Banking Agencies Issue Notice Of Proposed Rulemaking For US Basel II

Developments of Note

1. Banking Agencies Issue Notice of Proposed Rulemaking for US Basel II
2. Basel Committee Issues Paper on Business Continuity
3. SEC Staff Provides Grandfathering Relief on Auditor Independence for Newly Registered Hedge Fund Advisers Relying on Custody Rule’s Annual Audited Financial Statements Exception

The four federal banking agencies (the "Agencies") issued a notice of proposed rulemaking ("NPR") seeking comment on all aspects of the US implementation of Basel II (which currently is anticipated to begin in early 2008). The NPR follows an advanced notice of proposed rulemaking ("ANPR") issued in 2003 (see the July 15, 2003 Alert). Comments on the NPR are due 120 days after its publication in the Federal Register.

The NPR is a very extensive document, and the Agencies have stated that they will issue additional guidance in the future detailing the Agencies’ expectations. This Alert will address the credit components of the NPR. Future Alerts will address equities, securitization, and market risk proposals.

I. Overview. As has been discussed in previous issues of the Alert, the NPR reiterates that the Agencies intend to implement only the Advanced Internal Ratings Based Approach ("A-IRB Approach") for credit risk, and a coordinate Advanced Measurement Approach ("AMA Approach") for operational risk (collectively, the "Advanced Approach"). The Advanced Approach would be mandated for approximately 11 large US-based international banking institutions ("core banks," as defined below), and others could opt-in provided that they had the appropriate systems. In response to industry comment, however (see the August 1, 2006 Alert), the Agencies also inquire as to whether US banks should be permitted to use a version of the so-called "standardized" approach to Basel II.

All other U.S. banks would continue to use the current ratings based approach, as amended to take into account the Basel IA process (proposed rules are due out within the NPR’s comment period). As the NPR highlights, the Advanced Approach principally affects the risk-weight denominator for purposes of calculating Tier 1 and Total capital ratios (the "Risk-Based Capital Ratios"). The Advanced Approach generally does not affect the calculation of the numerator (i.e., the qualifying capital) of the Risk-Based Capital Ratios, the leverage capital ratio calculation or the ratios required under the Prompt Corrective Action Rules. Throughout the NPR, the Agencies ask for industry input on a series of specific questions (61 in total), including on the competitive impact of the proposal as between US banks applying the Advanced Approach and other US banking institutions.

II. Applicability and Implementation of the Advanced Approach. The Agencies propose to treat as a core bank any US banking organization that has either (1) consolidated total assets of $250 billion or more on year-end regulatory reports, or (2) consolidated total on-balance sheet foreign exposure of $10 billion or more at the most recent year-end. In addition, a US-chartered bank holding company ("BHC") is a core bank if the BHC either (i) meets the consolidated asset thresholds described above for core banks (excluding from the $250 billion asset calculation assets of insurance underwriting subsidiaries), or (ii) has a subsidiary bank that is a core or opt-in bank. This use of total assets, rather than merely total bank assets, as the metric for implementation at the BHC level is broader than in the ANPR. The NPR states the expansion is intended to prevent BHCs from structuring operations for regulatory arbitrage by moving bank assets into non-bank affiliates. The NPR also notes that the OTS does not intend to apply capital requirements to savings and loan holding companies.

Opt-in banks would have to notify their Agency well in advance of when they expect to use the Advanced Approach. Any US bank subsidiary of a foreign bank would apply the foregoing thresholds at the US institution level. Any banking organization seeking to apply the Advanced Approach would have to develop detailed, Board of Director-approved, implementation plans, and obtain its primary Agency’s approval. To ensure consistency, the Agencies will be developing interagency validation standards and procedures.

Banks would be required to use the Advanced Approach and current capital rules for 1 year (starting in 2008, at the earliest) prior to using the Advanced Approach on a stand-alone basis. Moreover, a banking institution would have minimum capital floors for three years (occuring in 2009-2011, at the earliest) after applying the Advanced Approach on a stand-alone basis (95% and 90% and 85%, respectively, of what the risk-weighted assets would be under the current rules). For purposes of applying the transitional percentage floors, the NPR states that the appropriate risk capital reference will be the general capital rules in place immediately before the US Basel proposal becomes effective (i.e., the floors may or may not take into account Basel IA). A "material" reduction in aggregate capital (e.g., >10 percent) or a wide dispersion in risk capital among relevant banks during the transitional periods would likely lead to further adjustments to the framework. During the transitional periods, a bank’s capital for all non-risk based capital purposes (e.g., Reg W) would be calculated using only the Advanced Approach. On an ongoing basis, the NPR would provide a bank 24 months after a merger to conform the target’s systems to its own.

