96-22546. Risk-Based Capital Standards: Market Risk  

  • [Federal Register Volume 61, Number 174 (Friday, September 6, 1996)]
    [Rules and Regulations]
    [Pages 47358-47378]
    From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
    [FR Doc No: 96-22546]
    
    
    
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    Part IV
    
    Department of the Treasury
    Office of the Comptroller of the Currency
    
    
    
    12 CFR Part 3
    
    Federal Reserve System
    
    
    
    12 CFR Parts 208 and 225
    
    Federal Deposit Insurance Corporation
    
    
    
    12 CFR Part 325
    
    
    
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    Risk-Based Capital Standards: Market Risk; Joint Final Rule
    
    Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 / 
    Rules and Regulations
    
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    DEPARTMENT OF THE TREASURY
    
    Office of the Comptroller of the Currency
    
    12 CFR Part 3
    
    [Docket No. 96-18]
    RIN 1557-AB14
    
    FEDERAL RESERVE SYSTEM
    
    12 CFR Parts 208 and 225
    
    [Regulations H and Y; Docket No. R-0884]
    
    FEDERAL DEPOSIT INSURANCE CORPORATION
    
    12 CFR Part 325
    
    RIN 3064-AB64
    
    
    Risk-Based Capital Standards: Market Risk
    
    AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of 
    Governors of the Federal Reserve System; and Federal Deposit Insurance 
    Corporation.
    
    ACTION: Joint final rule.
    
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    SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board 
    of Governors of the Federal Reserve System (Board), and the Federal 
    Deposit Insurance Corporation (FDIC) (collectively, the Agencies) are 
    amending their respective risk-based capital standards to incorporate a 
    measure for market risk to cover all positions located in an 
    institution's trading account and foreign exchange and commodity 
    positions wherever located. The final rule implements an amendment to 
    the Basle Capital Accord that sets forth a supervisory framework for 
    measuring market risk. The effect of the final rule is that any bank or 
    bank holding company (institution) regulated by the OCC, the Board, or 
    the FDIC, with significant exposure to market risk must measure that 
    risk using its own internal value-at-risk model, subject to the 
    parameters contained in this final rule, and must hold a commensurate 
    amount of capital.
    
    DATES: Effective date: January 1, 1997.
        Compliance date: Mandatory compliance January 1, 1998.
    
    FOR FURTHER INFORMATION CONTACT:
        OCC: Margot Schwadron, Financial Analyst, Roger Tufts, Senior 
    Economic Advisor, or Christina Benson, Capital Markets Specialist, 
    Office of the Chief National Bank Examiner (202/874-5070). For legal 
    issues, Andrew Gutierrez, Attorney, or Ron Shimabukuro, Senior 
    Attorney, Legislative and Regulatory Activities Division (202/874-
    5090), Office of the Comptroller of the Currency, 250 E Street, SW, 
    Washington, D.C. 20219.
        Board: Roger Cole, Deputy Associate Director (202/452-2618), James 
    Houpt, Assistant Director (202/452-3358), Barbara Bouchard, Supervisory 
    Financial Analyst (202/452-3072), Division of Banking Supervision and 
    Regulation; or Stephanie Martin, Senior Attorney (202/452-3198), Legal 
    Division. For the Hearing impaired only, Telecommunication Device for 
    the Deaf (TDD), Dorothea Thompson (202/452-3544), Federal Reserve 
    Board, 20th and C Streets, NW, Washington, D.C. 20551.
        FDIC: William A. Stark, Assistant Director (202/898-6972), Miguel 
    Browne, Deputy Assistant Director (202/898-6789), Kenton Fox, Senior 
    Capital Markets Specialist (202/898-7119), Division of Supervision; 
    Jamey Basham, Counsel (202/898-7265), Legal Division, Federal Deposit 
    Insurance Corporation, 550 17th Street, NW, Washington, D.C. 20429.
    
    SUPPLEMENTARY INFORMATION:
    
    I. Background
    
        The Agencies' risk-based capital standards are based upon 
    principles contained in the July 1988 agreement entitled 
    ``International Convergence of Capital Measurement and Capital 
    Standards'' (Accord). The Accord, developed by the Basle Committee on 
    Banking Supervision (Committee) and endorsed by the central bank 
    governors of the Group of Ten (G-10) countries,1 provides a 
    framework for assessing an institution's capital adequacy by weighting 
    its assets and off-balance-sheet exposures on the basis of counterparty 
    credit risk. In April 1995, the Committee issued a consultative 
    proposal to amend the Accord and require institutions to measure and 
    hold capital to cover their exposure to market risk, specifically, 
    market risk associated with foreign exchange and commodity positions, 
    and with debt and equity positions located in the trading 
    account.2
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        \1\ The G-10 countries are Belgium, Canada, France, Germany, 
    Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom, 
    and the United States. The Committee is comprised of representatives 
    of the central banks and supervisory authorities from the G-10 
    countries and Luxembourg. The Agencies each adopted risk-based 
    capital standards implementing the Accord in 1989.
        \2\ Market risk consists of general market risk and specific 
    risk. General market risk refers to changes in the market value of 
    on-balance-sheet assets and liabilities and off-balance-sheet items 
    resulting from broad market movements, such as changes in the 
    general level of interest rates, equity prices, foreign exchange 
    rates, and commodity prices. Specific risk refers to changes in the 
    market value of individual positions due to factors other than broad 
    market movements and includes such risks as the credit risk of an 
    instrument's issuer.
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    Market Risk Proposal
    
        On July 25, 1995, the Agencies published a joint proposal to amend 
    their respective risk-based capital standards in accordance with the 
    Committee's consultative proposal (60 FR 38082) (market risk proposal). 
    Under the market risk proposal, an institution with significant trading 
    activity must calculate a capital charge for market risk using either 
    its own internal risk measurement model (internal models approach) or a 
    risk-weighting process developed by the Committee (standardized 
    approach). The market risk proposal requires an institution to 
    integrate the market risk capital charge into its risk-based capital 
    ratios used for supervisory purposes no later than year-end 1997.
        The proposed internal models approach requires an institution to 
    employ an internal model to calculate daily value-at-risk (VAR) 
    measures 3 for each of four risk categories: interest rates, 
    equity prices, foreign exchange rates, and commodity prices, including 
    related options in each category. For regulatory capital purposes, the 
    market risk proposal requires an institution to calibrate VAR measures 
    to a ten-day movement in rates and prices and a 99 percent confidence 
    level. An institution must base its VAR measures upon rates and prices 
    observed over a period of at least one year. In deriving the overall 
    VAR measure, an institution could take into account historical 
    correlations within a risk category (e.g., between interest rates), but 
    not across risk categories (e.g., not between interest rates and equity 
    prices); in other words, the overall VAR measure equals the sum of the 
    VAR measures for each risk category. An institution's capital charge 
    for general market risk equals the greater of (1) the previous day's 
    overall VAR measure, or (2) the average of the preceding 60 days' 
    overall VAR measures multiplied by a factor of three (the 
    multiplication factor). Moreover, the market risk proposal requires an 
    institution to hold additional capital for specific risk associated 
    with debt and equity positions in the trading account to the extent 
    that its internal model does not incorporate that risk.
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        \3\ The VAR measure represents an estimate of the amount by 
    which an institution's positions in a risk category could decline 
    due to general market movements during a given holding period, 
    measured with a specified confidence level.
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        Under the market risk proposal, an institution's supervisor 
    evaluates its internal modeling and risk management process to ensure 
    that the institution is,
    
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    in fact, using its internal model for risk management purposes, that 
    the calculation of VAR for capital purposes conforms with the specified 
    quantitative criteria, and that the risk management process meets 
    certain qualitative criteria, such as requiring independent model 
    validations 4 and having an independent risk management unit. The 
    market risk proposal allows an institution's supervisor to increase its 
    multiplication factor (which applies to the 60-day VAR average) if 
    backtesting results suggest problems with the institution's internal 
    model or risk management process.
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        \4\ The proposed qualitative criteria identify backtesting and 
    stress testing as two model validation techniques. Backtests provide 
    information about the accuracy of an internal model by comparing an 
    institution's daily VAR measures to its corresponding daily trading 
    profits and losses. Stress tests provide information about the 
    impact of adverse market events on an institution's positions.
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        The standardized approach, the market risk proposal's alternative 
    to the internal models approach, requires an institution to apply 
    certain uniform techniques to calculate a capital charge for the 
    general market risk of positions in the four risk categories, as well 
    as for the specific risk of debt and equity positions located in the 
    trading account. The total capital charge is the sum of the capital 
    charges for each risk category.
        An institution supports its market risk capital charges using a 
    combination of Tier 1 and Tier 2 capital instruments (as defined in the 
    credit risk-based capital standards), as well as a proposed new type of 
    capital (Tier 3). Generally, Tier 3 capital consists of short-term 
    subordinated debt subject to certain criteria, including a lock-in 
    provision that prevents the issuer from repaying the debt even at 
    maturity if the issuer's risk-based capital ratio is less than 8.0 
    percent following the payment.
        In December 1995, the G-10 Governors endorsed a final amendment to 
    the Accord adopting, with some modification, the Committee's market 
    risk consultative proposal. At that same time, the Committee issued 
    supervisory guidance specifying the effect of backtesting results on an 
    institution's multiplication factor.
    
    Backtesting Proposal
    
        On March 7, 1996, the Agencies published for public comment a joint 
    proposal on backtesting (61 FR 9114) (backtesting proposal) that 
    reflected the Committee's backtesting guidance. The backtesting 
    proposal requires an institution to compare its daily net profits and 
    losses for the most recent 250 business days to the corresponding daily 
    VAR measures generated for internal risk management purposes, using a 
    99 percent confidence level and a one-day period of rate and price 
    movement. Each day for which a net trading loss exceeds the 
    corresponding VAR measure is counted as an exception. An institution 
    with five or more exceptions is presumed to have an inaccurate internal 
    model and must increase its multiplication factor from three up to a 
    maximum of four, depending on the number of exceptions. The backtesting 
    proposal requires an institution to begin backtesting one year after it 
    begins to calculate market risk capital charges. The delayed effective 
    date for backtesting provides an institution with sufficient time to 
    accumulate the required data for 250 business days.
    
