[Federal Register Volume 59, Number 100 (Wednesday, May 25, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11513]
[[Page Unknown]]
[Federal Register: May 25, 1994]
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Part II
Department of the Treasury
Office of the Comptroller of the Currency
12 CFR Part 3
Office of Thrift Supervision
12 CFR Part 567
Federal Reserve System
12 CFR Parts 208 and 225
Federal Deposit Insurance Corporation
12 CFR Part 325
Risk-Based Capital Requirements--Recourse and Direct Credit
Substitutes; Proposed Rule
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[DOCKET No. 94-07]
RIN 1557-AA91
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Docket No. R-0835]
RIN 7100-AB77
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN 3064-AB31
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Part 567
[Docket No. 93-238]
RIN 1550-AA70
Risk-Based Capital Requirements--Recourse and Direct Credit
Substitutes
AGENCIES: Office of the Comptroller of the Currency (OCC), Department
of the Treasury; Board of Governors of the Federal Reserve System
(FRB); Federal Deposit Insurance Corporation (FDIC); Office of Thrift
Supervision (OTS), Department of the Treasury.
ACTION: Notice of proposed rulemaking and advance notice of proposed
rulemaking.
SUMMARY: The FDIC, FRB, OCC, and OTS (the Agencies) are proposing
revisions to their risk-based capital standards to address the
regulatory capital treatment of recourse arrangements and direct credit
substitutes that expose banks, bank holding companies, and thrifts to
credit risk. The proposal is intended to correct certain
inconsistencies in the Agencies' risk-based capital standards and allow
banks and bank holding companies (banking organizations) to maintain
lower amounts of capital against low-level recourse transactions. The
proposal would require higher amounts of risk-based capital to be
maintained against certain direct credit substitutes, including, for
banking organizations, purchased servicing rights that provide loss
protection to the owners of the loans serviced and purchased
subordinated interests that absorb the first dollars of losses from the
underlying assets, and, for both banking organizations and thrifts,
certain guarantee-type arrangements (such as standby letters of credit)
provided for third-party assets that absorb the first dollars of losses
from those assets.
The OTS is proposing to change only the capital requirements for
the treatment of guarantee-type arrangements that absorb first dollar
losses. In all other respects, the OTS treatment of recourse and direct
credit substitutes would continue to follow existing OTS capital
regulations. The OTS regulations have been revised for clarity and now
include language codifying agency regulatory guidance.
In addition, the Agencies are publishing, in an advance notice of
proposed rulemaking (ANPR), a preliminary proposal to use credit
ratings to match the risk-based capital assessment more closely to an
institution's relative risk of loss in certain asset securitizations.
The Agencies are also requesting comment in the ANPR on the need for a
similar system for unrated asset securitizations and on how such a
system could be designed.
The Agencies intend that any final rules adopted in connection with
this notice of proposed rulemaking and ANPR that result in increased
risk-based capital requirements for banking organizations or thrifts
would apply only to transactions that are consummated after the
effective date of such final rules.
DATES: Comments must be received on or before July 25, 1994.
ADDRESSES: Commenters may respond to any or all of the Agencies. All
comments will be shared among all of the Agencies.
OCC: Written comments should be submitted to Docket No. 94-07,
Communications Division, Ninth Floor, Office of the Comptroller of the
Currency, 250 E Street SW., Washington, DC 20219, Attention: Karen
Carter. Comments will be available for inspection and photocopying at
that address.
FRB: Comments, which should refer to Docket No. R-0835, may be
mailed to the Board of Governors of the Federal Reserve System, 20th
Street and Constitution Avenue NW., Washington, DC 20551, to the
attention of Mr. William Wiles, Secretary. Comments addressed to the
attention of Mr. Wiles may be delivered to the FRB's mail room between
8:45 a.m. and 5:15 p.m., and to the security control room outside of
those hours. Both the mail room and the security control room are
accessible from the courtyard entrance on 20th Street between
Constitution Avenue and C Street NW. Comments may be inspected in room
B-1122 between 9 a.m. and 5 p.m. weekdays, except as provided in
Sec. 261.8 of the FRB's Rules Regarding Availability of Information, 12
CFR 261.8.
FDIC: Comments should be addressed to Robert E. Feldman, Acting
Executive Secretary, Federal Deposit Insurance Corporation, 550 17th
Street NW., Washington, DC 20429. Comments may also be hand-delivered
to Room F-400, 1776 F Street NW., between the hours of 8:30 a.m. and 5
p.m. on business days. They may be sent by facsimile transmission to
FAX Number (202) 898-3838]. Comments will be available for inspection
and photocopying in the FDIC's Reading Room, room 7118, 550 17th Street
NW., between 9 a.m. and 4:30 p.m. on business days.
OTS: Send comments to Director, Information Services Division,
Public Affairs, Office of Thrift Supervision, 1700 G Street NW.,
Washington, DC 20552, Attention Docket No. [93-238]. These submissions
may be hand-delivered to 1700 G Street NW., between 9 a.m. and 5 p.m.
on business days; they may be sent by facsimile transmission to FAX
Number (202) 906-7755. Submissions must be received by 5 p.m. on the
day they are due in order to be considered by the OTS. Late-filed,
misaddressed or misidentified submissions will not be considered in
this rulemaking. Comments will be available for inspection at 1700 G
Street NW., from 1 p.m. until 4 p.m. on business days. Visitors will be
escorted to and from the Public Reading Room at established intervals.
FOR FURTHER INFORMATION CONTACT:
OCC: Owen Carney, Senior Advisor for Investment Securities, Office
of the Chief National Bank Examiner (202/874-5070); David Thede, Senior
Attorney, Bank Operations and Assets Division (202/874-4460);
Christopher Beshouri, Financial Economist, Economics and Evaluation
(202/874-5220); Elizabeth Milor, Financial Economist, Regulatory and
Statistical Analysis (202/874-5240).
FRB: Rhoger H. Pugh, Assistant Director (202/728-5883); Thomas R.
Boemio, Supervisory Financial Analyst (202/452-2982); or David A.
Elkes, Financial Analyst (202/452-5218), Division of Banking
Supervision and Regulation. Telecommunication Device for the Deaf
(TDD), Dorothea Thompson (202/452-3544), Board of Governors of the
Federal Reserve System, 20th and C Streets NW., Washington, DC 20551.
FDIC: Robert F. Storch, Chief, Accounting Section, Division of
Supervision, (202/898-8906), or Cristeena G. Naser, Attorney, Legal
Division (202/898-3587).
OTS: John F. Connolly, Senior Program Manager for Capital Policy
(202/906-6465); Fred Phillips-Patrick, Senior Financial Economist (202/
906-7295); Robert Kazdin, Senior Project Manager (202/906-5759),
Policy; Karen Osterloh, Counsel, Banking and Finance (202/906-6639);
Deborah Dakin, Assistant Chief Counsel, Regulations and Legislation
Division (202/906-6445), Office of Thrift Supervision, 1700 G Street
NW., Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
I. Introduction and Background
A. Overview
Each of the Agencies is proposing to amend its risk-based capital
standards to clarify and revise the treatment of recourse arrangements
and certain direct credit substitutes that expose banking organizations
(banks and bank holding companies) and thrifts to credit risk. The
Banking Agencies (OCC, FRB, and FDIC) are also proposing to recommend
that the FFIEC make conforming revisions to the regulatory reporting
requirements applicable to asset transfers with recourse and direct
credit substitutes for insured commercial banks and FDIC-supervised
savings banks.
This notice of proposed rulemaking would amend the Agencies' risk-
based capital standards to:
Define the term ``recourse'' and expand the definition of
the term ``direct credit substitute'';1
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\1\The OTS is adding definitions for ``public sector entity''
and ``standby-type letter of credit'' to be consistent with the
Banking Agencies.
---------------------------------------------------------------------------
Create an exception to the Banking Agencies' current
guidelines that would reduce the amount of capital required for certain
low-level recourse transactions;2
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\2\The OTS risk-based capital regulation already permits thrifts
to hold reduced capital against low level recourse transactions and
requires thrifts to treat purchased recourse servicing and certain
purchased subordinated interests as recourse. 12 CFR
567.6(a)(2)(i)(C). The OTS is not proposing to amend these existing
treatments.
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Require banking organizations that purchase loan servicing
rights that provide loss protection to the owners of the loans serviced
to hold capital against those loans;
Require banking organizations that purchase subordinated
interests in loans or pools of loans that absorb the first dollars of
losses from those loans to hold capital against the subordinated
interest plus all more senior interests; and
Require banking organizations and thrifts that provide
financial standby letters of credit or other guarantee-type
arrangements for third-party assets that absorb the first dollars of
losses from those assets to hold the same amount of capital that they
would be required to hold under a recourse arrangement with equivalent
risk exposure.
The Agencies are also publishing as an advance notice of proposed
rulemaking (ANPR) a preliminary ``multi-level approach,'' that would
use credit ratings from nationally recognized statistical rating
organizations to measure relative exposure to risk in rated securitized
asset transactions and would allow the capital assessment to vary with
the risk. The Agencies are also requesting comment in the ANPR on the
need for a separate multi-level approach for unrated securitizations
and on how such a system could be designed.
B. Purpose and Effect
Implementation of all aspects of this proposal, including one or
more multi-level approaches for securitization transactions, would
result in more consistent treatments of recourse and similar
transactions among the Agencies, more consistent risk-based capital
treatments for transactions involving similar risk, and capital
requirements that more closely reflect a banking organization or
thrift's relative exposure to credit risk. In particular, the proposed
treatments of low-level recourse transactions, purchased loan servicing
rights that provide loss protection, and purchased subordinated
interests that absorb the first dollars of losses from the underlying
assets would bring the capital requirements of the Banking Agencies
into greater conformity with those of the OTS.
The proposal would allow banks and bank holding companies (banking
organizations) to maintain lower amounts of capital against low-level
recourse transactions. The proposal would also require higher amounts
of risk-based capital to be maintained against certain direct credit
substitutes, including, for banking organizations, purchased servicing
rights that provide loss protection to the owners of the loans serviced
and purchased subordinated interests that absorb the first dollars of
losses from the underlying assets, and, for both banking organizations
and thrifts, certain guarantee-type arrangements provided for third-
party assets that absorb the first dollars of losses from those assets.
Additionally, the Agencies expect that a multi-level approach will
provide a method for identifying participants in securitization
transactions that are relatively insulated from credit risk and
therefore eligible for reduced capital assessments.
The Agencies intend that any final rules adopted in connection with
this notice of proposed rulemaking and advance notice of proposed
rulemaking that result in increased risk-based capital requirements for
banking organizations or thrifts would apply only to transactions that
are consummated after the effective date of such final rules. The
Agencies intend that any final rules adopted in connection with this
notice that result in reduced risk-based capital requirements for
banking organizations or thrifts would apply to all transactions
outstanding as of the effective date of such final rules and to all
subsequent transactions.
The Agencies believe that the proposed rule would satisfy the
requirements of section 618(b)(3) of the Resolution Trust Corporation
Refinancing, Restructuring, and Improvement Act, since the proposed
rule would apply to multifamily residential property loans sold with
recourse.
C. Background
1. Recourse and Direct Credit Substitutes
Asset securitization is the process by which loans and other
receivables are pooled, reconstituted into one or more classes or
positions, and then sold. Securitizations typically carve up the risk
of credit losses from the underlying assets and distribute it to
different parties. The ``first dollar'' loss or subordinate position is
first to absorb credit losses, the ``senior'' investor position is
last, and there may be one or more loss positions in between (``second
dollar'' loss positions). Each loss position functions as a credit
enhancement for the more senior loss positions in the structure.
For residential mortgages that are sold through the federally
sponsored mortgage programs, a federal government agency or federally
sponsored agency guarantees the securities sold to investors. However,
many of today's asset securitization programs involve nonmortgage
assets and are not supported in any way by the federal government.
Sellers of these privately securitized assets therefore provide other
forms of credit enhancement--first and second dollar loss positions--to
reduce investors' risk of loss.
Sellers may provide this credit enhancement themselves through
recourse arrangements. For purposes of this notice, ``recourse'' refers
to any risk of loss that an institution may retain in connection with
the transfer of its assets. While banking organizations and thrifts
have long provided recourse in connection with sales of whole loans or
loan participations, recourse arrangements today are frequently
associated with asset securitization programs.
Sellers may also arrange for a third party to provide credit
enhancement in an asset securitization. If the third-party enhancement
is provided by another banking organization or thrift, that institution
assumes some portion of the assets' credit risk. For purposes of this
proposal, all forms of third-party enhancements, i.e., all arrangements
in which an institution assumes risk of loss from third-party assets or
other claims that it has not transferred, are referred to as ``direct
credit substitutes.''3 In economic terms, an institution's risk of
loss from providing a direct credit substitute can be identical to its
risk of loss from transferring an asset with recourse.
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\3\As used in this preamble, the terms ``credit enhancement''
and ``enhancement'' refer to both recourse arrangements and direct
credit substitutes.
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Depending upon the type of asset securitization, a portion of the
total credit enhancement may also be provided internally, as part of
the securitization structure, through the use of spread accounts,
overcollateralization, or other forms of self-enhancement. Many asset
securitizations use a combination of internal enhancement, recourse,
and third-party enhancement to protect investors from risk of loss.
2. Prior History
On June 29, 1990, the Federal Financial Institutions Examination
Council (FFIEC) published a request for comment on recourse
arrangements. See 55 FR 26766 (June 29, 1990). The publication
announced the Agencies' intent to review the regulatory capital,
reporting and lending limit treatments of assets transferred with
recourse and similar transactions, and set out a broad range of issues
for public comment. The FFIEC received approximately 150 comment
letters in response. The FFIEC then narrowed the scope of the review to
the reporting and capital treatments of recourse arrangements and
direct credit substitutes that expose banking organizations and thrifts
to credit-related risks.
In July 1992, after receiving preliminary recommendations from an
interagency staff working group, the FFIEC directed the staff to carry
out a study of the likely impact of those recommendations on banking
organizations and thrifts, financial markets and other affected
parties. As part of that study, the staff held a series of meetings
with representatives from thirteen organizations active in the
securitization and credit enhancement markets. Summaries of the
information provided to the staff and a copy of the staff's letter sent
to participants prior to the meetings are in the FFIEC's public file on
recourse arrangements and are available for public inspection and
photocopying. Additional material provided to the Agencies from
financial institutions and others since these meetings has also been
placed in the FFIEC's public file.
The FFIEC's offices are located at 2100 Pennsylvania Avenue, NW.,
suite 200, Washington, DC 20037. For public convenience, the Agencies
have also placed copies of all of the above material in the FRB's
public file, located at 20th Street and Constitution Avenue, NW.,
Washington, DC 20551, room B-1122.
D. Current Risk-Based Capital Treatments of Recourse and Direct Credit
Substitutes
Currently, the Agencies' risk-based capital standards apply
different treatments to recourse arrangements and direct credit
substitutes. As a result, capital requirements applicable to credit
enhancements do not consistently reflect credit risk. The Banking
Agencies' current rules are also not consistent with those of the OTS.
1. Recourse
a. Banking agencies. The Banking Agencies' risk-based capital
guidelines prescribe a single treatment for assets transferred with
recourse whether the transaction is reported as a financing or a sale
of assets in a bank's Consolidated Reports of Condition and Income
(Call Report). In either case, risk-based capital is held against the
full, risk-weighted amount of the transferred assets, regardless of the
amount of recourse that is provided.4
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\4\The Banking Agencies provide a limited exception to this
treatment for sales of mortgage loan pools where the bank or bank
holding company retains only minimal risk and meets certain other
conditions.
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Assets transferred with any amount of recourse in transactions
reported as financings remain on the balance sheet and continue to be
subject to the full risk-based capital charge (based on their risk-
weight).
Assets transferred with recourse in transactions that are reported
as sales create off-balance sheet exposures. The entire outstanding
amount of the assets sold (not just the amount of the recourse) is
converted into an on-balance sheet credit equivalent amount using a
100% credit conversion factor.
This capital treatment differs from the accounting treatment for
recourse arrangements under generally accepted accounting principles
(GAAP) and is intended to ensure that banking organizations that
transfer assets and retain the credit risk inherent in the assets
maintain adequate capital to support that risk. As is explained below,
the Banking Agencies believe that the GAAP accounting treatment would
not provide sufficient capital to support recourse arrangements.
b. OTS. OTS follows GAAP in according sales treatment to sales with
recourse for reporting purposes and for calculating the leverage ratios
of thrifts. Under the OTS risk-based capital regulation, thrifts must
also hold capital against the full value of assets transferred with
recourse in computing their risk-based capital requirements, unless the
capital charge would exceed the contractual maximum amount of the
recourse provided. If the capital charge would exceed the amount of the
recourse, then the thrift is only required to hold dollar-for-dollar
capital against the contractual maximum amount of the recourse (the
low-level recourse rule). (Footnote 17 below addresses the treatment of
recourse liability accounts.)
2. Direct Credit Substitutes
a. Banking agencies. Direct credit substitutes are treated
differently from recourse under the current risk-based capital
standards. Under the Banking Agencies' guidelines, off-balance sheet
direct credit substitutes, such as financial standby letters of credit
provided for third-party assets, carry a 100% credit conversion factor.
However, only the dollar amount of the direct credit substitute is
converted into an on-balance sheet credit equivalent so that capital is
held only against the face amount of the direct credit substitute. The
capital requirement for a recourse arrangement, in contrast, is based
on the full amount of the assets enhanced.
If a direct credit substitute covers less than 100% of the losses
on the assets enhanced, the current capital treatment results in a
lower capital charge for a direct credit substitute than for a
comparable recourse arrangement. For example, if a direct credit
substitute covers losses up to 20% of the amount of the assets
enhanced, then the on-balance sheet credit equivalent amount equals
that 20% amount. Risk-based capital is held against only the 20%
amount. In contrast, required capital for a 20% recourse arrangement is
higher because capital is held against the full outstanding amount of
the assets enhanced.5
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\5\If the direct credit substitute covers 100% of losses on the
assets enhanced, then the current capital treatment results in the
same capital charge for a direct credit substitute as for an asset
sold with recourse. The direct credit substitute is converted into
an on-balance sheet credit equivalent equal to 100% of the assets
enhanced and capital is required against that amount.
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Under the Agencies' proposal, the definition of direct credit
substitute would also be expanded to include some items that are
already partially reflected on the balance sheet, such as purchased
subordinated interests. Currently, under the Banking Agencies'
guidelines, these interests receive the same capital treatment as off-
balance sheet direct credit substitutes. Purchased subordinated
interests are placed in the appropriate risk-weight category and then
added to the banking organization's risk-weighted assets. In contrast,
if a banking organization retains a subordinated interest in connection
with the transfer of its own assets, this is considered recourse. The
institution must hold capital against the carrying amount of the
subordinated interest as well as the outstanding amount of all senior
interests that it supports.
b. OTS. The OTS risk-based capital regulation treats some forms of
direct credit substitutes (e.g., financial standby letters of credit)
the same as the Banking Agencies' guidelines. However, unlike the
Banking Agencies, the OTS treats purchased subordinated interests under
its general recourse provisions (except for certain high quality
subordinated mortgage-related securities). The risk-based capital
requirement is based on the carrying amount of the subordinated
interest plus all senior interests, as though the thrift owned the full
outstanding amount of the assets enhanced.
