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

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 327

RIN 3064-AD92

Assessments, Large Bank Pricing

AGENCY: Federal Deposit Insurance Corporation (FDIC).
ACTION: Final rule.
SUMMARY: The FDIC is amending its regulations by revising some of the definitions used to determine assessment rates for large and highly complex insured depository institutions.
DATES: Effective date:April 1, 2013.
FOR FURTHER INFORMATION CONTACT: Scott Ciardi, Chief, Large Bank Pricing Section, Division of Insurance and Research, (202) 898-7079; Brenda Bruno, Senior Financial Analyst, Division of Insurance and Research, (630) 241-0359 x 8312; Christopher Bellotto, Counsel, Legal Division, (202) 898-3801.
SUPPLEMENTARY INFORMATION: I. Background

On February 7, 2011, the FDIC Board adopted a final rule that amended its assessment regulations, by, among other things, establishing a new methodology for determining assessment rates for large and highly complex institutions (the February 2011 rule).1 2 The February 2011 rule eliminated risk categories for large banks3 and created two scorecards, one for highly complex banks and another for all other large banks, that combine CAMELS ratings and certain forward-looking financial ratios. The scorecards calculate a total score for each institution.4 The total score is then converted to the bank's initial base assessment rate, which, after certain adjustments, results in the institution's total assessment rate.5 To calculate the amount of the bank's quarterly assessment, the total assessment rate is multiplied by the bank's assessment base and the result is divided by four.

112 CFR 327.9.

2A large institution is defined as an insured depository institution: (1) That had assets of $10 billion or more as of December 31, 2006 (unless, by reporting assets of less than $10 billion for four consecutive quarters since then, it has become a small institution); or (2) that had assets of less than $10 billion as of December 31, 2006, but has since had $10 billion or more in total assets for at least four consecutive quarters, whether or not the institution is new. A “highly complex institution” is defined as: (1) An insured depository institution (excluding a credit card bank) that has had $50 billion or more in total assets for at least four consecutive quarters and that either is controlled by a U.S. parent holding company that has had $500 billion or more in total assets for four consecutive quarters, or is controlled by one or more intermediate U.S. parent holding companies that are controlled by a U.S. holding company that has had $500 billion or more in assets for four consecutive quarters, and (2) a processing bank or trust company. A processing bank or trust company is an insured depository institution whose last three years' non-lending interest income, fiduciary revenues, and investment banking fees, combined, exceed 50 percent of total revenues (and its last three years fiduciary revenues are non-zero), whose total fiduciary assets total $500 billion or more and whose total assets for at least four consecutive quarters have been $10 billion or more.

3The terms “bank” and “institution” are used interchangeably in the preamble of the final rule, unless the context suggests otherwise. Again, unless the context suggests otherwise, the terms include any insured depository institution that meets the definition of a large institution or highly complex institution as defined in 12 CFR 327.9(f) and (g).

4A large or highly complex institution's total score may be adjusted by the large bank adjustment. 12 CFR 327.9(b)(3).

5An institution's initial base assessment rate can be adjusted by the unsecured debt adjustment, the depository institution debt adjustment, and, for some institutions, the brokered deposit adjustment. 12 CFR 327.9(d).

One of the financial ratios used in the scorecards is the ratio of higher-risk assets to Tier 1 capital and reserves.6 Higher-risk assets are defined in the February 2011 rule as the sum of construction and land development (C&D) loans, leveraged loans, subprime loans, and nontraditional mortgage loans. The FDIC used existing interagency guidance to define leveraged loans, nontraditional mortgage loans, and subprime loans but refined the definitions to ensure consistency in reporting. In arriving at these definitions, the FDIC took into account comments that were received in response to the two notices of proposed rulemaking that led to adoption of the February 2011 rule.7

6Higher-risk assets are used to calculate the concentration score, which is part of both the large bank scorecard and the highly complex institution scorecard. For large banks, the concentration score is defined as the higher of: (a) The higher-risk assets to Tier 1 capital and reserves score or (b) the growth-adjusted portfolio concentration score. For highly complex institutions, it is defined as the higher of: (a) The higher-risk assets to Tier 1 capital and reserves score, (b) the largest counterparty exposure to Tier 1 capital and reserves score, or (c) the top 20 counterparty exposure to Tier 1 capital and reserves score.

775 FR 23516 (May 3, 2010); 75 FR 72612 (November 24, 2010).

While institutions already reported C&D loan data in their quarterly reports of condition and income (the Call Reports and the Thrift Financial Reports or TFRs), they did not report the data for the other loans, thus requiring new line items in these reports. Therefore, on March 16, 2011, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Office of Thrift Supervision, and the FDIC (collectively, the agencies) published a Paperwork Reduction Act of 1995 (PRA) notice under normal PRA clearance procedures requesting comment on proposed revisions to the reports that would provide the data needed by the FDIC to implement the February 2011 rule beginning with the June 30, 2011, report date (March PRA notice).8

876 FR 14460 (March 16, 2011).

Commenters on the March PRA notice raised concerns about their ability to report subprime and leveraged loan data consistent with the definitions used in the February 2011 rule. They also stated that they would be unable to report the required data by the June 30, 2011 report date. These data concerns had not been raised during the rulemaking process leading up to the February 2011 rule.9

9In response to the November 2010 NPR on the revised large institution assessment system, the FDIC received a number of comments recommending changes to the definitions of subprime and leveraged loans, which the FDIC took into account in its February 2011 rule amending its assessment regulations. For example, several commenters on the November 2010 NPR stated that updating data to evaluate loans for subprime or leveraged status would be burdensome and costly, and for certain types of retail loans, would be impossible because existing loan agreements do not require borrowers to routinely provide updated financial information. In response to these comments, the FDIC's February 2011 rule stated that large institutions should evaluate loans for subprime or leveraged status upon origination, refinance, or renewal. No comments, however, were received on the November 2010 NPR indicating that large institutions would be unable to identify and report subprime or leveraged loans in accordance with the final rule's definitions in their Call Reports and TFRs beginning as of June 30, 2011. The data availability concerns were first raised in comments on the March PRA notice.