    II. Comment Summary
    
    Market Risk Proposal
    
        Together, the Agencies received 33 public comments on the market 
    risk proposal. Commenters strongly supported the proposed internal 
    models approach.5 Most commenters believed that approach provides 
    greater accuracy in measuring market risk than the standardized 
    approach and creates incentives for institutions to continue improving 
    their risk modeling and management techniques. Nevertheless, most 
    commenters stated that the proposed modeling constraints were 
    unnecessarily rigid and, especially when combined with the 
    multiplication factor of three, result in excessive capital charges. 
    The following discussion summarizes the responses to the Agencies' 
    specific questions about the proposal.
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        \5\ Early versions of the Basle Committee's market risk 
    amendment did not allow for the use of internal models to determine 
    capital charges.
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    General Topics
        The Agencies asked commenters about the proposed criteria for 
    determining which institutions must calculate capital charges for 
    market risk. As proposed, the rule applied to: (1) Any institution with 
    total assets exceeding $5 billion and either trading activity totaling 
    at least 3 percent of total assets or the notional amount of trading 
    account derivative contracts in excess of $5 billion; and (2) any 
    institution with total assets of $5 billion or less and trading 
    activity representing at least 10 percent of total assets. Commenters 
    generally agreed that an institution with significant exposure to 
    market risk should hold capital against that exposure. However, some 
    believed it inappropriate to use the notional amount of trading account 
    derivative contracts as a criterion. Further, some objected to 
    different criteria for institutions of different asset size.
        The Agencies asked about the burden associated with applying the 
    market risk measure to both banks and bank holding companies and, with 
    regard to bank holding companies, the burden associated with applying 
    the measure both with and without Section 20 subsidiaries. The Agencies 
    received mixed comments on the bank and bank holding company issue. 
    Some believed the measure should apply only at the bank holding company 
    level, pointing out that market risk usually is managed on a 
    consolidated basis at the bank holding company level. Some favored 
    applying the measure at the bank level. Others believed that an 
    institution should have a choice, depending on how it manages risk. 
    Most commenters discussing the Section 20 subsidiary issue supported 
    applying the rule on a fully consolidated basis (i.e., including 
    Section 20 subsidiaries).
        The Agencies also asked whether to allow an institution to choose 
    either the standardized or internal models approaches, whether to allow 
    an institution to combine the two approaches for different risk 
    categories, and whether the two approaches result in similar capital 
    charges. While some commenters supported the flexibility of choosing 
    between the internal models and standardized approaches, those 
    commenters who anticipated that they would be subject to the market 
    risk capital requirements indicated that they intend to use only the 
    internal models approach. Other commenters thought that a choice of 
    approaches could be useful in certain situations, for example, when an 
    institution suddenly meets the applicability criteria but does not have 
    a completely developed internal model. Several commenters expressed 
    concerns about the accuracy of the standardized approach and urged its 
    elimination. The few commenters that addressed the question about 
    combining the two approaches supported the flexibility that this could 
    provide. A few commenters stated that capital charges would be higher 
    under the internal models approach than under the standardized 
    approach.6
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        \6\ The summary does not include comments on particular issues 
    that might arise in applying the standardized approach (other than 
    comments on specific risk) because, as discussed below, the Agencies 
    have decided not to adopt the standardized approach in the final 
    rule. Public comments are available from the Board's and OCC's 
    Freedom of Information Office and the FDIC's Reading Room.
    
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    The Internal Models Approach
        The market risk proposal imposed several quantitative standards on 
    VAR measures used for regulatory capital purposes. The Agencies asked 
    about the potential burden associated with these standards and whether 
    the resulting capital charge sufficiently covered market risk. 
    Commenters overwhelmingly responded that the proposed modeling 
    constraints were unnecessarily rigid and would result in an excessive 
    capital charge. Many commenters suggested the Agencies allow an 
    institution to use the same internal modeling parameters for regulatory 
    capital purposes as for internal risk management.
        Modeling Constraints. With regard to the proposed modeling 
    constraints, a few commenters supported basing capital charges on a 
    ten-day period of rate and price movements. Others indicated that the 
    period was too long, with most suggesting a one-day period. Some 
    commenters objected to any specified period. Several commenters opposed 
    the proposed 99 percent confidence level, noting that many institutions 
    use lower confidence levels. Others supported the proposed level and 
    still others suggested that regulators should not specify a confidence 
    level.
        Many commenters strongly asserted that the proposed multiplication 
    factor of three was too high and suggested, instead, a minimum factor 
    of one. Most of these commenters believed that the proposal did not 
    adequately explain the rationale for a multiplication factor greater 
    than one. Several asked for clarification about how the Agencies will 
    measure a model's accuracy and adjust an institution's multiplication 
    factor. They advocated objective, well-defined criteria to ensure that 
    the Agencies apply the rules consistently.
        Commenters strongly opposed the proposal's requirement that an 
    institution aggregate VAR measures by simple summation across the risk 
    categories. They asserted that ignoring the effects of cross 
    correlation among risk categories overstates exposure and understates 
    the merits of diversified portfolios.
        The Agencies asked whether to require an institution to calculate 
    VARs using two observation periods. Specifically, the Agencies asked 
    about the tradeoff between enhanced prudential coverage and additional 
    burden associated with requiring an institution to make two VAR 
    measures, one based on a short observation period and one based on a 
    longer (over one year) period. Most commenters believed dual 
    observation periods would result in unnecessary costs and operational 
    burden. Commenters had varying opinions about the optimal length of 
    time for an observation period. Some commenters suggested that the 
    Agencies allow an institution to choose an appropriate observation 
    period.
        Backtesting. The Agencies asked for comments about the potential 
    burden associated with backtesting to evaluate the accuracy of an 
    institution's internal model. Commenters generally viewed backtesting 
    as a useful tool for model validation purposes. Most believed that 
    backtesting should compare an institution's VAR calculated for internal 
    risk management purposes (rather than for regulatory capital purposes) 
    with actual profits and losses. A few commenters, noting the developing 
    nature of backtesting generally, urged regulators not to prescribe 
    specific regulations, guidelines, or methodologies for backtesting.
        The Agencies also asked for comment about the types of stress tests 
    institutions should perform as part of their internal risk management 
    process. Several commenters recognized generally the importance of 
    stress testing. These and other commenters responded that the Agencies 
    should allow an institution to choose its methodology. Other commenters 
    questioned whether a stress testing requirement was necessary.
        Specific Risk. The Agencies noted that the internal models approach 
    requires an institution to add a specific risk capital charge 
    calculated using the standardized approach if its internal model does 
    not adequately capture specific risk, and asked what modeling 
    techniques the Agencies should consider when evaluating an 
    institution's model for specific risk. While commenters generally 
    agreed that an institution should integrate specific risk into its 
    internal model, several objected to using capital charges calculated 
    under the standardized approach as the benchmark for specific risk 
    under the internal models approach. A few commenters asked for 
    clarification about what constitutes sufficient integration of specific 
    risk into a model to avoid the add-on capital charge. Some commenters 
    noted that internal models that incorporate specific risk elements are 
    still in the development stage, and stated that the Agencies should not 
    include a specific risk requirement in the internal models approach.
        The Agencies asked whether they should specifically define the term 
    ``liquid and well-diversified,'' as applied to specific risk in 
    equities, entitling an institution to a lower capital charge under the 
    standardized approach. Commenters differed as to the appropriate degree 
    of specificity. Some preferred a qualitative definition, as proposed, 
    and others supported a more explicit and objective definition.
    Other Issues
        Some commenters raised issues not directly addressed in the 
    Agencies' specific questions on the market risk proposal. One commenter 
    suggested that an institution could determine internally whether to 
    classify a debt instrument as qualifying or non-qualifying for purposes 
    of determining the applicable specific risk weight factor (qualifying 
    instruments receive a lower specific risk charge than non-qualifying 
    instruments). Another commenter recommended a zero percent specific 
    risk charge for debt instruments issued by local and regional 
    governments. Another recommended a zero percent specific risk charge 
    for instruments tracking an equity index.
        Several commenters said that the proposed qualitative standards for 
    an institution's risk management system were reasonable. One 
    institution noted the qualitative standards provided a comprehensive 
    set of guidelines. Some commenters questioned the marketability of 
    short-term subordinated debt included as Tier 3 capital. A few 
    commenters discussed the relationship between market risk and credit 
    risk, with some arguing that when aggregating capital charges for 
    credit and market risk the Agencies should permit an institution to 
    recognize correlations between the two types of risk.
    
    Backtesting Proposal
    
        Together, the Agencies received 17 public comments on the 
    backtesting proposal. Commenters to that proposal generally supported 
    backtesting as a useful component of risk management. Several expressed 
    concern that the proposal was unnecessarily rigid, noting that 
    backtesting techniques are evolving, and suggested that the Agencies 
    reexamine backtesting prior to implementation of the final rule. A few 
    commenters questioned linking backtesting results to capital 
    requirements. Some commenters expressed the view that the Agencies 
    should take into account the severity of an exception, not just the 
    number of exceptions. Other commenters believed that the Agencies 
    should base capital requirements on an overall evaluation of an 
    institution's risk management process and not merely on the number of 
    exceptions. A few commenters suggested that the Agencies retain the
    
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    flexibility to adjust the multiplication factor below three if an 
    institution's model exhibits superior performance.
        Among other specific questions, the Agencies asked about the merits 
    and problems associated with backtesting hypothetical trading outcomes 
    (profits and losses) versus backtesting actual trading outcomes.7 
    Almost all commenters supported using actual trading outcomes for 
    backtesting purposes rather than hypothetical outcomes. One commenter 
    supported giving an institution the option of what type of outcomes it 
    will backtest. Commenters who supported using actual trading outcomes 
    believed that these results appropriately included such factors as 
    gains and losses from trading activity, fee income, net interest 
    income, and management responses to changing portfolio conditions. 
    Commenters who objected to using hypothetical results noted that costs 
    associated with creating and operating a system for determining 
    hypothetical results were significant. Other commenters discussed the 
    potential burden of requiring an institution to calculate daily profits 
    and losses with an unreasonable degree of exactness. They noted that 
    global VARs are calculated by simulating changes in all market factors 
    and calculating resulting changes in portfolio values. They suggested 
    letting an institution estimate daily profit and losses using a 
    consistent, reasonable methodology.
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        \7\ Generally, hypothetical outcomes are trading outcomes that 
    would result if the trading position as of the end of one business 
    day went unchanged during the next business day. Hypothetical 
    outcomes differ from actual outcomes because of the effects of such 
    items as changes in portfolio composition over the holding period, 
    fee income, commissions, and income from trading.
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        The Agencies asked for comment on what types of events or regime 
    shifts (i.e., dramatic changes in market conditions that result in 
    numerous exceptions in a short period of time for the same reason) 
    might generate exceptions that do not warrant an increase in an 
    institution's multiplication factor. Several commenters asserted that 
    the Agencies should not list the types of regime shifts in advance. Two 
    commenters suggested that the Agencies should treat any market-wide or 
    asset-class event affecting a large number of institutions as a regime 
    shift. Commenters suggested the following examples of regime shifts: 
    sudden abnormal changes in interest or exchange rates, major political 
    events, and natural disasters. Some commenters suggested that the 
    Agencies should take into account an institution's reaction to 
    unanticipated trading results, such as how it adapts its internal model 
    to take into account changed conditions. A few commenters stated the 
    Agencies should not penalize an institution for exceptions after it 
    adjusts its model.
        The Agencies asked about the proposed sample size of 250 
    independent observations. While several commenters on this question 
    responded that the proposed sample size was appropriate, some believed 
    that an institution should have flexibility to increase or decrease the 
    sample size. A few commenters asserted that all institutions should use 
    the same sample size.
        Finally, the Agencies asked whether to require an institution to 
    backtest against its VAR measures generated for internal risk 
    management purposes, or against VAR measures calculated for market risk 
    capital requirements. Most commenters supported the former approach.
    
