On June 7, 2012 the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Fed), and the Federal Deposit Insurance Corporation (FDIC) (collectively, the Agencies) released revisions to their market risk capital rules in a final rule titled Risk-Based Capital Guidelines: Market Risk. The rule, which implements certain revisions made by the Basel Committee on Banking Supervision (BCBS) to its market risk framework between 2005 and 2010, requires large banking organizations to adjust their capital requirements to better capture the market risk in their trading activities. Consistent with certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the final rule does not include aspects of the BCBS’s market risk framework that rely on credit ratings and instead includes alternative standards for calculating standardized specific capital requirements for debt and securitization positions. The rule applies to banks with aggregate trading assets and trading liabilities equal to at least 10 percent of total assets or at least $1 billion dollars.
Definition of Covered Position
The final rule modifies the definition of “covered position” to include trading assets or trading liabilities that are trading positions. Thus, it includes positions held by banks for purposes of short-term resale or held with the intent of benefiting from actual or unexpected short-term price movements or to lock in arbitrage profits. The definition of covered position excludes, among other things, any:
- position that acts as a liquidity facility that provides support to asset-backed commercial paper as well as all intangible assets;
- hedge of a trading position that a primary federal supervisor deems to be outside a bank’s hedging strategy;
- equity positions that are not publicly traded (other than derivatives that reference a publicly traded equity);
- direct real estate holdings; and
- positions held with the intent to securitize (including a “pipeline” or “warehouse”).
The new definition also excludes a credit derivative that a bank recognizes as a guarantee for purposes of calculating risk-weighted assets under the Agencies’ credit-risk capital rules if the credit derivative is used to a hedge a non-covered position. The definition of covered position is substantially similar to the one used in the proposed Volcker rule in order to promote regulatory consistency.
Identifying Trading Positions and Managing Covered Positions
Every bank must have clearly defined policies and procedures for determining the scope of the bank’s trading positions which includes consideration of the extent to which a position or its hedge can be marked to market daily by reference to a two-way market and possible impairments to the liquidity of a position or its hedge. A bank also must have clearly defined trading and hedging strategies that are approved by senior management as well as policies and procedures for actively managing all of its covered positions.
Requirements for Internal Models
In addition, banks will be required to receive prior written approval from their primary federal supervisor before using internal models to calculate their market risk capital requirements and will have to notify that supervisor if they plan to extend the use of those models, if they make material changes to their modeling assumptions, or if they make any changes to their models that would result in material changes in the amount of risk-weighted assets for a portfolio or covered position. The Agencies clarified that vendor models will be acceptable if those models otherwise meet the requirements of the rule. The final rule also establishes procedures to validate internal models on an ongoing basis, implements stress testing of market risk of covered positions, and requires an internal audit function independent of business-line management that assesses the effectiveness of the controls supporting market risk measurement systems.
Capital Requirements for Market Risk
The rule requires banks to calculate their risk-based capital ratio denominator as the sum of their adjusted risk-weighted assets and market risk equivalent assets. For those banking organizations subject to the advanced approaches, the final rule is consistent with the risk-based capital ratio calculation requirements under the advanced approaches framework. Such banks will have to calculate both a general measure for market risk and an advanced measure for market risk. General market risk equivalent assets are calculated by multiplying general measure for market risk by 12.5. The same multiplier is used for banks subject to the advanced approaches. The final rule also eliminates Tier 3 capital from inclusion in a bank’s total risk-based capital numerator.
VaR-based Capital Requirements
Moreover, the final rule requires banks to use internal modeling to calculate daily VaR-based measures that reflect general market risk for all covered positions and certain specific risks. The existing quantitative requirements for the daily VaR measure remain unchanged. Banks also must calculate a stressed VaR-based measure at least weekly using the same internal models that they use to calculate their VaR-based measure. The model inputs will be calibrated to reflect historical data from a 12-month period of significant financial distress appropriate to each bank’s current portfolio.