As a consequence of this unexpected difficulty, the FDIC applied to the Office of Management and Budget (OMB) for an emergency clearance request to allow large and highly complex institutions to identify and report subprime and leveraged loans and securitizations originated or purchased prior to October 1, 2011, using either their existing internal methodologies or the definitions in existing supervisory guidance. The agencies also submitted corresponding reporting revisions under normal PRA clearance procedures and requested public comment on July 27, 2011 (July PRA notice).10

1076 FR 44987 (July 27, 2011).

In response to the PRA notices, commenters recommended extending the transition guidance for reporting subprime and leveraged loans until more workable and accurate definitions were developed.

On September 28, 2011, the FDIC informed large and highly complex institutions via email (followed bychanges to Call Report instructions) that the deadline for the transition guidance would be extended to April 1, 2012, and that the FDIC would review the definitions of subprime and leveraged loans to determine whether changes to the definitions would alleviate commenters' concerns without sacrificing accuracy in determining risk for deposit insurance pricing purposes. The FDIC subsequently extended the deadline for the transition guidance to April 1, 2013.

The FDIC considered all comments related to the higher-risk asset definitions that were submitted in response to the March and July 2011 PRA notices as part of its review. The FDIC also engaged in extensive discussions with bankers and industry trade groups to better understand their concerns and to solicit potential solutions to these concerns. As a result, the FDIC issued a notice of proposed rulemaking on March 20, 2012 (NPR) to resolve the problems raised in comments on the March and July PRA notices.

II. Comments Received

The FDIC sought comments on every aspect of the proposed rule. The FDIC received a total of 14 comment letters.11 The FDIC also conducted meetings with commenters and others. Summaries of these meetings are posted on the FDIC's Web site.12

11The FDIC also received a number of emails from commenters and other interested parties.

12 http://www.fdic.gov/regulations/laws/federal/2012/2012-ad92.html.

Comments are discussed in the relevant sections that follow.

III. The Final Rule: Assessment System for Large and Highly Complex Institutions

The FDIC has adopted this final rule to amend the assessment system for large and highly complex institutions by: (1) Revising the definitions of certain higher-risk assets, specifically leveraged loans, which are renamed “higher-risk C&I loans and securities,”13 and subprime consumer loans, which are renamed “higher-risk consumer loans”; (2) clarifying when an asset must be classified as higher risk; (3) clarifying the way securitizations are identified as higher risk; and (4) further defining terms that are used in the large bank pricing portions of 12 CFR 327.9. The names of the categories of assets included in the higher-risk assets to Tier 1 capital and reserves ratio have been changed to avoid confusion between the definitions used in the deposit insurance assessment regulations and those used within the industry and in other regulatory guidance. The FDIC has not amended the definition of C&D loans and the final rule retains the definitions used in the February 2011 rule. The FDIC also retains the definition of nontraditional mortgage loans; however, the final rule clarifies how securitizations of nontraditional mortgage loans are identified as higher risk. The final rule aggregates all securitizations that contain higher-risk assets into a newly defined category of higher-risk assets, “higher-risk securitizations.” While the nomenclature is new, the NPR proposed including all assets that meet this newly defined category as higher-risk assets. The FDIC believes that the final rule will result in more consistent reporting, better reflect risk to the Deposit Insurance Fund (DIF), significantly reduce reporting burden, and satisfy many of the concerns voiced by the industry after adoption of the February 2011 rule.

13“C&I” is an abbreviation for “commercial and industrial.”

The final rule will be effective on April 1, 2013, predicated on changes to the Call Report instructions having been made. The effective date is discussed in Section E below.

A. Higher-Risk Assets

The FDIC uses the amount of an institution's higher-risk assets to calculate the institution's higher-risk concentration measure, concentration score and total score. As noted in the February 2011 rule, the higher-risk concentration measure captures the risk associated with concentrated lending in higher-risk areas. This type of lending contributed to the failure of a number of large banks during the recent financial crisis and economic downturn.14

1476 FR 10672, 10692-10693 (February 25, 2011).

Higher-Risk C&I Loans and Securities Basic definition of a higher-risk C&I loan and security

The definition of a “higher-risk C&I loan and security” in the final rule incorporates suggestions from comment letters, including a joint comment letter (the joint letter) from several industry trade groups and discussions with a trade group; the definition differs from the definition proposed in the NPR.

The final rule introduces a new term, a “higher-risk C&I borrower,” which includes a borrower that owes the reporting bank (i.e.,the bank filing its Call Report) on a C&I loan originally made on or after the effective date of the rule (April 1, 2013), if the following conditions are met:15

15C&I loans are as defined as commercial and industrial loans in the instructions to Call Report Schedule RC-C Part I—Loans and Leases, as they may be amended from time to time. This definition includes purchased credit impaired loans and overdrafts.

• The C&I loan must have an original amount (including funded amounts and the amount of unfunded commitments, whether irrevocable or unconditionally cancellable) of at least $5 million;

• The loan must meet the purpose and materiality tests described below; and

• When the loan is made, the borrower must meet the leverage test, also described below.