    III. Final Rule
    
        The Agencies believe it is important for an institution with 
    significant market risk to measure its exposure and hold commensurate 
    amounts of capital. The Agencies support the market risk amendment to 
    the Accord and are now issuing uniform market risk standards that will 
    implement that amendment for institutions regulated by the Agencies. 
    The final rule incorporates a measure for exposure to market risk into 
    the Agencies' credit risk-based capital standards. By January 1, 1998, 
    an institution that meets the applicability criteria must use its 
    internal model to measure its exposure to market risk and hold capital 
    in support of that exposure. The Agencies concur with commenters that 
    an institution with significant exposure to market risk can most 
    accurately measure that risk using detailed information available to 
    the institution about its particular portfolio processed by its own 
    risk measurement model. The final rule does not include the proposed 
    standardized approach for measuring general market risk. The final rule 
    does retain, however, the standardized approach methodologies for 
    determining capital charges for specific risk, which an institution 
    must use as the basis for its specific risk charge for debt and equity 
    positions in its trading account.
        The final rule supplements the existing credit risk-based capital 
    standards by requiring an affected institution to adjust its risk-based 
    capital ratio to reflect market risk. Specifically, an institution must 
    adjust its risk-based capital ratio to take into account the general 
    market risk of all positions located in its trading account and of 
    foreign exchange and commodity positions, wherever located. 
    Additionally, the institution must account for the specific risk of 
    debt and equity positions located in its trading account. The positions 
    covered by this final rule (except for foreign exchange positions 
    outside the trading account and over-the-counter (OTC) derivatives) are 
    excluded from the credit risk capital charge. Foreign exchange 
    positions outside the trading account and OTC derivatives are subject 
    to the market risk capital charge, as well as the credit risk capital 
    charge.
        Thus, the minimum capital charge for an institution that meets the 
    applicability criteria is its credit risk capital charge as calculated 
    under the Agencies' credit risk-based capital standards (excluding the 
    positions previously noted) plus its measure for market risk as 
    calculated under this final rule. The institution's risk-based capital 
    ratio adjusted for market risk is its risk-based capital ratio for 
    purposes of prompt corrective action and other statutory and regulatory 
    purposes.
        Subject to supervisory approval that its internal model and risk 
    management processes meet the final rule's regulatory criteria, an 
    institution may choose to comply with the final rule as early as 
    January 1, 1997. Any institution that voluntarily complies with the 
    final rule prior to January 1, 1998, must comply with all of its 
    provisions, except for the backtesting provisions, which apply one year 
    after the institution begins to comply with the other provisions of the 
    final rule.
    
    Institutions Subject to the Final Rule (Section 1(b))
    
        The Agencies agree with commenters that all institutions with 
    significant market risk, regardless of size, should measure their 
    exposure and hold appropriate levels of capital. Thus, the Agencies 
    have revised the applicability criteria to eliminate the differential 
    criteria based on total asset size. The Agencies believe that the 
    capital requirements are appropriate both for an institution whose 
    trading activity is large relative to its total assets, and for an 
    institution with a substantial volume of trading activity.
        The final rule applies to any bank or bank holding company whose 
    trading activity equals 10 percent or more of its total assets, or 
    whose trading activity equals $1 billion or more.8 For purposes
    
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    of these criteria, an institution's trading activity is defined as the 
    sum of its trading assets and trading liabilities as reported in its 
    most recent Consolidated Report of Condition and Income (Call Report) 
    for a bank, or its most recent Y-9C Report for a bank holding company. 
    Total assets means quarter-end total assets as most recently reported 
    by the institution.
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        \8\ The Federal Reserve agrees with commenters that since market 
    risk usually is managed on a consolidated basis at the bank holding 
    company level, market risk should be measured at that level for 
    risk-based capital purposes. Thus, the final rule applies to bank 
    holding companies on a fully consolidated basis. In addition, 
    because the Accord applies to internationally active banks, the 
    final rule applies to consolidated banks. The Agencies may monitor 
    the market risk exposure of institutions on a non-consolidated basis 
    to ensure that significant imbalances within an organization do not 
    avoid supervision.
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        In addition, on a case-by-case basis, an Agency may require an 
    institution that does not meet the applicability criteria to comply 
    with the final rule if the Agency deems it necessary for safety and 
    soundness purposes, or may exclude an institution that meets the 
    applicability criteria. For example, an Agency may require an 
    institution with trading activity less than $1 billion and less than 10 
    percent of total assets, but with significant foreign exchange exposure 
    outside of its trading account to comply with the provisions of the 
    final rule. On the other hand, an Agency may exempt an institution with 
    trading activity that exceeds 10 percent of its total assets as a 
    result of accounting, operational, or similar considerations, provided 
    this does not raise safety and soundness concerns.
        An institution that does not meet the applicability criteria may, 
    subject to supervisory approval, comply voluntarily with the market 
    risk rule, but only if it complies with all of the final rule's 
    provisions (e.g., the backtesting requirements, after accumulating 
    sufficient trading outcomes).
    
    Covered Positions (Section 2(a))
    
        An institution subject to the final rule must hold capital to 
    support its exposure to general market risk arising from fluctuations 
    in interest rates, equity prices, foreign exchange rates, and commodity 
    prices and its exposure to specific risk associated with certain debt 
    and equity positions. Covered positions include all positions in an 
    institution's trading account and foreign exchange and commodity 
    positions throughout the institution (whether or not in the trading 
    account).
        For market risk capital purposes, an institution's trading account 
    is defined in the instructions to the Call Report. For example, the 
    trading account includes on- and off-balance-sheet positions in 
    financial instruments acquired with the intent to resell in order to 
    profit from short-term price or rate movements (or other price or rate 
    variations). An institution may include in its measure for general 
    market risk certain non-trading account instruments that it 
    deliberately uses to hedge trading positions. Those instruments are not 
    subject to a specific risk capital charge, but instead, remain subject 
    to the credit risk capital requirements. An institution may not include 
    items in, or exclude items from, its trading account to manipulate 
    associated capital charges. All positions included in the trading 
    account must be marked to market and reflected in an institution's 
    earnings statement.
        The market risk capital charge applies to all of an institution's 
    foreign exchange and commodities positions. An institution's foreign 
    exchange positions include, for each currency, such items as its net 
    spot position (including ordinary assets and liabilities denominated in 
    a foreign currency), forward positions, guarantees that are certain to 
    be called and likely to be unrecoverable, and any other items that 
    react primarily to changes in exchange rates. An institution may, 
    subject to supervisory approval, exclude from the market risk measure 
    any structural positions in foreign currencies. For this purpose, 
    structural positions include transactions designed to hedge an 
    institution's capital ratios against the effect of adverse exchange 
    rate movements on (1) subordinated debt, equity, or minority interests 
    in consolidated subsidiaries and capital assigned to foreign branches 
    that are denominated in foreign currencies, and (2) any positions 
    related to unconsolidated subsidiaries and other items that are 
    deducted from an institution's capital when calculating its capital 
    base. An institution's commodity positions include all positions that 
    react primarily to changes in commodity prices.
    
    Adjustment to the Risk-Based Capital Ratio Calculation (Section 3)
    
        An institution subject to the final rule must measure its market 
    risk and hold capital on a daily basis to maintain an overall minimum 
    8.0 percent ratio of total qualifying capital to risk-weighted assets 
    adjusted for market risk.
    Risk-Based Capital Ratio Denominator (Section 3(a))
        An institution's risk-based capital ratio denominator equals its 
    adjusted risk-weighted assets plus its market risk equivalent assets. 
    Adjusted risk-weighted assets are risk-weighted assets, as determined 
    under the credit risk-based capital standards, less the risk-weighted 
    amounts of all covered positions other than foreign exchange positions 
    outside the trading account and OTC derivatives. Covered positions 
    (except for foreign exchange positions outside the trading account and 
    OTC derivatives) are no longer subject to a credit risk capital charge. 
    An institution's market risk equivalent assets equals the measure for 
    market risk, as determined under this final rule, multiplied by 12.5 
    (the reciprocal of the minimum 8.0 percent capital ratio).
    Measure for Market Risk (Section 3(a)(2))
        The measure for market risk consists of an institution's VAR-based 
    capital charge plus an add-on capital charge for specific risk.\9\ The 
    VAR-based capital charge is the larger of either (1) the average VAR 
    measure for the last 60 business days, calculated under the regulatory 
    criteria and increased by a multiplication factor of between three and 
    four; or (2) the previous day's VAR, calculated under the regulatory 
    criteria but without the multiplication factor. An institution's 
    multiplication factor is three unless its backtesting results indicate 
    that a higher factor is appropriate or unless the institution's 
    supervisor determines that another action is appropriate.
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        \9\ The final rule also provides that, on a case-by-case basis, 
    an Agency may permit an institution to measure de minimis exposures 
    to market risk using other techniques, provided the exposure is 
    truly de minimis, the associated risk is adequately measured, and 
    integration of the exposure into the institution's internal model 
    would impose an unnecessary regulatory burden.
    ---------------------------------------------------------------------------
    
        The Agencies believe this comparative approach will result in an 
    institution holding capital sufficient to cover peak levels of market 
    volatility. While the Agencies acknowledge some commenters' concerns 
    that a multiplication factor of three (or higher) imposes excessive 
    capital charges, the Agencies believe that adjustments in the final 
    rule to the internal models approach (e.g., requiring only a single 
    observation period and recognizing cross correlations among risk 
    categories) result in capital charges that are appropriate, given 
    existing industry practices. As institutions implement the final rule, 
    the Agencies will monitor resulting capital charges, will continue to 
    evaluate the appropriateness of the multiplication factor, and may 
    consider further refinements or adjustments to the final rule.
    
    [[Page 47363]]
    
    Risk-Based Capital Ratio Numerator (Section 3(b))
        An institution's risk-based capital ratio numerator consists of a 
    combination of core (Tier 1) capital, supplemental (Tier 2) capital\10\ 
    and a third tier of capital (Tier 3), which consists of short-term 
    subordinated debt that meets certain conditions. Specifically, Tier 3 
    capital must have an original maturity of at least two years; it must 
    be unsecured and fully paid up; it must be subject to a lock-in clause 
    that prevents the issuer from repaying the debt even at maturity if the 
    issuer's capital ratio is, or with repayment would become, less than 
    the minimum 8.0 percent risk-based capital ratio; it must not be 
    redeemable before maturity without the prior approval of the 
    institution's supervisor; and it must not contain or be covered by any 
    covenants, terms, or restrictions that may be inconsistent with safe 
    and sound banking practices. An institution may use Tier 3 capital only 
    to meet market risk capital requirements.
    ---------------------------------------------------------------------------
    
        \10\ Tier 1 and Tier 2 capital components are discussed in the 
    Agencies' credit risk capital standards. Generally, Tier 1 includes 
    common stockholder's equity, noncumulative perpetual preferred 
    stock, and minority equity interests in consolidated subsidiaries, 
    less goodwill and other deductions. Bank holding companies may 
    include certain amounts of cumulative perpetual preferred stock in 
    Tier 1. Tier 2 includes the allowance for loan and lease losses, 
    other preferred stock, and subordinated debt with an original 
    average maturity of at least five years.
    ---------------------------------------------------------------------------
    
        To determine its risk-based capital ratio numerator, an institution 
    should first allocate Tier 1 and Tier 2 capital equal to 8.0 percent of 
    its risk-weighted assets (adjusted for the positions that are no longer 
    subject to the credit risk rules). Next, the institution should 
    allocate Tier 1, Tier 2, and Tier 3 capital to support its measure for 
    market risk. The risk-based capital ratio numerator (i.e., total 
    qualifying capital), is the sum of Tier 1 capital (whether or not 
    allocated for credit risk or market risk), Tier 2 capital (whether or 
    not allocated for credit risk or market risk and subject to certain 
    limits), and Tier 3 capital (allocated for market risk and subject to 
    certain limits).
        The Agencies continue to believe that Tier 1 capital should 
    constitute a substantial proportion of an institution's total capital. 
    Thus, the final rule includes the existing credit risk-based capital 
    constraints that at least 50 percent of an institution's total 
    qualifying capital must be Tier 1 capital, and that term subordinated 
    debt (and intermediate-term preferred stock and related surplus) may 
    not exceed 50 percent of Tier 1 capital. In addition, the sum of Tier 2 
    and Tier 3 capital allocated for market risk must not exceed 250 
    percent of Tier 1 capital allocated for market risk. This requirement 
    means that an institution must support at least 28.6 percent of its 
    measure for market risk with Tier 1 capital.
    