Standardized Specific Risk Capital Requirements
Sovereign Debt Position: Specific risk-weighting factors for sovereign debt positions will be based on the Country Risk Classifications (CRCs) established by the Organization for Economic Cooperation and Development (OECD). The CRC methodology classifies countries into a risk category from 0-7, with those assigned to the 0 category having the lowest risk assessment. Specific risk-weighting factors will be assigned from zero percent for countries assigned a CRC of 0 or 1 to 12 percent for those in the highest CRC categories. Where a sovereign has defaulted in the previous five years, a specific risk-weighting factor of 12 percent will be assigned regardless of the CRC. Specific risk-weighting factors for debt exposures to depository institutions, foreign banks, credit unions, and public sector entities will be related to the applicable specific risk-weighting factor of the entity’s sovereign of incorporation.
Exposure to Certain Supranational Entities and Multilateral Development Banks (MDBs): Debt positions that are exposures to the Bank for International Settlements, the European Central Bank, the European Commission, and International Monetary Fund each are assigned a zero percent specific risk-weight. The final rule assigns the same specific risk-weighting factor to MDBs. Exposures to regional development banks and multilateral lending banks that do not meet the rule’s requirements are treated as corporate debt positions.
Exposure to Government-sponsored Entities (GSE): Because GSE obligations are not explicitly backed by the full faith and credit of the United States, the final rule does not assign them a zero risk-weighting factor. Such debt positions will be assigned a 1.6 percent specific risk-weighting factor, while such equity exposures will be assigned a specific risk-weighting factor of 8.0 percent.
Corporate Debt Positions: The rule requires banks to assign specific risk-weighting factors to corporate debt positions of entities that have issued and outstanding public debt instruments using an investment grade methodology. Banks first will have to determine whether a corporate debt position meets the definition of investment grade under the final rule and then assign a specific risk-weighting factor based on the category and remaining contractual obligation of the position as described in the table below:
Table 1 – Specific Risk-Weighting Factors for Corporate Debt Positions Under the Investment Grade Methodology
Positions that are exposures to private corporations will be assigned an 8.0 percent risk-weighting factor. Corporate debt positions may not be assigned a risk-weighting factor lower than the specific risk-weighting factor corresponding to the CRC of the issuer’s sovereign of incorporation.
Securitization Positions: Banks will use the simplified supervisory formula approach (SSFA) to assign specific risk-weighting factors to securitization and securitization positions. Banks that do not use the SSFA must assign a specific risk-weighting factor of 100 percent of the securitized position (which is equivalent to a 1,250 percent risk weight). The rule also establishes a 20 percent absolute floor for specific risk-weighting factors assigned to securitized positions.
Additionally, the final rule includes disclosure requirements designed to increase transparency and to improve market discipline. Many of the requirements are already part of public disclosures by the banking industry, and the rule further encourages financial institutions to provide access to these disclosures on their websites. Also, the rule requires banks to provide a description of modeling approaches, information on their stress test scenarios, qualitative and quantitative disclosures relating to their securitization activities, and a breakdown of certain components of their market risk capital requirements.
Although the market risk capital rule does not currently apply to savings associations or savings and loan holding companies (SLHCs), in a notice of proposed rulemaking, Regulatory Capital Rules: Advanced Approaches Risk-based Capital Rule; Market Risk Capital Rule, released by the Agencies on the same day, the Agencies propose expanding the scope of the market risk rule to include saving associations and SLHCs that have trading activity equal to 10 percent or more of total assets or $1 billion or more.
If you have any questions, please contact any of the following individuals within Weil’s Financial Institutions Regulatory practice group:
 Risk-Based Capital Guidelines: Market Risk 46 (OCC joint final June 7, 2012) (to be codified at 12 C.F.R. Pt. 3) available at http://federalreserve.gov/newsevents/press/bcreg/bcreg20120607b1.pdf.