To ensure that the definition is equitably applied, all C&I loans that a borrower owes to the reporting bank that meet the purpose test when made and that are made within six months of each other must be aggregated to determine whether they have an original amount of at least $5 million; however, only loans in the original amount of $1 million or more need to be aggregated.16 Thus, for example, if a bank makes a $4 million C&I loan and 5 months later makes a $2 million C&I loan, both of which meet the purpose test, the loans will have an original amount of $6 million. For a C&I loan that meets the purpose test and that is syndicated or participated among banks, the original amount of the loan (for purposes of determining whether the original amount is at least $5 million and for purposes of applying the materiality test) is the total original amount of the loan, not just the syndicated or participated portion held by an individual bank.

16Loans made before the effective date of the rule need not be aggregated.

A “higher-risk C&I borrower” also includes a borrower that obtains a refinance17 of an existing C&I loan, where the refinance occurs on or after the effective date of the rule and the refinanced loan is owed to the reportingbank, if the following conditions are met:

17The definition of refinance is discussed in Appendix C. Two commenters had suggested that the definition proposed in the NPR was too broad and inconsistent with Regulation Z, Section 226.20. While the definition in the final rule differs from the Regulation Z definition, the two definitions serve different purposes. Regulation Z states that a refinancing occurs when an existing obligation is satisfied and replaced with a new obligation, and this new transaction requires new disclosures to the consumer. The purpose of Regulation Z is to determine when new disclosures should be required to be given to consumers. The purpose of the definition in the final rule is to determine when an institution should re-evaluate a loan for higher-risk status. Prior to proposing its definition of refinance in the NPR, the FDIC discussed it at length with the industry and other interested parties.

• The refinanced loan must be in an amount (including funded amounts and the amount of unfunded commitments, whether irrevocable or unconditionally cancellable) of at least $5 million;

• The C&I loan being refinanced must have met the purpose and materiality tests when it was originally made;

• The original loan must have been made no more than five years before the refinanced loan (the look-back period); and

• When the loan is refinanced, the borrower must meet the leverage test.

Again, to ensure that the definition is equitably applied, when a C&I loan is refinanced through more than one loan and the loans are made within six months of each other, they must be aggregated to determine whether they have an amount of at least $5 million. Thus, for example, an $8 million C&I refinancing loan that is split into two $4 million loans, where both are made within six months of each other, will still have an amount of $8 million.

A borrower ceases to be a “higher-risk C&I borrower” if: (1) The borrower no longer has any C&I loans owed to the reporting bank that, when originally made, met the purpose and materiality tests; (2) any such loans outstanding owed by the borrower to the reporting bank have all been refinanced more than five years after originally being made; or (3) the reporting bank makes a new C&I loan or refinances an existing C&I loan and the borrower no longer meets the leverage test. A borrower cannot cease to be a higher-risk borrower except as provided above.

Under the final rule, “higher-risk C&I loans or securities” include all C&I loans owed to the reporting bank by a higher-risk C&I borrower, except loans subject to an exclusion described below, and all securities issued by the higher-risk C&I borrower that are owned by the reporting bank, except securities classified as trading book, without regard to when the loans were made or the securities purchased.18

18The amount of a higher-risk C&I loan or security to be reported on the Call Report as of the end of a quarter is the amount of C&I loans, and unfunded C&I loan commitments, owed to the reporting bank by a higher-risk C&I borrower and the amount of securities issued by a higher-risk C&I borrower that are owned by the reporting bank.

Purpose Test

A loan or refinance meets the purpose test if it is to finance a buyout, acquisition or capital distribution. Under the final rule, an “acquisition” is the purchase by the borrower of any equity interest in another company or the purchase of all or a substantial portion of the assets of another company; a “buyout” is the purchase or repurchase by the borrower of the borrower's outstanding equity (a buyout includes, but is not limited to, an equity buyout or funding of an Employee Stock Ownership Plan (ESOP)); and a “capital distribution” is a dividend payment or other transaction designed to enhance shareholder value, such as repurchase of stock.19

19The NPR proposed to include as an acquisition “any of the assets and liabilities of another company.” The final rule narrows and clarifies this definition.

The purpose test will help identify risk and reflect the method used internally by most banks to identify higher-risk loans. The test identifies those borrowers with certain higher-risk characteristics, such as a heavy reliance on either enterprise value or improvement in the borrower's profitability.20

20Enterprise value is a measure of the borrower's value as a going concern.

Materiality Test

A loan or refinance meets the materiality test if the amount of the original loan (including funded amounts and the amount of unfunded commitments, whether irrevocable or unconditionally cancellable) equals or exceeds 20 percent of the total funded debt of the borrower. Total funded debt of the borrower is to be determined as of the date of the original loan and does not include the loan to which the materiality test is being applied.21 A loan also meets the materiality test if, before the loan was made, the borrower had no funded debt.

21When multiple loans must be aggregated to determine whether they total at least $5 million, the materiality test is to be applied as of the date of the last loan.

At the time of refinance, whether the original loan met the purpose or materiality tests may not be easily determined by a new lender. In such a case, the new lender must use its best efforts and reasonable due diligence to determine whether the original loan met these tests.

Leverage Test

A borrower meets the leverage test if the ratio of the borrower's total debt to trailing twelve-month EBITDA (commonly known as the operating leverage ratio) is greater than 4, or the ratio of the borrower's senior debt to trailing twelve-month EBITDA (also commonly known as the operating leverage ratio) is greater than 3.22

22EBITDA is defined as earnings before interest, taxes, depreciation, and amortization.

Appendix C provides detailed definitions of many of the terms used in the foregoing definitions.