    Internal Models (Section 4)
    
        The Agencies recognize that institutions can and will use different 
    assumptions and modeling techniques and that such differences often 
    reflect distinct business strategies and approaches to risk management. 
    For example, an institution may calculate VAR using internal models 
    based on variance-covariance matrices, historical simulations, Monte 
    Carlo simulations, or other statistical approaches. In all cases, 
    however, the model must cover the institution's material risks.\11\ 
    While the Agencies are not specifying modeling parameters for internal 
    risk management purposes, the final rule does include minimum 
    qualitative requirements for internal risk management processes, as 
    well as certain quantitative requirements for the parameters and 
    assumptions for internal models used to measure market risk exposure 
    for regulatory capital purposes.
    ---------------------------------------------------------------------------
    
        \11\ For an institution using an externally developed or 
    outsource risk measurement model, the model may be used for risk-
    based capital purposes provided it complies with the requirements of 
    the final rule, management fully understands the model, the model is 
    integrated into the institution's daily risk management, and the 
    institution's overall risk management process is sound.
    ---------------------------------------------------------------------------
    
    Qualitative Requirements (Section 4(b))
        The qualitative requirements reiterate several basic components of 
    sound risk management. For example, one of the final rule's qualitative 
    requirements is that an institution must have a risk control unit that 
    reports directly to senior management and that is independent from 
    business trading functions. The Agencies expect that a risk control 
    unit will conduct regular backtests to evaluate the model's accuracy 
    and stress tests to identify the impact of adverse market events on the 
    institution's portfolio.
        The other qualitative requirements in the final rule are also 
    elements of sound risk management practices. For example, an 
    institution must have an internal model that is integrated into its 
    daily management, must have policies and procedures for conducting 
    appropriate stress tests and backtests and for responding to the 
    results of those tests, and must conduct independent reviews of its 
    risk measurement and management systems at least annually.
        The Agencies agree with commenters that an institution should 
    develop and use stress tests appropriate to its particular situation. 
    Thus, the final rule does not require specific stress test 
    methodologies. The Agencies expect an institution to conduct stress 
    tests that are rigorous and comprehensive and that cover a range of 
    factors that could create extraordinary losses in a trading portfolio, 
    or make the control of risk in a portfolio difficult. The Agencies 
    believe stress tests should be both qualitative and quantitative, 
    should incorporate both market risk and liquidity aspects of market 
    disturbances, and should reflect the impact of an event on positions 
    with linear and non-linear price characteristics. Where stress tests 
    reveal a particular vulnerability, the institution should take 
    effective steps to appropriately manage those risks.
        An institution's independent review of its risk management process 
    should include both the activities of business trading units and the 
    risk control unit. For example, the Agencies expect that an 
    institution's review would include assessing whether its risk 
    management system is fully integrated into the daily management process 
    and whether its risk management system is adequately documented. The 
    review should evaluate the organizational structure of the risk control 
    unit and analyze the approval process for risk pricing models and 
    valuation systems. The review should also consider the scope of market 
    risks captured by the risk measurement model, the accuracy and 
    completeness of position data, the verification of the consistency, 
    timeliness, and reliability of data sources used to run the internal 
    model, the accuracy and appropriateness of volatility and correlation 
    assumptions, and the validity of valuation and risk transformation 
    calculations.
    Market Risk Factors (Section 4(c))
        The final rule provides that an institution's internal model must 
    use risk factors that address market risk associated with interest 
    rates, equity prices, exchange rates, and commodity prices, including 
    the market risk associated with options in each of these risk 
    categories. Although an institution has discretion to use market risk 
    factors that it has determined affect the value of its positions and 
    the risks to which it is exposed, the Agencies expect an institution to 
    use sufficient risk factors to cover the risks inherent in its 
    portfolio.
    
    [[Page 47364]]
    
        For example, the Agencies believe that interest rate risk factors 
    should correspond to interest rates in each currency in which the 
    institution has interest-rate-sensitive positions. The risk measurement 
    system should model the yield curve using one of a number of generally 
    accepted approaches, such as by estimating forward rates or zero coupon 
    yields, and should incorporate risk factors to capture spread risk. The 
    yield curve should be divided into various maturity segments to capture 
    variation in the volatility of rates along the yield curve. For 
    material exposures to interest rate movements in the major currencies 
    and markets, modeling techniques should capture at least six segments 
    of the yield curve.
        The risk measurement system should incorporate risk factors 
    corresponding to individual foreign currencies in which the 
    institution's positions are denominated, to each of the equity markets 
    in which the institution has significant positions (at a minimum, a 
    risk factor should capture market-wide movements in equity prices), and 
    to each of the commodity markets in which the institution has 
    significant positions. Risk factors should measure the volatilities of 
    rates and prices underlying option positions. An institution with a 
    large or complex options portfolio should measure the volatilities of 
    options positions by different maturities. The sophistication and 
    nature of the modeling techniques should correspond to the level of the 
    institution's exposure.
    Quantitative Requirements (Section 4(d))
        While an institution has flexibility in developing the precise 
    nature of its model for internal risk management purposes, the Agencies 
    continue to believe that when determining capital charges for exposure 
    to market risk an institution's VAR measures should meet certain 
    quantitative requirements. Such requirements are designed to ensure 
    that an institution with significant market risk holds prudential 
    levels of capital and that capital charges are sufficiently consistent 
    across institutions with similar exposures. The Agencies have 
    considered commenters' concerns that the proposed modeling constraints, 
    when combined, would result in excessive capital charges. The Agencies 
    believe that certain of the proposed constraints, such as a 99 percent 
    (one-tailed) confidence level and a ten-day movement in rates and 
    prices, are appropriate and therefore they have been retained in the 
    final rule. However, the Agencies agree with commenters that other 
    proposed or considered requirements are not necessary. For example, the 
    Agencies have determined that a dual observation period would 
    unnecessarily increase regulatory burden without providing a 
    substantial benefit. Thus, the final rule employs a single observation 
    period.
        The Agencies also agree with commenters that, for regulatory 
    capital purposes, an institution should be permitted to use models that 
    recognize cross correlations among risk categories. The final rule 
    permits an institution to recognize cross correlations. The Agencies 
    believe this revision eliminates a significant source of rigidity in 
    the market risk proposal and should result in internal modeling for 
    capital purposes that is more consistent with observed industry 
    practice. The Agencies also believe this revision will appropriately 
    recognize and reward portfolio diversification. These adjustments to 
    the quantitative requirements are consistent with the final amendment 
    to the Accord.
        The final rule contains the following quantitative requirements for 
    an institution's VAR measures, upon which regulatory capital 
    requirements are based:
        (1) VAR measures must be computed each business day based on a 99 
    percent (one-tailed) confidence level of estimated maximum loss.
        (2) VAR measures must be based on a price shock equivalent to a 
    ten-day movement in rates or prices. An institution may adjust VAR 
    measures (including VAR measures for options) based on shorter periods 
    to a ten-day standard (e.g., by multiplying by the square root of 
    time).12 The Agencies do not believe that a price or rate movement 
    period less than ten days is sufficient to reflect the risk associated 
    with options positions (or other instruments with non-linear price 
    characteristics), but recognize that it may be overly burdensome for an 
    institution to apply a ten-day price or rate movement to such positions 
    at this time. The Agencies expect an institution with concentrations of 
    options to make substantive progress in developing a modeling system 
    that measures the non-linear price characteristics of options positions 
    (or other instruments with non-linear price characteristics), over a 
    full ten-day period.
    ---------------------------------------------------------------------------
    
        \12\ For example, under certain statistical assumptions, an 
    institution can estimate the ten-day price volatility of an 
    instrument by multiplying the volatility calculated on one-day 
    changes by the square root of ten (approximately 3.16).
    ---------------------------------------------------------------------------
    
        (3) Internal models must include the non-linear price 
    characteristics of options positions and the sensitivity of the market 
    value of those positions to changes in the volatility of the option's 
    underlying rates and prices.
        (4) VAR measures must be based on a minimum historical observation 
    period of at least one year for estimating future price and rate 
    changes. A model that uses a weighting scheme or other method for the 
    historical observation period must use an effective observation period 
    of at least one year. That is, the weighted average time lag of the 
    individual observations must be at least six months, the figure that 
    would prevail in an equally weighted one-year observation period.
        (5) An institution must update its model data at least once every 
    three months and more frequently if market conditions warrant.
        (6) VAR measures may incorporate empirical correlations (calculated 
    from historical data on rates and prices) both within broad risk 
    categories and across broad risk categories, subject to agreement by 
    the institution's supervisor that the model's system for measuring such 
    correlation is sound. If an institution's model does not incorporate 
    empirical correlations across risk categories, then the bank must 
    calculate the VAR measures used for regulatory capital purposes by 
    summing the separate VAR measures for the four broad risk categories 
    (i.e., interest rates, equity prices, foreign exchange rates, and 
    commodity prices).
        The Agencies believe that, taken together, the modeling parameters 
    are appropriate for regulatory capital purposes and also that they are 
    compatible, as much as practicable, with existing modeling procedures. 
    During the examination process, the Agencies will review an 
    institution's risk management process and internal model to ensure that 
    the model processes all relevant data and that modeling and risk 
    management practices conform to the parameters and requirements of the 
    final rule.13
    ---------------------------------------------------------------------------
    
        \13\ When reviewing an institution's internal model for risk-
    based capital purposes, the Agencies may consider reports and 
    opinions about the accuracy of the model that have been generated by 
    external auditors or qualified consultants.
    ---------------------------------------------------------------------------
    
    Backtesting (Section 4(e))
    
        The Agencies have considered commenters' responses to the 
    backtesting proposal. The Agencies believe backtesting can be a useful 
    tool for internal model validation, and have determined to include the 
    backtesting provisions in the final rule, as proposed. An institution 
    subject to the final rule must perform backtests of its VAR measures as 
    calculated for internal risk management purposes. The backtests must 
    compare daily VAR measures
    
    [[Page 47365]]
    
    calibrated to a one-day movement in rates and prices and a 99 percent 
    (one-tailed) confidence level against the institution's actual daily 
    net trading profit or loss (trading outcome) for each of the preceding 
    250 business days. The backtests must be performed once each 
    quarter.14 Net trading outcomes include such items as fees and 
    commissions associated with trading activities, as well as changes in 
    market valuations associated with changing portfolio positions.
    ---------------------------------------------------------------------------
    
        \14\ An institution's obligation to backtest for regulatory 
    capital purposes does not arise until the institution has been 
    subject to the final rule for 250 business days (approximately one 
    year) and, thus, has accumulated the requisite number of 
    observations to be used in backtesting.
    ---------------------------------------------------------------------------
    
        An institution must identify the number of occurrences when its net 
    trading loss (if any) for a particular day exceeds the corresponding 
    daily VAR measure. In general, an institution's multiplication factor 
    increases incrementally beginning with five or more exceptions during 
    the previous 250 business days, and rises to a multiplication factor of 
    four for an institution with 10 or more exceptions during the period. 
    While the number of exceptions creates a presumption as to an 
    institution's multiplication factor, the institution's supervisor may 
    make other adjustments to the multiplication factor or may take other 
    appropriate actions. For example, the supervisor may exclude exceptions 
    that result from regime shifts, such as sudden abnormal changes in 
    interest rates or exchange rates, major political events, or natural 
    disasters. The supervisor may also consider such other factors as the 
    magnitude of an exception (that is, the extent of the difference 
    between the VAR measure and the actual trading loss), and an 
    institution's reaction in response to an exception.
        The Agencies recognize that backtesting is evolving and acknowledge 
    commenters' concerns that it may not be appropriate to penalize an 
    institution by applying a higher multiplication factor if the 
    institution has refined the accuracy of its model in response to an 
    exception or has taken other action to improve its risk management 
    processes. The Agencies emphasize that they will implement the 
    backtesting requirements of the final rule with significant flexibility 
    and examiner judgment. The Agencies will continue to monitor industry 
    progress in developing backtesting methodologies and may consider 
    adjusting the backtesting requirements in the near future.
    