3. Problems With Existing Risk-Based Capital Treatments of Recourse
Arrangements and Direct Credit Substitutes
The Agencies are proposing changes to the risk-based capital
standards to address the following major concerns with the current
treatments of recourse and direct credit substitutes:
Different amounts of capital can be required for recourse
arrangements and direct credit substitutes that expose a banking
organization or thrift to equivalent risk of loss.
The standards generally do not reduce the capital
requirement for banking organizations that reduce their risk by
transferring assets with low levels of recourse.
The capital assessment rate does not recognize the
difference in risk of loss between recourse or direct credit
substitutes that absorb first losses and recourse or direct credit
substitutes that absorb second losses from the underlying assets.
The current standards do not provide uniform definitions
of recourse, direct credit substitute, and associated terms.
E. GAAP Treatment of Recourse Arrangements
As was mentioned above, the Banking Agencies' regulatory capital
treatment of asset transfers with recourse differs from the accounting
treatment of asset transfers with recourse under generally accepted
accounting principles (GAAP).6 The Banking Agencies do not believe
it would be appropriate to conform the regulatory capital treatment of
recourse arrangements to GAAP.
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\6\The OTS requires thrifts to account for assets sold with
recourse in accordance with GAAP for reporting purposes and leverage
capital requirements, but assesses capital against assets sold with
recourse in computing the risk-based capital requirement for
thrifts.
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Under GAAP, a transfer of receivables with recourse is accounted
for as a sale if the transferor (1) surrenders control of the future
economic benefits of the assets, (2) is able to reasonably estimate its
obligations under the recourse provision, and (3) is not obligated to
repurchase the assets except pursuant to the recourse provision. These
provisions indicate that GAAP focuses on the transfer of benefits
rather than the retention of risk in determining whether an asset
transfer should be accounted for as a sale.
The transferor must accrue, as a separate liability, an amount
sufficient to absorb all estimated probable losses under the recourse
provision over the life of the assets transferred. This accrued amount
is referred to as the GAAP recourse liability. If a banking
organization reported assets transferred with recourse in accordance
with GAAP, and no regulatory capital were required for the transaction,
then the institution's only protection against losses would be the GAAP
recourse liability account. For a number of reasons, the Banking
Agencies are of the opinion that the GAAP recourse liability account
would be an inadequate substitute for an appropriate level of
regulatory capital.
First, the GAAP recourse liability account is intended to cover
only an institution's probable expected losses under the recourse
provision. In contrast, regulatory capital is intended to provide a
cushion against unexpected losses. In recognition of the distinctly
different purposes of the GAAP recourse liability account and
regulatory capital, the Banking Agencies explicitly exclude the GAAP
recourse liability account from regulatory capital.
Second, the amount of credit risk that is typically retained in a
recourse transaction greatly exceeds the normal, expected losses
associated with the transferred assets. Even though a transferor may
reduce its exposure to potential catastrophic losses by limiting the
amount of recourse it provides, in many cases the transferor still
retains the bulk of the risk inherent in the assets.
For example, if an institution transfers high quality assets with
10% recourse that have a reasonably estimated loss rate of 1%, the
transferor retains the risk of default up to a maximum of 10% of the
total amount of the assets transferred. Because the recourse provision
represents exposure to such a high amount of losses relative to the
expected losses, in the normal course of business the transferor will
sustain the same amount of losses as if the assets had not been sold.
Consequently, the Banking Agencies take the position that the
transferor in this example has not significantly reduced its risk for
purposes of assessing regulatory capital and should continue to be
assessed regulatory capital as though the assets have not been
transferred.
Third, the GAAP reliance on reasonable estimates of all probable
credit losses over the life of the receivables transferred poses
additional concerns for the Banking Agencies. While it may be possible
to make such estimates for pools of consumer loans or residential
mortgages, the Banking Agencies are of the view that it is difficult to
do so for other types of loans. Even if it is possible to make a
reasonable estimate of probable credit losses at the time an asset or
asset pool is transferred, the ability of an institution to make a
reasonable estimate may change over the life of the transferred assets.
Finally, the Banking Agencies are concerned that an institution
transferring assets with recourse might estimate that it would not have
any losses under the recourse provision, in which case it would not
establish any GAAP recourse liability account for the exposure. If the
transferor recorded either no liability or only a nominal liability in
the GAAP recourse liability account for a succession of asset
transfers, a cumulation of credit risk would occur that would not be
reflected, or would be only partially reflected, on the balance sheet.
II. Notice of Proposed Rulemaking
The Agencies' proposal to amend the risk-based capital standards
would do the following:
Define the term ``recourse,'' expand the definition of the
existing term ``direct credit substitute,'' and define the associated
terms ``standard representations and warranties'' and ``servicer cash
advance'';
Reduce the Banking Agencies' risk-based capital assessment
for certain low-level recourse arrangements; and
Require equivalent treatment of recourse arrangements and
certain direct credit substitutes that present equivalent risk of loss,
including
--requiring banking organizations that purchase certain loan servicing
rights which provide loss protection to the owners of the loans
serviced to hold capital against those loans,
--requiring banking organizations that purchase subordinated interests
which absorb the first dollars of losses from the underlying assets to
hold capital against the subordinated interest plus all more senior
interests, and
--requiring banking organizations and thrifts that provide financial
standby letters of credit or other guarantee-like arrangements for
third-party assets that absorb the first dollars of losses from those
assets to hold capital against the outstanding amount of the assets
enhanced.7
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\7\The OTS currently treats purchased loan servicing rights and
purchased subordinated interests as recourse. This treatment would
not change under this proposal.
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A. Definitions of Recourse and Direct Credit Substitute
1. Recourse
The proposal defines ``recourse'' to mean any risk of loss that a
banking organization or thrift retains in connection with an asset
transfer, if the risk of loss exceeds a pro rata share of the
institution's claim on the assets.8 The proposed definition of
recourse is consistent with the Banking Agencies' longstanding use of
this term, and is intended to incorporate into the risk-based capital
standards existing Agency practices regarding retention of risk in
asset transfers.9
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\8\If the institution transfers an asset or pool of assets in
whole or in part but shares the total credit risk from the assets on
a pro rata basis with the purchaser, this is not considered
recourse. In such transactions, capital is required only against the
transferor's pro rata share. Recourse exists when the transferor
retains a disproportionate amount of the credit risk relative to its
retained interest (if any) in the assets.
\9\The OTS currently defines the term ``recourse'' more broadly
than the proposal to include credit risk that a thrift assumes or
accepts from third-party assets as well as risk that it retains in
an asset transfer. Under the proposal, as explained below, credit
risk that a banking organization or thrift assumes from third-party
assets would fall under the definition of ``direct credit
substitute'' rather than ``recourse.''
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Currently, the term ``recourse'' is not explicitly defined in the
Banking Agencies' risk-based capital guidelines. Instead, the
guidelines use the term ``sale of assets with recourse,'' which is
defined by reference to the Call Report instructions. See Call Report
instructions, Glossary (entry for ``Sales of Assets''). Once a
definition of recourse is adopted in the risk-based capital guidelines,
the Banking Agencies would delete the cross-reference to the Call
Report instructions and would recommend to the FFIEC that these
instructions be revised to incorporate the risk-based capital
definition of recourse. The OTS capital regulation currently provides a
definition of the term ``recourse,'' which would also be replaced once
a final definition of recourse is adopted.
2. Direct Credit Substitute
The proposed definition of ``direct credit substitute'' is intended
to mirror the definition of recourse. The term ``direct credit
substitute'' would refer to any arrangement in which an institution
assumes risk of loss from assets or other claims it has not
transferred, if the risk of loss exceeds the institution's pro rata
share of the assets or other claims. Currently, under the Banking
Agencies' guidelines, this term covers guarantees and guarantee-type
arrangements. As revised, it would also explicitly include items such
as purchased subordinated interests and agreements to cover credit
losses that arise from purchased loan servicing rights.
3. Risks Other Than Credit Risks
These definitions cover arrangements that create exposure to all
types of risk. However, a capital charge would be assessed only against
arrangements that create exposure to credit or credit-related risks.
This continues the Agencies' current practice and is consistent with
the risk-based capital standards' current, primary focus on credit
risk.
4. Implicit Recourse
The definitions cover all arrangements that are recourse or direct
credit substitutes, in form or in substance. This continues the Banking
Agencies' current treatment of recourse under the Call Report
instructions.10 Recourse exists in substance, or implicitly, when
an institution demonstrates a pattern of providing recourse even though
it has no legal obligation to do so. For example, an institution that
regularly buys back or replaces problem assets when it is not required
to do so under the terms of the sale agreement may be providing
recourse. The Agencies will continue their current practice of
requiring institutions that demonstrate a pattern of providing implicit
recourse to treat those transactions and all similar outstanding
transactions as recourse for risk-based capital purposes. The Agencies
will follow the same approach, as appropriate, for direct credit
substitutes. Decisions concerning implicit recourse or implicit direct
credit substitute arrangements will be made on a case-by-case basis.
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\1\0See Call Report Instructions, Glossary--Sales of Assets:
Interpretations and illustrations of the general rule 1, A-49 (May
1989) (retention of risk depends on the substance of the
transaction, not the form).
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5. Subordinated Interests in Loans or Pools of Loans
The definitions explicitly cover an institution's ownership of
subordinated interests in loans or pools of loans. This continues the
Banking Agencies' longstanding treatment of retained subordinated
interests as recourse and recognizes that purchased subordinated
interests can also function as credit enhancements. Subordinated
interests generally absorb more than their pro rata share of losses
(principal or interest) from the underlying assets in the event of
default.11 For example, a multi-class asset securitization may
have several classes of subordinated securities, each of which provides
credit enhancement for the more senior classes. Generally, the holder
of any class that absorbs more than its pro rata share of losses from
the total underlying assets is providing recourse or a direct credit
substitute for all more senior classes.12
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\1\1A class of securities that receives payments of principal
(and, in some cases, interest) only after another class or classes
from the same issue is completely paid is generally not considered
recourse or a credit substitute, provided that losses are shared on
a pro rata basis in the event of default.
\1\2Current OTS risk-based capital guidelines exclude certain
high-quality subordinated mortgage-related securities from treatment
as recourse arrangements due to their credit quality. OTS is not
proposing to change this treatment.
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6. Second Mortgages
Second mortgages or home equity loans would generally not be
considered recourse or direct credit substitutes, unless they actually
functioned as credit enhancements by facilitating the sale of the first
mortgage. This is most likely to occur if a lender originates first and
second mortgages contemporaneously on the same property and then sells
the first mortgage and retains the second. In such a transaction, the
second mortgage would function as a substitute for a recourse
arrangement because it is intended that the second mortgage will absorb
losses before the first mortgage does if the borrower fails to make all
payments due on both loans. Under the proposal, a second mortgage that
is originated at or about the same time as the first mortgage would be
presumed to be a recourse arrangement or direct credit substitute
unless the holder was able to demonstrate that the second mortgage was
granted for some purpose other than providing credit enhancement for
the first mortgage (e.g., home improvement loans).
(Question 1) The Agencies specifically request comment on this
proposed treatment and on whether additional factors should be
considered in determining whether a second mortgage provides recourse
or a direct credit substitute.
7. Representations and Warranties
When a banking organization or thrift transfers assets, including
servicing rights, it customarily makes representations and warranties
concerning those assets. When a banking organization or thrift
purchases loan servicing rights, it may also assume representations and
warranties made by the seller or a prior servicer. These
representations and warranties give certain rights to other parties and
impose obligations upon the seller or servicer of the assets. The
definitions would treat as recourse or direct credit substitutes any
representations or warranties that create exposure to default risk or
any other form of open-ended, credit-related risk from the assets that
is not controllable by the seller or servicer. This reflects the
Agencies' current practice with respect to recourse arising out of
representations and warranties, and explicitly recognizes that a
servicer with purchased loan servicing rights can also take on risk
through servicer representations and warranties.
The Agencies recognize, however, that the market requires asset
transferors and servicers to make certain representations and
warranties, and that most of these present only normal, operational
risk. Currently, the Agencies have no formal standard for
distinguishing between these types of representations and warranties
and those that create recourse or direct credit substitutes. The
proposal therefore defines the term ``standard representations and
warranties'' and provides that seller or servicer representations or
warranties that meet this definition would not be considered recourse
or direct credit substitutes.
Under the proposal, ``standard representations and warranties'' are
those that refer to an existing state of facts that the seller or
servicer can either control or verify with reasonable due diligence at
the time the assets are sold or the servicing rights are transferred.
These representations and warranties will not be considered recourse or
direct credit substitutes, provided that the seller or servicer
performs due diligence prior to the transfer of the assets or servicing
rights to ensure that it has a reasonable basis for making the
representation or warranty. The term ``standard representations and
warranties'' would also cover contractual provisions that permit the
return of transferred assets in the event of fraud or documentation
deficiencies, (i.e., if the assets are not what the seller represented
them to be), consistent with the current Call Report instructions
governing the reporting of asset transfers. After a final definition of
``standard representations and warranties'' is adopted for the risk-
based capital standards, the Banking Agencies would recommend to the
FFIEC that the Call Report instructions be changed to conform to the
capital guidelines and the OTS would similarly amend the instructions
for the Thrift Financial Report (TFR).
Examples of ``standard representations and warranties'' include
seller representations that the transferred assets are current (i.e.,
not past due) at the time of sale; that the assets meet specific,
agreed-upon credit standards at the time of sale; or that the assets
are free and clear of any liens (provided that the seller has exercised
due diligence to verify these facts). An example of a nonstandard
representation and warranty would be a contractual provision stating
that all properties underlying a pool of transferred mortgages are free
of environmental hazards. This representation is not verifiable by the
seller or servicer with reasonable due diligence because it is not
possible to absolutely verify that a property is, in fact, free of all
environmental hazards. Such an open-ended guarantee against the risk
that unknown but currently existing hazards might be discovered in the
future would be considered recourse or a direct credit substitute.
However, a seller's representation that all properties underlying a
pool of transferred mortgages have undergone environmental studies and
that the studies revealed no known environmental hazards would be a
``standard representation and warranty'' (assuming that the seller
performed the requisite due diligence). This is a verifiable statement
of facts that would not be considered recourse or a direct credit
substitute.
8. Loan Servicing Arrangements
The definitions cover loan servicing arrangements if the servicer
is responsible for credit losses associated with the loans being
serviced. However, cash advances made by servicers to ensure an
uninterrupted flow of payments to investors or the timely collection of
the loans would be specifically excluded from the definitions of
recourse and direct credit substitute, provided that the servicer is
entitled to reimbursement for any significant advances.13 Such
advances are assessed risk-based capital only against the amount of the
cash advance, and are assigned to the risk-weight category appropriate
to the party that is obligated to reimburse the servicer.
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\1\3Servicer cash advances would include disbursements made to
cover foreclosure costs or other expenses arising from a loan in
order to facilitate its timely collection (but not to protect
investors from incurring these expenses).
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If the servicer is not entitled to full reimbursement, then the
maximum possible amount of any nonreimbursed advances on any one loan
must be contractually limited to an insignificant amount of the
outstanding principal on that loan in order for the cash advance to be
excluded from the definitions of recourse and direct credit substitute.
This treatment reflects the Agencies' traditional view that servicer
cash advances meeting these criteria are part of the normal servicing
function and do not constitute credit enhancements.
B. Low-level recourse rule
The Banking Agencies are proposing to reduce the capital
requirement for all recourse transactions in which a banking
organization contractually limits its exposure to less than the full,
effective risk-based capital requirement for the assets transferred
(referred to as ``low-level recourse transactions'').14 This
proposal would apply to low-level recourse transactions involving all
types of assets, including small business loans, commercial loans and
residential mortgages.
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\1\4The ``full effective risk-based capital charge'' is 8% for
100% risk-weighted assets and 4% for 50% risk-weighted assets.
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1. ``Dollar-for-dollar'' Capital Requirement Up to the Amount of the
Recourse Obligation for Low-Level Recourse
Under the proposed low-level recourse rule, a banking organization
that contractually limits its maximum recourse obligation to less than
the full effective risk-based capital requirement for the transferred
assets would be required to hold risk-based capital equal to the
contractual maximum amount of its recourse obligation. This would be a
``dollar-for-dollar'' capital requirement for the low-level recourse
exposure. For example, the risk-based capital requirement for a 100%
risk-weighted asset transferred with 3% recourse would be only 3% of
the value of the transferred assets rather than the currently required
8%. This would prevent a banking organization's capital requirement
from exceeding the contractual maximum amount that it could lose under
a recourse obligation.15 In addition, adoption of this proposal
would bring the Banking Agencies into conformity with the OTS, which
already applies the low-level recourse rule to thrifts.
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\1\5The proposed low-level recourse rule would supersede the
Banking Agencies' current risk-based capital treatment of mortgage
transfers with ``insignificant'' recourse. Under that treatment, the
sale of a residential mortgage with recourse is excluded from risk-
weighted assets if the institution does not retain significant risk
of loss, i.e., the institution's maximum contractual recourse
exposure does not exceed its reasonably estimated probable losses on
the transferred mortgages, and the institution establishes and
maintains a recourse liability account equal to the amount of its
recourse obligation.
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The Agencies will continue to evaluate the need for full capital
support for low-level recourse transactions and will consider, in
connection with development of the multi-level approaches that are
discussed in Section III, whether even greater reductions in the
capital requirement for low-level recourse transactions should be
proposed.
2. Low-level Recourse Arrangements for Mortgage-Related Securities or
Participation Certificates Retained in a Mortgage Loan Swap
When an institution swaps mortgage loans for mortgage-related
securities or participation certificates and retains low-level
recourse, the Banking Agencies currently base the capital requirement
on the underlying loans as if the loans were held as on-balance sheet
assets. The OTS bases the capital requirement for these arrangements on
its existing low-level recourse rule, with a minimum capital level of
1.6% of the mortgage-related securities or participation certificates.
(These certificates would include only high-quality mortgage related
securities.)
To recognize the risks related to such a participation certificate
and the retained recourse, the Agencies propose to change their capital
requirement for this arrangement. The requirement would equal the sum
of the amount of risk-based capital required for the portion of the
mortgage-related security or participation certificate not covered by
the institution's recourse obligation and the risk-based capital
required for the low-level recourse obligation retained on the
underlying loans, limited to the capital requirement for the underlying
loans as if the loans were held as on-balance sheet assets.
For example, if an institution swaps $1,000 of qualifying single-
family mortgage loans for a Freddie Mac participation certificate and
retains 1% recourse, the proposed capital requirement would equal the
sum of the following:
(1) $1,000 times (100% minus 1%)16 times 20% risk-weight times 8%
= $15.84, and
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\1\6This 99% piece is the portion of the loan pool not covered
by the institution's recourse obligation, which is guaranteed by
Freddie Mac. For operational simplicity, 100% may be used to
determine an institution's capital requirement.
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(2) $1,000 times 1% = $10
This sum, $25.84, is limited by the capital requirement on the
underlying loans as if they were held by the institution. This limit is
4% of $1,000 or $40. Thus, since the sum, $25.84, is less than the
limit, $40, the capital requirement is $25.84.
