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Daily Rules, Proposed Rules, and Notices of the Federal Government

FEDERAL DEPOSIT INSURANCE CORPORATION

Office of the Comptroller of the Currency

12 CFR Part 325

[Regulations H and Y; Docket No. R-1401]

RIN 3064-AD70

Risk-Based Capital Guidelines: Market Risk

AGENCY: Office of the Comptroller of the Currency, Department of the Treasury; Board of Governors of the Federal Reserve System; and Federal Deposit Insurance Corporation.
ACTION: Joint final rule.
SUMMARY: The Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Board), and Federal Deposit Insurance Corporation (FDIC) are revising their market risk capital rules to better capture positions for which the market risk capital rules are appropriate; reduce procyclicality; enhance the rules' sensitivity to risks that are not adequately captured under current methodologies; and increase transparency through enhanced disclosures. The final rule does not include all of the methodologies adopted by the Basel Committee on Banking Supervision for calculating the standardized specific risk capital requirements for debt and securitization positions due to their reliance on credit ratings, which is impermissible under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Instead, the final rule includes alternative methodologies for calculating standardized specific risk capital requirements for debt and securitization positions.
DATES: The final rule is effective January 1, 2013.
FOR FURTHER INFORMATION CONTACT: Board:Anna Lee Hewko, Assistant Director, (202) 530-6260, Connie Horsley, Manager, (202) 452-5239, Tom Boemio, Manager, (202) 452-2982, Dwight Smith, Senior Supervisory Financial Analyst, (202) 452-2773, or Jennifer Judge, Supervisory Financial Analyst, (202) 452-3089, Capital and Regulatory Policy, Division of Banking Supervision and Regulation; or Benjamin W. McDonough, Senior Counsel, (202) 452-2036, or April C. Snyder, Senior Counsel, (202) 452-3099, Legal Division. For the hearing impaired only, Telecommunication Device for the Deaf (TDD), (202) 263-4869.

FDIC:Karl Reitz, Chief, Capital Markets Strategies Section,kreitz@fdic.gov; Bobby R. Bean, Associate Director,bbean@fdic.gov; Ryan Billingsley, Chief, Capital Policy Section,rbillingsley@fdic.gov; David Riley, Senior Policy Analyst,dariley@fdic.gov, Capital Markets Branch, Division of Risk Management Supervision, (202) 898-6888; or Mark Handzlik, Counsel,mhandzlik@fdic.gov, Michael Phillips, Counsel,mphillips@fdic.gov, Greg Feder, Counsel,gfeder@fdic.gov, or Ryan Clougherty, Senior Attorney,rclougherty@fdic.gov; Supervision Branch, Legal Division, Federal Deposit Insurance Corporation, 550 17th Street NW., Washington, DC 20429. SUPPLEMENTARY INFORMATION: Table of Contents I. Introduction II. Overview of Comments 1. Comments on the January 2011 Proposal 2. Comments on the December 2011 Amendment III. Description of the Final Market Risk Capital Rule 1. Scope 2. Reservation of Authority 3. Definition of Covered Position 4. Requirements for the Identification of Trading Positions and Management of Covered Positions 5. General Requirements for Internal Models Model Approval and Ongoing Use Requirements Risks Reflected in Models Control, Oversight, and Validation Mechanisms Internal Assessment of Capital Adequacy Documentation 6. Capital Requirement for Market Risk Determination of the Multiplication Factor 7. VaR-based Capital Requirement Quantitative Requirements for VaR-based Measure 8. Stressed VaR-based Capital Requirement Quantitative Requirements for Stressed VaR-based Measure 9. Modeling Standards for Specific Risk 10. Standardized Specific Risk Capital Requirement Debt and Securitization Positions Treatment Under the Standardized Measurement Method for Specific Risk for Modeled Correlation Trading Positions and Non-modeled Securitization Positions Equity Positions Due Diligence Requirements for Securitization Positions 11. Incremental Risk Capital Requirement 12. Comprehensive Risk Capital Requirement 13. Disclosure Requirements IV. Regulatory Flexibility Act Analysis V. OCC Unfunded Mandates Reform Act of 1995 Determination VI. Paperwork Reduction Act VII. Plain Language I. Introduction

The first international capital framework for banks1 entitledInternational Convergence of Capital Measurement and Capital Standards(1988 Capital Accord) was developed by the Basel Committee on Banking Supervision (BCBS)2 and endorsed by the G-10 central bank governors in 1988. The OCC, the Board, and the FDIC (collectively, the agencies) implemented the 1988 Capital Accord in 1989 through the issuance of the general risk-based capital rules.3 In 1996, the BCBS amended the 1988 Capital Accord to require banks to measure and hold capital to cover their exposure to market risk associated with foreign exchange and commodity positions and positions located in the trading account (the Market Risk Amendment (MRA) or market risk framework).4 The agenciesimplemented the MRA with an effective date of January 1, 1997 (market risk capital rule).5

1For simplicity, and unless otherwise indicated, the preamble to this final rule uses the term “bank” to include banks and bank holding companies (BHCs). The terms “bank holding company” and “BHC” refer only to bank holding companies regulated by the Board.

2The BCBS is a committee of banking supervisory authorities, which was established by the central bank governors of the G-10 countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. Documents issued by the BCBS are available through the Bank for International Settlements Web site athttp://www.bis.org.

3The agencies' general risk-based capital rules are at 12 CFR part 3, appendix A and 12 CFR part 167 (OCC); 12 CFR parts 208 and 225, appendix A (Board); and 12 CFR part 325, appendix A (FDIC).

4In 1997, the BCBS modified the MRA to remove a provision pertaining to the specific risk capital requirement under the internal models approach (see http://www.bis.org/press/p970918a.htm).