    Specific Risk (Section 5)
    
        The Agencies agree with the provisions in the final amendment to 
    the Accord that require an institution to hold capital in support of 
    the specific risk associated with debt and equity positions in an 
    institution's trading account. Thus, the final rule provides that an 
    institution must measure and hold capital in support of specific risk 
    associated with those positions. The capital charge for specific risk 
    is determined either by an institution's internal model or by the 
    standardized risk measurement techniques specified by the Agencies (the 
    standardized approach).
    Standardized Approach
        Under the standardized approach, the specific risk charge for debt 
    positions is calculated by multiplying the current market value of each 
    net long or short position in a trading account debt instrument by the 
    appropriate specific risk weighting factor as set forth in the final 
    rule, based on the identity of the obligor, and in the case of some 
    instruments such as corporate debt, on the credit rating and remaining 
    maturity of the instrument. An institution must risk weight derivatives 
    (e.g., swaps, futures, forwards, or options on certain debt 
    instruments) according to the relevant underlying instrument. For 
    example, for a forward contract, an institution must risk weight the 
    market value of the effective notional amount of the underlying 
    instrument (or index portfolio). An institution may net long and short 
    positions in identical debt instruments with exactly the same issuer, 
    coupon, currency, and maturity. An institution may also offset a 
    matched position in a derivative instrument and its corresponding 
    underlying instrument. The specific risk weighting factor for debt 
    instruments of OECD 15 central governments is zero percent. Other 
    debt instruments with qualifying ratings (essentially investment grade 
    corporate securities) receive risk weights ranging from 0.25 percent to 
    1.6 percent, depending on remaining maturity. Nonqualifying debt 
    instruments receive a risk weight of 8.0 percent.
    ---------------------------------------------------------------------------
    
        \15\ The Organization for Economic Cooperation and Development 
    (OECD) is defined in the credit risk-based capital standards.
    ---------------------------------------------------------------------------
    
        The specific risk charge for equity positions is based on an 
    institution's gross equity position for each national market. The gross 
    equity position is defined as the sum of all long and short equity 
    positions, including positions arising from derivatives such as equity 
    swaps, forwards, futures, and options. An institution must risk weight 
    the current market value of each gross equity position by the 
    appropriate factor. An institution must risk weight derivatives 
    according to the relevant underlying equity instrument. An institution 
    may net long and short positions in identical equity issues or indices 
    in each national market. An institution may also offset a matched 
    position in a derivative instrument and its corresponding underlying 
    instrument.
        The specific risk charge is 8.0 percent of the gross equity 
    position, unless the institution's portfolio is both liquid and well-
    diversified, in which case the capital charge is 4.0 percent. A 
    portfolio is liquid and well-diversified if: (1) it is characterized by 
    a limited sensitivity to price changes of any single equity or closely 
    related group of equity issues held in a portfolio; (2) the volatility 
    of the portfolio's value is not dominated by the volatility of any 
    individual equity issue or by equity issues from any single industry or 
    economic sector; (3) it contains a large number of individual equity 
    positions, with no single position representing a substantial portion 
    of the portfolio's total market value; and (4) it consists mainly of 
    issues traded on organized exchanges or in well-established over-the-
    counter markets.
        For positions in an index comprising a diversified portfolio of 
    equities, the specific risk charge is 2.0 percent of the net long or 
    short position in the index. In addition, a 2.0 percent specific risk 
    charge applies to only one side (long or short) in the case of certain 
    futures-related arbitrage strategies (for instance, long and short 
    positions in the same index at different dates or different market 
    centers, and long and short positions at the same date in different, 
    but similar indices). Finally, under certain conditions, futures 
    positions on a broadly-based index that are matched against positions 
    in the equities comprising the index are subject to a specific risk 
    charge of 2.0 percent against each side of the transaction.
    Internal Models Approach
        The final rule permits an institution to use its internal model to 
    determine capital charges for specific risk if it can demonstrate to 
    its supervisor that the modeling process adequately addresses elements 
    of specific risk for debt and/or equity positions. In particular, an 
    institution may use the model-based estimates of specific risk in place 
    of the standardized capital charge. However, if the specific risk 
    component of the institution's VAR measure (when multiplied by the 
    backtesting multiplication factor, with respect to a
    
    [[Page 47366]]
    
    60-day average VAR figure) is not equal to at least 50 percent of the 
    specific risk charge resulting from the standardized calculation, then 
    the institution has a specific risk add-on in the amount of the 
    difference. For example, if the standardized approach indicates a 
    specific risk charge of $100, but the institution's 60-day average VAR 
    figure includes only $10 for specific risk, then the institution has a 
    specific risk add-on of $20 (that is, 50 percent of $100 minus three 
    times $10). However, if the 60-day average VAR figure includes $20 from 
    specific risk, then the institution would have no specific risk add-on 
    because the VAR-based charge (three times $20) exceeds 50 percent of 
    $100.
        An institution (in conjunction with its supervisor) must separately 
    determine whether its model incorporates specific risk for debt 
    positions and equity positions. For instance, if the model addresses 
    the specific risk of debt positions but not equity positions, then the 
    institution can use the model-based specific risk charge (subject to 
    the limitations described earlier) for debt positions, but must use the 
    full standard specific risk charge for equity positions. If, however, 
    the model addresses the specific risk of both debt and equity 
    positions, then the institution must make the comparison based on the 
    total specific risk figure for debt and equity positions, taking into 
    account any correlations between the specific risk of debt and equity 
    positions that are built into the model.
        This treatment provides an institution with an incentive to 
    incorporate specific risk into its internal model, while maintaining an 
    overall floor on the amount of capital it must hold against specific 
    risk. The Agencies believe that a minimum requirement for specific risk 
    is useful, at least for an initial period, since methods for 
    incorporating specific risk into VAR models are still in a process of 
    development at many institutions. The Agencies will continue to study 
    these developments and likely will issue further guidance on these 
    procedures as institutions implement this final rule in the coming 
    months.
    
    IV. Regulatory Flexibility Act Analysis
    
    OCC Regulatory Flexibility Act Analysis
    
        Pursuant to section 605(b) of the Regulatory Flexibility Act, the 
    OCC certifies that this final rule will not have a significant impact 
    on a substantial number of small business entities in accord with the 
    spirit and purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et 
    seq.). Accordingly, a regulatory flexibility analysis is not required. 
    The impact of this final rule on banks regardless of size is expected 
    to be minimal. Further, the OCC's comparison of the applicability 
    section of this final rule to Call Report data on all existing banks 
    shows that application of the rule to small banks will be the rare 
    exception.
    
    Board Regulatory Flexibility Act Analysis
    
        Pursuant to section 605(b) of the Regulatory Flexibility Act, the 
    Board does not believe this final rule will have a significant impact 
    on a substantial number of small business entities in accord with the 
    spirit and purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et 
    seq.). The Board's comparison of the applicability section of this 
    final rule to Call Report data on all existing banks shows that 
    application of the rule to small entities will be the rare exception. 
    Accordingly, a regulatory flexibility analysis is not required. In 
    addition, because the risk-based capital standards generally do not 
    apply to bank holding companies with consolidated assets of less than 
    $150 million, this rule will not affect such companies.
    
    FDIC Regulatory Flexibility Act Analysis
    
        Pursuant to section 605(b) of the Regulatory Flexibility Act (Pub. 
    L. 96-354, 5 U.S.C. 601 et seq.), it is certified that the final rule 
    will not have a significant impact on a substantial number of small 
    entities. The FDIC's comparison of the applicability section of this 
    final rule to Call Report data on all existing banks shows that 
    application of the rule to small entities will be the rare exception.
    
    V. Paperwork Reduction Act
    
    OCC Paperwork Reduction Act
    
        The OCC has determined that his final rule does not increase the 
    regulatory paperwork burden of banking organizations pursuant to the 
    provisions of the Paperwork Reduction Act (44 U.S.C. 3501 et seq.).
    
    Board Paperwork Reduction Act
    
        In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
    Ch. 3506; 5 CFR 1320 Appendix A.1), the Board reviewed the proposed 
    rule under the authority delegated to the Board by the Office of 
    Management and Budget. No collections of information pursuant to the 
    Paperwork Reduction Act are contained in the final rule.
    
    FDIC Paperwork Reduction Act
    
        The FDIC has determined that this final rule does not contain any 
    collections of information as defined by the Paperwork Reduction Act 
    (44 U.S.C. 3501 et seq.).
    
    VI. OCC Executive Order 12866 Determination
    
        The OCC has determined that this final rule is not a significant 
    regulatory action under Executive Order 12866.
    
    VII. OCC Unfunded Mandates Reform Act of 1995 Determination
    
        The OCC has determined that this final rule will not result in 
    expenditures by state, local, and tribal governments, or by the private 
    sector, of $100 million or more in any one year. Accordingly, a 
    budgetary impact statement is not required under section 202 of the 
    Unfunded Mandates Reform Act of 1995. This final rule will apply only 
    to a small number of national banks. Moreover, most (if not all) of 
    those banks already have internal VAR models that measure market risk, 
    thus reducing this final rule's implementation costs.
    
    List of Subjects
    
    12 CFR Part 3
    
        Administrative practice and procedure, Capital, National banks, 
    Reporting and recordkeeping requirements, Risk.
    
    12 CFR Part 208
    
        Accounting, Agriculture, Banks, banking, Confidential business 
    information, Crime, Currency, Federal Reserve System, Mortgages, 
    Reporting and recordkeeping requirements, Securities.
    
    12 CFR Part 225
    
        Administrative practice and procedure, Banks, banking, Federal 
    Reserve System, Holding companies, Reporting and recordkeeping 
    requirements, Securities.
    
    12 CFR Part 325
    
        Administrative practice and procedure, Banks, banking, Capital 
    adequacy, Reporting and recordkeeping requirements, Savings 
    associations, State non-member banks.
    
