) stress test descriptions.
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Comments on the NPR will be due within 90 days of its publication in the Federal Register.