Comments on the Proposed Definition

In the joint letter, commenters took issue with several parts of the NPR's proposed definitions related to higher-risk C&I loans.23 The NPR proposed that a C&I loan of any size that was made within the past seven years and that met the purpose and materiality tests, whether made by the reporting bank or another institution, would make all C&I loans to a leveraged borrower higher risk if the borrower had a total of at least $5 million in C&I loans owed to the reporting bank. The commenters suggested that a $5 million threshold should be part of the purpose test, on the grounds that a loan of less than $5 million at origination or refinance would not be sufficiently material to be “higher risk” even if it financed an acquisition, buyout or capital distribution, and that requiring a lender to consider loans under $5 million to a borrower would be expensive and time consuming. The commenters further suggested that the look back at thepurpose and materiality of debt should apply only when currently outstanding debt isrefinanced,on the grounds that the definition of higher-risk is intended to identify risk when it is created. Finally, the commenters recommended that the look-back period should be, at most, five years rather than the seven years proposed in the NPR, on the grounds that most large banks track the past borrowing history of a borrower only three years back through a review of their financial statements and that the purpose of debt becomes murkier as it grows older and as new debt is added.

23The NPR proposed the following definition of a “higher-risk C&I loan and security”:

• Any commercial loan (funded or unfunded, including irrevocable and revocable commitments) owed by a borrower to the evaluating depository institution with an original amount greater than $5 million if the conditions specified in (a) or (b) below are met as of origination, or, if the loan has been refinanced, as of refinance, and the loan does not meet the asset-based lending (ABL) exclusion or the floor plan line of credit exclusion (discussed in Appendix C).

(a)(i) The purpose of any of the borrower's debt (whether owed to the evaluating insured depository institution or another lender) that was incurred within the previous seven years was to finance a buyout, acquisition or capital distribution and such debt was material; and

(ii) The ratio of the borrower's total debt to trailing twelve-month EBITDA (i.e.,operating leverage ratio) is greater than 4 or the ratio of the borrower's senior debt to trailing twelve-month EBITDA (i.e.,operating leverage ratio) is greater than 3; or

(b) Any of the borrower's debt (whether owed to the evaluating institution or another lender) is designated as a highly leveraged transaction (HLT) by a syndication agent.

• All securities held by the evaluating institution that are issued by a commercial borrower, if the conditions specified in (a) or (b) above are met, except securities classified as trading book; and

• All securitizations held by the evaluating institution that are more than 50 percent collateralized by commercial loans or securities that would meet the higher-risk C&I loans and securities definition if directly held by the evaluating institution, except securities classified as trading book.

Under the proposed definition, multiple loans to one borrower were to be aggregated to determine whether the outstanding amount exceeded $5 million to the extent that the institution's loan data systems could do so without undue cost. If the cost was excessive, the institution could treat multiple loans to one borrower as separate loans.

The final rule adopts these suggestions with some modifications primarily intended either to simplify the rule or to ensure that the intent of the definitions cannot be easily circumvented.

In the joint letter and a subsequent email, commenters suggested that debt incurred to fund ordinary business actions such as dividends to make tax payments should be excluded from the definition of a capital distribution in the purpose test. The final rule does not adopt this suggestion because the materiality test should be sufficient to exclude most loans made in the ordinary course of business.

Several industry trade groups and one bank commented that a material increase in debt should be defined as a 50 percent increase in funded debt within one year rather than the proposed 20 percent increase, arguing that 20 percent would include loans made to firms for routine acquisitions in the normal course of business. According to the commenters, such loans might include financing for a modest stock redemption or basic dividend program. Commenters also suggested that the materiality test should apply only to debt that meets the purpose test, rather than all debt. The final rule adopts the suggestion to consider only purpose loans in the materiality test.

Because the materiality test will measure only the increase in total funded debt that results from loans that meet the purpose test, rather than the total increase in funded debt from any source, the final rule continues to define a material increase as at least 20 percent. Increasing the threshold above 20 percent could exclude borrowers that were highly leveraged before obtaining a loan that meets the purpose test, even if the loan was large. Furthermore, the final rule already adopts a narrower definition of higher-risk C&I loans than existing and proposed regulatory guidelines on leveraged lending, which do not contain any materiality test.24 The final rule also simplifies the materiality test by requiring that a loan that meets the purpose test must be at least 20 percent of total funded debt as of the date of origination, rather than as of one year earlier.

24OCC's February 2008 Comptroller's Handbook on Leverage Lending (pages 2 and 3) and the (interagency) Proposed Guidelines on Leveraged Lending, 77 FR 19417 (March 30, 2012).

The FDIC received no comments on the definition of the leverage test proposed in the NPR.

Exclusions From the Definition of Higher-Risk C&I Loan and Security

As proposed in the NPR, the definition of a higher-risk C&I loan and security in the final rule excludes the maximum amount that is recoverable from the U.S. government under guarantee or insurance provisions, as well as loans (including syndicated or participated loans) that are fully secured by cash collateral.25 26

25To exclude a loan based on cash collateral, the cash must be in the form of a savings or time deposit held by an insured depository institution. The insured depository institution (or lead institution or agent bank in the case of a participation or syndication) must have a perfected first priority security interest, a security agreement, and a collateral assignment of the deposit account that is irrevocable for the remaining term of the loan or commitment. In addition, the institution must place a hold on the deposit account that alerts the institution's employees to an attempted withdrawal. If the cash collateral is held at another institution or at multiple institutions, a security agreement must be in place and each institution must have in place an account control agreement (as defined in Appendix C). For the exclusion to apply to a revolving line of credit, the cash collateral must be equal to or greater than the amount of the total loan commitment (the aggregate funded and unfunded balance of the loan).

