United States: Federal Banking Agencies Propose Amended Market Risk Capital Rules

(Financial Services Alert – Developments of Note)

1. Federal Banking Agencies Propose Amended Market Risk Capital Rules
2. FASB Issues Standard on Fair Value Measurements
3. Lawmakers Urge Final Nontraditional Mortgage Product Guidance
4. Recent Class-Action Lawsuits Filed Alleging the Payment of Excessive Fees by 401(k) Plans
5. SEC Holds Roundtable on Results of Economic Studies under Regulation SHO Pilot Temporarily Suspending Short Sale Price Tests for Selected Issuers on the New York Stock Exchange and NASDAQ
6. IRS Issues Proposed Regulations to Ease Reporting When Foreign Tax Benefits Pass to RIC Shareholders

As reported in the September 12 issue of the Alert, the four federal banking agencies (the "Agencies") have issued a notice of proposed rulemaking seeking comment on the US implementation of the New Basel Capital Accord ("Basel II"). Accompanying that notice is another joint notice of proposed rulemaking (the "NPR") seeking comment on amendments to the existing market risk capital rules, which were adopted in 1996 by the FRB, FDIC and the OCC. The proposed rules implement changes proposed in a joint publication of the Basel Committee and the International Organization of Securities Commissions titled "The Application of Basel II to Trading Activities and the Treatment of Double Default Effects" (see the July 26, 2005 Alert). In addition to banks and bank holding companies, the proposed rules will apply to qualifying savings associations (all of which are referred to herein as "banks" for ease of reference). Comments on all the proposals are due by January 23, 2007.

Below is a general description of the market risk capital rules, with special attention to the material proposed modifications. The effective date of the proposed rules is expected to be January 1, 2008, with certain exceptions described below.

Scope of the Market Risk Capital Rules. The market risk capital rules supplement and adjust the Agencies’ credit risk capital rules. The market risk capital rules apply to any bank with aggregate trading assets and liabilities equal to 10 percent or more of total assets, or $1 billion or more. A bank that does not meet the threshold criteria may request that its primary federal supervisor apply the market risk capital rule to it. Moreover, if a bank’s primary federal supervisor deems it necessary or appropriate for safe and sound banking practices, it may apply the market risk capital rule to a bank or exempt a bank from the rules. The rules also provide for a reservation of authority permitting a regulator to increase or decrease capital requirements as appropriate in specific circumstances. The proposed rules add a provision permitting a regulator to require a bank to calculate risk based capital requirements for specific positions or portfolios under the market risk rules or the credit risk rules for the purpose of more accurately reflecting the risks of the positions.

The key objectives of the market risk amendments are to more closely align capital requirements to actual market risks and to enhance modeling requirements to reflect advances in risk management.

Definition of Covered Position. The rule requires banks to maintain capital against the market risk of their covered positions, as defined below. One way the amendments seek to enhance risk sensitivity is through a more detailed definition of "covered position" designed to limit application of the market risk capital rules to liquid and tradable positions and to add certain market positions that are not covered by the current rule but that are frequently entered into by banks for hedging or trading purposes, such as credit default swaps, collateralized debt obligations, and other structured products.

The proposed rules modify the definition of "covered position" by permitting a bank to include positions that hedge other covered positions, as long as those hedges fall within the bank’s hedging strategy, as discussed below. In addition, the proposed rules require that trading assets or liabilities be free of restrictions on tradability, or that the bank be able to hedge its material risk in a liquid or "two-way" market. The Agencies express concern in the NPR that banks might seek to have positions qualify as trading positions by entering into related hedging transactions for the purpose of avoiding treatment under the credit risk rules, and as a result the NPR states that the Agencies will scrutinize banks’ hedging strategies to prevent such manipulation.