    Office of the Comptroller of the Currency
    
    12 CFR CHAPTER I
    
    Authority and Issuance
    
        For the reasons set out in the joint preamble, part 3 of title 12, 
    chapter I of the Code of Federal Regulations is amended as follows:
    
    PART 3--[AMENDED]
    
        1. The authority citation for part 3 continues to read as follows:
    
    
    [[Page 47367]]
    
    
        Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n 
    note, 1835, 3907, and 3909.
    
        2. Section 3.6 is amended by revising paragraph (a) to read as 
    follows:
    
    
    Sec. 3.6  Minimum capital ratios.
    
        (a) Risk-based capital ratio. All national banks must have and 
    maintain the minimum risk-based capital ratio as set forth in appendix 
    A (and, for certain banks, in appendix B).
    * * * * *
        3. A new appendix B is added to part 3 to read as follows:
    
    Appendix B to Part 3--Risk-Based Capital Guidelines; Market Risk 
    Adjustment
    
    Section 1. Purpose, Applicability, Scope, and Effective Date
    
        (a) Purpose. The purpose of this appendix is to ensure that 
    banks with significant exposure to market risk maintain adequate 
    capital to support that exposure.1 This appendix supplements 
    and adjusts the risk-based capital ratio calculations under appendix 
    A of this part with respect to those banks.
    ---------------------------------------------------------------------------
    
        \1\ This appendix is based on a framework developed jointly by 
    supervisory authorities from the countries represented on the Basle 
    Committee on Banking Supervision and endorsed by the Group of Ten 
    Central Bank Governors. The framework is described in a Basle 
    Committee paper entitled ``Amendment to the Capital Accord to 
    Incorporate Market Risk,'' January 1996.
    ---------------------------------------------------------------------------
    
        (b) Applicability. (1) This appendix applies to any national 
    bank whose trading activity 2 (on a worldwide consolidated 
    basis) equals:
    ---------------------------------------------------------------------------
    
        \2\ Trading activity means the gross sum of trading assets and 
    liabilities as reported in the bank's most recent quarterly 
    Consolidated Report of Condition and Income (Call Report).
    ---------------------------------------------------------------------------
    
        (i) 10 percent or more of total assets; 3 or
    ---------------------------------------------------------------------------
    
        \3\ Total assets means quarter-end total assets as reported in 
    the bank's most recent Call Report.
    ---------------------------------------------------------------------------
    
        (ii) $1 billion or more.
        (2) The OCC may apply this appendix to any national bank if the 
    OCC deems it necessary or appropriate for safe and sound banking 
    practices.
        (3) The OCC may exclude a national bank otherwise meeting the 
    criteria of paragraph (b)(1) of this section from coverage under 
    this appendix if it determines the bank meets such criteria as a 
    consequence of accounting, operational, or similar considerations, 
    and the OCC deems it consistent with safe and sound banking 
    practices.
        (c) Scope. The capital requirements of this appendix support 
    market risk associated with a bank's covered positions.
        (d) Effective date. This appendix is effective as of January 1, 
    1997. Compliance is not mandatory until January 1, 1998. Subject to 
    supervisory approval, a bank may opt to comply with this appendix as 
    early as January 1, 1997.4
    ---------------------------------------------------------------------------
    
        \4\ A bank that voluntarily complies with the final rule prior 
    to January 1, 1998, must comply with all of its provisions.
    ---------------------------------------------------------------------------
    
    Section 2. Definitions
    
        For purposes of this appendix, the following definitions apply:
        (a) Covered positions means all positions in a bank's trading 
    account, and all foreign exchange 5 and commodity positions, 
    whether or not in the trading account.6 Positions include on-
    balance-sheet assets and liabilities and off-balance-sheet items. 
    Securities subject to repurchase and lending agreements are included 
    as if they are still owned by the lender.
    ---------------------------------------------------------------------------
    
        \5\ Subject to supervisory review, a bank may exclude structural 
    positions in foreign currencies from its covered positions.
        \6\ The term trading account is defined in the instructions to 
    the Call Report.
    ---------------------------------------------------------------------------
    
        (b) Market risk means the risk of loss resulting from movements 
    in market prices. Market risk consists of general market risk and 
    specific risk components.
        (1) General market risk means changes in the market value of 
    covered positions resulting from broad market movements, such as 
    changes in the general level of interest rates, equity prices, 
    foreign exchange rates, or commodity prices.
        (2) Specific risk means changes in the market value of specific 
    positions due to factors other than broad market movements and 
    includes such risk as the credit risk of an instrument's issuer.
        (c) Tier 1 and Tier 2 capital are the same as defined in 
    appendix A of this part.
        (d) Tier 3 capital is subordinated debt that is unsecured; is 
    fully paid up; has an original maturity of at least two years; is 
    not redeemable before maturity without prior approval by the OCC; 
    includes a lock-in clause precluding payment of either interest or 
    principal (even at maturity) if the payment would cause the issuing 
    bank's risk-based capital ratio to fall or remain below the minimum 
    required under appendix A of this part; and does not contain and is 
    not covered by any covenants, terms, or restrictions that are 
    inconsistent with safe and sound banking practices.
        (e) Value-at-risk (VAR) means the estimate of the maximum amount 
    that the value of covered positions could decline during a fixed 
    holding period within a stated confidence level, measured in 
    accordance with section 4 of this appendix.
    
    Section 3. Adjustments to the Risk-Based Capital Ratio Calculations
    
        (a) Risk-based capital ratio denominator. A bank subject to this 
    appendix shall calculate its risk-based capital ratio denominator as 
    follows:
        (1) Adjusted risk-weighted assets. Calculate adjusted risk-
    weighted assets, which equals risk-weighted assets (as determined in 
    accordance with appendix A of this part), excluding the risk-
    weighted amounts of all covered positions (except foreign exchange 
    positions outside the trading account and over-the-counter 
    derivative positions).7
    ---------------------------------------------------------------------------
    
        \7\ Foreign exchange positions outside the trading account and 
    all over-the-counter derivative positions, whether or not in the 
    trading account, must be included in adjusted risk-weighted assets 
    as determined in appendix A of this part.
    ---------------------------------------------------------------------------
    
        (2) Measure for market risk. Calculate the measure for market 
    risk, which equals the sum of the VAR-based capital charge, the 
    specific risk add-on (if any), and the capital charge for de minimis 
    exposure (if any).
        (i) VAR-based capital charge. The VAR-based capital charge 
    equals the higher of:
        (A) The previous day's VAR measure; or
        (B) The average of the daily VAR measures for each of the 
    preceding 60 business days multiplied by three, except as provided 
    in section 4(e) of this appendix;
        (ii) Specific risk add-on. The specific risk add-on is 
    calculated in accordance with section 5 of this appendix; and
        (iii) Capital charge for de minimis exposure. The capital charge 
    for de minimis exposure is calculated in accordance with section 
    4(a) of this appendix.
        (3) Market risk equivalent assets. Calculate market risk 
    equivalent assets by multiplying the measure for market risk (as 
    calculated in paragraph (a)(2) of this section) by 12.5.
        (4) Denominator calculation. Add market risk equivalent assets 
    (as calculated in paragraph (a)(3) of this section) to adjusted 
    risk-weighted assets (as calculated in paragraph (a)(1) of this 
    section). The resulting sum is the bank's risk-based capital ratio 
    denominator.
        (b) Risk-based capital ratio numerator. A bank subject to this 
    appendix shall calculate its risk-based capital ratio numerator by 
    allocating capital as follows:
        (1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital 
    equal to 8.0 percent of adjusted risk-weighted assets (as calculated 
    in paragraph (a)(1) of this section).8
    ---------------------------------------------------------------------------
    
        \8\ A bank may not allocate Tier 3 capital to support credit 
    risk (as calculated under appendix A).
    ---------------------------------------------------------------------------
    
        (2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3 
    capital equal to the measure for market risk as calculated in 
    paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3 
    capital allocated for market risk must not exceed 250 percent of 
    Tier 1 capital allocated for market risk. (This requirement means 
    that Tier 1 capital allocated in this paragraph (b)(2) must equal at 
    least 28.6 percent of the measure for market risk.)
        (3) Restrictions. (i) The sum of Tier 2 capital (both allocated 
    and excess) and Tier 3 capital (allocated in paragraph (b)(2) of 
    this section) may not exceed 100 percent of Tier 1 capital (both 
    allocated and excess).9
    ---------------------------------------------------------------------------
    
        \9\ Excess Tier 1 capital means Tier 1 capital that has not been 
    allocated in paragraphs (b)(1) and (b)(2) of this section. Excess 
    Tier 2 capital means Tier 2 capital that has not been allocated in 
    paragraph (b)(1) and (b)(2) of this section, subject to the 
    restrictions in paragraph (b)(3) of this section.
    ---------------------------------------------------------------------------
    
        (ii) Term subordinated debt (and intermediate-term preferred 
    stock and related surplus) included in Tier 2 capital (both 
    allocated and excess) may not exceed 50 percent of Tier 1 capital 
    (both allocated and excess).
        (4) Numerator calculation. Add Tier 1 capital (both allocated 
    and excess), Tier 2 capital (both allocated and excess), and Tier 3 
    capital (allocated under paragraph (b)(2) of this section). The 
    resulting sum is the bank's risk-based capital ratio numerator.
    
    Section 4. Internal Models
    
        (a) General. For risk-based capital purposes, a bank subject to 
    this appendix
    
    [[Page 47368]]
    
    must use its internal model to measure its daily VAR, in accordance 
    with the requirements of this section.10 The OCC may permit a 
    bank to use alternative techniques to measure the market risk of de 
    minimis exposures so long as the techniques adequately measure 
    associated market risk.
    ---------------------------------------------------------------------------
    
        \10\ A bank's internal model may use any generally accepted 
    measurement techniques, such as variance-covariance models, 
    historical simulations, or Monte Carlo simulations. However, the 
    level of sophistication and accuracy of a bank's internal model must 
    be commensurate with the nature and size of its covered positions. A 
    bank that modifies its existing modeling procedures to comply with 
    the requirements of this appendix for risk-based capital purposes 
    should, nonetheless, continue to use the internal model it considers 
    most appropriate in evaluating risks for other purposes.
    ---------------------------------------------------------------------------
    
        (b) Qualitative requirements. A bank subject to this appendix 
    must have a risk management system that meets the following minimum 
    qualitative requirements:
        (1) The bank must have a risk control unit that reports directly 
    to senior management and is independent from business trading units.
        (2) The bank's internal risk measurement model must be 
    integrated into the daily management process.
        (3) The bank's policies and procedures must identify, and the 
    bank must conduct, appropriate stress tests and backtests.11 
    The bank's policies and procedures must identify the procedures to 
    follow in response to the results of such tests.
    ---------------------------------------------------------------------------
    
        \11\ Stress tests provide information about the impact of 
    adverse market events on a bank's covered positions. Backtests 
    provide information about the accuracy of an internal model by 
    comparing a bank's daily VAR measures to its corresponding daily 
    trading profits and losses.
    ---------------------------------------------------------------------------
    
        (4) The bank must conduct independent reviews of its risk 
    measurement and risk management systems at least annually.
        (c) Market risk factors. The bank's internal model must use risk 
    factors sufficient to measure the market risk inherent in all 
    covered positions. The risk factors must address interest rate 
    risk,12 equity price risk, foreign exchange rate risk, and 
    commodity price risk.
    ---------------------------------------------------------------------------
    