III. The A-IRB Approach. The A-IRB approach is based on an evaluation of possible losses with respect to credit exposures over a 1 year time horizon, with a confidence level of 99.9%. Unlike in the ANPR, in making these calculations the NPR generally allows the banks to focus on unexpected losses, rather than also include expected losses ("EL"). Excluding EL entirely, however, is dependent upon a bank maintaining sufficient eligible credit reserves to offset the EL (despite industry comment, the NPR does not allow EL to be offset by future margin income, or for a reserve to be avoided for exposures where consistent with prudent best practices). The A-IRB capital formulas basically divide credit into two categories: wholesale and retail (the other 2 categories of assets covered by the NPR are securitizations and equities, which as noted above will be addressed in a future Alert).

Wholesale Exposures. Wholesale exposures generally would include corporate, sovereign, and interbank exposures, as well as specialized lending exposures (but not securitizations, or certain small-business exposures that qualify for retail exposure treatment). With limited exceptions for exposures to certain speculative development loans called high volatility commercial real estate ("HVCRE") (which would receive less favorable capital treatment), the ANPR proposes the same A-IRB capital formula for all wholesale exposures. In contrast to the Basel Accord, the NPR would not provide lower risk weights for exposures to small-and medium-sized enterprises ("SME").

The first A-IRB input for general wholesale exposures is probability of default ("PD"), which is based on an internal rating the institution assigns to each wholesale obligor, with a general minimum PD of 3 basis points (except for certain very high quality exposures, such as sovereigns). The second principal inputs are loss given default ("LGD") and expected loss given default ("ELGD"), which are expressed as a percentage of the bank’s total exposure at default ("EAD") (taking into account recoveries, guarantees (including possible double default treatment), etc.). The LGD may never be less than the ELGD. Rather, the LGD can be thought of as the ELGD plus an increase if appropriate to reflect economic downturn conditions. The NPR currently does not require banks to determine downturn conditions for a particular category of exposures on less than a national level, but asks for comment as to whether a more granular analysis is appropriate. A bank may generate LGD either with its own internal estimates (after regulatory approval), or by applying a supervisory mapping function to ELGD.

The third principal input is EAD, which is the amount legally owed to the bank in the event of default (i.e., on balance sheet amounts, plus an estimate of off-balance sheet amounts). The final principal input is the effective maturity of the obligation, which generally would be set between 1 and 5 years (with exceptions for repo-style transactions and similar obligations). Having established the exposures subject to the wholesale category and these inputs, the bank (1) assigns wholesale obligors and exposures to rating grades (at least 7 non-default grades in the case of wholesale exposures); (2) assigns risk parameters (e.g., the inputs) to wholesale obligors and exposures, and (3) calculates risk weighted assets for the exposures based on regulatory formulae.

Retail Exposures. The retail exposure category encompasses the vast majority of credit exposures to individuals. This category has 3 subcategories: (1) residential mortgages (first or subsequent liens); (2) qualifying revolving exposures ("QREs", generally credit cards and overdraft lines); and (3) other retail exposures (including auto, student and consumer installment loans, and some SMEs). The principal distinction between retail and wholesale exposures is that the former are risk-weighted in pools, rather than on an individual basis. These pools generally would be segregated by their risk drivers, with PD, ELGD, LGD and EAD (but not maturity) remaining important A-IRB inputs. As to PD, the NPR requires two different approaches depending upon the materiality of the seasoning effects in the pool. As with wholesale exposures, there would be a 3 basis point PD minimum, and also a 10% LGD minimum for residential mortgages not federally-guaranteed. The NPR also provides that a 1991 federal law mandates a 50 percent risk weight for certain 1-4 family construction loans and a 100 percent risk weight for certain construction loan for which the purchase contract is cancelled, and asks how those statutory standards should be applied in light of the new framework.

Default. As the foregoing evidences, the definition of "default" is critical to the inputs of US Basel II. In response to industry comment, the Agencies have amended the definition to more closely correlate to industry standards. In the case of wholesale exposures, the term "default" will include any obligation (1) placed on non-accrual status consistent with Call Report instructions, (2) for which a full or partial charge off has been taken because of the obligor’s financial condition, or (3) for which the bank incurred a credit related loss of 5 percent or more on sale. For retail exposures, the NPR tracks the standards in the FFIEC’s Uniform Retail Credit Classification and Account Management Policy. Unlike with wholesale classifications, the definition of default for retail purposes (1) does not include exposures placed on non-accrual status, and (2) is determined on an exposure-by-exposure basis (as opposed to obligor basis, as with wholesale).

IV. Credit Risk Mitigation. The NPR also focuses on risk mitigation techniques that banks can use to offset the capital affects of credit exposures. In the case of wholesale exposures, the collateral generally effects the ELGD and LGD estimation process; for retail exposures the PD, ELGD and LGD estimation process is principally impacted. However, the NPR first discusses how, with respect to repo-style, margin loans and similar securities finance transactions, a bank may be able to adjust EAD rather than LGD or ELGD. The NPR details how a bank has three alternatives – the collateral haircut approach, the simple VaR methodology, and the internal models methodology, when assessing repo-style transactions and eligible margin loan transactions. OTC derivative transactions may involve an internal models methodology, and either current exposure or the collateral haircut approach. The NPR extensively describes the systems banks must develop for these approaches, and their implementation, referring to the Basel Trading Activities paper summarized in the July 26, 2005 Alert for a discussion of internal modeling.