Consistent with the current definition, a covered position would also include any foreign exchange or commodity position, although the proposed rules clarify that with prior supervisory approval, a bank may exclude structural positions in foreign currency. In addition to the current exclusion of liquidity facilities for asset-backed commercial paper, the proposed rules also exclude from the definition of "covered security" the following: intangible assets, including servicing assets; hedges of trading positions that are not within the scope of a bank’s hedging strategy; certain credit derivatives and interest rate hedges; and certain residual securitization positions.

The proposed rules permit banks to include in their market risk measure repurchase agreements and securities loans with a term greater than one business day (overnight repos and open loans are already included in the definition of "covered position" as a general matter) and residual securitization positions that are trading assets or liabilities. Term repo-style transactions may only be included if they satisfy specific conditions, including that (i) the transaction is based solely on liquid and readily marketable securities or cash; (ii) the transaction is marked-to-market daily and subject to daily margin maintenance requirements; (iii) the transaction is executed under an agreement that provides certain rights of acceleration, termination, close-out and set-off; and (iv) the bank has conducted and documented sufficient legal review to conclude that the agreement includes these rights and is legally binding. The NPR notes that repo-style transactions and residual securitization positions included in the market risk measure will continue to be subject to credit risk capital requirements as well.

Policies and Procedures, Monitoring and Testing. The NPR notes a trend among banks of including as covered positions more credit risk-based, less liquid and less actively traded products. Under the proposed rule, banks will be required to have clearly defined policies and procedures for determining which of their assets and liabilities are trading positions. These policies and procedures must take into account the extent to which positions and their related hedges can be marked-to-market by reference to a liquid two-way market, as well as possible impairments to the liquidity of a position or its hedge. Banks will also be required to have clearly defined and detailed trading and hedging strategies approved by senior management. Senior management will be required to monitor daily the active management (including daily marking to market and daily risk assessment) of all covered positions. The various components of a bank’s risk management policies will be subject to annual reassessment by senior management to ensure the effectiveness of risk modeling and management techniques. The proposed rule adds a requirement that banks have policies and procedures for the valuation of their covered positions, which again reflects the Agencies’ concerns over the treatment of less liquid trading positions.

In addition to continuing to require that a bank have an independent risk control unit reporting directly to senior management, appropriate stress tests and backtests, and independent annual reviews of risk measurement and risk standards similar to those included in the Agencies’ proposed credit risk rules. These include independent validation and review of the model’s adequacy and effectiveness.

Requirements for Internal Models. Consistent with the existing rule, the amended rule will require that a bank use one or more internal models to calculate a daily VaR (value at risk) based measure that reflects general market risk for its covered positions. In addition to the market risk components mentioned in the current rules (interest rate risk, credit spread risk, equity price risk, foreign exchange rate risk, and commodity price risk) and risks related to options, the proposed rules add new position-specific components that must also be covered. Designed to reflect industry trends toward holding more complex, less liquid products, these concepts include basis risk, prepayment risk and risks arising from illiquidity and limited price transparency. The NPR notes that the Agencies are considering including prepayment risk as a required component of the market risk measure (and not just of specific risk), given the growth of securitization and other large pools of debt securities.

Specific risk of one or more portfolios of covered positions may be included in the VaR measure as well. Under the current rules, to the extent specific risk is not included in a bank’s model, a specific risk add-on is prescribed. Until January 1, 2010, transition rules similar to the current rules will apply to banks that partially model specific risk. Beginning on January 1, 2010, banks that cannot model all aspects of specific risk of a portfolio will be subject to a "standard" specific risk add-on of between 0% and 12%. The rules will utilize the ratings of nationally recognized statistical rating organizations to determine the extent of the add-on for a given portfolio. In this respect, the proposed rule reflects the Agencies’ recognition of the increased use of external ratings (which are evidenced in Basel II and the proposed credit risk capital rules). The proposed rule recognizes the effect of total return swaps and similar instruments for purposes of calculating specific risk add-ons.

The proposed rule would also require banks to model "incremental default risk," which is the default risk that is not reflected in the VaR model (such as a default on the underlying assets in a securitization exposure), beginning on January 1, 2010. If unable to measure incremental default risk using an internal model, a bank using the advanced method under Basel II must measure incremental default risk under the credit risk rules, and all other banks must use the new "standard" method for specific risk set forth in the proposed market risk rules.