561 FR 47358 (September 6, 1996). In 1996, the Office of Thrift Supervision did not implement the market risk framework for savings associations and savings and loan holding companies. However, also included in today'sFederal Register, the agencies are proposing to expand the scope of their market risk capital rules to apply to Federal and state savings associations as well as savings and loan holding companies. Therefore, the market risk rule would not apply to savings associations or savings and loan holding companies until such times as the agencies' were to finalize their proposal to expand the scope of their market risk capital rules. The agencies' market risk capital rules are at 12 CFR part 3, appendix B (OCC); 12 CFR parts 208 and 225, appendix E (Board); and 12 CFR part 325, appendix C (FDIC).

In June 2004, the BCBS issued a document entitledInternational Convergence of Capital Measurement and Capital Standards: A Revised Framework(Basel II), which was intended for use by individual countries as the basis for national consultation and implementation. Basel II sets forth a “three-pillar” framework that includes (1) Risk-based capital requirements for credit risk, market risk, and operational risk (Pillar 1); (2) supervisory review of capital adequacy (Pillar 2); and (3) market discipline through enhanced public disclosures (Pillar 3).

Basel II retained much of the MRA; however, after its release, the BCBS announced that it would develop improvements to the market risk framework, especially with respect to the treatment of specific risk, which refers to the risk of loss on a position due to factors other than broad-based movements in market prices. As a result, in July 2005, the BCBS and the International Organization of Securities Commissions (IOSCO) jointly publishedThe Application of Basel II to Trading Activities and the Treatment of Double Default Effects(the 2005 revisions). The BCBS incorporated the 2005 revisions into the June 2006 comprehensive version of Basel II and followed its “three-pillar” structure. Specifically, the Pillar 1 changes narrow the types of positions that are subject to the market risk framework and revise modeling standards and procedures for calculating minimum regulatory capital requirements. The Pillar 2 changes require banks to conduct internal assessments of their capital adequacy with respect to market risk, taking into account the output of their internal models, valuation adjustments, and stress tests. The Pillar 3 changes require banks to disclose certain quantitative and qualitative information, including their valuation techniques for covered positions, the soundness standard used for modeling purposes, and their internal capital adequacy assessment methodologies.

The BCBS began work on significant changes to the market risk framework in 2007 and developed reforms aimed at addressing issues highlighted by the financial crisis. These changes were published in the BCBS'sRevisions to the Basel II Market Risk Framework, Guidelines for Computing Capital for Incremental Risk in the Trading Book,andEnhancements to the Basel II Framework(collectively, the 2009 revisions).

The 2009 revisions place additional prudential requirements on banks' internal models for measuring market risk and require enhanced qualitative and quantitative disclosures, particularly with respect to banks' securitization activities. The revisions also introduce an incremental risk capital requirement to capture default and credit quality migration risk for non-securitization credit products. With respect to securitizations, the 2009 revisions require banks to apply a standardized measurement method for specific risk to these positions, except for “correlation trading” positions (described further below), for which banks may choose to model all material price risks. The 2009 revisions also add a stressed Value-at-Risk (VaR)-based capital requirement to banks' existing general VaR-based capital requirement. In June 2010, the BCBS published additional revisions to the market risk framework including a floor on the risk-based capital requirement for modeled correlation trading positions (2010 revisions).6

6The June 2010 revisions can be found in their entirety athttp://bis.org/press/p100618/annex.pdf.

Both the 2005 and 2009 revisions include provisions that reference credit ratings. The 2005 revisions also expanded the “government” category of debt positions to include all sovereign debt and changed the standardized specific risk-weighting factor for sovereign debt from zero percent to a range of zero to 12.0 percent based on the credit rating of the obligor and the remaining contractual maturity of the debt position.7

7In the context of the market risk capital rules, the specific risk-weighting factor is a scaled measure that is similar to the “risk weights” used in the general risk-based capital rules (e.g., the zero, 20 percent, 50 percent, and 100 percent risk weights) for determining risk-weighted assets. The measure for market risk is multiplied by 12.5 to convert it to market risk equivalent assets, which are then added to the denominator of the risk-based capital ratios.

The 2009 revisions include changes to the specific risk-weighting factors for rated and unrated securitization positions. For rated securitization positions, the revisions assign a specific risk-weighting factor based on the credit rating of a position, and whether such rating represents a long-term credit rating or a short-term credit rating. In addition, the 2009 revisions provide for the application of higher specific risk-weighting factors to rated resecuritization positions relative to similarly-rated securitization exposures. Under the 2009 revisions, unrated securitization positions were to be deducted from total capital, except when the unrated position was held by a bank that had approval and ability to use the supervisory formula approach (SFA) to determine the specific risk add-on for the unrated position. Finally, underBasel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems(Basel III), published by the BCBS in December 2010, and revised in June 2011, certain items, including certain securitization positions, that had been deducted from total capital are assigned a risk weight of 1,250 percent.

On January 11, 2011, the agencies issued a joint notice of proposed rulemaking (January 2011 proposal) that sought public comment on revisions to the agencies' market risk capital rules to implement the 2005, 2009, and 2010 revisions.8 The key objectives of the proposal were to enhance the rule's sensitivity to risks not adequately captured, including default and credit migration; enhance modeling requirements in a manner that is consistent with advances in risk management since the agencies' initial implementation of the MRA; modify the definition of “covered position” to better capture positions for which treatment under the rule is appropriate; address shortcomings in the modeling of certain risks; address procyclicality; and increase transparency through enhanced disclosures. The objective of enhancing the risk sensitivity of the market risk capital rule is particularly important because of banks' increased exposures to traded credit and other structured products, such as credit default swaps (CDSs) and asset-backed securities, and exposures to less liquid products. Generally, the risks of these products have not been fully captured by VaR models that rely on a 10-business-day, one-tail, 99.0 percent confidence level soundness standard.