26The NPR proposed excluding from the definition of a higher-risk C&I loan and security “the maximum amount that is recoverable from * * * [GSEs] under guarantee or insurance provisions,” but the final rule omits this language because no GSE guarantees or insures C&I loans or securities issued by a C&I borrower.

In the joint letter, commenters recommended excluding loans that are collateralized by securities issued by the U.S. government, its agencies, or government-sponsored enterprises (GSEs). The final rule, however, does not exclude loans so collateralized because the collateral is subject to interest rate risk and collateral arrangements are subject to operational risk. Commenters also recommended excluding loans that are fully secured by brokerage account collateral (securities-based loans). The final rule does not exclude these loans because the value of the collateral is subject to several sources of risk, including operational, credit and market risk.

A bank suggested that the definition of higher-risk C&I loans exclude loans acquired at a discount or marked to fair value. Another commenter suggested that the definition exclude modified loans. The final rule does not adopt these suggestions. The higher-risk concentration ratio is a forward looking financial measure aimed at capturing the risk of concentrations in higher-risk assets, irrespective of how the assets are valued on the balance sheet or whether they are modified. These loans have the characteristics of higher-risk loans, despite being recorded at a discount or at fair value at the date of acquisition or having been modified from the original terms. The future performance of these assets remains uncertain; the institution still faces the risk of additional losses on these assets.

In the joint letter, commenters recommended that unplanned overdrafts not be included as higher-risk C&I loans, arguing that they create exposures that are incidental and cured within a few days, if not overnight. The final rule, however, defines C&I loans consistent with the Call Report definition of such loans, which includes unplanned overdrafts. An overdraft alone is unlikely to cause a borrower to be considered higher risk, however; it is only likely to be included as higher-risk to the extent that other loans cause a C&I borrower to be considered higher risk.

Exclusions for Asset-Based Lending and Floor Plan Lending

The definition of higher-risk C&I loans and securities excludes certain well-collateralized asset-based loans and floor plan loans.27 Excluding these loans should result in better differentiation of risk among banks and will reduce reporting burden. Because these loans carry significant operational risk, the exclusions apply only to loans that are well secured by self-liquidating collateral (i.e.,accounts receivable and inventory), and only when the institution can demonstrate that it has a history of strong risk management and internal controls over these loans. The final rule provides that, if a bank's primary federal regulator (PFR) has criticized (i.e.,included in Matters Requiring Attention or MRA) the bank's controls or administration of its asset-based or floor plan loan portfolios, the exclusion will not apply.

27The proposal included asset-based lending guidance. The final rule, however, incorporates this guidance into the asset-based lending exclusion conditions in Appendix C.

The final rule details the conditions that institutions must meet to be eligible for the asset-based and floor plan lending exclusions. The differencesbetween the final rule and the NPR are generally the result of recommendations from commenters. The final rule requires that a new borrowing base certificate be obtained within 30 days before or after each draw or advance on a loan, as opposed to requiring a new borrowing base certificate at each draw or advance, as proposed in the NPR.28 A bank is required to validate the borrowing base, but is not required to do so at each draw, as was proposed in the NPR.29 In their joint letter, commenters stated that it is not standard practice for lenders to obtain a new borrowing base certificate at each advance or draw on a loan, and noted that it is not unusual for draws to occur on a daily basis. The commenters further stated that requiring lenders to obtain a new borrowing base certificate at each advance or draw would impose a major administrative burden on banks and their borrowers. In the joint letter, commenters recommended that a new borrowing base certificate be required within 60 days of each draw or advance. The final rule adopts a 30-day requirement on the grounds that 60 days does not provide sufficient assurance that the loan is fully secured.

28A “borrowing base certificate” is defined in Appendix C.

29The requirements of the validation process are discussed further in Appendix C.

The final rule permits a bank to exclude an asset-based loan from higher-risk C&I loans owed by a higher-risk C&I borrower, provided that the advance rate on the accounts receivables that serve as collateral for the loan does not exceed 85 percent. This is a change from the NPR, which proposed that advance rates on accounts receivable shouldgenerallynot exceed 75 percent to 85 percent of eligible receivables. One commenter noted that the term “generally” gave institutions the option to allow advance rates of greater than 85 percent of eligible accounts receivable when appropriate. Because advance rates in excess of 85 percent expose the lender to the risk of loss from a relatively small default rate on accounts receivable, however, the final rule requires that advance rates never exceed 85 percent for the exclusion to apply.

In response to comments, the final rule also provides that:

• The borrowing base may include other assets, but a loan must be fully secured by the portion of the borrowing base that is composed of accounts receivable and inventory.

• Appraisals will not be required for accounts receivable collateral. In addition, when there is a readily available and determinable market price for inventory from a recognized exchange or third-party industry source, inventory may be valued using these sources in lieu of an appraisal.

• An institution need not have the unconditional ability to take control of a borrower's deposit accounts to be eligible for the asset-based lending exclusion; rather, it is sufficient if the lending institution has the legally enforceable ability to take dominion over the borrower's deposit accounts without further consent by the borrower (or any other party). In all cases, the lending bank must have a perfected first priority security interest in the deposit account, a security agreement must be in place and, if the account is held at an institution other than the lending institution, an account control agreement must also be in place.30

30For the purposes of this rule, an account control agreement means a written agreement between the lending bank (the secured party), the borrower, and the institution that holds the deposit account serving as collateral (the depository bank), that the depository bank will comply with instructions originated by the secured party directing disposition of the funds in the deposit account without further consent by the borrower (or any other party).

• The lending bank must have the ability to withhold funding of a draw or loan advance if the outstanding balance on the loan is not within the collateral formula prescribed by the loan agreement.

• A bank's lending policies or procedures must address the maintenance of an inventory loan agreement with the borrower, consistent with the requirements for an accounts receivable loan agreement.