3. Reporting of Low-Level Recourse Transactions
The Banking Agencies are also proposing to recommend to the FFIEC
that banks be permitted to report low-level recourse transactions as
sales of assets (rather than financings) in the Call Report, if they
establish and maintain a recourse liability account for the contractual
maximum amount of the recourse obligation. (Otherwise, these
transactions would continue to be reported as financings in the Call
Report.) The recourse liability account could be established either by
a charge to expense or to the allowance for loan and lease losses, as
appropriate. The recourse liability account would not be part of the
allowance for loan and lease losses and would therefore be excluded
from the bank's capital base. Banks that fully reserve against their
recourse exposure in this manner would not be assessed any risk-based
capital for the transaction, which would be consistent with the current
treatment of such transactions for thrifts. The accounting entries
which permit the removal of the assets from a bank's balance sheet on
the condition that the low-level risk exposures are either expensed or
fully reserved for (either of which produces a change in the bank's
equity capital position) result in an appropriately adjusted leverage
capital ratio.
The Banking Agencies currently permit banks to report as sales in
the Call Report certain residential and agricultural mortgage transfers
with recourse that qualify as sales under GAAP. The FRB requires bank
holding companies to report all asset sales with recourse in accordance
with GAAP on the consolidated financial statement for bank holding
companies (Form FR Y-9C). The OTS requires thrifts to report all
transfers of receivables with recourse in accordance with GAAP on their
TFRs. The Agencies are not proposing to change these existing
regulatory reporting treatments.
4. GAAP Recourse Liability Account
As previously explained, under GAAP, when a transfer of receivables
with recourse qualifies to be recognized as a sale, the seller must
establish a recourse liability account at the date of sale that covers
all probable credit losses under the recourse provision over the life
of the receivables transferred.
(Question 2) The Banking Agencies request comment on how the GAAP
recourse liability account should be treated under the proposed low-
level recourse rule for transfers of receivables with recourse that are
currently reported as sales in the Call Report and FR Y-9C.17 That
is, when a banking organization transfers assets in such transactions,
should the amount of capital required under the low-level recourse rule
be adjusted to take account of the institution's GAAP recourse
liability account?
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\1\7The OTS is not proposing to change its current policy, which
permits a thrift to deduct the amount of its GAAP recourse liability
account (1) from the contractual maximum amount of its recourse
obligation in applying the low-level recourse rule, and (2) from the
amount of loans sold with recourse in assessing the full effective
risk-based capital requirement for all loans.
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The two options are: (1) Not taking the GAAP recourse liability
account into consideration at all; or (2) requiring risk-based capital
equal to the amount of the banking organization's low-level recourse
obligation minus the balance of its GAAP recourse liability account so
that the recourse liability account plus required capital would equal
the banking organization's contractual maximum exposure under the
recourse obligation.18 The latter option would conform the Banking
Agencies' treatment to that of the OTS in this area.
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\1\8The GAAP recourse liability account must be excluded from an
institution's risk-based and leverage capital base.
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The Banking Agencies' existing risk-based capital guidelines also
do not indicate how the GAAP recourse liability account should be taken
into account in general when determining the credit equivalent amounts
of assets transferred with recourse that are currently reported as
sales in the Call Report or FR Y-9C. The Banking Agencies expect to
apply the GAAP recourse liability account treatment that they adopt for
low-level recourse transactions that are reported as sales in the Call
Report or FR Y-9C to all asset transfers with recourse that are
currently reported as sales in the Call Report or FR Y-9C, and to
clarify their risk-based capital guidelines accordingly.
C. Treatment of Direct Credit Substitutes
The Agencies are proposing to extend the current risk-based capital
treatment of asset transfers with recourse (including the proposed low-
level recourse rule) to certain direct credit substitutes. As
previously explained, the current risk-based capital assessment for a
direct credit substitute may be dramatically lower than the assessment
for a recourse provision that creates an identical exposure to risk.
Based on the Agencies' conclusion that asset transfers with recourse
should be assessed risk-based capital against the full amount of the
assets enhanced19 (except in low-level recourse transactions), the
Agencies are of the opinion that direct credit substitutes that present
equivalent risk should be subject to an equivalent risk-based capital
treatment.
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\1\9See earlier comparison to GAAP accounting requirements.
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Under this proposal, the general treatment of direct credit
substitutes would be to assess capital against the amount of the asset
or pool of assets that is enhanced, rather than the face amount of the
direct credit substitute. Like low-level recourse arrangements, direct
credit substitutes that cover only losses below the full effective
risk-based capital requirement for the assets would be assessed a
dollar-for-dollar capital requirement.20
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\2\0As indicated in Section II(B), the Agencies are continuing
to evaluate the need for a dollar-for-dollar capital requirement on
low-level recourse transactions. Any modification to the proposed
treatment of low level recourse transactions would also apply to low
level direct credit substitutes (i.e., those that cover losses below
the full, effective risk-based capital charge for the total
outstanding amount of the assets enhanced). See Section III for
additional discussion.
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The proposed treatment of direct credit substitutes would not
affect the current treatment of purchased subordinated interests and
financial standby letters of credit that absorb only the second dollars
of losses from the assets enhanced.21 The Agencies intend to
determine the appropriate risk-based capital treatment of these second
dollar loss direct credit substitutes as part of the development of the
multi-level approaches discussed in Section III. In the event that the
Agencies do not proceed with implementation of one or more multi-level
approaches, the Agencies would expect to propose amendments to the
risk-based capital standards that would assess risk-based capital
against all second dollar loss direct credit substitutes based on their
face amounts plus the face amounts of all more senior outstanding
positions.
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\2\1For purposes of this proposal, and until the Agencies
implement one or more multi-level approaches, a direct credit
substitute absorbs the second dollars of losses from assets if there
is prior credit enhancement that absorbs first dollars of losses
from those assets. For OTS only, purchased subordinated interests
whether in the first or second loss position will continue to be
treated as recourse.
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The currently proposed change to the treatment of direct credit
substitutes would primarily affect the following transactions:
Loan servicing rights purchased by banking organizations
if they embody a direct credit substitute,
Subordinated interests purchased by banking organizations
that absorb the first dollars of losses from the underlying loans or
pools of loans, and
Financial standby letters of credit and other guarantee-
like arrangements provided by banking organizations or thrifts that
absorb the first dollars of losses from third-party assets.
Each of these is discussed below.
1. Purchased Loan Servicing Rights That Embody a Direct Credit
Substitute
Banking organizations and thrifts that sell receivables often
retain the servicing rights on the transferred assets. Banking
organizations and thrifts may also acquire loan servicing rights as
separate assets such as purchased mortgage servicing rights. The terms
of some loan servicing agreements require the servicer to absorb credit
losses on the loans, so that the servicer effectively extends a credit
enhancement (in the form of recourse or a direct credit substitute) to
the owners of the loans.
Currently, all of the Agencies treat as recourse retained loan
servicing rights that embody an obligation to provide credit or other
loss protection to the owners of the loans. Accordingly, risk-based
capital is required against the full amount of the assets serviced.
Under the Banking Agencies' proposal, banking organizations with
purchased loan servicing rights that extend credit protection (a direct
credit substitute) to the owners of the loans being serviced would also
be required to hold capital against the total outstanding amount of
those loans.22 Thus, banking organizations that purchase such
servicing rights would be required to apply the 100% credit conversion
factor to the amount of assets enhanced (the amount of the loans
serviced) to convert this off-balance sheet exposure into an on-balance
sheet credit equivalent amount.23
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\2\2The OTS already requires thrifts to hold capital against the
total outstanding amount of these loans.
\2\3The risk-based capital requirement for the servicer's
exposure to credit risk from the loans would be in addition to the
separate risk-based capital requirement that is currently required
to support qualifying intangible assets under the risk-based capital
standards.
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The proposed low-level recourse rule would apply if the servicer's
maximum retained recourse obligation is contractually limited to an
amount that is less than the amount of capital that would be required
against the total amount of the loans serviced.
(Question 3) The Agencies request comment on whether purchased loan
servicing rights agreements exist that obligate the servicer to provide
credit loss protection for only the second dollars of losses from the
loans. In determining a servicer's loss position, the Agencies do not
consider access to loan collateral upon default to place the servicer
in a second loss position.
Adoption of the proposal would align the Banking Agencies'
treatment of purchased loan servicing rights that embody a direct
credit substitute with that of the OTS, which already explicitly
requires capital support for these arrangements.24 Currently, the
FDIC and OCC do not explicitly require capital support for these
arrangements.25 (Capital is required for the allowed portion of
the intangible asset generated by the purchase of mortgage servicing
rights, but not for the servicer's separate risk of loss on the
underlying loans). The FRB considers purchased mortgage servicing
rights that provide credit protection to be a direct credit substitute
and requires capital support for the risk associated with the
underlying mortgage loans. Thus, the proposal would make this treatment
explicit in the FRB's guidelines.
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\2\4The OTS capital regulation provides that ``loans serviced by
associations where the association is subject to losses on the
loans, commonly known as recourse servicing,'' are to be converted
at 100% to an on-balance sheet credit equivalent. 12 CFR
567.6(a)(2)(i)(C).
\2\5The Agencies are not at this time addressing the risk-based
capital treatment of servicing rights associated with mortgage pools
that back securities guaranteed by the Government National Mortgage
Association.
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2. Purchased Subordinated Interests
The proposal would extend the current risk-based capital treatment
of retained subordinated interests to purchased subordinated interests
that absorb the first dollars of losses from the underlying loans or
loan pools. Currently, banking organizations with purchased
subordinated interests are required to hold risk-based capital only
against the carrying value of the subordinated interest. In contrast,
the OTS currently treats purchased subordinated interests in the same
manner as retained subordinated interests, i.e., as recourse, except
for certain high quality subordinated interests.26
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\2\6The OTS will continue to recognize the 20 percent risk-
weight for high quality residential mortgage-backed senior and
subordinated interests that qualify under the Secondary Mortgage
Market Enhancement Act of 1984 (SMMEA), Section 3(a)(41) of the
Securities Exchange Act of 1934, 15 U.S.C. 78c(a)(41), except as
discussed in Regulatory Bulletin 26. These types of securities are
commonly referred to as ``SMMEA securities.''
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Under this proposal, banking organizations with direct credit
substitutes in the form of purchased subordinated interests that absorb
the first dollars of losses from the underlying assets would be
required to hold risk-based capital against the carrying value of the
subordinated interest plus the outstanding amount of all more senior
interests that the subordinated interest supports.27 If the
carrying value of the most subordinated portion of the loan, or pool of
loans, is less than the full, effective risk-based capital requirement
for the total underlying loan, or pool of loans, then the low-level
treatment would apply, i.e., the subordinated portion would be assessed
risk-based capital dollar-for-dollar against its carrying value. For
example, if the most subordinated portion of a pool of mortgage assets
that qualifies for the 50% risk-weight is held by a banking
organization and its carrying value represents only 3% of the total
pool, the capital requirement for the subordinated portion would be 3%
of the total pool rather than 4% (i.e., the carrying value of the
subordinated portion rather than the full effective capital requirement
for the pool).
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\2\7If the subordinated portion of the loan, or pool of loans,
is held by several banking organizations or thrifts, each
institution would be required to hold risk-based capital against the
carrying value of its subordinated interest plus its proportionate
share of all more senior interests that the subordinated interest
supports.
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The Banking Agencies' risk-based capital treatment of purchased
subordinated interests that represent middle or mezzanine level loss
positions in terms of exposure to total losses from the assets (i.e.,
purchased subordinated interests that absorb losses only after prior
enhancements that absorb the first dollars of losses have been fully
exhausted) would not be affected by this proposal.28 Risk-based
capital would continue to be assessed at the 100% risk-weight against
the carrying value of this type of purchased subordinated interest.
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\2\8The OTS would continue to treat such purchased subordinated
interests (except for SMMEA securities) as recourse.
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3. Financial Standby Letters of Credit and Guarantee-Like Arrangements
The proposal would extend the risk-based capital treatment that is
currently applied to asset transfers with recourse to financial standby
letters of credit and guarantee-like arrangements that absorb the first
dollars of losses from third-party assets. The risk-based capital
assessment for this form of credit enhancement would be based on the
full amount of the assets enhanced rather than the face amount of the
standby letter of credit or guarantee-like arrangement.
The risk-based capital treatment of standby letters of credit or
guarantee-like arrangements that represent second dollar loss
enhancements provided for third-party assets would not be affected by
this proposal. For purposes of this part of the proposal, a second
dollar loss standby letter of credit or guarantee-like arrangement is
one that covers any percentage portion of loss after some level of the
first dollars of loss is covered by another party or through internal
enhancement (e.g., losses from 6 to 20% of the asset value when another
party provides first dollar loss enhancement that covers losses from 0
to 6% of the asset value\29\). These second dollar loss direct credit
substitutes would continue to be assessed risk-based capital based on
their risk-weighted face amounts.
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\29\If the enhancement is a back-up for the 0 to 6% coverage
(i.e., the first party covers the first 6% of losses and the second
party covers the first 20% of losses but expects to absorb losses at
the 0 to 6% level only if the first party fails to perform), then
this is not a ``second dollar loss'' enhancement. The second party
has exposure to the risk that the first party will not perform and
would be charged capital for that exposure at the risk-weight
appropriate for claims against the first party.
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The proposed rule also addresses participations in financial
standby letters of credit and guarantee-like arrangements.
D. Summary
The proposal would increase capital requirements for first dollar
loss financial standby letters of credit and guarantee-like
arrangements that cover less than 100% of the face value of the total
assets enhanced. There would be no change, however, in the risk-based
capital requirement for arrangements that cover the entire amount of
losses from a third party's assets, because the current guidelines
already require capital to be held against the full asset amount in
such direct credit substitute transactions. Based on Agency staff
discussions with market participants, the Agencies believe that the
majority of first dollar loss financial standby letters of credit and
similar arrangements that are provided by banking organizations and
thrifts in the current market are of this latter type. Thus, the
Agencies do not expect that many banking organizations or thrifts would
face increased risk-based capital requirements as a result of this
aspect of the proposal.
Moreover, as was previously mentioned, the Agencies are considering
options for matching the risk-based capital requirement more closely to
the risk associated with second dollar loss subordinated interests and
financial standby letters of credit and guarantee-like arrangements in
connection with the development of one or more multi-level approaches.
The multi-level approaches, in conjunction with the proposed rules
above, would ensure that banking organizations maintain adequate
capital against the risks associated with credit enhancements, would
recognize when an institution has reduced its risk, and make capital
treatment more consistent across the various types of depository
institutions.
III. Advance Notice of Proposed Rulemaking
Many asset securitizations carve up the risk of credit losses from
the underlying assets and distribute it to different parties. The first
dollar loss or subordinate position is first to absorb credit losses,
the senior investor position is last, and there may be one or more loss
positions in between. Each loss position functions as a credit
enhancement for the more senior loss positions in the structure.
Currently, the risk-based capital standards do not vary the rate of
capital assessment with differences in credit risk represented by
different credit enhancement or loss positions.
To address this issue, the Agencies are requesting comment on a
preliminary proposal to adopt a multi-level approach that would assess
risk-based capital against all banking organization and thrift
participants in certain asset securitizations (i.e., recourse
providers, direct credit substitute providers and investors) based on
their relative exposure to risk of loss from the underlying assets.
Credit ratings from nationally recognized statistical rating
organizations would be used to determine relative exposure to risk of
loss. This proposal, referred to as the ratings-based multi-level
approach, would permit reduced risk-based capital assessments for
second dollar loss credit enhancers (both recourse and direct credit
substitute providers) and for senior investors in eligible
securitization transactions.\30\ The Agencies also seek comment on
whether a multi-level approach is needed for unrated securitization
transactions and, if so, on how such a system could be designed.
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\30\The reduction in the risk-based capital charge for second
dollar loss enhancements would be in relation to the treatment that
the Agencies are considering proposing for second dollar loss direct
credit substitutes that do not qualify for the ratings-based multi-
level approach (see discussion below).
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A. Ratings-Based Multi-Level Approach
1. Threshold Criteria
The ratings-based multi-level approach would be restricted to
transactions involving the securitization of large, diversified asset
pools in which all forms of first dollar loss credit enhancement are
either completely free of third-party performance risk (i.e., the
inability of the credit enhancer to perform) or are provided internally
as part of the securitization structure, as specified below. The
diversification requirement and the requirement that all first dollar
loss credit enhancement be free from third-party performance risk are
intended to protect the first dollar loss enhancement from default risk
associated with any single party. For purposes of applying a multi-
level approach, it is important to minimize the possibility that the
first dollar loss enhancement will be exhausted because the presence of
this prior enhancement will be the basis, in most transactions, for
allowing lower risk-based capital assessments on the second dollar loss
and senior positions.
For a transaction to qualify for the ratings-based multi-level
approach, the first dollar loss credit enhancement could be provided in
any of the following four ways:
Cash collateral accounts;\31\
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\31\A cash collateral account is a separate account funded with
a loan from the provider of the enhancement. Funds in the account
are available to cover potential losses.
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Subordinated interests or classes of securities;
Spread accounts, including those that are funded initially
with a loan that is repaid from excess cash flows;\32\ and
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\32\A spread account is typically a trust or special account
that the issuer establishes to retain interest rate payments in
excess of the amounts due investors from the underlying assets, plus
a normal servicing fee rate. The excess spread serves as a cushion
to cover potential losses on the underlying loans.
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Other forms of overcollateralization involving excess cash
flows, e.g., placing excess receivables into the pool so that total
cash flows expected to be received exceed cash flows needed to pay
investors.
Cash collateral accounts and subordinated interests are free of
third-party performance risk because they stand ready to absorb a given
percentage of total losses from the underlying assets regardless of the
financial condition of the party that funds the cash collateral account
or holds the subordinated interest. Spread accounts and other forms of
overcollateralization can provide a similar type of insulation from
exposure to any one party if the asset securitization is based on a
large, well diversified pool of assets. These forms of internal credit
enhancement depend on expected excess cash flows from the underlying
assets and thus are subject to the risk that the excess cash may not
materialize if default rates among the underlying borrowers exceed
expectations. Restricting application of the ratings-based multi-level
approach to large, well diversified asset pools is intended to minimize
this risk.
Transactions with first dollar loss credit enhancements that are
subject to third-party performance risk, such as financial standby
letters of credit or repurchase obligations (which are subject to the
risk that the provider fails to perform), and transactions that do not
involve the securitization of large, well diversified asset pools would
not be eligible for the ratings-based multi-level approach. Banking
organizations and thrifts that participate as credit enhancers or
investors in these types of securitization transactions would not be
eligible for the reduced risk-based capital assessments available under
this approach.
2. Risk-Based Capital Treatment of First Dollar Loss Positions
The risk-based capital treatment of credit enhancements provided by
banking organizations or thrifts in transactions that qualify for the
ratings-based multi-level approach would depend on the loss position of
the credit enhancement. First dollar loss enhancements, whether
provided as recourse or direct credit substitutes, would be required to
hold capital dollar-for-dollar against their face amount, up to the
full, effective risk-based capital requirement for the outstanding
amount of the assets enhanced.\33\ This would essentially incorporate
the proposed low-level recourse rule into the treatment of first dollar
loss enhancements under the ratings-based multi-level approach. The
dollar-for-dollar capital requirement would apply to the holders of
subordinated interests as well as against the providers of loans used
to fund either cash collateral accounts or spread accounts.\34\
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\33\See note 13. In no event would a single institution be
required to hold capital in excess of the amount that would be
required for the full amount of the assets underlying the
securitization.
\34\First dollar loss enhancement provided through
overcollateralization or a spread account (after any banking
organization or thrift's initial loan to that account is repaid)
does not impose risk of loss on any banking organization or thrift
(assuming it is not capitalized in any fashion) and would therefore
not be subject to an explicit risk-based capital charge.