876 FR 1890 (January 11, 2011).

When publishing the January 2011 proposal, the agencies did not propose to implement those aspects of the 2005 and 2009 revisions that rely on the use of credit ratings due to certain provisions of the Dodd-Frank WallStreet Reform and Consumer Protection Act (the Dodd-Frank Act).9 The January 2011 proposal did not include new specific risk add-ons but included as an interim solution the treatment under the agencies' current market risk capital rules. Subsequently, after developing and considering alternative standards of creditworthiness, the agencies issued in December 2011 a joint notice of proposed rulemaking (NPR) that amended the January 2011 proposal (December 2011 amendment) to include alternative methodologies for calculating the specific risk capital requirements for covered debt and securitization positions under the market risk capital rules, consistent with section 939A of the Dodd-Frank Act. The agencies are now adopting a final rule, which incorporates comments received on both the January 2011 proposal and December 2011 amendment and includes aspects of the BCBS's 2005, 2009, and 2010 revisions (collectively, the MRA revisions) to the market risk framework.

9Public Law 111-203, 124 Stat. 1376 (July 21, 2010). Section 939A(a) of the Dodd-Frank Act provides that not later than 1 year after the date of enactment, each Federal agency shall: (1) Review any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and (2) any references to or requirements in such regulations regarding credit ratings. Section 939A further provides that each such agency “shall modify any such regulations identified by the review under subsection (a) to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations.”See15 U.S.C. 78o-7 note.

II. Overview of Comments

The agencies received six comment letters on the January 2011 proposal and 30 comment letters on the December 2011 amendment from banking organizations, trade associations representing the banking or financial services industry, and other interested parties. This section of the preamble highlights commenters' main concerns and briefly describes how the agencies have responded to comments received in the final rule. A more detailed discussion of comments on specific provisions of the final rule is provided in section III of this preamble.

1. Comments on the January 2011 Proposal

While commenters expressed general support for the proposed revisions to the agencies' market risk capital rules, many noted that the BCBS's market risk framework required further improvement in certain areas. For example, some commenters expressed concern about certain duplications in the capital requirements, such as the requirement for both a VaR-based measure and a stressed VaR-based measure, because such redundancies would result in excessive capital requirements and distortions in risk management. A different commenter noted that the use of numerous risk measures with different time horizons and conceptual approaches may encourage excessive risk taking.

Although commenters characterized the conceptual overlap of certain provisions of the January 2011 proposal as resulting in duplicative capital requirements, the agencies believe that these provisions provide a prudent level of conservatism in the market risk capital rule.

One commenter noted that the rule's VaR-based measure has notable shortcomings because it may encourage procyclical behavior and regulatory arbitrage. This commenter also asserted that because marked-to-market assets can experience significant price volatility, the proposal's required capital levels may not be sufficient to address this volatility. The agencies are concerned about these issues but believe that the January 2011 proposal addressed these concerns, for example, through the addition of a stressed VaR-based measure.

Commenters generally encouraged the agencies to continue work on the fundamental review of the market risk framework recently published as a consultative document through the BCBS, and one asserted that the agencies should wait until this work is completed before revising the agencies' market risk capital rules.10 While the agencies are committed to continued improvement of the market risk framework, they believe that the proposed modifications to the market risk capital rules are necessary to address current significant shortcomings in banks' measurement and capitalization of market risk.

10The consultative document is available athttp://www.bis.org/publ/bcbs219.htm.

Commenters also expressed concern that the January 2011 proposal differs from the 2005 and 2009 revisions in some respects, such as excluding from the definition of covered position a hedge that is not within the scope of the bank's hedging strategy, providing a more restrictive definition of two-way market, and establishing a surcharge for correlation trading position equal to 15 percent of the specific risk capital requirements for such positions. Commenters expressed concern that such differences could place U.S. banks at a competitive disadvantage to certain foreign banking organizations. In response to commenters' concerns, the agencies have revised the definition of two-way market and adjusted the surcharge as discussed more fully in sections II.3 and II.12, respectively, of this preamble.

2. Comments on the December 2011 Amendment

While many commenters responding to the December 2011 amendment commended the agencies' efforts to develop viable alternatives to credit ratings, most commenters indicated that the amendment did not strike a reasonable balance between accurate measurement of risk and implementation burden. Commenters' general concerns with the December 2011 amendment include its overall lack of risk sensitivity and its complexity. The agencies have incorporated a number of changes into the final rule based on feedback received from commenters, including modifications to the approaches for determining capital requirements for corporate debt positions and securitization positions proposed in the December 2011 amendment. These changes are intended to increase the risk sensitivity of the approaches as well as simplify and reduce the difficulty of implementing the approaches.

A few commenters asserted that the proposal exceeded the intent of the Dodd-Frank Act because the Dodd-Frank Act was limited to the replacement of credit ratings and did not include provisions that, in their estimation, would significantly increase capital requirements and thus negatively affect the economy. While the agencies acknowledge that capital requirements may generally increase under the final rule, the agencies also believe that the approach provides a prudent level of conservatism to address factors such as modeling uncertainties and that changes to the current rules are necessary to address significant shortcomings in the measurement and capitalization of market risk.

One commenter suggested that the agencies allow banks a transition period of at least one year to implement the market risk capital rule after incorporation of alternatives to credit ratings. The agencies believe that a one-year transition period is not necessary for banks to implement the credit ratings alternatives in the final rule. The agencies have determined based on comments and discussions with commenters that the information required for calculation of capital requirements under the final rule willbe available to banks. Other commenters indicated that the proposal would be burdensome for community banks if the agencies used the proposed approaches to address the use of credit ratings in the general risk-based capital rules. The agencies believe that it is important to align the methodologies for calculating specific risk-weighting factors for debt positions and securitization positions in the market risk capital rules with methodologies for assigning risk weights under the agencies' other capital rules. Such alignment reduces the potential for regulatory arbitrage between rules. The agencies are proposing similar credit rating alternatives in the three notices of proposed rulemaking for the risk-based capital requirements that are published elsewhere in today'sFederal Register.