• Banks are required to obtain financial statements from dealer floor plan borrowers, but the statements need not be audited. Original Equipment Manufacturers (OEM) financial statements, otherwise known as dealer statements, will be sufficient.

Higher-Risk Consumer Loans

“Higher-risk consumer loans” are defined as all consumer loans where, as of origination, or, if the loan has been refinanced, as of refinance, the probability of default (PD) within two years (the two-year PD) is greater than 20 percent, excluding those consumer loans that meet the definition of a nontraditional mortgage loan.31 32

31For the purposes of this rule, consumer loans consist of all loans secured by 1-4 family residential properties as well as loans and leases made to individuals for household, family, and other personal expenditures, as defined in the instructions to the Reports of Condition and Income, Schedule RC-C, as the instructions may be amended from time to time.

32A loan that meets both the definitions of a nontraditional mortgage loan and a higher-risk consumer loan at the time of origination should be reported as a nontraditional mortgage loan. If the loan later ceases to meet the definition of nontraditional mortgage loan but continues to qualify as a higher-risk consumer loan, however, it must then be reported as a higher-risk consumer loan.

Higher-risk PD Threshold

As noted by commenters, the FDIC may need to adjust the higher-risk PD threshold after reviewing data for the first reporting period, since the 20 percent threshold in the definition was determined based on preliminary score-to-default rate mappings received from a few credit score providers.

The NPR proposed that the FDIC could change the PD threshold without further notice-and-comment rulemaking. Several trade groups commented that the higher-risk PD threshold, after a potential adjustment following the first reporting period, should remain invariant and not be changed without notice-and-comment rulemaking.

The final rule is generally consistent with these comments.33 Under the final rule, the FDIC retains the flexibility to change the 20 percent threshold without further notice-and-comment rulemaking, but only as the result of reviewing data for up to the first two reporting periods. The FDIC will give banks at least one quarter advance notice of any change through a Financial Institution Letter. Any subsequent changes to the threshold will be made through notice-and-comment rulemaking.

33Several commenters also suggested that, if the FDIC were to adjust the PD threshold, the new threshold should only apply to loans originated or refinanced after the effective date of the change, and the determination that a loan is or is not higher risk will be based on the previous threshold. In the commenters' view, this suggestion would allow institutions to adjust their pricing policies prospectively to account for the cost of making a new loan that meets the revised threshold. Because the final rule requires notice-and-comment rulemaking before changing the PD threshold (except for a potential change after the first or second reporting period under the final rule), this issue would be addressed in any such future rulemaking.

A threshold of 20 percent was found to be generally consistent with score-based definitions of subprime commonly used by the industry, capturing the riskiest 10 to 20 percent of consumer loans on a national basis. If, once the final rule is in effect, the overall proportion of consumer loans reported as higher-risk among large institutions differs materially from this preliminary estimate of 10 to 20 percent of consumer loans, the FDIC may decide to adjust the 20 percent threshold. The final rule, like the proposed rule, gives the FDIC the flexibility to make this change without further notice-and-comment rulemaking (as a result of reviewing data reported for the first one or two reporting periods) so that a re-calibration of the measure can be accomplished quickly to prevent banks from being unfairly assessed. Before making any such change, the FDIC will analyze the potential effect of changing the PD threshold on the distribution of higher-risk consumer loans among institutions and the resulting effect on assessments collected from the industry.

One bank commented that the higher-risk PD threshold should vary by product type, and that volatility in default rates is more relevant than the average level of default rates. As an example, the bank noted that, although credit card default rates were higher than default rates on some other products during the recent crisis, the default rates on credit cards rose less than the default rates on other products. In particular, the default rates on mortgages rose significantly and unexpectedly, causing losses that threatened institutions and the financial system. The bank also commented that other risk factors, such as historic default rates, yields, and resilience to stress, should be taken into account.

While the factors that the commenter mentioned are relevant, taking them into account in the definition of a higher-risk consumer loan would introduce excessive complexity with uncertain improvements in risk differentiation. Under the final rule, as proposed in the NPR, institutions must estimate the two-year PD for a consumer loan based on how loans with similar risk characteristics performed during the recent crisis. The FDIC chose to use the recent stress period for PD estimation, as opposed to a longer history, to capture the consumer behavior that generated significant unexpected losses. The PDs estimated using the specified time periods are not intended to reflect long-run mean default rates or capture product-by-product differences in more favorable periods.

Methodology for Estimating PDs

Time period.Under the final rule, and as proposed in the NPR, an institution must estimate the two-year PD for a consumer loan based on the observed stress period default rate (defined below) for loans of a similar product type made to consumers with credit risk comparable to the borrower being evaluated, all as detailed in the estimation guidelines in Appendix C. To capture the default behavior of consumers during a period of economic stress, the default rate is to be calculated as the average of the two, 24-month default rates from July 2007 to June 2009, and July 2009 to June 2011.34

34Institutions must use the formula in Appendix C to calculate the average default rate.

Several trade groups and two institutions commented that the time periods used for PD estimation should be updated bi-annually. These commenters suggested that the average default rates could be calculated on a rolling basis, using the two most recent consecutive 24-month periods, or on a cumulative basis using all consecutive 24-month periods from July 2007 forward. They noted that it is standard industry practice to recalibrate credit models at least once a year, and that model parameters more than two years old are generally considered unreliable. Furthermore, the commenters stated that specifying a regular interval for updating the time periods would make the process more predictable and give institutions an opportunity to adjust their credit policies and pricing in advance of any changes, thus promoting a more stable flow of credit to consumers.