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As previously noted, the Agencies are continuing to evaluate the
risk-based capital requirements for low-level recourse arrangements and
low-level direct credit substitutes. Because the proposed treatment of
first dollar loss positions under the ratings-based multi-level
approach incorporates the low-level recourse rule, any modification of
the low-level recourse rule would also affect the proposed treatment of
first dollar loss positions. The capital requirement for these
positions should reflect the fact that they generally carry a higher
probability of loss relative to other loss positions in the
securitization. However, the Agencies also recognize that the capital
requirement for these positions may appear to be excessive because the
probability of total loss for low-level recourse positions is unlikely
to be 100 percent.
Consequently, the Agencies request comment on the proposed
treatment of low-level recourse and direct credit substitute
transactions and of first dollar loss positions. In particular, the
Agencies invite comment on the following questions:
(Question 4) Is the proposed dollar-for-dollar capital requirement
(up to the full, effective risk-based capital requirement for the
underlying assets) too high for low-level recourse and direct credit
substitute transactions or for first dollar loss positions? If so, why?
(Question 5) If this proposed capital requirement is too high, how
can this be demonstrated or quantified? What methodology could be used
to reduce the capital requirement without jeopardizing safety and
soundness?
(Question 6) If less than dollar-for-dollar capital is required for
low-level or other first dollar loss positions, then the probability of
loss to the insurance funds increases. How should the Agencies deal
with this increased probability of loss?
3. Risk-Based Capital Treatment of Second Dollar Loss Positions
Second dollar loss enhancements that qualify for the ratings-based
multi-level approach, whether provided as recourse or direct credit
substitutes, would be assessed risk-based capital only against the
amount of the enhancement, and not against the more senior portions of
the pool. This would continue the Banking Agencies' current risk-based
capital treatment of direct credit substitutes and would significantly
reduce the amount of capital that is currently required for second
dollar loss recourse positions. All qualifying second dollar loss
enhancements, including subordinated mortgage-backed securities, would
be assigned to the 100% risk-weight category. This would continue the
Banking Agencies' current treatment of purchased subordinated
positions.
To qualify for treatment as a second dollar loss enhancement under
the ratings-based multi-level approach, two requirements must be
satisfied:\35\
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\35\The Agencies intend that any position in a securitization
that meets these requirements would qualify for treatment as a
``second dollar loss enhancement'' under the ratings-based multi-
level approach.
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The securitization transaction itself would have to
qualify for this approach (i.e., it would involve a large, well
diversified pool of assets and all forms of first dollar loss
enhancement would be limited to the four types that are described
above), and
The enhancement would have to meet specified minimum
credit rating requirements, as explained below.
For second dollar loss enhancements in the form of middle level or
subordinated interests or securities, the interest or security would
need a formal credit rating of at least investment grade from a
nationally recognized statistical rating organization. The rating would
be acceptable only if the same rating organization also provided the
credit rating for each rated portion or security of the securitization.
Risk-based capital would be assessed against qualifying middle level or
subordinated interests or securities at the 100% risk-weight, based on
the carrying value of the interest or security. No additional risk-
based capital would be required for these qualifying interests or
securities to support the more senior interests in the pool. See
Example 1.
For second dollar loss enhancements in the form of financial
standby letters of credit or other guarantee-type arrangements, the
Agencies are considering two alternatives. One alternative would
require that the portion of the underlying asset pool covered by the
standby letter of credit must receive a formal credit rating of at
least investment grade from a nationally recognized statistical rating
organization. See Example 2A. The second alternative would require that
the entire asset pool receive a formal credit rating of investment
grade prior to the addition of the standby letter of credit.\36\ See
Example 2B.
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\36\The credit ratings required under both alternatives are not
the same as the credit rating that would be obtained for purposes of
marketing the senior investment portions of the pool, which would
represent an evaluation of the credit quality of the top portion of
the asset pool, after the second dollar loss enhancement (and any
other enhancement) is added.
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(Question 7) The Agencies request comment on which of these
alternatives would be more appropriate for purposes of applying the
ratings-based multi-level approach.
(Question 8) The Agencies request comment on whether the above-
described credit rating requirement for second dollar loss enhancements
should be established at a higher level than investment grade. In
particular, the Agencies seek information on the extent to which
banking organizations and thrifts currently purchase subordinated
interests (including middle level subordinated interests) and on the
typical credit ratings for such purchased subordinated interests.
(Question 9) The Agencies request comment on how application of the
ratings-based multi-level approach to second dollar loss enhancements
would affect banking organizations or thrifts that provide financial
standby letters of credit for asset-backed commercial paper programs
and other asset securitizations.
A second dollar loss enhancement could qualify for this treatment
even if it were not free of third-party performance risk. For example,
a financial standby letter of credit, which has third party performance
risk, could qualify for this preferential capital treatment if it had
qualifying first-loss protection. That is, even though a financial
standby letter of credit would not be considered to qualify for first
loss protection for purposes of determining the capital requirement of
more senior loss positions, the standby letter of credit itself could
qualify for the treatment described above. Risk-based capital would be
assessed at the 100% risk-weight against the face amount of the standby
letter of credit.
It is possible that an asset securitization involving a large,
well-diversified asset pool might satisfy the above credit rating
requirements simply on the basis of asset quality, without the addition
of any credit enhancement. In this circumstance, the risk of loss
associated with providing credit enhancement for investment grade
assets should be the same, regardless of whether the investment grade
rating is based solely on asset quality or on some combination of asset
quality plus first dollar loss credit enhancement. Therefore, the
Agencies are considering whether to treat ``first dollar loss''
enhancements that provide credit support to pools or portions of pools
(depending on which alternative is selected, as explained above) that
have a formal credit rating of at least investment grade rating on a
stand-alone basis in the same manner that qualifying second dollar loss
enhancements would be treated under the ratings-based multi-level
approach. See Example 3.
(Question 10) The Agencies request comment on this possible
treatment of ``first dollar loss'' enhancements of investment grade
assets.
Second dollar loss credit enhancements that are rated below
investment grade or do not meet the other criteria stated above would
not qualify for reduced capital requirements under the ratings-based
multi-level approach.\37\ The Agencies are considering requiring risk-
based capital for such second dollar loss enhancements based on the
amount of the enhancement plus all more senior positions, up to the
lower of the size of the enhancement or the full risk-based capital
requirement. (The provider of the second dollar loss enhancement would
not be required to hold risk-based capital against the portion of the
asset pool that is covered by the first dollar loss enhancement.)
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\37\Because banks and thrifts are generally restricted from
purchasing corporate debt securities rated below investment grade,
this discussion primarily applies to second dollar loss positions,
such as financial standby letters of credit, that are not in the
form of subordinated securities.
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The Agencies are concerned that assigning a single capital
treatment to all second dollar loss positions rated below investment
grade may not adequately reflect the variation in credit risk of assets
rated below investment grade.
(Question 11) The Agencies request comment on modifications to the
capital requirement for second dollar loss enhancements rated below
investment grade to better reflect different levels of credit risk.
In the event that the Agencies do not proceed with implementation
of a multi-level approach, the Agencies would expect to propose
amendments to the risk-based capital standards that would assess risk-
based capital against all second dollar loss positions based on their
face amounts plus the face amounts of all more senior outstanding
positions (up to the maximum size of the second dollar loss position).
For this reason the Agencies are particularly interested in receiving
comment on all aspects of the ratings-based multi-level approach.
4. Risk-Based Capital Treatment of Senior Securities
Under the ratings-based multi-level approach, a senior security
could qualify for a 20 percent risk weight, regardless of the risk-
weight of the underlying assets, if:
The securitization involves a large, well diversified pool
of assets,
All prior credit enhancement is limited to the permissible
forms, and
The security has received the highest possible rating from
the same rating organization that provided the credit rating (if any)
associated with the second dollar loss enhancement.
This preferential risk-based capital treatment for qualifying
senior securities would apply regardless of whether a second dollar
loss enhancement for the same transaction also qualifies for
preferential treatment under the ratings-based multi-level approach.
Senior securities that do not meet all of the specified conditions
would be required to hold capital at the risk-weight appropriate to the
pooled assets, in accordance with the current risk-based capital
standards.
The term ``senior security'' would mean that no class of securities
has a prior claim to payment from the underlying assets. Securities
that do not have the first claim to payment would be treated as first
or second dollar loss enhancements under the ratings-based multi-level
approach (regardless of their credit rating).\38\
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\38\Senior securities that are not paid out until after another
class or classes of securities from the same issue is completely
paid out would be considered ``senior securities'' for purposes of
the ratings-based multi-level approach, provided that they do not
provide credit enhancement for another class of securities and that
losses are shared on a pro rata basis in the event of default.
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(Question 12) The Agencies request comment on whether a class of
securities that receives the highest investment grade rating but is not
the most senior class in a qualifying transaction should also be
eligible for the 20% risk-weight category under the ratings-based
multi-level approach.
(Question 13) The Agencies request comment on whether the ratings-
based multi-level approach should be further adjusted to reflect the
reduced risk of loss associated with positions rated above the minimum
investment grade rating but below the highest investment grade rating.
The proposed favorable risk-based capital treatment of senior
securities would be restricted to transactions in which all of the
credit enhancement, including all second dollar loss credit
enhancements, is either completely free of third-party performance risk
or is provided internally through the securitization structure. Thus,
to be eligible for the reduced risk-based capital assessment, a senior
security would have to be supported solely by cash collateral accounts,
subordinated interests (including middle level subordinated positions),
spread accounts, or other forms of overcollateralization. If any part
of the total credit enhancement provided is subject to third-party
performance risk, then the senior portion of the issue would not be
eligible for a reduced risk-based capital requirement under the
ratings-based multi-level approach, regardless of its rating.\39\ For
example, if a financial standby letter of credit provides second dollar
loss enhancement for an asset securitization, then the senior portion
of that securitization would not be eligible for the 20% risk-weight.
Risk-based capital would be held against the amount of the standby
letter of credit and all portions of the transaction that are senior to
the standby letter of credit in accordance with the current risk-based
capital standards. See Example 4.
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\39\The OTS would continue to apply the 20% risk-weight to any
SMMEA security regardless of the type of credit enhancement provided
in the transaction.
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5. Maintenance of Minimum Ratings
The proposed favorable risk-based capital treatments for second
dollar loss enhancements and senior securities under the ratings-based
multi-level approach would be contingent upon maintenance of the
required minimum ratings. If second dollar loss enhancement is
downgraded below investment grade, if the senior securities are
downgraded below the highest possible rating, or if either rating is
withdrawn by the rating organization that provided the initial ratings,
then the capital requirement would be adjusted accordingly.\40\
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\40\The incorporation of the ratings-based multi-level approach
into the risk-based capital standards would also not affect the
Agencies' authority to require banking organizations and thrifts to
hold additional capital beyond the minimum regulatory requirements,
when warranted.
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6. Conclusion
The Agencies believe that this preliminary proposal for a ratings-
based multi-level approach could eliminate or reduce many of the
concerns with the current treatment of recourse and direct credit
substitutes. This approach would:
Incorporate the proposed low-level recourse rule, so that
an institution's capital would never exceed the contractual maximum
amount of its exposure;
Equalize the treatment of recourse arrangements and direct
credit substitutes that present equivalent risk of loss; and
Add flexibility to the regulatory capital requirements for
recourse arrangements and direct credit substitutes by taking into
account the different degrees of credit risk associated with first
dollar loss and second dollar loss credit enhancements and senior
positions for those asset securitizations where formal credit ratings
are provided for the various positions.
The use of credit ratings would provide a way for the Agencies to
use market determinations of credit quality to identify different loss
positions for capital purposes in an asset securitization structure.
The use of ratings could also enable the approach to be applied to
large, well diversified pools of non-homogeneous assets, such as small
business loans, because the market would determine the level of credit
support necessary to obtain the various credit ratings. This may permit
the Agencies to give more equitable treatment to a wide variety of
transactions and structures in administering the risk-based capital
system.
The flexibility of such a system would be particularly apparent in
transactions that use overcollateralization to provide first dollar
loss credit enhancement because the amount of the excess collateral
will vary based on factors such as the quality of the underlying
assets. One pool of assets may require 5% overcollateralization and
another may require 20% overcollateralization to raise the credit
quality of the pools to the investment grade level. Even though the
second pool in this example has a greater amount of
overcollateralization, the provider of second dollar loss enhancement
for this transaction would not necessarily be in a safer loss position
than the provider of second dollar loss enhancement for the pool that
required only 5% overcollateralization. The use of credit ratings to
determine the amount of first dollar loss protection could provide the
Agencies with an inherently flexible method for identifying when an
adequate first dollar loss position has been reached and when the
second dollar loss position begins.
(Question 14) While the agencies believe that a ratings-based
multi-level approach may be less costly for banking organizations and
thrifts than a multi-level approach that depends more heavily on
quantitative and qualitative analysis of individual securitizations and
the positions within them, the agencies request comment on the costs of
obtaining and monitoring ratings over time and on how these costs might
compare with the cost of having to examine each position for purposes
of determining its risk-based capital requirement.
B. Multi-Level Approach for Unrated Securitizations
The ratings-based multi-level approach relies on credit ratings to
permit reduced risk-based capital requirements for qualifying credit
enhancements and senior securities in certain asset securitizations.
However, not all asset securitizations are rated and, in some
securitizations, certain portions may be rated while others may be
unrated. The Agencies recognize that there could be a need for a
separate multi-level approach to establish capital requirements for
unrated securitizations and unrated portions of rated securitizations.
In theory, there are several ways to proceed.
The ideal multi-level approach for unrated securitizations would
set capital requirements roughly equivalent to those for rated
securitizations. To determine whether the credit quality of an unrated
credit enhancement or security is similar to a rated credit enhancement
or security, banking organizations and thrifts would need to: (1) Know
the current loss position of the credit enhancement or security being
evaluated, and (2) have current information on the credit quality of
the underlying assets. This information could then be used in
conjunction with a formula that relates the capital requirement for a
credit enhancement or security to its loss position and the credit
quality of the underlying assets.
Alternatively, the Agencies could develop a multi-level approach
for unrated securitizations that assigns capital requirements based
purely on a quantitative measure of sequential loss exposure (that is,
the amount of loss protection provided by more junior positions),
without regard to underlying asset quality. A refinement in this
approach would be to develop quantitative measures for each asset type
to reflect each type's default characteristics.
These alternatives represent two of the possible ways to establish
a multi-level approach for unrated securitizations. The Agencies
request comment on these and any other options.
If the Agencies do not proceed with a multi-level approach for
unrated securitizations, they expect to extend the current risk-based
capital treatment of recourse transactions to all unrated credit
enhancements (i.e., capital would be required against the face amount
of the credit enhancement plus all more senior positions).
The Agencies request comment on the following questions:
(Question 15) Is there a need for a multi-level approach for
unrated securitizations and unrated portions of rated securitizations?
(Question 16) Should the credit quality of the underlying loans be
given additional consideration (beyond that present in the current
risk-based capital requirements) in the capital requirements for
unrated transactions? If so, how would this be accomplished? What other
information, if any, should be considered in determining the capital
requirements?
(Question 17) Should the loss position of the credit enhancement or
security be taken into account in determining capital requirements for
unrated transactions? If so, how would the loss position be determined?
In particular, how should forms of prior enhancement such as
overcollateralization and spread accounts be treated?
(Question 18) If the Agencies were to develop a multi-level
approach that incorporates both qualitative and quantitative elements
(the first alternative presented above), what problems might banking
organizations and thrifts encounter in obtaining and maintaining the
necessary information on loss positions and credit quality? How could
the Agencies ensure consistent use of this information in determining
loss positions and assigning capital requirements?
(Question 19) If the Agencies were to develop a multi-level
approach based solely on quantitative measurement of loss positions
(the second alternative presented above), how should such an approach
be designed?
(Question 20) How might a multi-level approach be designed so that
positions that would not, if rated, qualify for reduced capital
requirements under the ratings-based approach, also would not qualify
for reduced capital requirements under the multi-level approach for
unrated transactions?
(Question 21) How can a multi-level approach for unrated
securitizations be designed so it does not create an unreasonable bias
toward or away from obtaining ratings?
IV. Application of Any Final Rules
The Agencies intend that any final rules adopted in connection with
this notice of proposed rulemaking and advance notice of proposed
rulemaking that result in increased risk-based capital requirements for
banking organizations or thrifts would apply only to transactions that
are consummated after the effective date of such final rules. The
Agencies intend that any final rules adopted in connection with this
notice that result in reduced risk-based capital requirements for
banking organizations or thrifts would apply to all transactions
outstanding as of the effective date of such final rules and to all
subsequent transactions.
V. Sample Applications of the Ratings-Based Multi-Level Approach
Example 1A--Senior/Subordinated Structure
Bank A issues three classes of securities that are backed by a $212
million, well-diversified pool of residential mortgage loans that
individually qualify for the 50% risk-weight category--a bottom-level
subordinated class of $12 million, a middle-level subordinated class of
$20 million and a senior class of $180 million. Bank A retains the
bottom-level class and sells the other two classes to banking
organizations or thrifts.
Bank A, retaining the bottom-level subordinated class, would be
required to hold risk-based capital equal to 4% of the $212 million
pool (i.e., the full effective risk-based capital requirement for the
outstanding amount of the assets enhanced). Because this subordinated
class provides sufficient first dollar loss enhancement, a nationally
recognized statistical rating organization gives the $20 million middle
class an investment grade rating. Since this class is rated investment
grade, risk-based capital would be held against it at the 100% risk-
weight, based solely on its carrying value. That is, the holder of the
middle-level class would not be required to hold any capital against
the senior class it supports. The same rating organization gives its
highest credit rating to the $180 million senior class. Since this is
the most senior class, has the highest possible credit rating, and all
prior enhancements are performance risk-free, risk-based capital would
be calculated at the 20% risk-weight. Table 1 summarizes this example.
Table 1.--Senior-Subordinated Structure
[Underlying Assets--Type: Residential Mortgage Loans; Amount: $212 million]
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Current
Current treatment Ratings
Loss position Size ($ Credit rating treatment for proposal ($
mill) for thrifts banks\1\ ($ mill)
($ mill) mill)
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1st...................... $12 No IG rating..................... $8.48 $8.48 $8.48
2nd...................... 20 IG............................... 8.00 1.60 1.60
3rd...................... 180 Highest IG rating................ 2.88 7.20 2.88
TOTAL CAPITAL: In Dollars ........... ................................. 19.36 17.28 12.96
As Percent Of Pool... ........... ................................. 9.1% 8.2% 6.1%
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IG=Investment Grade
\1\Under the Banking Agencies' existing capital rules the capital charges for retained first and second loss
positions differ from the capital requirements for purchased first and second loss positions. For example, a
bank must hold regulatory capital equal to 8 percent of the carrying value of a purchased subordinated
position at the 100% risk-weight, whereas a retained subordinated position is subject to a capital requirement
against the full value of all the assets enhanced. (In contrast, the OTS treats both of these positions in the
same way, requiring capital against the full value of the assets enhanced.) The proposed new rules would
eliminate such disparate capital treatment by focusing the capital charge on the risk of recourse arrangements
or credit substitutes, rather than the manner in which they are acquired. Note, however, that other rules
restricting banks from purchasing or holding securities that are of less than investment grade quality already
limit the opportunities to exploit the disparities present in existing capital rules.
Example 1B--A First Loss Position That Qualifies for the Low-Level
Recourse Rule
Bank A issues three classes of securities that are backed by a $212
million, well-diversified pool of consumer loans that individually
qualify for the 100% risk-weight category--a bottom-level subordinated
class of $12 million, a middle-level subordinated class of $20 million
and a senior class of $180 million. Bank A retains the bottom-level
class and sells the other two classes to banking organizations or
thrifts.