The quantitative requirements for a bank’s VaR model under the proposed rules remain consistent with those in the current rules: a one-tailed, 99.0% confidence level with a ten business day holding period, based on a historical observation period of at least one year, with the data set updated at least every three months. Under the proposed rules, backtesting of a bank’s internal model (including the application of a multiplier in the case of multiple exceptions) would be required immediately, but banks would not take into account fees, commissions, reserves and net interest income associated with trading activities for purposes of determining their backtesting results. Incremental default risk would be measured at a 99.9% confidence interval, assuming a constant level of risk and adjusted for the impact of liquidity, concentrations, hedging and optionality. The Agencies expect that banks would measure incremental default risk using a separate model from that used to measure market risk, because of the differing confidence intervals. The Agencies are working with the Accord Implementation Group of the Basel Committee on Banking Supervision to develop guidance on measuring incremental risk.

The proposed rule requires a bank to have in place rigorous processes for evaluating and updating its models to ensure their continued effectiveness. These would include expanded stress testing to account for concentration and liquidity risk, and internal audit of risk management systems. The proposed rule also explicitly adds a requirement that a bank have a process for assessing its overall capital adequacy relative to its market risk that takes into account risks that may not be captured appropriately in the VaR based measure. Also, banks will be required to adequately document all material aspects of their internal models, management and valuation of covered positions, and other activities under the market risk capital rules.

A bank must receive the prior written approval of its primary federal supervisor before using, or making material changes to, an internal model or extending the model to a new business line or product type.

Market Risk Disclosures. Consistent with Basel II’s reliance on market discipline as a pillar of the new risk capital rules, the proposed rule requires banks to have a formal disclosure policy approved by its board of directors that addresses the bank’s approach for determining its market risk disclosures, including related internal controls and disclosure controls and procedures.

Banks will be required to disclose to the public, no less frequently than quarterly, various components of their VaR measurements, as well as a comparison of historical VaR measures together with actual results and related analysis. Detailed annual disclosures of material portfolio holdings, policies and procedures, and a description of the bank’s internal models and its testing of those models will also be required. The proposed rules include a requirement that the bank disclose "the soundness standard on which the bank’s internal capital adequacy assessment under this rule is based" and that the bank’s chief financial officer certify that the bank’s market risk disclosures are "appropriate."

Proposed requirements for regulatory reports are detailed in a companion release to the NPR. The proposed requirements include a detailed analysis of the components of the bank’s market risk capital charge for the purpose of enabling the Agencies to assess the reasonableness and accuracy of the bank’s calculations. The regulatory reports would be shared among the Agencies but would not be available to the public.

The Financial Accounting Standards Board issued Statement of Accounting Standards No. 157, Fair Value Measurements ("FAS 157"), which establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosure regarding fair value measurements. FAS 157 applies whenever other standards require or permit fair value measurements; FAS 157 does not require any new fair value measurements. In general terms, FAS 157 defines fair value to refer to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity would make such a transaction, i.e., the principal or most advantageous market for the asset or liability, and therefore should be based on the assumptions market participants would use when pricing the asset or liability. FAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to "unobservable data," e.g., valuation data generated internally by the reporting entity. FAS 157 also expands required disclosures regarding the use of fair value to value assets and liabilities in interim and annual periods subsequent to initial recognition. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, with early adoption permitted. Consistent with efforts towards international convergence of accounting standards, the International Accounting Standards Board ("IASB") is expected to issue FAS 157 to its constituents in the form of a preliminary views document.