Several commenters requested extensions of the comment period citing the complexity of the December 2011 amendment and resulting difficulty of assessing its impact in the time period given as well as the considerable burden faced by banks in evaluating various regulations related to the Dodd-Frank Act within similar time periods. The agencies considered these requests but believe that sufficient time was provided between the agencies' announcement of the proposed amendment on December 7, 2011, and the close of the comment period on February 3, 2012, to allow for adequate analysis of the proposal. The agencies also met with a number of industry participants during the comment period and thereafter in order to clarify the intent of the comments. Accordingly, the agencies chose not to extend the comment period on the December 2011 amendment.

III. Description of the Final Market Risk Capital Rule 1. Scope

The market risk capital rule supplements both the agencies' general risk-based capital rules and the advanced capital adequacy guidelines (advanced approaches rules) (collectively, the credit risk capital rules)11 by requiring any bank subject to the market risk capital rule to adjust its risk-based capital ratios to reflect the market risk in its trading activities. The agencies did not propose to amend the scope of application of the market risk capital rule, which applies to any bank with aggregate trading assets and trading liabilities equal to 10 percent or more of total assets or $1 billion or more. One commenter stated that the $1 billion threshold for the application of the market risk capital rule is not a particularly risk-sensitive means for determining the applicability of the rule. This commenter also expressed concern that the proposed threshold is too low, and recommended an adjustment to recognize the relative risk of exposures, calculated by offsetting trading assets and liabilities. The agencies believe that the current scope of application of the market risk requirements reasonably identifies banks with significant levels of trading activity and therefore have retained the existing threshold criteria. While the agencies are concerned about placing undue burden on banks, the agencies believe that the thresholds provided in the final rule are reasonable given the risk profile of banks identified by the current scope of application.

11The agencies' advanced approaches rules are at 12 CFR part 3, appendix C (OCC); 12 CFR part 208, appendix F, and 12 CFR part 225, appendix G (Board); and 12 CFR part 325, appendix D (FDIC). For purposes of this preamble, the term “credit risk capital rules” refers to the general risk-based capital rules and the advanced approaches rules (that also include operational risk capital requirements), as applicable to the bank using the market risk capital rule.

Consistent with the January 2011 proposal, under the final rule, the primary federal supervisor of a bank that does not meet the threshold criteria would be still be able to apply the market risk capital rule to a bank. Conversely, the primary federal supervisor may exclude a bank from application of the rule if the supervisor were to deem it necessary or appropriate given the level of market risk of the bank or to ensure safe and sound banking practices.

2. Reservation of Authority

The January 2011 proposal contained a reservation of authority that affirmed the authority of a bank's primary federal supervisor to require the bank to hold an overall amount of capital greater than would otherwise be required under the rule if that supervisor determined that the bank's capital requirement for market risk under the rule was not commensurate with the market risk of the bank's covered positions. In addition, the agencies anticipated that there may be instances when the January 2011 proposal would generate a risk-based capital requirement for a specific covered position or portfolio of covered positions that is not commensurate with the risks of the covered position or portfolio. In these circumstances, a bank's primary federal supervisor could require the bank to assign a different risk-based capital requirement to the covered position or portfolio of covered positions that more accurately reflects the risk of the position or portfolio. The January 2011 proposal also provided authority for a bank's primary federal supervisor to require the bank to calculate capital requirements for specific positions or portfolios using either the market risk capital rule or the credit risk capital rules, depending on which outcome more appropriately reflected the risks of the positions. The agencies did not receive any comment on the proposed reservation of authority and have adopted it without change in the final rule.

3. Definition of Covered Position

The January 2011 proposal modified the definition of a covered position to include trading assets or trading liabilities (as reported on schedule RC-D of the Call Report or Schedule HC-D of the Consolidated Financial Statements for Bank Holding Companies) that are trading positions. The January 2011 proposal defined a trading position as a position that is held by the bank 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. Therefore, the characterization of an asset or liability as “trading” for purposes of U.S. Generally Accepted Accounting Principles (U.S. GAAP) would not on its own determine whether the asset or liability is a “trading position” for purposes of the January 2011 proposal. That is, being reported as a trading asset or trading liability on the regulatory reporting schedules is a necessary, but not sufficient, condition for meeting this aspect of the covered position definition under the January 2011 proposal. Such a position would also need to be either a trading position or hedge another covered position. In addition, the trading asset or trading liability must be free of any restrictive covenants on its tradability or the bank must be able to hedge the material risk elements of the position in a two-way market.

One commenter was concerned that this and other references to a two-way market in the January 2011 proposal could be construed to require that there be a two-way market for every covered position. The January 2011 proposal did not require that there be a two-way market for every covered position but did use that standard for defining some covered positions, such as certain correlation trading positions. Rather, in identifying its trading positions, a bank's policies and procedures must take into account the extent to which a position, or a hedge of its material risks, can be marked-to-market daily by reference to a two-way market.

The January 2011 proposal defined a two-way market as a market where there are independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined within one day and settled at that price within five business days. Commenters expressed concern about the proposed definition of a two-way market including a requirement for settlement within five business days because it would automatically exclude a number of markets where settlement periods are longer than this time frame. In light of commenters' concerns, the agencies have modified this aspect of the definition in the final rule to require settlement within a “relatively short time frame conforming to trade custom.”