Identifying higher-risk consumer loans based on PD estimates from a time of economic stress is consistent with the FDIC's objective of assessing large institutions during favorable periods based on how they are likely to perform during periods of stress, as explained in the February 2011 rule. If the time period were to be updated on a rolling or cumulative basis, as suggested, the resulting PD estimates would eventually not reflect the performance of loans during the recent crisis. While the updated default rates might be closer to realized two-year default rates during favorable periods, they would generally not capture the relative differences in default behavior among product types that can be expected to occur under stress conditions (and that actually did occur during the recent financial crisis). In addition, unless changes were made to the higher-risk PD threshold of 20 percent, any regular updating of the time period could introduce an undesirable level of pro-cyclicality into the higher-risk concentration measure, whereby the volume of higher-risk loans would tend to rise as credit conditions deteriorated, and fall as conditions improved. This type of volatility could occur even if the distribution of credit scores in a loan portfolio remained static over time. The final rule avoids this volatility by using a fixed historical period for measuring default rates.

Default rates calculated using the recent crisis period may not reflect future changes in macroeconomic factors, industry standards, or consumer behavior that affect the riskiness of different product types. To ensure that the PD methodology continues to accurately identify higher-risk consumer loans, the FDIC may need to update the time period used for PD estimation at some point. Under the final rule, unlike the proposed rule, a change in the time period would require further notice-and-comment rulemaking.

Default rate and definition of “active loan.”The final rule requires institutions to calculate the default rate for each 24-month time period as the number of active loans that experienced at least one default event during the period divided by the total number of active loans as of the observation date (i.e.,the beginning of the 24-month period). An “active” loan is defined as any loan that was open and not in default as of the observation date, and on which a payment was made within the 12 months prior to the observation date. This definition differs from the one proposed in the NPR, which had defined an active loan as a loan that was open and not in default as of the observation date, and had a positive balance any time within the 12 months prior to the observation date. The FDIC had proposed this balance-based definition to exclude accounts that, while open and available for use, were generally not being used. Including these accounts in the default rate calculation could result in PD estimates that understate the default experience of truly active accounts. The FDIC also based its proposal on indications that historical balance data were available in the credit bureau data used by third-party providers of consumer credit scores.

One credit reporting bureau, however, informed the FDIC that historical data on account balances are often either unavailable or difficult to obtain. The credit reporting bureau also suggested that the proposed approach could miss active revolving loans where the balance is completely paid off each month. As an alternative, the credit reporting bureau suggested that an active account could be defined as any loan reported by the lender in the 12 months prior to the observation date, or any loan that has a positive balance as of the observation date.

The FDIC concluded, based on discussions with the three major credit reporting bureaus, that the date of last payment is information that is generally reported and maintained historically. In addition, defining an active loan using the date of last payment should better capture active revolving accounts that pay off monthly compared to both the proposed definition and a definitionthat would rely on the balance only as of the observation date. While the commenter's suggestion to include any loan reported by the lender in the 12 months prior to the observation date would also capture these revolving accounts, this definition could capture accounts that are no longer open as of the observation date or are otherwise inactive.

Additional risk factors.The final rule requires that, at a minimum, the PD estimate of a loan must be based on the product type and credit score of the borrower. In response to a comment, the final rule clarifies that institutions may consider risk factors other than product type and credit score (e.g.,geography) in estimating the PD of a loan, because these factors may improve PD estimates. All estimation requirements detailed in the final rule, including the minimum sample size, however, must be satisfied regardless of the number of factors used.

Mapping scores to default rates.The final rule requires partitioning the entire credit score range generated by a given scoring system into a minimum of 15 credit score bands. A PD for each credit score band and loan product type (and for any other risk factor being considered) must be estimated as the average of two particular 24-month default rates as described in Appendix C. Each 24-month default rate must be calculated using a random sample of at least 1,200 active loans. Although each score band will likely include multiple credit scores, each credit score will need to have a unique PD associated with it. Therefore, when the number of score bands is less than the number of unique credit scores (as will almost always be the case), banks must use a linear interpolation between adjacent default rates to determine the PD for a particular score. The observed default rate for each band must be assumed to correspond to the midpoint of the range for that band. For example, if one score band ranges from 621 to 625 and has an observed default rate of 4 percent, while the next lowest band ranges from 616 to 620 and has an observed default rate of 6 percent, a 620 score must be assigned a default rate of 5.2 percent, calculated as

ER31OC12.025

One provider of consumer credit scores recommended an alternative to the proposed method of assigning PDs to individual score values. This commenter suggested that the FDIC permit banks to use a least-squares regression or other accepted statistical methodology to estimate the score-to-default rate relationship. The commenter noted that the relationship between the logarithm of the odds of not defaulting and the FICO score is very close to linear. The commenter argued that PDs estimated using a regression would be less dependent on the way institutions structure score bins and provide more reliable estimates of future default rates for a given score.

Depending on the nature of the data, least-squares regression and alternative methods of estimating the score-to-default rate relationship may, in fact, have certain advantages over the proposed approach. Given the minimum sample size and score band requirements, however, estimates generated using the proposed approach should be similar to those generated using alternative statistical methods. While the industry generally understands and uses linear interpolation, many banks that try to develop their own PD estimates according to the requirements may lack the expertise to apply more sophisticated fitting methods to their data. To ensure consistency among estimation methods, the final rule retains the linear interpolation approach.