Without the proposed low-level recourse rule, Bank A's capital
requirement for the $12 million bottom-level subordinated class would
be $16.96 million, i.e., a full risk-based capital requirement of 8%
against the $212 million mortgage pool enhanced by this class. The low-
level recourse rule, however, would allow the risk-based capital
requirement to fall below the full effective capital requirement when
the recourse obligation falls below the full effective capital
requirement. Thus, the capital requirement would be the lesser of
either the maximum contractual recourse obligation or the full
effective capital requirement. Consequently, the bottom-level class in
this example would be assessed dollar-for-dollar capital up to its $12
million carrying value, for a capital requirement of $12 million.
Because the bottom-level subordinated class provides sufficient
first dollar loss enhancement, a nationally recognized statistical
rating organization gives the $20 million middle class an investment
grade rating. Since this class is rated investment grade, risk-based
capital would be assessed against it at the 100% risk-weight, based
solely on its carrying value. That is, the holder of the middle-level
class would not be assessed any capital against the senior class it
supports. The same rating organization gives its highest credit rating
to the $180 million senior class. Since this is the most senior class,
has the highest possible credit rating, and all prior enhancements are
performance risk-free, risk-based capital would be assessed against
this class at the 20% risk-weight. Table 2 summarizes this example.
Table 2.--An Application of the Low-Level Recourse Rule
[Underlying Assets--Type: Consumer Loans; Amount: $212 million]
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Current Current
treatment Treatment Ratings
Loss position Size ($ Credit rating for for proposal ($
mill) thrifts\1\ Banks\2\ ($ mill)
($ mill) mill)
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1st...................... $12 No IG rating..................... $12.00 $16.96 $12.00
2nd...................... 20 IG............................... 16.00 1.60 1.60
3rd...................... 180 Highest IG rating................ 14.40 14.40 2.88
TOTAL CAPITAL: In Dollars ........... ................................. 42.40 32.96 16.48
As Percent Of Pool... ........... ................................. 20.0% 15.6% 7.8%
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IG=Investment Grade
\1\OTS already has a low-level recourse rule in place for thrifts.
\2\See note 1 to Table 1.
Example 2A--Investment Grade Rating Applied to Portion of Pool Covered
by Standby Letter of Credit
The XYZ Company is seeking the highest possible credit rating on an
asset-backed commercial paper issuance that is backed by a large, well-
diversified pool of trade receivables. A total of $200 million of
commercial paper is issued against the pool, which contains $212
million worth of trade receivables. Thus, there is $12 million of
overcollateralization available to provide loss protection.
To obtain the highest rating for the commercial paper, the XYZ
Company also purchases a standby letter of credit from Bank B that
covers the next $20 million of losses after the $12 million of
overcollateralization. This letter of credit provides loss protection
analogous to the middle-level subordinated class of securities in
Examples 1A and 1B above. A nationally recognized statistical rating
organization provides a formal credit rating of investment grade for
the position, i.e., that portion of pool losses that represents the
exposure to be covered by the $20 million letter of credit. As a
result, under the Agencies' first alternative for application of the
ratings-based multi-level approach to this type of transaction, risk-
based capital would be assessed against the $20 million standby letter
of credit at the 100% risk-weight, based on its credit equivalent
amount. That is, Bank B would not be required to hold capital against
the additional $180 million supported by the standby letter of credit.
If the rating given to the letter of credit was not at least investment
grade, then Bank B would be required to hold capital at the 100% risk-
weight against the credit equivalent amount of its letter of credit and
all senior classes that it supports (in this case, against $200
million).
Example 2B--Investment Grade Rating Applied to the Entire Pool of
Assets
The details of the transaction here are identical to those of
example 2A, except that the investment grade rating provided by a
nationally recognized statistical rating organization is not on the
second loss position, but on the entire $212 million pool, prior to the
addition of Bank B's standby letter of credit. As a result, under the
Agencies' second alternative for application of the ratings-based
multi-level approach to this type of transaction, risk-based capital
would be assessed against the $20 million standby letter of credit at
the 100% risk-weight, based on its credit equivalent amount. That is,
Bank B would not be required to hold capital against the $180 million
of the pool that the standby letter of credit supports, but does not
cover. If the rating given to the entire pool prior to the addition of
the letter of credit were not at least investment grade, then Bank B
would be required to hold capital at the 100% risk-weight against the
credit equivalent amount of its letter of credit and all the senior
classes that it supports (in this case, against $200 million).
Example 3--Investment Grade Rating on First Loss Position
If the Agencies adopt the proposed alternative to treat certain
``first dollar loss'' enhancements that have a formal credit rating of
at least investment grade in the same manner as qualifying second
dollar loss enhancements, the following example would apply:
Bank C issues two classes of securities that are backed by a $212
million, well-diversified pool of auto loans--a subordinated class of
$12 million and a senior class of $200 million. Bank C retains the
bottom-level class and sells the other class to either a banking
organization or thrift.
Because of the high credit quality of the underlying loans, a
nationally-recognized statistical rating organization gives the $212
million pool of auto loans a rating equal to one level above investment
grade on a stand-alone basis. The $12 million subordinated class is
given an investment grade rating. Since this class is rated investment
grade, risk-based capital would be assessed against it at the 100
percent risk-weight, based solely on its carrying value. That is, Bank
C would not be assessed any capital against the senior class it
supports. On the basis of the high credit quality of the underlying
loans, and the loss protection provided by the subordinated class, the
same rating organization gives its highest credit rating to the $200
million senior class. Since this is the most senior class, has the
highest possible credit rating, and all prior enhancements are
performance risk-free, risk-based capital would be assessed against
this class at the 20 percent risk-weight. Table 3 summarizes this
example.
Table 3.--Investment Grade Rating on the First Loss Position
[Underlying Assets--Type: Auto Loans; Amount: $212 million]
----------------------------------------------------------------------------------------------------------------
Current
Current treatment Ratings
Loss position Size ($ Credit rating treatment for proposal ($
mill) for thrifts banks\1\ ($ mill)
($ mill) mill)
----------------------------------------------------------------------------------------------------------------
1st...................... $12 IG............................... $12.00 $16.96 $0.96
2nd...................... 200 Highest IG rating................ 16.00 16.00 3.20
TOTAL CAPITAL: In Dollars ........... ................................. 28.00 32.96 4.16
As Percent Of Pool... ........... ................................. 13.2% 15.6% 2.0%
----------------------------------------------------------------------------------------------------------------
IG = Investment Grade
\1\See note 1 to Table 1.
Example 4--Nonqualifying Senior Position
Bank D issues two classes of securities backed by a $212 million,
well-diversified pool of consumer loans--a subordinated class of $12
million, which would be rated below investment grade, and a senior
class of $200 million. Bank D retains the bottom-level class and sells
the other class to a banking organization or thrift. In the absence of
additional credit enhancements, a nationally recognized statistical
rating organization will rate the senior class one grade below its
highest credit rating as a result of the first dollar loss enhancement
from the subordinated class.
Bank D obtains a letter of credit to provide additional enhancement
to the transaction from a company whose obligations have the highest
possible credit rating from the same credit rating organization. The
credit rating organization now gives its highest possible credit rating
to the senior class in this transaction. However, since this credit
rating is a result of a prior enhancement that is provided in the form
of a standby letter of credit, which has performance risk, risk-based
capital would be assessed against the senior class at the 100% risk-
weight rather than at the 20% risk-weight. Under the ratings-based
multi-level approach, the 20% risk-weight would only be applied to
qualifying senior interests that are supported by prior credit
enhancements that are in the form of overcollateralization, spread
accounts, cash collateral accounts, or subordinated interests. Table 4
summarizes this example.
Table 4.--Non-Qualifying Senior Position
[Underlying Assets--Type: Consumer Loans; Amount: $212 million]
----------------------------------------------------------------------------------------------------------------
Current
Current treatment
Loss position Size ($ Credit rating treatment for Ratingsproposal
mill) for thrifts banks\1\ ($ ($ mill)
($ mill) mill)
----------------------------------------------------------------------------------------------------------------
1st.................. $12 No IG rating..................... $12.00 $16.96 $12.00
2nd.................. 200 Highest IG rating\2\............. 16.00 16.00 16.00
TOTAL CAPITAL: In ........... ................................. 28.00 32.96 28.00
Dollars.
As Percent Of ........... ................................. 13.2% 15.6% 13.2%
Pool.
----------------------------------------------------------------------------------------------------------------
IG = Investment Grade
\1\See note 1 to Table 1.
\2\Highest credit rating achieved because of a standby letter of credit issued on the senior class by a company
whose obligations have the highest credit rating.
VI. Additional Issues for Comment
The Agencies request comment on all aspects of the proposed
amendments to the risk-based capital treatment of recourse and direct
credit substitutes and on all aspects of the proposal to adopt a multi-
level approach. In addition to the questions set out above, the
agencies request comment on the following:
A. Proposal
1. Definitions of Recourse and Direct Credit Substitutes
(Question 22) Does the proposed definition of the term ``standard
representations and warranties'' provide a workable definition for
determining whether a representation or warranty will be considered
recourse or a direct credit substitute?
(Question 23) Does the proposed definition of a ``servicer cash
advance'' provide a workable definition for determining whether a cash
advance will be considered recourse or a direct credit substitute?
2. Low-Level Recourse Rule
(Question 24) Would the low-level recourse rule lower transaction
costs or otherwise help facilitate the sale or securitization of
banking organization assets?
3. Treatment of Direct Credit Substitutes
(Question 25) For banking organizations and thrifts in general, or
for your particular institution, please answer the following questions:
(a) For securitized or pooled transactions, and separately for non-
securitized transactions, approximately what portion of third-party
financial standby letters of credit provides less than 100% loss
protection for the underlying assets? What are the typical
circumstances of such arrangements?
(b) For securitized or pooled transactions, and separately for non-
securitized transactions, do financial standby letters of credit
typically absorb the first dollars of losses or the second dollars of
losses from third-party assets, as defined in this section of the
proposal? What is the approximate dollar amount of financial standby
letters of credit provided by banking organizations and thrifts that
absorb the first dollars of losses from third-party assets?
(c) What is the approximate dollar amount of purchased subordinated
interests that absorb the first dollars of losses from third-party
assets, as defined in this section of the proposal?
B. Advance Notice of Proposed Rulemaking--Ratings-Based Multi-Level
Approach
(Question 26) Should the Agencies require that prior credit
enhancements be free of performance risk in order for second dollar
loss enhancements and senior positions to qualify for reduced risk-
based capital requirements?
(Question 27) The discussion of the multi-level approach deals with
varying the capital requirement in asset securitizations based on an
institution's degree of exposure to credit risk. Does a multi-level
approach have any applicability to sales or participations of
individual, secured, unrated loans (including multifamily loans) with
recourse under various loss sharing arrangements?
VII. Regulatory Flexibility Act
It is hereby certified that the proposed changes to the Agencies'
risk-based capital standards will not have a significant economic
impact on a substantial number of small entities, in accord with the
spirit and purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et
seq.). Most of the transactions that will be affected by the proposed
changes are conducted by large banking organizations and large thrifts.
In addition, consistent with current policy, the FRB's revised
guidelines generally will not apply to bank holding companies with
consolidated assets of less than $150 million. The intent of the
proposal is to correct certain inconsistencies in the Agencies' risk-
based capital standards and to allow banking organizations to maintain
lower amounts of capital against low-level recourse obligations by
adopting the current OTS capital treatment of those transactions.
Accordingly, a Regulatory Flexibility Act Analysis is not required.
VIII. Executive Order 12866
OCC and OTS have determined that the proposed rule described in
this notice is not a significant regulatory action under Executive
Order 12866. Accordingly, a regulatory impact analysis is not required.
The intent of the proposal is to correct certain inconsistencies in the
Agencies' risk-based capital standards and to allow banking
organizations to maintain lower amounts of capital against low-level
recourse obligations by adopting the current OTS capital treatment of
those transactions. Under the proposal, each institution's measured
risk-based capital ratio may change. However, this change in measured
capital ratios should have no material effect on the safety and
soundness of the banking and thrift industries. Most banks and thrifts
have capital ratios much in excess of minimum requirements. Of the
11,071 commercial banks in operation at the end of September 1993,
10,824 were well-capitalized (risk-based capital ratios in excess of 10
percent). For the thrift industry, as of June 30, 1993, 1,561 of 1,752
savings associations were similarly well-capitalized. Given the high
level of capitalization in the industry, the net effect on the safety
and soundness of the banking industry and the overall economy should be
minimal.
IX. Paperwork Reduction Act
The following information about paperwork relates only to Federal
Reserve (FR) reports, which are approved by the Federal Reserve Board
under delegated authority from the Office of Management and Budget
(OMB).
The proposed amendments to the Capital Adequacy Guidelines may
require reporting revisions to the Consolidated Financial Statements
for Bank Holding Companies With Total Consolidated Assets of $150
Million or More or With More Than One Subsidiary Bank (FR Y-9C; OMB No.
7100-0128). Any revisions will be determined by the Federal Reserve
Board under delegated authority from OMB.
Description of Affected Report
Report Title: Consolidated Financial Statements for Bank Holding
Companies With Total Consolidated Assets of $150 Million or More, or
With More than One Subsidiary Bank.
This report is filed by all bank holding companies that have total
consolidated assets of $150 million or more and by all multibank
holding companies regardless of size. The following bank holding
companies are exempt from filing the FR Y-9C, unless the FRB
specifically requires an exempt company to file the report: bank
holding companies that are subsidiaries of another bank holding company
and have total consolidated assets of less than $1 billion; bank
holding companies that have been granted a hardship exemption by the
FRB under section 4(d) of the Bank Holding Company Act, 12 U.S.C.
1843(d); and foreign banking organizations as defined by section
211.23(b) of Regulation K.
List of Subjects
12 CFR Part 3
Administrative practice and procedure, Capital risk, National
banks, Reporting and recordkeeping requirements.
12 CFR Part 208
Accounting, Agriculture, Banks, Banking, Branches, Capital
adequacy, Confidential business information, Currency, Reporting and
recordkeeping requirements, Securities, State member banks.
12 CFR Part 225
Administrative practice and procedure, Banks, Banking, Capital
adequacy, Holding companies, Reporting and recordkeeping requirements,
Securities.
12 CFR Part 325
Bank deposit insurance, Banks, Banking, Capital adequacy, Reporting
and recordkeeping requirements, Savings associations, State nonmember
banks.
12 CFR Part 567
Capital, Reporting and recordkeeping requirements, Savings
associations.
DEPARTMENT OF THE TREASURY
COMPTROLLER OF THE CURRENCY
12 CFR Chapter I
Authority and Issuance
For the reasons set out in the preamble, part 3 of chapter I of
title 12 of the Code of Federal Regulations is proposed to be amended
as follows:
PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES
1. The authority citation for part 3 continues to read as follows:
Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n
note, 3907 and 3909.
Appendix A [Amended]
2. In appendix A, section 1, paragraphs (c)(10) through (c)(29) are
redesignated as follows:
------------------------------------------------------------------------
Oldparagraph Newparagraph
------------------------------------------------------------------------
(c)(10)............................ (c)(11)
(c)(11)............................ (c)(13)
(c)(12)............................ (c)(14)
(c)(13)............................ (c)(15)
(c)(14)............................ (c)(16)
(c)(15)............................ (c)(17)
(c)(16)............................ (c)(18)
(c)(17)............................ (c)(19)
(c)(18)............................ (c)(21)
(c)(19)............................ (c)(22)
(c)(20)............................ (c)(23)
(c)(21)............................ (c)(25)
(c)(22)............................ (c)(26)
(c)(23)............................ (c)(27)
(c)(24)............................ (c)(30)
(c)(25)............................ (c)(31)
(c)(26)............................ (c)(32)
(c)(27)............................ (c)(33)
(c)(28)............................ (c)(34)
(c)(29)............................ (c)(35)
------------------------------------------------------------------------
3. In appendix A, section 1, new paragraphs (c)(10), (12), (20),
(24), (28) and (29) are added and paragraph (c)(22) is revised, to read
as follows:
Appendix A to Part 3--Risk-Based Capital Guidelines
* * * * *
Section 1. Purpose, Applicability of Guidelines, and Definitions.
* * * * *
(c) * * *
(10) Direct credit substitute means the assumption, in form or
in substance (other than through providing recourse), of any risk of
loss directly or indirectly associated with an asset or other claim,
that exceeds the national bank's pro rata share of the asset or
claim. If a national bank has no claim on the asset, then the
assumption of any risk of loss is a direct credit substitute. Direct
credit substitutes include, but are not limited to:
(i) Financial guarantee-type standby letters of credit that
support financial claims on the account party;
(ii) Guarantees and guarantee-type instruments backing financial
claims;
(iii) Purchased subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
and
(iv) Purchased loan servicing rights if the servicer is
responsible for losses associated with the loans being serviced
(other than servicer cash advances as defined in this section 1(c)
of this appendix A), or if the servicer makes or assumes
representations and warranties about the loans other than standard
representations and warranties as defined in this section 1(c) of
this appendix A).
* * * * *
(12) Financial guarantee-type standby letter of credit means any
letter of credit or similar arrangement, however named or described,
which represents an irrevocable obligation to the beneficiary on the
part of the issuer (1) to repay money borrowed by or advanced to or
for the account of the account party, or (2) to make payment on
account of any indebtedness undertaken by the account party, in the
event that the account party fails to fulfill its obligation to the
beneficiary.
* * * * *
(20) Performance-based standby letter of credit means any letter
of credit, or similar arrangement, however named or described, which
represents an irrevocable obligation to the beneficiary on the part
of the issuer to make payment on account of any default by the
account party in the performance of a nonfinancial or commercial
obligation.
* * * * *
(22) Public-sector entities includes states, local authorities
and governmental subdivisions below the central government level in
an OECD country. In the United States, this definition encompasses a
state, county, city, town or other municipal corporation, a public
authority, and generally any publicly-owned entity that is an
instrumentality of a state or municipal corporation. This definition
does not include commercial companies owned by the public sector.
* * * * *
(24) Recourse means the retention, in form or substance, of any
risk of loss directly or indirectly associated with a transferred
asset that exceeds a pro rata share of a national bank's claim on
the asset. If a national bank has no claim on a transferred asset,
then the retention of any risk of loss is recourse. A recourse
arrangement typically arises when an institution transfers assets
and retains an obligation to repurchase the assets or absorb losses
due to a default of principal or interest or any other deficiency in
the performance of the underlying obligor or some other party.
Recourse arrangements include, but are not limited to:
(i) Representations and warranties about the transferred assets
other than standard representations and warranties as defined in
this section 1(c) of this appendix A;
(ii) Retained loan servicing rights if the servicer is
responsible for losses associated with the loans being serviced
(other than servicer cash advances as defined in this section 1(c)
of this appendix A;
(iii) Retained subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
(iv) Assets sold under an agreement to repurchase; and
(v) Loan strips sold without direct recourse where the maturity
of the participation is shorter than the maturity of the underlying
loan.
* * * * *
(28) Servicer cash advance means funds that a loan servicer
advances to ensure an uninterrupted flow of payments or the timely
collection of loans, including disbursements made to cover
foreclosure costs or other expenses arising from a loan to
facilitate its timely collection. A servicer cash advance is not
recourse or a direct credit substitute if the servicer is entitled
to full reimbursement, or for any one loan, nonreimbursable amounts
are contractually limited to an insignificant amount of the
outstanding principal on that loan.
