Introduction
The Board of Governors of the Federal Reserve System (FRB), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (collectively, the Banking Agencies) recently approved a joint final rule regarding the amount of capital required under risk-based capital rules to cover market risk (the Market Risk Rule or Rule). The Market Risk Rule is intended to revise banking organizations' internal modeling practices for their trading positions to better reflect current risks and risks that may arise during periods of financial stress, to remove credit ratings from risk assessments as required by section 939A of the Dodd-Frank Act, and to increase transpa-rency through disclosure requirements. The Rule will go into effect on January 1, 2013.
The Market Risk Rule applies (i) to all commercial banks and (ii) to bank holding companies that are domiciled in the U.S. and have $500 million or more of total consolidated assets, when the bank or bank holding company has aggregate trading assets and trading liabilities equal to or greater than $1 billion or 10% of its total consolidated assets.1 The Banking
Agencies have reserved the authority to apply the Rule to banking organizations that do not meet these criteria, to exempt banking organi-zations that do meet these criteria, to require more capital than is called for under the Rule, and to require banking organizations to use different models to calculate risk.
The Rule lays out standards for how banking organizations must analyze and calculate their exposure to market risk in their trading positions, as well as standards for ensuring those methods are rigorous, reliable, and timely.
Analyzing Risk Exposure Under the Market Risk Rule
The Market Risk Rule applies to "covered positions," which it defines as assets or liabilities "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."2 A covered position must be fully tradable, or alternatively, the banking organization must be able to hedge the "material risk elements" of the covered position in a two-way market.3
Internal Models
The Rule seeks to ensure that banking organizations have internal models that properly calculate risk during periods both of calm and of financial stress. Banking organizations must use their internal models to set a daily value-at-risk (VaR) for all covered positions. VaR measures the market risk embedded in an asset using historical data, market trends, and asset-specific volatilities. Under the Rule, banking organizations must also calculate a "stressed VaR measure" for each position, using model inputs calibrated to reflect a period of significant financial stress. A banking organization must provide empirical data to demonstrate how it calculated its stressed VaR test, and the calculation must be performed at least once a week.
These models must calculate both general risks (broad changes in the markets such as fluctuations in interest rates and commodity prices) and risks that are specific to the covered positions, including event risk and idiosyncratic risk. Banking organizations must also calculate an "incremental risk measure to address risks not adequately captured in the VaR-based measure," 4 such as default risk and credit migration risk (i.e., a risk that might arise due to a change in the underlying credit quality of a position).
Banking organizations are required to evaluate and assess their models on an ongoing basis through means such as backtesting, and must retool their models as necessary after conducting such tests.
Unless a banking organization has been approved by the appropriate Banking Agency to use an internal model to calculate specific risk capital requirements in its debt positions and securitization positions, it must use a standardized method, as described below. 5
Requirements for Sovereign Debt, Public Sector and Bank Debt, and Corporate Debt
The capital requirements for sovereign debt positions are based on country risk classifications (CRCs) that are published by the Organization for Economic Cooperation and Development. Positions that are exposures to the U.S. government will be assigned a risk-weighting factor of 0%, while positions that are exposures to other sovereign debt positions will have a risk-weighting factor based on the CRC between 0% and 12%. A sovereign that has defaulted during the previous five years will be assigned a risk-weighting factor of 12%. A sovereign that does not have a CRC will be assigned a risk-weighting factor of 8%.
For a debt position that is an exposure to a public sector entity, depository institution, foreign bank, or credit union organized in a country with a CRC in the three highest categories, the risk-weighting factor will be calculated using the CRC of the country where the entity is incorpo-rated, along with the remaining contractual maturity of the position.
For exposures to corporate debt positions, the capital requirements will be based on whether or not the exposure is "investment grade." A position is investment grade if a banking organization determines that the entity to which it is exposed "has adequate capacity to meet financial commitments for the projected life of the asset or expo-sure," which may be established "if the risk of its default is low and the full and timely repayment of principal and interest is expected."6
Standard for Specific Risk Capital Requirements for Securitization Positions
The Rule also sets a new standard for determining specific risk capital requirements for individual securitization positions. It creates a new, simplified supervisory formula approach (SSFA) that generally requires higher capital requirements for the most junior, riskier tranches and lower capital requirements for the most senior, less risky tranches. Banking organizations need to posses certain information about a securitization in order to use the SSFA, such as the base capital requirement for the underlying assets of the securitization, level of subordination, size of the position within the securitization, and amount of realized losses on the underlying assets. Under the Rule, capital requirements on securitizations will move up or down depending on whether delinquencies on the underlying assets increase or decrease.
Interim 8% Surcharge
The Rule also allows banking organizations to set up a comprehensive risk model to measure all securitization positions that are correlation trading positions, which are defined as positions "for which 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" and non-securitizations that hedge such positions.7 However, the Rule imposes an 8% capital surcharge on these positions until a banking organization's comprehensive model has been approved by its primary federal supervisor and has met the requirements of the Rule for at least one year. Once a banking organization's comprehensive risk model has been approved, the banking organization may use the floor approach, in which "capital requirements are the greater of either the capital calculated using the comprehensive risk model, or 8 percent of the total standardized specific risk capital requirement for correlation trading positions." 8
New Disclosure and Transparency Requirements
Finally, the Rule provides for new and enhanced disclosure requirements for banking organizations, consistent with the Basel Committee on Banking Supervision proposals to increase transparency and market discipline for financial institutions across the globe. Under the Rule, banking organizations are mandated to disclose the components of their market risk capital requirement, their modeling approaches, and "qualitative and quantitative disclosures relating to securitization activities."9 Banking organizations are not required to disclose any material that is proprietary or confidential, "if the banking organization believes that disclosure of the information would seriously prejudice its position."10 If a banking organization invokes this protection, it must release information regarding the subject matter of the requirement and explain why it believes the specific pieces of information that are withheld are protected and should not be disclosed.
Footnotes
1 The Market Risk Rule does not apply to savings and loan associations or to savings and loan holding companies. The Banking Agencies have issued proposed rules that would extend the Rule to cover these institutions, but the Market Risk Rule will not apply to them until the Banking Agencies finalize their proposals. Unlike the treatment of bank holding companies in the Rule, savings and loan holding companies with less than $500 million of total consolidated assets would not be exempt. See Introduction to the common rules, at 3 n.5. All citations to the Market Risk Rule are to the version released by the
FRB on June 7, 2012, available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20120607b1.pdf .
2 Common rules, section 2, at 91.
3 Id. at 85.
4 FRB Staff Memo on the Market Risk Rule, at 7.
5 According to a memorandum by FRB staff, this requirement does not apply to "certain positions that are correlation trad-ing positions." Correlation trading positions are described in the memorandum as "tranched credit products with corpo-rate debt positions as the underlying assets." Id. at 8.
6 Common rules, section 2, at 87.
7 Common rules, section 9, at 104.
8 FRB Staff Memo on the Market Risk Rule, at 15.
9 Id.
10 Id.
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