Alternative methodology.Like the proposed rule, the final rule allows institutions to request to use default rates calculated using fewer observations or score bands than the specified minimums, either in advance of, or concurrent with, actual reporting under the requested approach. The request must explain in detail how the requested approach differs from the rule specifications and include, at a minimum, a table with default rates and the number of observations used in each score and product segment. The FDIC will evaluate the proposed methodology and may request additional information from the institution, which the institution must provide. The institution may report using its approach while the FDIC evaluates the request. If, after reviewing the request, the FDIC determines that the institution's approach is unacceptable, the institution may be required to amend its Call Reports and treat any loan whose PD had been estimated using the disapproved methodology as an unscorable domestic consumer loan subject to the de minimis approach described above; the institution, however, will be required to submit amended information for no more than the two most recently dated and filed Call Reports preceding the FDIC's determination.

One trade group commented that the FDIC should publish its criteria for evaluating methodologies that deviate from the PD estimation requirements. The trade group stated that providing the criteria would help smaller institutions evaluate their options before devoting time and resources to developing an alternative methodology. Because the final rule allows institutions to request the use of PD estimates that differ from the specifications only in the two specific respects noted previously (using fewer observations or score bands than the specified minimums), institutions should not be expending resources developing an entirely different methodology. While providing more specific guidance on acceptable alternatives to the score band and sample size requirements may make the decision process easier for institutions, the range of potentially acceptable alternatives is broad enough to preclude the final rule from providing predetermined criteria.

In the joint letter, commenters suggested that a simplified method of reporting should be permitted for banks with minimal exposure to higher-risk consumer loans. The commenters stated that the potential benefit to the FDIC would be small relative to the cost these banks would incur to comply with the new definition. The commenters suggested that if a bank's subprime loans—defined based on the 2001 interagency guidance—were less than one percent of Tier 1 capital and reserves, they should be allowed to report the amount as higher-risk if it is less costly for them to do so. One trade group suggested that if a portfolio has a default rate consistently below 10 percent and the bank maintains prudent underwriting criteria and appropriate monitoring for loans placed in that portfolio, the bank should not be required to estimate and report the PDs of loans in the portfolio. This same trade group stated that loans made before the effective date of the rule should be exempt from PD reporting, or the FDIC should provide a transitional period of at least three years.

Under the final rule, as proposed in the NPR, banks must calculate the PDs ofalloutstanding consumer loans following the effective date of the rule. Because the 2001 interagency guidance for subprime lending differs from the definition in the final rule, allowing banks to determine their level of exposure using this alternative standard could result in inconsistent treatment of loans across banks. This same inconsistency could result if alternative criteria were used, such as having a default rate consistently below 10 percent. While banks will need sometime to modify systems and processes to report under the definitions in the final rule, the suggested transition period of three years could result in the assessment system failing to identify higher-risk concentrations for too long. The effective date of April 1, 2013, should give banks sufficient time to comply with the final rule.

Unscorable Consumer Loans

The final rule definition, like the definition proposed in the NPR, requires institutions to estimate the two-year PD of a loan based, in part, on the credit risk of the borrower as reflected in a credit score.35 When a consumer loan has a co-signer or co-borrower, the PD may be determined using the most favorable individual credit score. For unscorable consumer loans—where the available information is insufficient to determine a credit score—the final rule specifies the following treatment: if the total outstanding balance of unscorable consumer loans of a particular product type exceeds 5 percent of the total outstanding balance for that product type, including both foreign and domestic loans, the excess amount shall be treated as higher-risk (the de minimis approach). Otherwise, the total outstanding balance of unscorable consumer loans of a particular product type will not be considered higher-risk. The consumer product types used to determine whether the 5 percent test is satisfied shall correspond to the product types listed in the table used for reporting PD estimates. If, after the origination or refinance of the loan, an unscorable consumer loan becomes scoreable, the final rule requires institutions to reclassify the loan using the PD estimated according to the rule specifications. Based upon that PD, the loan will be determined to be either higher risk or not, and that determination will remain in effect until a refinancing occurs, at which time the loan must be re-evaluated. An unscorable loan must be reviewed at least annually to determine if a credit score has become available.

35As detailed in Appendix C, the credit risk of the borrower must be determined using a third-party or internal scoring system that qualifies as empirically derived, demonstrably and statistically sound (EDDSS), as defined in 12 CFR 202.2(p), as amended from time to time, and that has been approved by the bank's model risk oversight and governance process and internal audit mechanism.

Several trade groups commented that the proposed rule did not consider how large banks are to treat consumer credits with no credit histories or scores. These groups noted that this issue is relevant for all types of consumer loans, but especially for student and credit card loans. One trade group argued that an institution should not be automatically required to classify unscorable loans as higher-risk, because doing so would cause some products, such as student loans, to become more expensive or less available. In the joint letter, commenters suggested that, to account for unscorable loans, large banks with sufficient data on the performance of such loans should be allowed to develop internal PD estimates using the same time period and sample size requirements in the rule. For large banks that do not have sufficient data to create such a mapping, the commenters stated that unscorable loans could initially be treated as higher-risk and subsequently re-evaluated according to the rule specifications once a credit score becomes available for the borrower. The commenters also noted that, although initially classifying unscorable loans as higher-risk is excessively conservative, it would be considered generally acceptable to large banks so long as a subsequent re-evaluation of these loans is permitted. For unscorable student loans, however, the commenters recommended that a PD distribution based on the bank's long-term default experience be permitted as opposed to initially classifying the loans as higher-risk.

Unscorable loans were not addressed in the proposed rule. In evaluating treatment options for purposes of the final rule, the FDIC sought information from a few credit score providers on the performance of unscorable loans by product type as well as data from large banks on the volume of unscorable loans outstanding. Data on the historical performance of unscorable loans were generally unavailable. Further, where data were available, the performance of unscorable loans relative to their scored counterparts was found to vary significantly by product type, and product definitions were not consistent with the Call Report definitions expected to b