(29) Standard representations and warranties means contractual
provisions that a national bank extends when it transfers assets
(including loan servicing rights), or assumes when it purchases loan
servicing rights, that refer to existing facts at the time the
assets are transferred or servicing rights are acquired and that
have been verified with reasonable due diligence by the transferor
or servicer. Standard representations and warranties also include
contractual provisions for the return of assets in the event of
fraud or documentation deficiencies. Standard representations and
warranties do not constitute recourse or direct credit substitutes.
* * * * *
Appendix A [Amended]
4. In appendix A, section 3, a new paragraph is added after the
second paragraph of the introductory text and prior to paragraph (a),
paragraphs (b)(1)(i) and (ii) are revised, paragraph (b)(1)(iii) is
removed and reserved, a new paragraph (c) is added, and footnotes 16,
17, and 18 are revised, to read as follows:
* * * * *
Section 3. Risk Categories/Weights for On-Balance Sheet Assets and
Off-Balance Sheet Items
* * * * *
Assets transferred with recourse are treated in accordance with
section 3(c) of this appendix A.
* * * * *
(b) * * *
(1) * * * (i) Recourse arrangements and direct credit
substitutes,\13\ in accordance with section 3(c) of this appendix
A.\14\
---------------------------------------------------------------------------
\13\[Reserved]
\14\Mortgage loans sold in transactions in which the bank
retains only an insignificant amount of risk and makes concurrent
provision for that risk are not considered assets sold with recourse
under section 3. In order to qualify for sales treatment, such
transactions must meet three conditions: (1) The bank has not
retained any significant risk of loss, either directly or
indirectly; (2) The bank's maximum contractual exposure under the
recourse provision (or through the retention of a subordinated
interest in the mortgages) at the time of the transfer is equal to
or less than the amount of probable loss that the bank has
reasonably estimated that it will incur on the transferred
mortgages; and (3) The bank must have created a liability account or
other special reserve in an amount equal to its maximum exposure.
The amount of this liability account or other special reserve may
not be included in capital for the purpose of determining compliance
with either the risk-based capital requirement or the leverage
ratio; nor may it be included in the allowance for loan and lease
losses.
---------------------------------------------------------------------------
(ii) Risk participations purchased in bankers acceptances.
(iii) [Reserved]
* * * * *
(2) * * *
(i) * * *\16\ * * *
---------------------------------------------------------------------------
\16\Participations in performance-based standby letters of
credit are treated in accordance with section 3(c) of this appendix
A.
---------------------------------------------------------------------------
(ii) * * *\17\ * * *
---------------------------------------------------------------------------
\17\Participations in commitments are treated in accordance with
section 3(c) of this appendix A.
---------------------------------------------------------------------------
* * * * *
(4) * * *
(ii) * * *\18\ * * *
---------------------------------------------------------------------------
\18\See definition of ``unconditionally cancelable'' in section
1(c) of this appendix A.
---------------------------------------------------------------------------
(c) Recourse arrangements and direct credit substitutes--(1)
Risk-weighted asset amount--on-balance sheet assets. To calculate
the risk-weighted asset amount for a recourse arrangement that is an
on-balance sheet asset, multiply the amount of assets from which
risk of loss is directly or indirectly retained by the appropriate
risk weight using the criteria regarding obligors, guarantors, and
collateral listed in section 3(a) of this appendix A.
(2) Risk-weighted asset amount--off-balance sheet items. To
calculate the risk-weighted asset amount for a recourse arrangement
or direct credit substitute that is not an on-balance sheet asset,
multiply the on-balance sheet credit equivalent amount by the
appropriate risk weight using the criteria regarding obligors,
guarantors, and collateral listed in section 3(a) of this appendix
A.
(3) On-balance sheet credit equivalent amount. Except as
otherwise provided by this paragraph, the on-balance sheet credit
equivalent amount for a recourse arrangement or direct credit
substitute is the amount of assets from which risk of loss is
directly or indirectly retained or assumed. For purposes of this
section 3(c) of this appendix A, the amount of assets from which
risk of loss is directly or indirectly retained or assumed means:
(i) For a financial guarantee-type standby letter of credit,
guarantee, or other guarantee-type arrangement, the assets that the
direct credit substitute fully or partially supports;
(ii) For a subordinated interest or security, the amount of the
subordinated interest or security plus all more senior interests or
securities;
(iii) For mortgage servicing rights that are recourse
arrangements or direct credit substitutes, the outstanding amount of
the loans serviced;
(iv) For representations and warranties (other than standard
representations and warranties), the amount of the loans subject to
the representations or warranties; and
(v) For loans strips that are recourse arrangements or direct
credit substitutes, the amount of the loans.
(4) Second-loss position direct credit substitutes. The on-
balance sheet credit equivalent amount for a direct credit
substitute is the face amount of the direct credit substitute if:
(i) There is a prior credit enhancement that absorbs the first
dollars of loss from the underlying assets that the direct credit
substitute fully or partially supports; and
(ii) The direct credit substitute is either:
(A) A financial guarantee-type standby letter of credit,
guarantee or other guarantee-type arrangement that absorbs the
second dollars of loss from the underlying assets; or
(B) A purchased subordinated interest or security that absorbs
the second dollars of loss from the underlying assets.
(5) Participations. The on-balance sheet credit equivalent
amount for a participation interest in a standby letter of credit,
guarantee, or other guarantee-type arrangement is calculated as
follows:
(i) Determine the on-balance sheet credit equivalent amount as
if the bank held all of the interests in the participation.
(ii) Multiply the on-balance sheet credit equivalent amount
determined under section 3(c)(5)(i) of this appendix A by the
percentage of the bank's participation interest.
(iii) If the bank is exposed to more than its pro rata share of
the risk of loss on the direct credit substitute (e.g., the bank
remains secondarily liable on participations held by others), add to
the amount computed under section 3(c)(5)(ii) of this appendix A an
amount computed as follows: multiply the amount computed under
3(c)(5)(i) by the percentage of the direct credit substitute held by
others and then multiply the result by the risk-weight appropriate
for the holders of those interests. (Note that this risk-weighting
is in addition to the risk-weighting done to convert the on-balance
sheet credit equivalent amount to the risk-weighted asset amount
under section 3(c)(2) of this appendix A.)
(6) Limitations on risk-based capital requirements--(i) Low-
level exposure. If the maximum contractual liability or exposure to
loss retained or assumed by a bank in connection with a recourse
arrangement or a direct credit substitute is less than the risk-
based capital required to support the recourse obligation or direct
credit substitute, the risk-based capital requirement is limited to
the maximum contractual liability or exposure to loss.
(ii) Mortgage-related securities or participation certificates
retained in a mortgage loan swap. If a bank holds a mortgage-related
security or a participation certificate as a result of a mortgage
loan swap with recourse, capital is required to support the recourse
obligation and that percentage of the mortgage-related security or
participation certificate that is not covered by the recourse
obligation. The total amount of capital required for the on-balance
sheet asset and the recourse obligation, however, is limited to the
capital requirement for the underlying loans, calculated as if the
bank continued to hold these loans as an on-balance sheet asset.
* * * * *
Appendix A [Amended]
4. In appendix A, Table 2, paragraph 1 under ``100 Percent
Conversion Factor'' is revised to read as follows:
Table 2--Credit Conversion Factors for Off-Balance Sheet Items
100 Percent Conversion Factor
1. Direct credit substitutes (arrangements to assume risk of
loss from assets other than through providing recourse, including
purchased subordinated interests and general guarantees of
indebtedness and guarantee-type instruments, such as standby letters
of credit serving as financial guarantees for, or supporting, loans
and securities).
* * * * *
FEDERAL RESERVE SYSTEM
12 CFR Chapter II
Authority and Issuance
For the reasons set out in the preamble, parts 208 and 225 of
chapter II of title 12 of the Code of Federal Regulations are proposed
to be amended as follows:
PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL
RESERVE SYSTEM (REGULATION H)
1. The authority citation for part 208 is revised to read as
follows:
Authority: 12 U.S.C. 248(a) and 248(c), 321-328, 461, 481-486,
601, 611, 1814, 1818, 1823(j), and 1831o.
2. Section III of appendix A to part 208 is amended by adding a new
paragraph B.5, and by revising the introductory text to paragraph D and
paragraph D.1 to read as follows:
Appendix A to Part 208--Capital Adequacy Guidelines For State Member
Banks: Risk-Based Measure
* * * * *
III. Procedures for Computing Weighted Risk Assets and Off-Balance
Sheet Items
* * * * *
B. * * *
5. Recourse arrangements and direct credit substitutes. Banks
may engage in activities--such as securitizing pools of assets,
selling single assets, and entering into certain off-balance sheet
transactions--that result in the provision of a credit enhancement
in the form of a recourse arrangement or a direct credit substitute.
The risk-based capital treatment of recourse arrangements and direct
credit substitutes is discussed in section III.D of this appendix A.
The following definitions of the terms ``recourse'' and ``direct
credit substitute'' apply for risk-based capital purposes.
Recourse is the retention, in form or in substance, of any risk
of loss directly or indirectly associated with an asset a bank has
transferred that is in excess of the bank's pro rata share of the
asset. A recourse arrangement typically arises when an institution
transfers an asset and retains an obligation to repurchase the asset
or to absorb losses on the asset arising from a default of principal
or interest or any other deficiencies in the performance of the
underlying obligor or some other party.
A direct credit substitute is the assumption, in form or
substance through a nonrecourse arrangement, of any risk of loss
directly or indirectly associated with an asset or other claim in
excess of the bank's pro rata share of the asset or other claim. A
direct credit substitute arrangement typically arises when an
institution issues a standby letter of credit, purchases a
subordinated security that provides loss protection to more senior
securities, or purchases servicing rights, such as mortgage
servicing rights, that obligate the servicer to provide credit
protection to the third-party owners of the assets being serviced.
For most direct credit substitutes, the amount of the bank's
exposure to be converted to an on-balance sheet credit equivalent
typically is the full face value of the item. However, for direct
credit substitutes, such as purchased subordinated securities that
are carried on the balance sheet and directly or indirectly absorb
the first losses from a third-party asset, pool of assets, or other
claim, the full amount of the bank's off-balance sheet exposure that
is to be converted is the entire outstanding principal amount of the
asset, pool of assets, or other claim, less the amount of the on-
balance sheet direct credit substitute against which capital is
already held. This treatment applies regardless of whether the
direct credit substitute fully or partially supports the asset, pool
of assets, or other claim. The full amount of the bank's off-balance
sheet exposure to be converted may be the same or greater than the
face value of the direct credit substitute. For instance, in the
case of purchased subordinated securities that absorb first losses,
the entire outstanding principal amount of all more senior
securities that are supported by that subordinated interest (to the
extent they are not already reported on the bank's balance sheet)
are converted to an on-balance sheet credit-equivalent amount.
For risk-based capital purposes, non-standard representations or
warranties a bank may extend in transferring assets (including the
transfer of servicing rights), or may assume in other transactions,
including the acquisition of loan servicing rights, are treated as
recourse or direct credit substitutes.24a Standard
representations and warranties, which normally do not constitute
recourse or direct credit substitutes for risk-based capital
purposes, are contractual provisions referring to an existing set of
facts that has been verified with reasonable due diligence by the
seller or servicer at the time the assets are transferred or loan
servicing rights are acquired. Standard representations and
warranties also include contractual provisions that provide for the
return of the assets to the seller in instances of fraud or upon
determination by the purchaser that the assets transferred are not
fully and properly documented or otherwise as represented by the
seller.
---------------------------------------------------------------------------
\2\4aRepresentations are statements, express or implied,
regarding a past or existing fact, circumstance, or state of facts
pertinent to the contract, which is influential in bringing about
the agreement. Warranties are promises that certain facts are truly
as they are represented to be and that they will remain so, subject
to specified limitations.
---------------------------------------------------------------------------
A cash advance by a loan servicer does not constitute recourse
or a direct credit substitute if the servicer is entitled to full
reimbursement, or for any one loan, nonreimbursable amounts are
contractually limited to an insignificant amount of the outstanding
principal on that loan. A servicer cash advance is an arrangement
under which the servicer advances funds to ensure an uninterrupted
flow of payments to investors or the timely collection of loans.
Funds advanced to ensure the timely collection of loans include
disbursements made to cover foreclosure costs or other expenses
incurred to facilitate the timely collection of a loan.
* * * * *
D. * * *
Before an off-balance sheet item can be incorporated into the
risk-based capital ratio, the on-balance sheet credit-equivalent
amount of the item must be determined. Once the credit-equivalent
amount is determined, the amount is then assigned to the appropriate
risk category according to the obligor, or if relevant, the
guarantor or the nature of the collateral.40 The method for
determining the credit-equivalent amount of an interest-rate or
exchange-rate contract is set forth in section III.E.2 of this
appendix A. For most other types of off-balance sheet items, the on-
balance sheet credit-equivalent amount is determined by multiplying
the full amount of the bank's exposure under the item by the
applicable credit conversion factor as set forth below and in
Attachment IV to this appendix A.
---------------------------------------------------------------------------
\4\0The sufficiency of collateral and guarantees for off-balance
sheet items is determined by the market value of the collateral or
the amount of the guarantee in relation to the face amount of the
item, except for interest- and exchange-rate contracts, for which
this determination is made in relation to the credit-equivalent
amount. Collateral and guarantees are subject to the same provisions
noted under section III.B of this appendix A.
---------------------------------------------------------------------------
However, in the case of direct credit substitutes--which are
described in detail in section III.B.5 of this appendix A and
section III.D.1 of this appendix A--that directly or indirectly
absorb the first losses from an asset, pool of assets, or other
claim, the full amount of a bank's exposure that is to be converted
is the entire outstanding principal amount of the asset, pool of
assets, or other claim, less the amount of any on-balance sheet
exposure associated with the item against which capital is already
held. This treatment applies regardless of whether the direct credit
substitute fully or partially supports the asset, pool of assets, or
other claim. The full amount of the bank's exposure to be converted
may be the same or greater than the face value of the direct credit
substitute. For instance, in the case of standby letters of credit
that absorb first losses, the entire outstanding principal amount of
a customer's loan or debt instrument that is supported by the letter
of credit is converted to an on-balance sheet credit-equivalent
amount.
Generally, the full face value of an off-balance sheet item is
converted to an on-balance sheet credit-equivalent amount and
incorporated in weighted risk assets and, thus, is subject to a full
effective risk-based capital requirement. However, the aggregate
capital requirement on a first loss direct credit substitute or a
recourse transaction (including a transaction reported as a
financing on a bank's balance sheet) is limited to the maximum
contractual amount of loss to which the direct credit substitute or
recourse arrangement exposes the institution if this amount is less
than the effective risk-based capital charge for the asset, pool of
assets, or other claim supported by the direct credit substitutes or
recourse arrangement.
1. Items with a 100 percent conversion factor. A 100 percent
conversion factor applies to direct credit substitutes, which
include guarantees, or equivalent instruments, backing financial
claims such as outstanding securities, loans, and other financial
liabilities, or that back off-balance sheet items that require
capital under the risk-based capital framework. Direct credit
substitutes include, for example, financial standby letters of
credit, or other equivalent irrevocable undertakings or surety
arrangements, that guarantee repayment of financial obligations such
as: commercial paper, tax-exempt securities, commercial or
individual loans or debt obligations, or standby or commercial
letters of credit. As described in section III.B.5 of this appendix
A, purchases of subordinated securities or of servicing rights may
give rise to a direct credit substitute. Direct credit substitutes
also include the acquisition of risk participations in bankers
acceptances and standby letters of credit, since both of these
transactions, in effect, constitute a guarantee by the acquiring
bank that the underlying account party (obligor) will repay its
obligation to the originating, or issuing, institution.41
(Standby letters of credit that are performance-related are
discussed below and have a credit conversion factor of 50 percent.)
---------------------------------------------------------------------------
\4\1Credit-equivalent amounts of acquisitions of risk
participations are assigned to the risk category appropriate to the
account party obligor, or if relevant, the guarantor or the nature
of the collateral.
---------------------------------------------------------------------------
The full amount of a bank's exposure under a direct credit
substitute is converted at 100 percent and the resulting credit
equivalent amount is assigned to the risk category appropriate to
the obligor or, if relevant, the guarantor or the nature of the
collateral. In the case of a direct credit substitute in which a
risk participation42 has been conveyed, the full amount of the
bank's exposure is still converted at 100 percent. However, the
credit equivalent amount that has been conveyed is assigned to
whichever risk category is lower: the risk category appropriate to
the obligor, after giving effect to any relevant guarantees or
collateral, or the risk category appropriate to the institution
acquiring the participation. Any remainder is assigned to the risk
category appropriate to the obligor, guarantor, or collateral. For
example, the portion of a direct credit substitute conveyed as a
risk participation to a U.S. domestic depository institution or
foreign bank is assigned to the risk category appropriate to claims
guaranteed by those institutions, that is, the 20 percent risk
category.43 This approach recognizes that such conveyances
replace the originating bank's exposure to the obligor with an
exposure to the institutions acquiring the risk
participations.44
---------------------------------------------------------------------------
\4\2That is, a participation in which the originating banking
organization remains liable to the beneficiary for the full amount
of the direct credit substitute if the party that has acquired the
participation fails to pay when the instrument is drawn.
\4\3Risk participations with a remaining maturity of over one
year that are conveyed to non-OECD banks are to be assigned to the
100 percent risk category, unless a lower risk category is
appropriate to the obligor, guarantor, or collateral.
\4\4A risk participation in bankers acceptances conveyed to
other institutions is also assigned to the risk category appropriate
to the institution acquiring the participation or, if relevant, the
guarantor or nature of the collateral.
---------------------------------------------------------------------------
In the case of direct credit substitutes that take the form of a
syndication as defined in the instructions to the commercial bank
Call Report, that is, where each bank is obligated only for its pro
rata share of the risk and there is no recourse to the originating
bank, each bank will only include its pro rata share of its exposure
under the direct credit substitute in its risk-based capital
calculation.
Financial standby letters of credit are distinguished from loan
commitments (discussed below) in that standbys are irrevocable
obligations of the bank to pay a third-party beneficiary when a
customer (account party) fails to repay an outstanding loan or debt
instrument (direct credit substitute). Performance standby letters
of credit (performance bonds) are irrevocable obligations of the
bank to pay a third-party beneficiary when a customer (account
party) fails to perform some other contractual non-financial
obligation.
The distinguishing characteristics of a standby letter of credit
for risk-based capital purposes is the combination of irrevocability
with the fact that funding is triggered by some failure to repay or
perform an obligation. Thus, any commitment (by whatever name) that
involves an irrevocable obligation to make a payment to the customer
or to a third-party in the event the customer fails to repay an
outstanding debt obligation or fails to perform a contractual
obligation is treated, for risk-based capital purposes, as
respectively, a financial guarantee standby letter of credit or a
performance standby.
A loan commitment, on the other hand, involves an obligation
(with or without a material adverse change or similar clause) of the
bank to fund its customer in the normal course of business should
the customer seek to draw down the commitment.