In a hearing last week on Capital Hill, Senate Banking Committee members expressed concern that the sharp increase in nontraditional mortgage products—primarily interest-only and payment-option adjustable-rate mortgage loans—over the last few years could soon pose problems for both banks and borrowers. Although such loans have increased affordability for some borrowers, they could lead to significant monthly payment increases (so-called "payment shock") for borrowers and corresponding credit risk for banks. Unless refinanced or the underlying properties sold, such loans eventually reach points when interest-only and deferred payment periods end and higher, fully amortizing payments begin. Borrowers may find it more difficult to refinance or sell their homes to avoid these higher payments, particularly in a rising interest rate environment or if the equity in their homes fell because only minimum monthly payments were made of less than the accrued interest (causing the loan balance to increase, which is referred to as "negative amortization") or home values dropped. As a result, delinquencies and defaults could rise.

As a first step toward addressing these risks, Committee members urged federal banking regulators to finalize proposed interagency guidance released in December of last year that recommends, among other things, that banks provide enhanced disclosures on such loans and follow prudent underwriting, portfolio and risk management practices. The guidance is aimed at educating borrowers on payment shock through adequate disclosures and promoting safety and soundness by, among other things, recommending that banks underwrite such loans based on the borrowers’ ability to repay the higher, fully amortizing payments. (For a more detailed discussion of the guidance, please refer to the Alerts of December 27, 2005 and February 21, 2006.)

The Committee members supported their case with a recently released Government Accountability Office study on such loans. The study concludes that borrowers of such loan may not fully understand their risks because (1) such loans have complicated terms and features, (2) advertising sometimes emphasizes the benefits of such loans over their risks, (3) mortgage disclosures can be unclear and hard to understand, and (4) current federal disclosure requirements do not require lenders to address the unique terms and risks of such loans.

A representative of the FRB testified at the hearing about potential revisions to Regulation Z that may address these concerns. Sandra F. Braunstein, Director of the Division of Consumer and Community Affairs, stated that the FRB is considering a number of changes, including: (a) simplifying and clarifying Regulation Z’s adjustable-rate mortgage disclosures to make them easier to understand and more useful to consumers, (b) requiring a "worst case" payment disclosure illustrating payment shock, and (c) requiring additional disclosures for negative amortization loans.

Representatives of the federal banking agencies testifying at the hearing indicated that the proposed interagency guidance on nontraditional mortgage loans may be finalized in the next few weeks, and that the final version is expected to be substantially similar to the proposal.

Earlier this month, a number of class-action lawsuits were filed against sponsors of 401(k) plans (and certain of their officers, directors, and employees) alleging that fees paid by the plans to recordkeepers, trustees, and other service providers were unreasonable and in violation of the Employee Retirement Income Security Act of 1974 ("ERISA"). In particular, the lawsuits claim that the fees paid to service providers were excessive when considered in conjunction with amounts received by the service providers under certain revenue-sharing arrangements. According to the lawsuits, under these arrangements a portion of the asset-based fee charged against a plan’s investment in a mutual fund (or other investment vehicle) was shared by the fund or its manager with the parties providing services to the plan, but the defendants failed to take this into account in negotiating fees to be paid by the plans to the service providers.

On September 15, the SEC held a roundtable at its headquarters on the results of the Regulation SHO pilot. (See the June 29, 2004 Alert for a discussion of the adoption of new Regulation SHO and the pilot program, which ends in August 2007.) Under the pilot, the SEC suspended the short sale price test restrictions under the Securities Exchange Act of 1934, as amended (the "1934 Act"), with respect to certain stocks (which were selected by the SEC because they were deemed relatively less susceptible to manipulation based on their capitalization and liquidity) for a period of time in order to generate data on the effect of Regulation SHO on market execution. The short sale price test restrictions of Regulation

SHO are designed to restrict short selling in a declining market. Data from the pilot program were intended to permit the SEC to analyze the effects of relatively unrestricted short selling on market volatility, price efficiency and liquidity and to assess additional potential changes to short sale regulations, including a previously proposed uniform bid test.