        \12\ For material exposures in the major currencies and markets, 
    modeling techniques must capture spread risk and must incorporate 
    enough segments of the yield curve--at least six--to capture 
    differences in volatility and less than perfect correlation of rates 
    along the yield curve.
    ---------------------------------------------------------------------------
    
        (d) Quantitative requirements. For regulatory capital purposes, 
    VAR measures must meet the following quantitative requirements:
        (1) The VAR measures must be calculated on a daily basis using a 
    99 percent, one-tailed confidence level with a price shock 
    equivalent to a ten-business day movement in rates and prices. In 
    order to calculate VAR measures based on a ten-day price shock, the 
    bank may either calculate ten-day figures directly or convert VAR 
    figures based on holding periods other than ten days to the 
    equivalent of a ten-day holding period (for instance, by multiplying 
    a one-day VAR measure by the square root of ten).
        (2) The VAR measures must be based on an historical observation 
    period (or effective observation period for a bank using a weighting 
    scheme or other similar method) of at least one year. The bank must 
    update data sets at least once every three months or more frequently 
    as market conditions warrant.
        (3) The VAR measures must include the risks arising from the 
    non-linear price characteristics of options positions and the 
    sensitivity of the market value of the positions to changes in the 
    volatility of the underlying rates or prices. A bank with a large or 
    complex options portfolio must measure the volatility of options 
    positions by different maturities.
        (4) The VAR measures may incorporate empirical correlations 
    within and across risk categories, provided that the bank's process 
    for measuring correlations is sound. In the event that the VAR 
    measures do not incorporate empirical correlations across risk 
    categories, then the bank must add the separate VAR measures for the 
    four major risk categories to determine its aggregate VAR measure.
        (e) Backtesting. (1) Beginning one year after a bank starts to 
    comply with this appendix, a bank must conduct backtesting by 
    comparing each of its most recent 250 business days' actual net 
    trading profit or loss 13 with the corresponding daily VAR 
    measures generated for internal risk measurement purposes and 
    calibrated to a one-day holding period and a 99 percent, one-tailed 
    confidence level.
    ---------------------------------------------------------------------------
    
        \13\ Actual net trading profits and losses typically include 
    such things as realized and unrealized gains and losses on portfolio 
    positions as well as fee income and commissions associated with 
    trading activities.
    ---------------------------------------------------------------------------
    
        (2) Once each quarter, the bank must identify the number of 
    exceptions, that is, the number of business days for which the 
    magnitude of the actual daily net trading loss, if any, exceeds the 
    corresponding daily VAR measure.
        (3) A bank must use the multiplication factor indicated in Table 
    1 of this appendix in determining its capital charge for market risk 
    under section 3(a)(2)(i)(B) of this appendix until it obtains the 
    next quarter's backtesting results, unless the OCC determines that a 
    different adjustment or other action is appropriate.
    
         Table 1.--Multiplication Factor Based on Results of Backtesting    
    ------------------------------------------------------------------------
                                                              Multiplication
                      Number of exceptions                        factor    
    ------------------------------------------------------------------------
    4 or fewer..............................................          3.00  
    5.......................................................          3.40  
    6.......................................................          3.50  
    7.......................................................          3.65  
    8.......................................................          3.75  
    9.......................................................          3.85  
    10 or more..............................................          4.00  
    ------------------------------------------------------------------------
    
    Section 5. Specific Risk
    
        (a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of 
    this appendix, a bank's specific risk add-on equals the standard 
    specific risk capital charge calculated under paragraph (c) of this 
    section. If, however, a bank can demonstrate to the OCC that its 
    internal model measures the specific risk of covered debt and/or 
    equity positions and that those measures are included in the VAR-
    based capital charge in section 3(a)(2)(i) of this appendix, then 
    the bank may reduce or eliminate its specific risk add-on under this 
    section. The determination as to whether a model incorporates 
    specific risk must be made separately for covered debt and equity 
    positions.
        (1) If a model includes the specific risk of covered debt 
    positions but not covered equity positions (or vice versa), then the 
    bank can reduce its specific risk charge for the included positions 
    under paragraph (b) of this section. The specific risk charge for 
    the positions not included equals the standard specific risk capital 
    charge under paragraph (c) of this section.
        (2) If a model addresses the specific risk of both covered debt 
    and equity positions, then the bank can reduce its specific risk 
    charge for both covered debt and equity positions under paragraph 
    (b) of this section. In this case, the comparison described in 
    paragraph (b) of this section must be based on the total VAR-based 
    figure for the specific risk of debt and equity positions, taking 
    into account any correlations that are built into the model.
        (b) VAR-based specific risk capital charge. In all cases where a 
    bank measures specific risk in its internal model, the total capital 
    charge for specific risk (i.e., the VAR-based specific risk capital 
    charge plus the specific risk add-on) must equal at least 50 percent 
    of the standard specific risk capital charge (this amount is the 
    minimum specific risk charge).
        (1) If the portion of a bank's VAR measure that is attributable 
    to specific risk (multiplied by the bank's multiplication factor if 
    required in section 3(a)(2) of this appendix) is greater than or 
    equal to the minimum specific risk charge, then the bank has no 
    specific risk add-on and its capital charge for specific risk is the 
    portion included in the VAR measure.
        (2) If the portion of a bank's VAR measure that is attributable 
    to specific risk (multiplied by the bank's multiplication factor if 
    required in section 3(a)(2) of this appendix) is less than the 
    minimum specific risk charge, then the bank's specific risk add-on 
    is the difference between the minimum specific risk charge and the 
    specific risk portion of the VAR measure (multiplied by the bank's 
    multiplication factor if required in section 3(a)(2) of this 
    appendix).
        (c) Standard specific risk capital charge. The standard specific 
    risk capital charge equals the sum of the components for covered 
    debt and equity positions as follows:
        (1) Covered debt positions. (i) For purposes of this section 5, 
    covered debt positions means fixed-rate or floating-rate debt 
    instruments located in the trading account and instruments located 
    in the trading account with values that react primarily to changes 
    in interest rates, including certain non-convertible preferred 
    stock, convertible bonds, and instruments subject to repurchase and 
    lending agreements. Also included are derivatives (including written 
    and purchased options) for which the underlying instrument is a 
    covered debt instrument that is subject to a non-zero specific risk 
    capital charge.
        (A) For covered debt positions that are derivatives, a bank must 
    risk-weight (as
    
    [[Page 47369]]
    
    described in paragraph (c)(1)(iii) of this section) the market value 
    of the effective notional amount of the underlying debt instrument 
    or index portfolio. Swaps must be included as the notional position 
    in the underlying debt instrument or index portfolio, with a 
    receiving side treated as a long position and a paying side treated 
    as a short position; and
        (B) For covered debt positions that are options, whether long or 
    short, a bank must risk-weight (as described in paragraph 
    (c)(1)(iii) of this section) the market value of the effective 
    notional amount of the underlying debt instrument or index 
    multiplied by the option's delta.
        (ii) A bank may net long and short covered debt positions 
    (including derivatives) in identical debt issues or indices.
        (iii) A bank must multiply the absolute value of the current 
    market value of each net long or short covered debt position by the 
    appropriate specific risk weighting factor indicated in Table 2 of 
    this appendix. The specific risk capital charge component for 
    covered debt positions is the sum of the weighted values.
    
       Table 2--Specific Risk Weighting Factors for Covered Debt Positions  
    ------------------------------------------------------------------------
                                                                   Weighting
                                             Remaining maturity      factor 
                  Category                     (contractual)          (in   
                                                                    percent)
    ------------------------------------------------------------------------
    Government \1\......................  N/A....................       0.00
    Qualifying \2\......................  6 months or less.......       0.25
                                          Over 6 months to 24           1.00
                                           months.                          
                                          Over 24 months.........       1.60
    Other \3\...........................  N/A....................      8.00 
    ------------------------------------------------------------------------
    \1\ The ``government'' category includes all debt instruments of central
      governments of OECD countries (as defined in appendix A of this part) 
      including bonds, Treasury bills, and other short-term instruments, as 
      well as local currency instruments of non-OECD central governments to 
      the extent the bank has liabilities booked in that currency.          
    \2\ The ``qualifying'' category includes debt instruments of U.S.       
      government-sponsored agencies (as defined in appendix A of this part),
      general obligation debt instruments issued by states and other        
      political subdivisions of OECD countries, multilateral development    
      banks (as defined in appendix A of this part), and debt instruments   
      issued by U.S. depository institutions or OECD-banks (as defined in   
      appendix A of this part) that do not qualify as capital of the issuing
      institution. This category also includes other debt instruments,      
      including corporate debt and revenue instruments issued by states and 
      other political subdivisions of OECD countries, that are: (1) Rated   
      investment grade by at least two nationally recognized credit rating  
      services; (2) rated investment grade by one nationally recognized     
      credit rating agency and not rated less than investment grade by any  
      other credit rating agency; or (3) unrated, but deemed to be of       
      comparable investment quality by the reporting bank and the issuer has
      instruments listed on a recognized stock exchange, subject to review  
      by the OCC.                                                           
    \3\ The ``other'' category includes debt instruments that are not       
      included in the government or qualifying categories.                  
    
    
        (2) Covered equity positions. (i) For purposes of this section 
    5, covered equity positions means equity instruments located in the 
    trading account and instruments located in the trading account with 
    values that react primarily to changes in equity prices, including 
    voting or non-voting common stock, certain convertible bonds, and 
    commitments to buy or sell equity instruments. Also included are 
    derivatives (including written and purchased options) for which the 
    underlying is a covered equity position.
        (A) For covered equity positions that are derivatives, a bank 
    must risk weight (as described in paragraph (c)(2)(iii) of this 
    section) the market value of the effective notional amount of the 
    underlying equity instrument or equity portfolio. Swaps must be 
    included as the notional position in the underlying equity 
    instrument or index portfolio, with a receiving side treated as a 
    long position and a paying side treated as a short position; and
        (B) For covered equity positions that are options, whether long 
    or short, a bank must risk weight (as described in paragraph 
    (c)(2)(iii) of this section) the market value of the effective 
    notional amount of the underlying equity instrument or index 
    multiplied by the option's delta.
        (ii) A bank may net long and short covered equity positions 
    (including derivatives) in identical equity issues or equity indices 
    in the same market.14
    ---------------------------------------------------------------------------
    
        \14\ A bank may also net positions in depository receipts 
    against an opposite position in the underlying equity or identical 
    equity in different markets, provided that the bank includes the 
    costs of conversion.
    ---------------------------------------------------------------------------
    
        (iii)(A) A bank must multiply the absolute value of the current 
    market value of each net long or short covered equity position by a 
    risk weighting factor of 8.0 percent, or by 4.0 percent if the 
    equity is held in a portfolio that is both liquid and well-
    diversified.15 For covered equity positions that are index 
    contracts comprising a well-diversified portfolio of equity 
    instruments, the net long or short position is multiplied by a risk 
    weighting factor of 2.0 percent.
    ---------------------------------------------------------------------------
    
        \15\ A portfolio is liquid and well-diversified if: (1) It is 
    characterized by a limited sensitivity to price changes of any 
    single equity issue or closely related group of equity issues held 
    in the portfolio; (2) the volatility of the portfolio's value is not 
    dominated by the volatility of any individual equity issue or by 
    equity issues from any single industry or economic sector; (3) it 
    contains a large number of individual equity positions, with no 
    single position representing a substantial portion of the 
    portfolio's total market value; and (4) it consists mainly of issues 
    traded on organized exchanges or in well-established over-the-
    counter markets.
    ---------------------------------------------------------------------------
    
        (B) For covered equity positions from the following futures-
    related arbitrage strategies, a bank may apply a 2.0 percent risk 
    weighting factor to one side (long or short) of each position with 
    the opposite side exempt from charge:
        (1) Long and short positions in exactly the same index at 
    different dates or in different market centers; or
        (2) Long and short positions in index contracts at the same date 
    in different but similar indices.
        (C) For futures contracts on broadly-based indices that are 
    matched by offsetting positions in a basket of stocks comprising the 
    index, a bank may apply a 2.0 percent risk weighting factor to the 
    futures and stock basket positions (long and short), provided that 
    such trades are deliberately entered into and separately controlled, 
    and that the basket of stocks comprises at least 90 percent of the 
    capitalization of the index.
        (iv) The specific risk capital charge component for covered 
    equity positions is the sum of the weighted values.
    