The NPR also discusses the extent to which derivatives can hedge wholesale exposures, and the effect of maturity or currency mismatches. The NPR permits double default treatment for certain hedged exposures, with the eligible providers of such protection effectively limited to financial firms whose normal business includes credit protection. Finally, as to retail exposures, the NPR does not provide the same express limitations and requirements as with wholesale exposures, but does seek to broadly differentiate between eligible retail guarantees (in which the bank could recognize the benefits of the high quality guarantee (e.g., PMI, sovereign exposure) when estimating ELGD and LGD) and non-eligible guarantees (whereby the bank would treat the hedged exposure effectively as a wholesale exposure of the guarantor).

The Basel Committee on Banking Supervision (the "Basel Committee") issued a paper entitled "High-level principles for business continuity" (the "Paper"). The Basel Committee noted that, in the aftermath of recent acts of terrorism, the outbreak of the Avian Flu and various other widespread natural disasters, it is clear that business continuity is "an ongoing priority" for financial institutions ("FIs") and their banking supervisors ("Supervisors") and that such events pose "a substantial risk of major operational disruptions to the financial system." The Paper states that effective business continuity management generally incorporates "business impact analyses, recovery strategies and business continuity plans" as well as testing, training and awareness and communication and crisis management programs.

The Paper sets forth seven high-level principles for business continuity, the first six of which are applicable to both FIs and Supervisors, and the seventh of which applies only to Supervisors. The seven principles are summarized as follows:

Principle 1. Board and Senior Management Responsibilities. Business continuity management is a key element of overall risk management, and the FI’s Board and senior management are responsible for developing and adopting policies that appropriately address these issues and promote a culture that puts a high priority on addressing business continuity risk.

Principle 2. Major Operational Disruptions. FIs and Supervisors should incorporate the risk of a major operational disruption into their business continuity program, which should address how the organization would respond to a major operational disruption.

Principle 3. Recovery Objectives. FIs should develop recovery objectives that reflect the size and complexity of their respective operations and the risk they pose to the operation of the financial system. Recovery objectives may be established in a consultation with, or by, the FIs’ Supervisors.

Principle 4. Communications. FIs’ and Supervisors’ business continuity plans should include procedures for communicating in the event of a major operational disruption both within the organization and with external parties.

Principle 5. Cross-Border Communications. FIs’ and supervisors’ communications procedures should address communications with Supervisors in other countries in the event of major operational disruptions with cross-border implications.

Principle 6. Testing. FIs and Supervisors should engage in ongoing testing of the effectiveness of their business continuity plans and should update their program when appropriate.

Principle 7. Business Continuity Management Reviews by Supervisors. Supervisors should incorporate business continuity risk management reviews into their examination framework for FIs.

The Paper provides five case studies of major operational disruptions and lessons learned from FIs’ and Supervisors’ responses to the disruptive event. The Paper concludes by providing a bibliography concerning business continuity risk management.

The Office of the Chief Accountant, Division of Investment Management of the SEC (the "Staff") issued interpretive guidance in response to a request from a group of accounting firms, regarding application of Section 206(4) of the Investment Advisers Act of 1940, as amended (the "Advisers Act"), and Advisers Act Rule 206(4)-2 (the "Custody Rule"), to certain registered advisers who registered after January 1, 2005 pursuant to Advisers Act Rule 203(b)(3)-2, the now vacated hedge fund adviser rule ("newly registered advisers"). The request for guidance concerned the manner in which newly registered advisers may comply with the Custody Rule by providing annual audited financial statements in lieu of quarterly statements of holdings and transactions to the investors in the advisers’ hedge funds. The accounting firms making the request were concerned that non-audit work performed for a hedge fund or its affiliates would cause them to fail to meet the auditor independence requirements of Regulation S-X that apply to audited financial statements delivered to satisfy the Custody Rule.

In its response, the Staff stated it would not recommend enforcement action against a newly registered adviser providing audited financial statements in lieu of quarterly reports to its clients in cases where the financial statements’ auditor could not satisfy the Reg. S-X independence requirements, so long as: (i) the services and relationships preventing the auditor from being considered "independent" do not impair the auditor’s independence under the independence standards applicable to an audit of the adviser prior to registration; and (ii) those services and relationships prohibited by Reg. S-X cease no later than June 30, 2007. Advisers relying on this guidance must also disclose in the footnotes to their audited financial statements: (a) that the auditor was independent under the standards applicable prior to the adviser’s registering with the SEC; (b) that the auditor is not independent under the SEC’s independence rules; (c) the general reasons why the auditor was not independent; and (d) a brief description of the interpretive relief and the duration of the relief granted by the Staff.

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