Following introductory remarks by SEC Chairman Cox, the roundtable consisted of two panel discussions by academic economists. In the first session, economists presented and critiqued papers based on the pilot data assessing effects of the price test restrictions on the market. In the second session, which was moderated by Chester Spatt, Chief Economist for the SEC, and Bob Colby, Deputy Director of Market Regulation, panelists (including two former chief economists for the SEC) discussed policy implications of the data presented. The second panel was unanimous in its opposition to Regulation SHO. One panelist noted that the infamous "bear raid" scenario of depressing a stock through manipulative shorting, if indeed it exists at all, is much rarer than the opposite scenario of "pump and dump" (or manipulation of a stock price upwards, generally followed by insider selling) and said that short sellers were a natural ally of the SEC in deflating "pump and dumps." Another panelist noted that the tick test (the form of short sale price restriction in use on the NYSE, which forbids a short sale on a downtick in the price) may function as a short-acting circuit breaker by causing moderate congestion in markets. A third panelist observed that the focus of Regulation SHO was downward price manipulation, while no one was focusing on the upward price manipulation that may be caused by open collusion in withholding securities from the lending market.

Panelists spoke out against the locate rule (which requires brokers effecting short sales to follow procedures designed to ensure that they can locate securities to borrow and thus close the short sale), saying that the penalty for naked shorting was too draconian and should be replaced with a series of moderate penalties (perhaps 100-300 bps) aimed at creating a transparent market in securities lending with clear price information. Panelists also discussed the consequences of settlement failures and concerns regarding the effect on corporate governance of unclear share ownership.

At the close of the panel, it remained unclear whether or not the SEC will act on the unanimous recommendation of the economists who served on the panels to repeal the price test restrictions provided under Regulation SHO. The SEC release extending the term of the pilot until August 2007 indicated that the staff would evaluate the results of the pilot and determine whether to recommend changes to the current short sale regulatory scheme. A proposal to amend Regulation SHO by further tightening the rules regarding failures to locate stock for delivery is currently pending; the comment period for that proposal closed September 19, 2006.

The IRS proposed regulations (REG-105248-04) under Section 853 of the Internal Revenue Code ("Code") that will simplify the reporting requirements of both regulated investment companies ("RICs") and their shareholders when foreign tax benefits are passed through to RIC shareholders. In general, shareholders of a RIC do not take into account a RIC’s deductions and credits when determining their individual incomes. Section 853 of the Code provides an exception, however, whereby a RIC with at least 50 percent of its assets invested in the securities of foreign corporations may elect to forego its RIC-level deductions and credits for foreign taxes and, instead, pass such items through directly to its shareholders.

Under the proposed regulations, RICs making an election under Section 853 of the Code will report to each shareholder only the shareholder’s proportionate share of creditable foreign taxes paid and income from foreign countries. Such reporting will be made on an aggregate basis. This proposed change alters the current requirement that RICs report such information to shareholders on a detailed, country-by-country basis. Additionally, the proposed regulations will extend the deadline by which RICs need notify shareholders that the Section 853 election has been made to 60 days after the close of the RIC’s taxable year. Under the current regulations, such notice must be provided to shareholders within 45 days of the close of the RIC’s taxable year. On their individual returns, shareholders will use Form 1116 to report foreign tax information on an aggregate basis, rather than on a country-by-country basis.

The proposed changes reflect modifications made in 1976 to the Code’s foreign tax credit provisions, but not yet reflected in the regulations. The 1976 changes altered the application of the foreign tax credit limitation such that it is now applied on a separate category of income basis, rather than on a country-by-country basis. The IRS further hopes that the new regulations will reduce shareholder confusion experienced upon receipt of extensive charts and data which currently detail the per-country information. Additionally, RICs will likely see a reduction in administrative costs and time spent distributing the per-country information to their shareholders. However, RICs must continue to transmit per-country information to the IRS as part of their Form 1120-RIC.

The IRS is seeking comments on the proposed rule (and requests for a public hearing) by December 18, 2006.

To read previous Financial Services Alerts please click here and go to 'Publications' on Goodwin Procter's site.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2006 Goodwin Procter LLP. All rights reserved.