Sale and repurchase agreements and asset sales with recourse (to
the extent not included on the balance sheet) and forward agreements
also are converted at 100 percent. Accordingly, the entire amount of
any assets transferred with recourse that are not already included
on the balance sheet, including pools of 1- to 4-family residential
mortgages, is to be converted at 100 percent and assigned to the
risk category appropriate to the obligor, or if relevant, the
guarantor or the nature of the collateral. In certain recourse
transactions (including those that are reported as a financing on a
bank's balance sheet) the amount of the institution's contractual
liability may be limited to an amount less than the effective risk-
based capital requirement for the assets being transferred with
recourse. In such cases, the amount of total capital that must be
maintained against the transaction is equal to the maximum amount of
possible loss under the recourse provision. So-called ``loan
strips'' (that is, short-term advances sold under long-term
commitments without direct recourse) are defined in the instructions
to the commercial bank Call Report and for risk-based capital
purposes as assets sold with recourse. The definition of the term
``recourse'' is set forth in section III.B.5 of this appendix A.
Forward agreements are legally binding contractual obligations
to purchase assets with certain drawdown at a specified future date.
Such obligations include forward purchases, forward forward deposits
placed,45 and partly-paid shares and securities; they do not
include commitments to make residential mortgage loans or forward
foreign exchange contracts.
---------------------------------------------------------------------------
\4\5Forward forward deposits accepted are treated as interest
rate contracts.
---------------------------------------------------------------------------
Securities lent by a bank are treated in one of two ways,
depending upon whether the lender is at risk of loss. If a bank, as
agent for a customer, lends the customer's securities and does not
indemnify the customer against loss, then the transaction is
excluded from the risk-based capital calculation. If, alternatively,
a bank lends its own securities, or acting as agent for a customer,
lends the customer's securities and indemnifies the customer against
loss, the transaction is converted at 100 percent and assigned to
the risk weight category appropriate to the obligor, to any
collateral delivered to the lending bank, or, if applicable, to the
independent custodian acting on the lender's behalf. Where a bank is
acting as agent for a customer in a transaction involving the
lending or sale of securities that is collateralized by cash
delivered to the bank, the transaction is deemed to be
collateralized by cash on deposit in the bank for purposes of
determining the appropriate risk weight category, provided that any
indemnification is limited to no more than the difference between
the market value of the securities and the cash collateral received
and any reinvestment risk associated with that cash collateral is
borne by the customer.
* * * * *
PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL
(REGULATION Y)
3. The authority citation for part 225 is revised to read as
follows:
Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1831p-1,
1843(c)(8), 1844(b), 1972(l), 3106, 3108, 3310, 3331-3351, 3907, and
3909.
4. Section III of appendix A to part 225 is amended by adding a new
paragraph B.5 and by revising the introductory text of paragraph D and
paragraph D.1 to read as follows:
Appendix A to Part 225--Capital Adequacy Guidelines for Bank Holding
Companies: Risked-Based Measure
* * * * *
III. Procedures for Computing Weighted Risk Assets and Off-Balance
Sheet Items
* * * * *
B. * * *
5. Recourse Arrangements and Direct Credit Substitutes. Banking
organizations may engage in activities--such as securitizing pools
of assets, selling single assets, and entering into certain off-
balance sheet transactions--that result in the provision of a credit
enhancement in the form of a recourse arrangement or a direct credit
substitute. The risk-based capital treatment of recourse
arrangements and direct credit substitutes is discussed in section
III.D of this appendix A. The following definitions of the terms
``recourse'' and ``direct credit substitute'' apply for risk-based
capital purposes.
Recourse is the retention, in form or in substance, of any risk
of loss directly or indirectly associated with an asset a banking
organization has transferred that is in excess of the banking
organization's pro rata share of the asset. A recourse arrangement
typically arises when an institution transfers an asset and retains
an obligation to repurchase the asset or to absorb losses on the
asset arising from (a) a default of principal or interest or (b) any
other deficiencies in the performance of the underlying obligor or
some other party.
A direct credit substitute is the assumption, in form or
substance through a nonrecourse arrangement, of any risk of loss
directly or indirectly associated with an asset or other claim in
excess of the banking organization's pro rata share of the asset or
other claim. A direct credit substitute arrangement typically arises
when an institution issues a standby letter of credit, purchases a
subordinated security that provides loss protection to more senior
securities, or purchases servicing rights, such as mortgage
servicing rights, that obligate the servicer to provide credit
protection to the third-party owners of the assets being serviced.
For most direct credit substitutes, the amount of the banking
organization's exposure to be converted to an on-balance sheet
credit equivalent typically is the full face value of the item.
However, for direct credit substitutes, such as purchased
subordinated securities that are carried on the balance sheet that
directly or indirectly absorb the first losses from a third-party
asset, pool of assets, or other claim, the full amount of the
banking organization's off-balance sheet exposure that is to be
converted is the entire outstanding principal amount of the asset,
pool of assets, or other claim, less the amount of the on-balance
sheet direct credit substitute against which capital is already
held. This treatment applies regardless of whether the direct credit
substitute fully or partially supports the asset, pool of assets, or
other claim. The full amount of the banking organization's off-
balance sheet exposure may be the same or greater than the face
amount of the direct credit substitute. For instance, in the case of
purchased subordinated securities that absorb first losses, the
entire outstanding principal amount of all more senior securities
that are supported by that subordinated interest (to the extent they
are not already reported on the banking organization's balance
sheet) are converted to an on-balance sheet credit equivalent
amount.
For risk-based capital purposes, non-standard representations or
warranties a banking organization may extend in transferring assets
(including the transfer of servicing rights), or may assume in other
transactions, including the acquisition of loan servicing rights,
are treated as recourse or direct credit substitutes.27a
Standard representations and warranties, which normally do not
constitute recourse or direct credit substitutes for risk-based
capital purposes, are contractual provisions referring to an
existing set of facts that has been verified with reasonable due
diligence by the seller or servicer at the time the assets are
transferred or loan servicing rights are acquired. Standard
representations and warranties also include contractual provisions
that provide for the return of the assets to the seller in instances
of fraud or upon determination by the purchaser that the assets
transferred are not fully and properly documented or otherwise as
represented by the seller.
---------------------------------------------------------------------------
\2\7aRepresentations are statements, express or implied,
regarding a past or existing fact, circumstance, or state of facts
pertinent to a contract, which is influential in bringing about the
agreement. Warranties are promises that certain facts are truly as
they are represented to be and that they will remain so, subject to
specified limitations.
---------------------------------------------------------------------------
A cash advance by a loan servicer does not constitute recourse
or a direct credit substitute if the servicer is entitled to full
reimbursement, or for any one loan, nonreimbursable amounts are
contractually limited to an insignificant amount of the outstanding
principal on that loan. A servicer cash advance is an arrangement
under which the servicer advances funds to ensure an uninterrupted
flow of payments to investors or the timely collection of loans.
Funds advanced to ensure the timely collection of loans include
disbursements made to cover foreclosure costs or other expenses
incurred to facilitate the timely collection of a loan.
* * * * *
D. * * *
Before an off-balance sheet item can be incorporated into the
risk-based capital ratio, the on-balance sheet credit-equivalent
amount of the item must be determined. Once the credit-equivalent is
determined, the amount is then assigned to the appropriate risk
category according to the obligor, or, if relevant, the guarantor or
the nature of the collateral.43 The method for determining the
credit-equivalent amount of an interest-rate or exchange-rate
contract is set forth in section III.E.2 of this appendix A. For
most other types of off-balance sheet items, the on-balance sheet
credit-equivalent amount is determined by multiplying the full
amount of the banking organization's exposure under the item by the
applicable credit conversion factor as set forth below and in
Attachment IV to this appendix A.
---------------------------------------------------------------------------
\4\3The sufficiency of collateral and guarantees for off-balance
sheet items is determined by the market value of the collateral or
the amount of the guarantee in relation to the face amount of the
item, except for interest- and exchange-rate contracts, for which
this determination is made in relation to the credit-equivalent
amount. Collateral and guarantees are subject to the same provisions
noted under section III.B of this Appendix A.
---------------------------------------------------------------------------
However, in the case of direct credit substitutes--which are
described in detail in sections III.B.5 and III.D.1 of this appendix
A--that directly or indirectly absorb the first losses from an
asset, pool of assets, or other claim, the full amount of a banking
organization's exposure that is to be converted is the entire
outstanding principal amount of the asset, pool of assets, or other
claim, less the amount of any on-balance sheet exposure associated
with the item against which capital is already held. This treatment
applies regardless of whether the direct credit substitute fully or
partially supports the asset, pool of assets, or other claim. The
full amount of banking organization's exposure may be the same or
greater than the face amount of the direct credit substitute. For
instance, in the case of standby letters of credit that absorb first
losses, the entire outstanding principal amount of a customer's loan
or debt instrument that is supported by the letter of credit is
converted to an on-balance sheet credit equivalent amount.
Generally, the full face value of an off-balance sheet item is
converted to an on-balance sheet credit equivalent amount and
incorporated in weighted risk assets and, thus, is subject to a full
effective risk-based capital requirement. However, the aggregate
capital requirement on a first loss direct credit substitute or a
recourse transaction is limited to the maximum contractual amount of
loss to which the direct credit substitute or recourse arrangement
exposes the institution if this amount is less than the effective
risk-based capital charge for the asset, pool of assets, or other
claim supported by the direct credit substitute or recourse
arrangement.
1. Items with a 100 percent conversion factor. A 100 percent
conversion factor applies to direct credit substitutes, which
include guarantees, or equivalent instruments, backing financial
claims such as outstanding securities, loans, and other financial
liabilities, or that back off-balance sheet items that require
capital under the risk-based capital framework. Direct credit
substitutes include, for example, financial standby letters of
credit, or other equivalent irrevocable undertakings or surety
arrangements, that guarantee repayment of financial obligations such
as: commercial paper, tax-exempt securities, commercial or
individual loans or debt obligations, or standby or commercial
letters of credit. As described in section III.B.5 of this appendix
A, purchases of subordinated securities or of servicing rights may
give rise to a direct credit substitute. Direct credit substitutes
also include the acquisition of risk participations in bankers
acceptances and standby letters of credit, since both of these
transactions, in effect, constitute a guarantee by the acquiring
banking organization that the underlying account party (obligor)
will repay its obligation to the originating, or issuing,
institution.44 (Standby letters of credit that are performance-
related are discussed below and have a credit conversion factor of
50 percent.)
---------------------------------------------------------------------------
\4\4Credit-equivalent amounts of acquisitions of risk
participations are assigned to the risk category appropriate to the
account party obligor, or if relevant, the guarantor or nature of
the collateral.
---------------------------------------------------------------------------
The full amount of a banking organization's exposure under a
direct credit substitute is converted at 100 percent and the
resulting credit-equivalent amount is assigned to the risk category
appropriate to the obligor or, if relevant, the guarantor or the
nature of the collateral. In the case of a direct credit substitute
in which a risk participation45 has been conveyed, the full
amount of the banking organization's exposure is still converted at
100 percent. However, the credit-equivalent amount that has been
conveyed is assigned to whichever risk category is lower: the risk
category appropriate to the obligor, after giving effect to any
relevant guarantees or collateral, or the risk category appropriate
to the institution acquiring the participation. Any remainder is
assigned to the risk category appropriate to the obligor, guarantor,
or collateral. For example, the portion of a direct credit
substitute conveyed as a risk participation to a U.S. domestic
depository institution or foreign bank is assigned to the risk
category appropriate to claims guaranteed by those institutions,
that is, the 20 percent risk category.46 This approach
recognizes that such conveyances replace the originating banking
organization's exposure to the obligor with an exposure to the
institutions acquiring the risk participations.47
---------------------------------------------------------------------------
\4\5That is, a participation in which the originating banking
organization remains liable to the beneficiary for the full amount
of the direct credit substitute if the party that has acquired the
participation fails to pay when the instrument is drawn.
\4\6Risk participations with a remaining maturity of over one
year that are conveyed to non-OECD banks are to be assigned to the
100 percent risk category, unless a lower risk category is
appropriate to the obligor, guarantor, or collateral.
\4\7A risk participation in bankers acceptances conveyed to
other institutions is also assigned to the risk category appropriate
to the institution acquiring the participation or, if relevant, the
guarantor or nature of the collateral.
---------------------------------------------------------------------------
In the case of direct credit substitutes that take the form of a
syndication, that is, where each banking organization is obligated
only for its pro rata share of the risk and there is no recourse to
the originating banking organization, each banking organization will
only include its pro rata share of its exposure under the direct
credit substitute in its risk-based capital calculation.
Financial standby letters of credit are distinguished from loan
commitments (discussed below) in that standbys are irrevocable
obligations of the banking organization to pay a third-party
beneficiary when a customer (account party) fails to repay an
outstanding loan or debt instrument (direct credit substitute).
Performance standby letters of credit (performance bonds) are
irrevocable obligations of the banking organization to pay a third-
party beneficiary when a customer (account party) fails to perform
some other contractual non-financial obligation.
The distinguishing characteristics of a standby letter of credit
for risk-based capital purposes is the combination of irrevocability
with the fact that funding is triggered by some failure to repay or
perform an obligation. Thus, any commitment (by whatever name) that
involves an irrevocable obligation to make a payment to the customer
or to a third-party in the event the customer fails to repay an
outstanding debt obligation or fails to perform a contractual
obligation is treated, for risk-based capital purposes, as
respectively, a financial guarantee standby letter of credit or a
performance standby.
A loan commitment, on the other hand, involves an obligation
(with or without a material adverse change or similar clause) of the
banking organization to fund its customer in the normal course of
business should the customer seek to draw down the commitment.
Sale and repurchase agreements and asset sales with recourse (to
the extent not included on the balance sheet) and forward agreements
also are converted at 100 percent.\48\ So-called ``loan strips''
(that is, short-term advances sold under long-term commitments
without direct recourse) are treated for risk-based capital purposes
as assets sold with recourse and, accordingly, are also converted at
100 percent. The definition of the term ``recourse'' is set forth in
section III.B.5 of this appendix A.
---------------------------------------------------------------------------
\48\In the regulatory reports and under GAAP, bank holding
companies are permitted to treat some asset sales with recourse as
``true'' sales. For risk-based capital purposes, however, such
assets sold with recourse and reported as ``true'' sales by bank
holding companies are converted at 100 percent and assigned to the
risk category appropriate to the underlying obligor or, if relevant
the guarantor or nature of the collateral, provided that the
transactions meet the definition of assets sold with recourse,
including the sale of 1- to 4-family residential mortgages, that is
contained in the instructions to the commercial bank Consolidated
Reports of Condition and Income (Call Report). Accordingly, the
entire amount of any assets transferred with recourse that are not
already included on the balance sheet, including pools of 1- to 4-
family residential mortgages, is to be converted at 100 percent and
assigned to the risk category appropriate to the obligor, or if
relevant, the guarantor or the nature of the collateral. In certain
recourse transactions the amount of the institution's contractual
liability may be limited to an amount less than the effective risk-
based capital requirement for the assets being transferred with
recourse. In such cases, the amount of total capital that must be
maintained against the transaction is equal to the maximum amount of
possible loss under the recourse provision.
---------------------------------------------------------------------------
Forward agreements are legally binding contractual obligations
to purchase assets with certain drawdown at a specified future date.
Such obligations include forward purchases, forward deposits
placed,\49\ and partly-paid shares and securities; they do not
include commitments to make residential mortgage loans or forward
foreign exchange contracts.
---------------------------------------------------------------------------
\49\Forward forward deposits accepted are treated as interest
rate contracts.
---------------------------------------------------------------------------
Securities lent by a banking organization are treated in one of
two ways, depending upon whether the lender is at risk of loss. If a
banking organization, as agent for a customer, lends the customer's
securities and does not indemnify the customer against loss, then
the transaction is excluded from the risk-based capital calculation.
If, alternatively, a banking organization lends its own securities,
or acting as agent for a customer, lends the customer's securities
and indemnifies the customer against loss, the transaction is
converted at 100 percent and assigned to the risk weight category
appropriate to the obligor, to any collateral delivered to the
lending banking organization, or, if applicable, to the independent
custodian acting on the lender's behalf. Where a banking
organization is acting as agent for a customer in a transaction
involving the lending or sale of securities that is collateralized
by cash delivered to the banking organization, the transaction is
deemed to be collateralized by cash on deposit in the banking
organization for purposes of determining the appropriate risk weight
category, provided that any indemnification is limited to no more
than the difference between the market value of the securities and
the cash collateral received and any reinvestment risk associated
with that cash collateral is borne by the customer.
* * * * *
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Chapter III
Authority and Issuance
For the reasons set forth in the preamble, the Board of Directors
of the Federal Deposit Insurance Corporation proposes to amend part 325
of title 12 of the Code of Federal Regulations as follows:
PART 325--CAPITAL MAINTENANCE
1. The authority citation for part 325 continues to read as
follows:
Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b),
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n),
1828(o), 1831o, 3907, 3909; Pub. L. 102-233, 105 Stat. 1761, 1789,
1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat. 2236, 2355,
2386 (12 U.S.C. 1828 note).
2. Section II of appendix A to part 325 is amended by:
a. Adding paragraph 6 to section II.B;
b. Removing the undesignated introductory paragraph in section II.D
and adding in its place three new paragraphs; and
c. Revising the first and the second through fifth paragraphs under
paragraph 1 in section II.D, to read as follows:
Appendix A to Part 325--Statement of Policy on Risk-Based Capital
* * * * *
II. Procedures For Computing Risk-Weighted Assets
* * * * *
B. * * *
6. Recourse Arrangements and Direct Credit Substitutes. For
purposes of determining the risk-based capital treatment of
securitized pools of assets, sales of single assets, and certain
off-balance sheet transactions in which a bank provides credit
enhancement, the following definitions of the terms ``recourse'' and
``direct credit substitute'' apply. The risk-based capital treatment
of recourse arrangements and direct credit substitutes is discussed
in section II.D of this appendix A.
Recourse is the retention, in form or in substance, of any risk
of loss directly or indirectly associated with an asset a bank has
transferred that is in excess of the bank's pro rata share of the
asset. A recourse arrangement typically arises when an institution
transfers an asset and retains an obligation to repurchase the asset
or to absorb losses on the asset arising from: (a) a default of
principal or interest or (b) any other deficiencies in the
performance of the underlying obligor or some other party.
A direct credit substitute is the assumption, in form or in
substance through a nonrecourse arrangement, of any risk of loss
directly or indirectly associated with an asset or other claim in
excess of the bank's pro rata share of the asset or other claim. A
direct credit substitute arrangement typically arises when an
institution issues a financial standby letter of credit, purchases a
subordinated security that provides loss protection to more senior
securities, or purchases servicing rights, such as mortgage
servicing rights, that obligate the servicer to provide credit
protection to the third party owners of the assets being serviced.
For most direct credit substitutes, the amount of the bank's
exposure to be converted into an on-balance sheet credit equivalent
amount typically is the full face value of the direct credit
substitute. However, for direct credit substitutes carried on the
balance sheet that directly or indirectly absorb the first losses
from an asset, pool of assets, or other claim, the full amount of
the bank's off-balance sheet exposure that is to be converted is the
entire outstanding principal amount of the asset, pool of assets, or
other claim, less the amount of the on-balance sheet direct credit
substitute which is itself being assigned to one of the four broad
risk weight categories. This treatment applies regardless of whether
the direct credit substitute fully or partially supports the asset,
pool of assets, or other claim. The full amount of the bank's
exposure to be converted may be the same or greater than the face
value of the direct credit substitute. For instance, in the case of
purchased subordinated securities that absorb first losses, the
entire outstanding principal amount of all more senior securities
that are supported by that subordinated interest (to the extent they
are not already reported on the bank's balance sheet) are converted
to an on-balance sheet credit equivalent amount.