Another commenter requested clarification regarding whether securities held as available for sale under U.S. GAAP may be treated as covered positions under the rule. This commenter also indicated that a narrow reading of the definitions of trading position and covered position could be interpreted to require banks to move positions between treatment under the market risk and the credit risk capital rules during periods of market stress. In particular, the commenter expressed concern about changes in capital treatment due to changes in a bank's short-term trading intent or the lack of a two-way market during periods of market stress that might be temporary. The commenter suggested that a bank should be able to continue to treat a position as a covered position if it met the definitional requirements when the position was established, notwithstanding changes in markets that led to a longer than expected time horizon for sale or hedging.

The agencies note that under section 3 of the final rule, as under the proposed rule, a bank must have clearly defined policies and procedures that determine which of its positions are trading positions. With respect to the frequency of movement of positions, consistent with the requirements under U.S. GAAP, the agencies generally would expect re-designations of positions as trading or non-trading to be rare. Thus, in general, the agencies would not expect temporary market movements as described by the commenter to result in re-designations. In those limited circumstances where a bank re-designates a covered position, the bank should document the reasons for such action.

Commenters suggested allowing a bank to treat as a covered position any hedge that is outside of the bank's hedging strategy. The proposed definition of covered position included hedges that offset the risk of trading positions. The agencies are concerned that a bank could craft its hedging strategies to recognize as covered positions certain non-trading positions that are more appropriately treated under the credit risk capital rules. For example, mortgage-backed securities that are not held with the intent to trade, but are hedged with interest rate swaps, would not be covered positions. The agencies will review a bank's hedging strategies to ensure that they are not being manipulated in an inappropriate manner. Consistent with the concerns raised above, the agencies continue to believe that a position that hedges a trading position must be within the scope of a bank's hedging strategy as described in the rule. Thus, the final rule retains the treatment that hedges outside of a bank's hedging strategy as described in the final rule are not covered positions.

Other commenters sought clarification as to whether an internal hedge (between a banking unit and a trading unit of the same bank) could be treated as a covered position if it materially or completely offset the risk of a non-covered position or set of positions, provided the hedge meets the definition of a covered position. The agencies note that internal hedges are not recognized for regulatory capital purposes because they are eliminated in consolidation.

Commenters inquired as to whether the phrase “restrictive covenants on its tradability,” in the covered position definition, applies to securities transferable only to qualified institutional buyers as required under Rule 144A of the Securities Act of 1933. The agencies do not believe an instrument's designation as a 144A security in and of itself would preclude the instrument from meeting the definition of covered position. Another commenter asked whether level 3 securities could be treated as covered positions.12 The agencies note that there is no explicit exclusion of level 3 securities from being designated as covered positions, as long as they meet the requirements of the covered position definition.

12 SeeFinancial Accounting Standards Board Statement 157. This statement defines fair value, establishes a framework for measuring fair value in U.S. GAAP and expands disclosures about fair value measurement. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). Level 3 securities are those for which inputs are unobservable in the market.

One commenter requested clarification as to whether the rule would permit a bank to determine at the portfolio level whether a set of positions satisfies the definition of covered position, provided the bank is able to demonstrate a sufficiently robust process for making this determination. Another commenter found it confusing and operationally challenging that the definition of covered position had requirements both at the position level, for example, specific exclusions, and at the portfolio level, in regard to hedging strategies. The commenter felt that many of the definitional requirements are better suited to assessment at a portfolio level based on robust policies and procedures. The agencies require that the covered position determination be made at the individual position level. The requirements for policies and procedures for identifying trading positions, defining hedging strategies, and management of covered positions are requirements for application of the market risk capital rule broadly.

The January 2011 proposal included within the definition of a covered position any foreign exchange or commodity position, regardless of whether it is a trading asset or trading liability. With prior supervisory approval, a bank could exclude from its covered positions any structural position in a foreign currency, which was defined as a position that is not a trading position and that is (1) Subordinated debt, equity, or minority interest in a consolidated subsidiary that is denominated in a foreign currency; (2) capital assigned to a foreign branch that is denominated in a foreign currency; (3) a position related to an unconsolidated subsidiary or another item that is denominated in a foreign currency and that is deducted from the bank's tier 1 and tier 2 capital; or (4) a position designed to hedge a bank's capital ratios or earnings against the effect of adverse exchange rate movements on (1), (2), or (3).

Also, the proposed definition of covered position had several explicit exclusions. It explicitly excluded any position that, in form or substance, acts as a liquidity facility that provides support to asset-backed commercial paper, as well as all intangible assets, including servicing assets. Intangible assets were excluded because their risks are explicitly addressed in the credit risk capital rules, often through a deduction from capital. The agencies received no comment on these exclusions and have incorporated them into the final rule.

The definition of covered positions also excluded any hedge of a tradingposition that the bank's primary federal supervisor determines is outside the scope of a bank's hedging strategy. One commenter objected to that exclusion; however, the agencies believe that sound risk management should be guided by explicit strategies subject to appropriate oversight by bank management and, therefore, have retained this provision in the final rule.

Under the final rule and as proposed, the covered position definition excludes any equity position that is not publicly traded, other than a derivative that references a publicly traded equity; any direct real estate holding; and any position that a bank holds with the intent to securitize. Equity positions that are not publicly traded include private equity investments, most hedge fund investments, and other such closely-held and non-liquid investments that are not easily marketable. Direct real estate holdings include real estate for which the bank holds title, such as “other real estate owned” held from foreclosure activities, and bank premises used by a bank as part of its ongoing business activities. With respect to such real estate holdings, the determination of marketability and liquidity can be difficult or even impractical because the assets are an integral part of the bank's ongoing business. Indirect investments in real estate, such as through real estate investment trusts or special purpose vehicles, must meet the definition of a trading position to be a covered position. One commenter sought clarification that indirect real estate holdings (such as an exposure to a real estate investment trust) could qualify as a covered position. The agencies note that such an indirect investment may qualify, provided the position otherwise meets the definition of a covered position.