For risk-based capital purposes, nonstandard representations or
warranties that a bank may extend in transferring assets (including
the transfer of servicing rights) or assume in other transactions
(including the acquisition of loan servicing rights) are treated as
recourse or direct credit substitutes. Standard representations and
warranties, which normally do not constitute recourse or direct
credit substitutes for risk-based capital purposes, are contractual
provisions referring to an existing set of facts that has been
verified with reasonable due diligence by the seller or servicer at
the time the assets are transferred or loan servicing rights are
acquired. Standard representations and warranties are also generally
accompanied by contractual provisions that provide for the return of
the assets to the seller in instances of fraud or upon determination
by the purchaser that the assets transferred are not fully and
properly documented or otherwise as represented by the seller.
A servicer cash advance is an arrangement under which the
servicer of a loan advances funds to ensure an uninterrupted flow of
payments to investors or the timely collection of loans. Funds
advanced to ensure the timely collection of loans include
disbursements made to cover foreclosure costs or other expenses
incurred to facilitate the timely collection of a loan. A servicer
cash advance does not constitute recourse or a direct credit
substitute if: (a) the servicer is entitled to full reimbursement
for the amount of the advance or (b) for any one loan,
nonreimbursable amounts are contractually limited to an
insignificant amount of the outstanding principal on that loan.
* * * * *
D. * * *
In order for an off-balance sheet item to be incorporated into a
bank's risk-weighted assets, the on-balance sheet credit equivalent
amount of the item must first be determined. Once the credit
equivalent amount is determined, this amount is assigned to the
appropriate risk category according to the obligor or, if relevant,
the guarantor or the nature of the collateral. The method for
determining the credit equivalent amount of an interest rate or
foreign exchange rate contract is set forth in section II.E.1 of
this appendix A. For most other types of off-balance sheet items,
the on-balance sheet credit equivalent amount is determined by
multiplying the full amount of the bank's exposure under the item by
the applicable credit conversion factor as set forth below.
However, in the case of direct credit substitutes--which are
described in detail in sections II.B.6 and II.D.1 of this appendix
A--that directly or indirectly absorb the first losses from an
asset, pool of assets, or other claim, the full amount of the bank's
exposure that must be converted to a credit equivalent amount is the
entire outstanding principal amount of the asset, pool of assets, or
other claim, less the amount of any on-balance sheet exposure
associated with the item which is itself being assigned to one of
the four risk weight categories. This treatment applies regardless
of whether the direct credit substitute fully or partially supports
the asset, pool of assets, or other claim. The full amount of the
bank's exposure that must be converted to a credit equivalent amount
may be the same as or greater than the face value of the direct
credit substitute. For instance, in the case of financial standby
letters of credit that absorb first losses, the entire outstanding
principal amount of the customer's loan or debt instrument that is
supported by the letter of credit is converted to an on-balance
sheet credit equivalent amount.
Generally, the full amount of the bank's exposure under an off-
balance sheet item is converted to an on-balance sheet credit
equivalent amount and then incorporated in risk-weighted assets and,
thus, is subject to a full effective risk-based capital charge.
However, the aggregate capital requirement on a first loss direct
credit substitute or a recourse transaction (including a transaction
reported as a financing on a bank's balance sheet) is limited to the
maximum contractual amount of loss to which the direct credit
substitute or recourse arrangement exposes the bank if this amount
is less than the full effective risk-based capital charge for the
asset, pool of assets, or other claim that is supported by the bank.
1. Items With a 100 Percent Conversion Factor. A 100 percent
conversion factor applies to direct credit substitutes, which
include guarantees, or equivalent instruments, backing financial
claims, such as outstanding securities, loans, and other financial
obligations, or backing off-balance sheet items that require capital
under the risk-based capital framework. These direct credit
substitutes include, for example, financial standby letters of
credit, or other equivalent irrevocable undertakings or surety
arrangements, that effectively guarantee repayment of financial
obligations such as: commercial paper, tax-exempt securities,
commercial or individual loans or other debt obligations, or standby
or commercial letters of credit. As described in section II.B.6 of
this appendix A, purchases of subordinated securities or of
servicing rights may give rise to a direct credit substitute. The
full amount of a bank's exposure under a direct credit substitute is
converted at 100 percent and the resulting credit equivalent amount
is assigned to the risk category appropriate to the obligor or, if
relevant, the guarantor or the nature of the collateral.
* * * * *
Therefore, the distinguishing characteristics of a financial
standby letter of credit for risk-based capital purposes is the
combination of irrevocability with the notion that funding is
triggered by some failure to repay or perform on a financial
obligation. Thus, any commitment (by whatever name) that involves an
irrevocable obligation to make a payment to the customer or to a
third party in the event the customer fails to repay an outstanding
debt obligation will be treated, for risk-based capital purposes, as
a financial standby letter of credit and the full amount of the
bank's exposure under the letter of credit will be assigned a 100
percent conversion factor. (Performance-related standby letters of
credit are assigned a conversion factor of 50 percent.)
A bank that has conveyed a risk participation\35\ in a direct
credit substitute to a third party should convert the full amount of
its exposure under the direct credit substitute at a 100 percent
conversion factor without deducting the risk participations
conveyed. However, portions of direct credit substitutes that have
been conveyed as risk participations to U.S. depository institutions
and OECD banks may then be assigned to the 20 percent risk category
that is appropriate for claims guaranteed by U.S. depository
institutions and OECD banks, rather than to the risk category
appropriate to the account party obligor.\36\ A bank acquiring a
risk participation in a direct credit substitute or bankers
acceptance should convert the full amount of its exposure under the
participation at 100 percent and then assign the credit equivalent
amount to the risk category that is appropriate to the account party
obligor or, if relevant, the guarantor or the nature of the
collateral.
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\35\That is, participations in which the originating bank
remains liable to the beneficiary for the full amount of the direct
credit substitute if the party that has acquired the participation
fails to pay when the instrument is drawn upon.
\36\Risk participations with a remaining maturity of one year or
less that are conveyed to non-OECD banks are also assigned to the 20
percent risk weight category.
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In the case of direct credit substitutes that are structured in
the form of a syndication as defined in the instructions for the
preparation of the Consolidated Reports of Condition and Income
(that is, where each bank is obligated only for its pro rata share
of the risk and there is no recourse to the originating bank), each
bank will only include its pro rata share of its exposure under the
direct credit substitute in its risk-based capital calculation.
Sale and repurchase agreements and asset sales with recourse, if
not already included on the balance sheet, and forward agreements
are also converted at 100 percent. Accordingly, the entire amount of
any assets transferred with recourse that are not already included
on the balance sheet, including pools of one-to-four family
residential mortgages, is to be converted at 100 percent and
assigned to the risk category appropriate to the obligor or, if
relevant, the guarantor or the nature of the collateral. In certain
recourse transactions (including those that are reported as
financings on a bank's balance sheet) the amount of the bank's
contractual liability may be limited to an amount less than the full
effective risk-based capital requirement for the assets being
transferred with recourse. In such cases, the amount of capital that
must be maintained against the transaction is limited to the maximum
amount of possible loss under the recourse provision. So-called
``loan strips'' and similar arrangements involving short-term loans
sold by a bank without direct recourse but subject to long-term loan
commitments by the bank are accorded the same treatment for risk-
based capital purposes as assets sold with recourse. The definition
of the term ``recourse'' is set forth in section II.B.6 of this
appendix A. Forward agreements are legally binding contractual
obligations to purchase assets with drawdown which is certain at a
specified future date. These obligations include forward purchases,
forward deposits placed, and partly paid shares and securities but
do not include forward foreign exchange rate contracts or
commitments to make residential mortgage loans.
* * * * *
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Chapter V
Authority and Issuance
For the reasons set out in the preamble, part 567 of chapter V of
title 12 of the Code of Federal Regulations is proposed to be amended
as follows:
SUBCHAPTER D--REGULATIONS APPLICABLE TO ALL SAVINGS ASSOCIATIONS
PART 567--CAPITAL
1. The authority citation for part 567 continues to read as
follows:
Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1476a, 1828(note).
2. Section 567.1 is amended by revising paragraphs (f) and (kk) and
by adding new paragraphs (mm), (nn), (oo) and (pp) to read as follows:
Sec. 567.1 Definitions.
* * * * *
(f) Direct credit substitute. The term direct credit substitute
means the assumption, in form or substance (other than recourse
obligations as defined in Sec. 567.1(kk)), of any risk of loss directly
or indirectly associated with an asset or other claim, that exceeds the
savings association's pro rata share of the asset or claim. If a
savings association has no claim on an asset, the assumption of any
risk of loss is a direct credit substitute. Direct credit substitutes
include, but are not limited to:
(1) Financial guarantee-type standby letters of credit that support
financial claims on the account party;
(2) Guarantees and guarantee-type instruments backing financial
claims;
(3) Purchased subordinated interests or securities that absorb more
than their pro rata share of losses from the underlying assets; and
(4) Purchased loan servicing rights if the servicer is responsible
for losses associated with the loans being serviced (other than
servicer cash advances as defined in Sec. 567.1(nn)), or if the
servicer makes or assumes representations or warranties about the loans
(other than standard representations and warranties as defined in
Sec. 567.1(oo)).
* * * * *
(kk) Recourse. The term recourse means the retention, in form or
substance, of any risk of loss directly or indirectly associated with a
transferred asset, that exceeds a pro rata share of the savings
association's claim on the asset. If the savings association has no
claim on a transferred asset, the retention of any risk of loss is
recourse. A recourse obligation typically arises when an institution
transfers assets and retains an obligation to repurchase the assets, or
to absorb losses due to: a default of principal or interest; or any
other deficiency in the performance of the underlying obligor or some
other party. Recourse arrangements include, but are not limited to:
(1) Representations or warranties about the transferred assets
other than standard representations and warranties as defined in
Sec. 567.1(oo);
(2) Retained loan servicing rights if the servicer is responsible
for losses associated with the loans serviced (other than servicer cash
advances as defined in Sec. 567.1(nn));
(3) Retained subordinated interests or securities that absorb more
than a pro rata share of losses from the underlying assets;
(4) Assets sold under an agreement to repurchase; and
(5) Loan strips sold without direct recourse where the maturity of
the participation is shorter than the maturity of the underlying loan.
* * * * *
(mm) Public-sector entities. The term public-sector entities
includes states, local authorities and governmental subdivisions below
the central government level in an OECD-based country. In the United
States, this definition encompasses a state, county, city, town or
other municipal corporation, a public authority, and generally any
publicly-owned entity that is an instrumentality of a state or
municipal corporation. This definition does not include commercial
companies owned by the public sector.
(nn) Servicer cash advances. The term servicer cash advances means
funds that a loan servicer advances to ensure an uninterrupted flow of
payments or the timely collection of loans, including disbursements
made to cover foreclosure costs or other expenses arising from a loan
to facilitate its timely collection. A servicer cash advance is not a
recourse arrangement (as defined in Sec. 567.1(kk)) or a direct credit
substitute (as defined in Sec. 567.1(ff)), if:
(1) The servicer is entitled to full reimbursement; or
(2) For any one loan, nonreimbursed advances are contractually
limited to an insignificant amount of the outstanding principal on that
loan.
(oo) Standard representations and warranties. The term standard
representations and warranties means contractual provisions that a
savings association extends when it transfers assets (including loan
servicing rights) or assumes when it purchases loan servicing rights,
that refer to existing facts at the time the assets are transferred or
the servicing rights are acquired, and that have been verified with
reasonable due diligence by the transferor or servicer. Standard
representations and warranties also include contractual provisions for
the return of assets in the event of fraud or documentation
deficiencies. Standard representations and warranties are not recourse
obligations as defined in Sec. 567.1(kk) or direct credit substitutes
as defined in Sec. 567.1(ff).
(pp) Standby letters of credit. (1) A financial guarantee-type
standby letter of credit is any letter of credit, or similar
arrangement, however named or described, which represents an
irrevocable obligation to the beneficiary on the part of the issuer:
(i) To repay money borrowed by or advanced to or for the account of
the account party; or
(ii) To make payment on account of any indebtedness undertaken by
the account party, in the event that the account party fails to fulfill
its obligation to the beneficiary.
(2) A performance-based standby letter of credit is any letter of
credit, or similar arrangement, however named or described, which
represents an irrevocable obligation to the beneficiary on the part of
the issuer to make payment on account of any default by the account
party in the performance of a nonfinancial or commercial obligation.
3. In Sec. 567.6, the first sentence of paragraph (a)(2)
introductory text is revised, the fifth sentence of paragraph (a)(2)
introductory text is removed, paragraph (a)(2)(i)(A) and (C) are
removed and reserved, paragraph (a)(2)(i)(B) is revised, and a new
paragraph (a)(3) is added to read as follows:
Sec. 567.6 Risk-based capital credit risk weight categories.
(a) * * *
(2) Off-balance sheet activities. Except for recourse obligations
and direct credit substitutes which are specifically discussed in
paragraph (a)(3) of this section, risk weights for off-balance sheet
items are determined by the following two-step process. * * *
(i) * * *
(A) [Reserved]
(B) Risk participations purchased in bankers acceptances;
(C) [Reserved]
* * * * *
(3) Recourse arrangements and direct credit substitutes--(i) Risk-
weighted asset amounts. To calculate the risk-weighted asset amount for
a recourse arrangement or for a direct credit substitute, multiply the
on-balance sheet credit equivalent amount by the appropriate risk
weight using the criteria regarding obligors, guarantors, and
collateral listed in paragraph (a)(1) of this section.
(ii) On-balance sheet credit equivalent amount. Except as otherwise
provided by this paragraph (a)(3), the on-balance sheet credit
equivalent amount for a recourse arrangement or direct credit
substitute is the amount of assets from which risk of loss is directly
or indirectly retained or assumed. For the purposes of this paragraph
(a)(3), the amount of assets from which risk of loss is directly or
indirectly assumed or retained means:
(A) For a financial guarantee-type standby letter of credit,
guarantee, or other guarantee-type arrangement, the assets that the
direct credit substitute fully or partially supports;
(B) For a subordinated interest or security, the amount of the
subordinated interest or security plus all more senior interests or
securities;
(C) For mortgage servicing rights that are recourse arrangements or
direct credit substitutes, the outstanding amount of the loans
serviced;
(D) For representations and warranties (other than standard
representations and warranties), the amount of the loans subject to the
representations or warranties;
(E) For assets sold with recourse, the amount of assets from which
risk of loss is directly or indirectly retained excluding the amount of
the recourse liability account established in accordance with GAAP
standards; and
(F) For loans strips that are recourse arrangements or direct
credit substitutes, the amount of the loans.
(iii) Second-loss position direct credit substitutes. The on-
balance sheet credit equivalent amount for certain direct credit
substitutes is the face amount of the direct credit substitute if:
(A) There is a prior credit enhancement that absorbs the first
dollars of loss from the underlying assets that the direct credit
substitute fully or partially supports; and
(B) The direct credit substitute is a financial guarantee-type
standby letter of credit, a guarantee or other guarantee-type
arrangement that absorbs the second dollars of loss from the underlying
assets.
(iv) Participations. The on-balance sheet credit equivalent amount
for a participation interest in a financial guarantee-type standby
letter of credit, a guarantee or other guarantee-type is calculated as
follows:
(A) Determine the on-balance credit sheet equivalent amount as if
the savings association held all of interests in the participation. See
paragraph (a)(3)(ii) of this section (direct credit substitute in the
first loss position) and paragraph (a)(3)(iii) of this section (direct
credit substitute in the second loss position).
(B) Multiply the on-balance sheet credit equivalent amount
determined under paragraph (a)(3)(iv)(A) of this section by the
percentage of the savings association's participation interest.
(C) If the savings association is exposed to more than its pro rata
share of the risk of loss on the direct credit substitute (e.g., the
savings association remains secondarily liable on participations held
by others), add to the amount computed under paragraph (a)(3)(iv)(B) of
this section, an amount computed as follows: multiply the amount
computed under paragraph (a)(3)(iv)(A) of this section, by the percent
of the direct credit substitute held by others and the multiply the
result by the risk weight appropriate for other holders of those
interest. (Note: This risk-weighting is in addition to the risk-
weighting done to convert the on-balance sheet credit equivalent amount
to the risk-weighted asset amount under paragraph (a)(3)(i) of this
section.)
(v) Related on-balance sheet assets. To the extent that an asset is
included in the calculation of the capital requirement for a recourse
arrangement or direct credit substitute under this paragraph (a)(3),
and may also be included as an on-balance sheet asset under paragraph
(a)(1) of this section, the asset shall be risk-weighted only under
this paragraph (a)(3) except:
(A) Excess mortgage servicing rights that are recourse
arrangements, and purchased mortgage servicing rights and purchased
credit card relationships that are direct credit substitutes are risk
weighted as on-balance sheet assets under paragraph (a)(1) of this
section, and the related recourse arrangements and direct credit
substitutes are risk weighted under this paragraph (a)(3).
(B) Purchased subordinated interests that are high quality
mortgage-related securities are not subject to risk-weighting under
this paragraph (a)(3). Rather, these assets are risk weighted as on-
balance sheet assets under paragraph (a)(1)(ii)(H) of this section.
(vi) Limitations on risk-based capital requirement--(A) Low-level
exposure. If the maximum contractual liability or exposure to loss
retained or assumed by a savings association in connection with a
recourse arrangement or direct credit substitute is less than the
capital required to support the recourse obligation or direct credit
substitute, the capital requirement is limited to the maximum
contractual liability or exposure to loss. For assets sold with
recourse, the amount of capital required to support the recourse
obligation is limited to the maximum contractual liability or exposure
to loss less the amount of the recourse liability account established
in accordance with GAAP standards.
(B) Mortgage-related securities or participation certificates
retained in a mortgage loan swap. If a savings association holds a
mortgage related security or a participation certificate as a result of
a mortgage loan swap with recourse, capital is required to support that
percentage of the mortgage related security or participation
certificate that is not covered by the recourse obligation, and the
recourse obligation. The total amount of capital required for the on-
balance sheet asset and the recourse obligation, however, is limited to
the capital requirement for the underlying loans, calculated as if the
savings association continued to hold these loans as an on-balance
sheet asset.
(vii) Obligations of subsidiaries. If a savings association retains
a recourse arrangement or assumes a direct credit substitute on the
obligation of a subsidiary that is not an includable subsidiary and the
recourse obligation or direct credit substitute is an equity investment
in the subsidiary under GAAP standards, the face amount of the recourse
obligation or direct credit substitute is deducted from capital under
Secs. 567.5(a)(2) and 567.9(c). All other recourse obligations and
direct credit substitutes retained or assumed by a savings association
on the obligations of a subsidiary are risk-weighted in accordance with
paragraphs (a)(3) (i) through (vi) of this section.
* * * * *
Dated: December 8, 1993.
Eugene A. Ludwig,
Comptroller of the Currency.
By order of the Board of Directors.
Dated at Washington, DC, this 12th day of April, 1994.
Federal Deposit Insurance Corporation.
Robert E. Feldman,
Acting Executive Secretary.
Dated: May 4, 1994.
Board of Governors of the Federal Reserve System.
William W. Wiles,
Secretary of the Board.
Dated: December 15, 1993.
By the Office of Thrift Supervision.
Jonathan L. Fiechter,
Acting Director.
[FR Doc. 94-11513 Filed 5-24-94; 8:45 am]
BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P