Commenters requested clarification regarding whether hedge fund exposures that hedge a covered position are within the scope of a bank's hedging strategy qualify for inclusion in the definition of a covered position. Generally, hedge fund exposures are not covered positions because they typically are equity positions (as defined under the final rule) that are not publicly traded. The fact that a bank has a hedging strategy for excluded equity positions would not alone qualify such positions to be treated as covered positions under the rule.

Positions that a bank holds with the intent to securitize include a “pipeline” or “warehouse” of loans being held for securitization. The agencies do not view the intent to securitize these positions as synonymous with the intent to trade them. Consistent with the 2009 revisions, the agencies believe the positions excluded from the covered position definition have significant constraints in terms of a bank's ability to liquidate them readily and value them reliably on a daily basis.

The covered position definition also excludes a credit derivative that a bank recognizes as a guarantee for purposes of calculating its risk-weighted assets under the agencies' credit risk capital rules if the credit derivative is used to hedge a position that is not a covered position (for example, a credit derivative hedge of a loan that is not a covered position). This treatment requires the bank to include the credit derivative in its risk-weighted assets for credit risk and exclude it from its VaR-based measure for market risk. This treatment of a credit derivative hedge avoids the mismatch that arises when the hedged position (for example, a loan) is not a covered position and the credit derivative hedge is a covered position. This mismatch has the potential to overstate the VaR-based measure of market risk because only one side of the transaction would be reflected in that measure. Accordingly, the final rule adopts this aspect of the proposed definition of covered position without change.

Under the January 2011 proposal, in addition to commodities and foreign exchange positions, a covered position includes debt positions, equity positions, and securitization positions. Consistent with the January 2011 proposal, the final rule defines a debt position as a covered position that is not a securitization position or a correlation trading position and that has a value that reacts primarily to changes in interest rates or credit spreads. Examples of debt positions include corporate and government bonds, certain nonconvertible preferred stock, certain convertible bonds, and derivatives (including written and purchased options) for which the underlying instrument is a debt position.

The final rule defines an equity position as a covered position that is not a securitization position or a correlation trading position and that has a value that reacts primarily to changes in equity prices. Examples of equity positions include voting or nonvoting common stock, certain convertible bonds, commitments to buy or sell equity instruments, equity indices, and a derivative for which the underlying instrument is an equity position.

Under the final rule as under the January 2011 proposal, a securitization is defined as a transaction in which (1) All or a portion of the credit risk of one or more underlying exposures is transferred to one or more third parties; (2) the credit risk associated with the underlying exposures has been separated into at least two tranches that reflect different levels of seniority; (3) performance of the securitization exposures depends upon the performance of the underlying exposures; (4) all or substantially all of the underlying exposures are financial exposures (such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities); (5) for non-synthetic securitizations, the underlying exposures are not owned by an operating company;13 (6) the underlying exposures are not owned by a small business investment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682); and (7) the underlying exposures are not owned by a firm an investment in which qualifies as a community development investment under 12 U.S.C. 24 (Eleventh).

13In a synthetic securitization, a company uses credit derivatives or guarantees to transfer a portion of the credit risk of one or more underlying exposures to third-party protection providers. The credit derivative or guarantee may be collateralized or uncollateralized.

Under the final rule, a bank's primary federal supervisor may determine that a transaction in which the underlying exposures are owned by an investment firm that exercises substantially unfettered control over the size and composition of its assets, liabilities, and off-balance sheet exposures is not a securitization based on the transaction's leverage, risk profile, or economic substance. Generally, the agencies would consider investment firms that can easily change the size and composition of their capital structure, as well as the size and composition of their assets and off-balance sheet exposures, as eligible for exclusion from the securitization definition.

Based on a particular transaction's leverage, risk profile, or economic substance, a bank's primary federal supervisor may also deem an exposure to a transaction to be a securitization exposure, even if the exposure does not meet the criteria in provisions (5), (6), or (7) above. A securitization position is a covered position that is (1) an on-balance sheet or off-balance sheet credit exposure (including credit-enhancing representations and warranties) that arises from a securitization (including a resecuritization) or (2) an exposure that directly or indirectly references asecuritization exposure described in (1) above.

Under the final rule as under the January 2011 proposal, a securitization position includes nth-to-default credit derivatives and resecuritization positions. The rule defines an nth-to-default credit derivative as a credit derivative that provides credit protection only for the nth-defaulting reference exposure in a group of reference exposures. In addition, a resecuritization is defined as a securitization in which one or more of the underlying exposures is a securitization exposure. A resecuritization position is (1) an on- or off-balance sheet exposure to a resecuritization or (2) an exposure that directly or indirectly references a resecuritization exposure described in (1).

Some commenters expressed the desire to align the proposed definition of securitization in the market risk capital rule with the Basel II definition. For instance, one commenter suggested excluding from the definition of a securitization exposures that do not resemble what is customarily thought of as a securitization. The agencies note that the proposed definition is consistent with the definition contained in the agencies' advanced approaches rules and believe that remaining consistent is important in order to reduce regulatory capital arbitrage opportunities across the rules.

The January 2011 proposal and the final rule define a correlation trading position as (1) 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 (2) a position that is not a securitization position and that hedges a position described in (1) above. Under this definition, a correlation trading position does not include a resecuritization position, a derivative of a securitization position that does not provide a pro rata share in the proceeds of a securitization tranche, or a securitization position for which the underlying assets or reference exposures are retail exposures, residential mortgage exposures, or commercial mortgage exposures. Correlation trading positions may include collateralized debt obligation (CDO) index tranches, bespoke CDO tranches, and nth-to-default credit derivatives. Standardized CDS indices and single-name CDSs are examples of instruments used to hedge these positions. While banks typically hedge correlation trading positions, hedging frequently does not reduce a bank's net exposure to a position because the hedges often do not perfectly match the position. The agencies are adopting the definition of a debt, equity, securitization, and correlation trading position in the final rule as proposed.

The agencies note that certain aspects of the final rule, including the definition of “covered position,” are substantially similar to the definitions of similar terms used in the agencies' proposed rule that would implement section 619 of the Dodd-Frank Act, familiarly referred to as the “Volcker rule.” The agencies intend to promote consistency across regulations employing similar concepts to increase regulatory effectiveness and reduce unnecessary burden.

Section 619 of the Dodd-Frank Act contains certain prohibitions and restrictions on the ability of a bank (or nonbank financial company supervised by the Board under Title I of the Dodd-Frank Act) to engage in proprietary trading and have certain interests in, or relationships with, a covered fund as defined under section 619 of the Dodd-Frank Act and applicable regulations or private equity fund. Section 619 defines proprietary trading to mean engaging as a principal for the trading account, as defined under section 619(h)(6), of a bank (or relevant nonbank) in the purchase or sale of securities and other financial instruments.

In November 2011, the agencies, together with the SEC sought comment on an NPR that would implement section 619 of the Dodd-Frank Act (the Volcker NPR). The Volcker NPR includes in the definition of “trading account” all exposures of a bank subject to the market risk capital rule that fall within the definition of “covered position,” except for certain foreign exchange and commodity positions, unless they otherwise are in an account that meets the other prongs of the Volcker NPR “trading account” definition. Those prongs focus on determining whether a banking entity subject to section 619 of the Dodd-Frank Act is acquiring or taking a position in securities or other covered instruments principally for the purpose of short-term trading. Specifically, the definition of “trading account” under the Volcker NPR would include any account that is used by a bank to acquire or take one or more covered financial positions for the purpose of (1) Short-term resale, (2) benefitting from actual or expected short-term price movements, (3) realizing short-term arbitrage profits, or (4) hedging one or more such positions.

These standards correspond with the definition of “trading position” under the final market risk capital rule and are generally the type of positions to which the proprietary trading restrictions of section 13 of the BHC Act, which implements section 619 of the Dodd-Frank Act, were intended to apply. Thus, the Volcker NPR would cover all positions of a bank that receive trading position treatment under the final market risk capital rule because they meet a nearly identical standard regarding short-term trading intent, thereby eliminating the potential for inconsistency or regulatory arbitrage in which a bank might characterize a position as “trading” for regulatory capital purposes but not for purposes of the Volcker NPR.

Covered positions generally would be subject to the Volcker NPR unless they are foreign exchange or commodity positions that would not otherwise fall into the definition of “trading account” under the Volcker NPR or would otherwise be eligible for one of the exemptions to the prohibitions under the Volcker NPR and section 619 of the Dodd-Frank Act.

4. Requirements for the Identification of Trading Positions and Management of Covered Positions

Section 3 of the January 2011 proposal introduced new requirements for the identification of trading positions and the management of covered positions. These new requirements would enhance prudent capital management to address the issues that arise when banks include more credit risk-related, less liquid, and less actively traded products in their covered positions. The risks of these positions may not be fully reflected in the requirements of the market risk capital rule and may be more appropriately captured under credit risk capital rules.

Consistent with the January 2011 proposal, the final rule requires a bank 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. In determining the scope of trading positions, the bank must consider (1) the extent to which a position (or a hedge of its material risks) can be marked to market daily by reference to a two-way market; and (2) possible impairments to the liquidity of a position or its hedge.

In addition, a bank must have clearly defined trading and hedging strategies. The bank's trading and hedging strategies for its trading positions mustbe approved by senior management. The trading strategy must articulate the expected holding period of, and the market risk associated with, each portfolio of trading positions. The hedging strategy must articulate for each portfolio the level of market risk the bank is willing to accept and must detail the instruments, techniques, and strategies the bank will use to hedge the risk of the portfolio. The hedging strategy should be applied at the level at which trading positions are risk managed at the bank (for example, trading desk, portfolio levels).

Also consistent with the January 2011 proposal, the final rule requires a bank to have clearly defined policies and procedures for actively managing all covered positions. In the context of non-traded commodities and foreign exchange positions, active management includes managing the risks of those positions within the bank's risk limits. For all covered positions, these policies and procedures, at a minimum, must require (1) Marking positions to market or model on a daily basis; (2) assessing on a daily basis the bank's ability to hedge position and portfolio risks and the extent of market liquidity; (3) establishment and daily monitoring of limits on positions by a risk control unit independent of the trading business unit; (4) daily monitoring by senior management of the information described in (1) through (3) above; (5) at least annual reassessment by senior management of established limits on positions; and (6) at least annual assessments by qualified personnel of the quality of market inputs to the valuation process, the soundness of key assumptions, the reliability of parameter estimation in pricing models, and the stability and accuracy of model calibration under alternative market scenarios.

The January 2011 proposal introduced new requirements for the prudent valuation of covered positions, including maintaining policies and procedures for valuation, marking positions to market or to model, independent price verification, and valuation adjustments or reserves. Under the proposal, a bank's valuation of covered positions would be required to consider, as appropriate, unearned credit spreads, close-out costs, early termination costs, investing and funding costs, future administrative costs, liquidity, and model risk. These valuation requirements reflect the agencies' concerns about deficiencies in banks' valuation of less liquid trading positions, especially in light of the prior focus of the market risk capital rule on a 10-business-day time horizon and a one-tail, 99.0 percent confidence level, which has proven at times to be inadequate in reflecting the full extent of the market risk of less liquid positions.

Several commenters expressed concern about including consideration of future administrative costs in the valuation process because they believe calculation of this estimate would be difficult and arbitrary and would result in only a minor increase in total costs. In response to commenters' concern, the agencies removed this requirement from the final rule. In all other respects, the agencies are adopting the proposed requirements for the valuation of covered positions.

5. General Requirements for Internal Models

Model Approval and Ongoing Use Requirements.The January 2011 proposal would have required a bank to receive the prior written approval of its primary federal supervisor before using any internal model to calculate its market risk capital requirement. Also, a bank would be required to promptly notify its primary federal supervisor when the bank plans to extend the use of a model that the primary federal supervisor has approved to an additional business line or product type. The agencies consider these requirements to be appropriate and are adopting them in the final rule.

One commenter on the January 2011 proposal inquired as to whether models used by the bank, but developed by parties outside of the bank (commonly referred to as vendor models), are permissible for calculating market risk capital requirements given approval from the bank's primary federal supervisor. The agencies believe that a vendor model may be acceptable for purposes of calculating a bank's risk-based capital requirements if it otherwise meets the requirements of the rule and is properly understood and implemented by the bank.

The final rule, consistent with the January 2011 proposal, requires a bank to notify its primary federal supervisor promptly if it makes any change to an internal model that would result in a material change in the amount of risk-weighted assets for a portfolio of covered positions or when the bank makes any material change to its modeling assumptions. The bank's primary federal supervisor may rescind its approval, in whole or in part, of the use of any internal model and determine an appropriate regulatory capital requirement for the covered positions to which the model would apply, if it determines that the model no longer complies with the market risk capital rule or fails to reflect accurately the risks of the bank's covered positions. For example, if adverse market events or other developments reveal that a material assumption in an approved model is flawed, the bank's primary federal supervisor may require the bank to revise its model assumptions and resubmit the model specifications for review. In the final rule, the agencies made minor modifications to this provision in section 3(c)(3) to improve clarity and correct a cross-reference.

Financial markets evolve rapidly, and internal models that were state-of-the-art at the time they were approved for use in risk-based capital calculations can become less effective as the risks of covered positions evolve and as the industry develops more sophisticated modeling techniques that better capture material risks. Therefore, under the final rule, as under the January 2011 proposal, a bank must review its internal models periodically, but no less frequently than annually, in light of developments in financial markets and modeling technologies, and to enhance those models as appropriate to ensure that they continue to meet the agencies' standards for model approval and employ risk measurement methodologies that are, in the bank's judgment, most appropriate for the bank's covered positions. It is essential that a bank continually review, and as appropriate, make adjustments to its models to help ensure that its market risk capital requirement reflects the risk of the bank's covered positions. A bank's primary federal supervisor will closely review the bank's model review practices as a matter of safety and soundness. The agencies are adopting these requirements in the final rule.

Risks Reflected in Models.The final rule requires a bank to 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 bank's models must be commensurate with the complexity and amount of its covered positions. To measure its market risk, a bank's internal models may use any generally accepted modeling approach, including but not limited to variance-covariance models, historical simulations, or Monte Carlo simulations. A bank's internal models must properly measure all material risks in the covered positions to which they are applied. Consistent with the January 2011 proposal, the final rule requires that risks arising from less liquid positions and positions with limited price transparency be modeledconservatively under realistic market scenarios. The January 2011 proposal also would require a bank to have a rigorous process for re-estimating, re-evaluating, and updating its models to ensure continued applicability and relevance. The final rule retains these proposed requirements for internal models.

Control, Oversight, and Validation Mechanisms.The final rule, consistent with the January 2011 proposal, requires a bank to have a risk control unit that reports directly to senior management and that is independent of its business trading units. In addition, the final rule provides specific model validation standards similar to those in the advanced approaches rules. Specifically, the final rule requires a bank to validate its internal models initially and on an ongoing basis. The validation process must be independent of the internal models' development, implementation, and operation, or the validation process must be subjected to an independent review of its adequacy and effectiveness. The review personnel do not necessarily have to be external to the bank in order to achieve the required independence. A bank should ensure that individuals who perform the review are not biased in their assessment due to their involvement in the development, implementation, or operation of the models.

Also consistent with the January 2011 proposal, the final rule requires validation to include an evaluation of the conceptual soundness of the internal models. This should include an evaluation of empirical evidence and documentation supporting the methodologies used; important model assumptions and their limitations; adequacy and robustness of empirical data used in parameter estimation and model calibration; and evidence of a model's strengths and weaknesses.

Validation also must include an ongoing monitoring process that includes a review of all model processes and verification that these processes are functioning as intended and the comparison of the bank's model outputs with relevant internal and external data sources or estimation techniques. The results of this comparison provide a valuable diagnostic tool for identifying potential weaknesses in a bank's models. As part of this comparison, the bank should investigate the source of any differences between the model estimates and the relevant internal or external data or estimation techniques and whether the extent of the differences is appropriate.

Validation of internal models must include an outcomes analysis process that includes backtesting. Consistent with the 2009 revisions, the January 2011 proposal required a bank's validation process for internal models used to calculate its VaR-based measure to include an outcomes analysis process that includes a comparison of the changes in the bank's portfolio value that would have occurred were end-of-day positions to remain unchanged (therefore, excluding fees, commissions, reserves, net interest income, and intraday trading) with VaR-based measures during a sample period not used in model development.

The final rule, consistent with the January 2011 proposal, requires a bank 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. The stress tests must take into account concentration risk, illiquidity under stressed market conditions, and other risks arising from the bank's trading activities that may not be captured adequately in the bank's internal models. For example, it may be appropriate for a bank to include in its stress testing large price movements, one-way markets, nonlinear or deep out-of-the-money product