    Section 6. Reservation of Authority
    
        The OCC reserves the authority to modify the application of any 
    of the provisions in this appendix to any bank, upon reasonable 
    justification.
    
        Dated: August 6, 1996.
    Eugene A. Ludwig,
    Comptroller of the Currency.
    
    Federal Reserve System
    
    12 CFR CHAPTER II
    
        For the reasons set out in the joint preamble, parts 208 and 225 of 
    title 12 of chapter II of the Code of Federal Regulations are 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. 36, 248(a), 248(c), 321-338a, 371d, 461, 
    481-486, 601, 611, 1814, 1823(j), 1828(o), 1831o, 1831p-1, 3105, 
    3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g), 
    78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w; 31 U.S.C. 5318; 42 U.S.C. 
    4012a, 4104a, 4104b, 4106, and 4128.
    
        2. Section 208.13 is revised to read as follows:
    
    
    Sec. 208.13  Capital Adequacy.
    
        The standards and guidelines by which the capital adequacy of state 
    member banks will be evaluated by the Board are set forth in appendix A 
    and appendix E for risk-based capital purposes, and, with respect to 
    the ratios relating capital to total assets, in appendix B to part 208 
    and in appendix B to the Board's Regulation Y, 12 CFR part 225.
        3. Appendix A is amended in the introductory text by adding a new 
    paragraph after the second undesignated paragraph to read as follows:
    
    [[Page 47370]]
    
    Appendix A to Part 208--Capital Adequacy Guidelines for State Member 
    Banks; Risk Based Measure
    
    * * * * *
        In addition, when certain banks that engage in trading activities 
    calculate their risk-based capital ratio under this appendix A, they 
    must also refer to appendix E of this part, which incorporates capital 
    charges for certain market risks into the risk-based capital ratio. 
    When calculating their risk-based capital ratio under this appendix A, 
    such banks are required to refer to appendix E of this part for 
    supplemental rules to determine qualifying and excess capital, 
    calculate risk-weighted assets, calculate market risk equivalent 
    assets, and calculate risk-based capital ratios adjusted for market 
    risk.
    * * * * *
        4. A new appendix E is added to read as follows:
    
    Appendix E to Part 208--Capital Adequacy Guidelines for State Member 
    Banks; Market Risk Measure
    
    Section 1. Purpose, Applicability, Scope, and Effective Date
    
        (a) Purpose. The purpose of this appendix is to ensure that 
    banks with significant exposure to market risk maintain adequate 
    capital to support that exposure.1 This appendix supplements 
    and adjusts the risk-based capital ratio calculations under appendix 
    A of this part with respect to those banks.
    ---------------------------------------------------------------------------
    
        \1\ This appendix is based on a framework developed jointly by 
    supervisory authorities from the countries represented on the Basle 
    Committee on Banking Supervision and endorsed by the Group of Ten 
    Central Bank Governors. The framework is described in a Basle 
    Committee paper entitled ``Amendment to the Capital Accord to 
    Incorporate Market Risk,'' January 1996.
    ---------------------------------------------------------------------------
    
        (b) Applicability. (1) This appendix applies to any insured 
    state member bank whose trading activity 2 (on a worldwide 
    consolidated basis) equals:
    ---------------------------------------------------------------------------
    
        \2\ Trading activity means the gross sum of trading assets and 
    liabilities as reported in the bank's most recent quarterly 
    Consolidated Report of Condition and Income (Call Report).
    ---------------------------------------------------------------------------
    
        (i) 10 percent or more of total assets; 3 or
    ---------------------------------------------------------------------------
    
        \3\ Total assets means quarter-end total assets as reported in 
    the bank's most recent Call Report.
    ---------------------------------------------------------------------------
    
        (ii) $1 billion or more.
        (2) The Federal Reserve may additionally apply this appendix to 
    any insured state member bank if the Federal Reserve deems it 
    necessary or appropriate for safe and sound banking practices.
        (3) The Federal Reserve may exclude an insured state member bank 
    otherwise meeting the criteria of paragraph (b)(1) of this section 
    from coverage under this appendix if it determines the bank meets 
    such criteria as a consequence of accounting, operational, or 
    similar considerations, and the Federal Reserve deems it consistent 
    with safe and sound banking practices.
        (c) Scope. The capital requirements of this appendix support 
    market risk associated with a bank's covered positions.
        (d) Effective date. This appendix is effective as of January 1, 
    1997. Compliance is not mandatory until January 1, 1998. Subject to 
    supervisory approval, a bank may opt to comply with this appendix as 
    early as January 1, 1997.4
    ---------------------------------------------------------------------------
    
        \4\ A bank that voluntarily complies with the final rule prior 
    to January 1, 1998, must comply with all of its provisions.
    ---------------------------------------------------------------------------
    
    Section 2. Definitions
    
        For purposes of this appendix, the following definitions apply:
        (a) Covered positions means all positions in a bank's trading 
    account, and all foreign exchange 5 and commodity positions, 
    whether or not in the trading account.6 Positions include on-
    balance-sheet assets and liabilities and off-balance-sheet items. 
    Securities subject to repurchase and lending agreements are included 
    as if they are still owned by the lender.
    ---------------------------------------------------------------------------
    
        \5\ Subject to supervisory review, a bank may exclude structural 
    positions in foreign currencies from its covered positions.
        \6\ The term trading account is defined in the instructions to 
    the Call Report.
    ---------------------------------------------------------------------------
    
        (b) Market risk means the risk of loss resulting from movements 
    in market prices. Market risk consists of general market risk and 
    specific risk components.
        (1) General market risk means changes in the market value of 
    covered positions resulting from broad market movements, such as 
    changes in the general level of interest rates, equity prices, 
    foreign exchange rates, or commodity prices.
        (2) Specific risk means changes in the market value of specific 
    positions due to factors other than broad market movements and 
    includes such risk as the credit risk of an instrument's issuer.
        (c) Tier 1 and Tier 2 capital are defined in appendix A of this 
    part.
        (d) Tier 3 capital is subordinated debt that is unsecured; is 
    fully paid up; has an original maturity of at least two years; is 
    not redeemable before maturity without prior approval by the Federal 
    Reserve; includes a lock-in clause precluding payment of either 
    interest or principal (even at maturity) if the payment would cause 
    the issuing bank's risk-based capital ratio to fall or remain below 
    the minimum required under appendix A of this part; and does not 
    contain and is not covered by any covenants, terms, or restrictions 
    that are inconsistent with safe and sound banking practices.
        (e) Value-at-risk (VAR) means the estimate of the maximum amount 
    that the value of covered positions could decline during a fixed 
    holding period within a stated confidence level, measured in 
    accordance with section 4 of this appendix.
    
    Section 3. Adjustments to the Risk-Based Capital Ratio Calculations
    
        (a) Risk-based capital ratio denominator. A bank subject to this 
    appendix shall calculate its risk-based capital ratio denominator as 
    follows:
        (1) Adjusted risk-weighted assets. Calculate adjusted risk-
    weighted assets, which equals risk-weighted assets (as determined in 
    accordance with appendix A of this part), excluding the risk-
    weighted amounts of all covered positions (except foreign exchange 
    positions outside the trading account and over-the-counter 
    derivative positions).7
    ---------------------------------------------------------------------------
    
        \7\ Foreign exchange positions outside the trading account and 
    all over-the-counter derivative positions, whether or not in the 
    trading account, must be included in adjusted risk weighted assets 
    as determined in appendix A of this part.
    ---------------------------------------------------------------------------
    
        (2) Measure for market risk. Calculate the measure for market 
    risk, which equals the sum of the VAR-based capital charge, the 
    specific risk add-on (if any), and the capital charge for de minimis 
    exposures (if any).
        (i) VAR-based capital charge. The VAR-based capital charge 
    equals the higher of:
        (A) The previous day's VAR measure; or
        (B) The average of the daily VAR measures for each of the 
    preceding 60 business days multiplied by three, except as provided 
    in section 4(e) of this appendix;
        (ii) Specific risk add-on. The specific risk add-on is 
    calculated in accordance with section 5 of this appendix; and
        (iii) Capital charge for de minimis exposure. The capital charge 
    for de minimis exposure is calculated in accordance with section 
    4(a) of this appendix.
        (3) Market risk equivalent assets. Calculate market risk 
    equivalent assets by multiplying the measure for market risk (as 
    calculated in paragraph (a)(2) of this section) by 12.5.
        (4) Denominator calculation. Add market risk equivalent assets 
    (as calculated in paragraph (a)(3) of this section) to adjusted 
    risk-weighted assets (as calculated in paragraph (a)(1) of this 
    section). The resulting sum is the bank's risk-based capital ratio 
    denominator.
        (b) Risk-based capital ratio numerator. A bank subject to this 
    appendix shall calculate its risk-based capital ratio numerator by 
    allocating capital as follows:
        (1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital 
    equal to 8.0 percent of adjusted risk-weighted assets (as calculated 
    in paragraph (a)(1) of this section).8
    ---------------------------------------------------------------------------
    
        \8\ A bank may not allocate Tier 3 capital to support credit 
    risk (as calculated under appendix A of this part).
    ---------------------------------------------------------------------------
    
        (2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3 
    capital equal to the measure for market risk as calculated in 
    paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3 
    capital allocated for market risk must not exceed 250 percent of 
    Tier 1 capital allocated for market risk. (This requirement means 
    that Tier 1 capital allocated in this paragraph (b)(2) must equal at 
    least 28.6 percent of the measure for market risk.)
        (3) Restrictions. (i) The sum of Tier 2 capital (both allocated 
    and excess) and Tier 3 capital (allocated in paragraph (b)(2) of 
    this section) may not exceed 100 percent of Tier 1 capital (both 
    allocated and excess).9
    ---------------------------------------------------------------------------
    
        \9\ Excess Tier 1 capital means Tier 1 capital that has not been 
    allocated in paragraphs (b)(1) and (b)(2) of this section. Excess 
    Tier 2 capital means Tier 2 capital that has not been allocated in 
    paragraph (b)(1) and (b)(2) of this section, subject to the 
    restrictions in paragraph (b)(3) of this section.
    ---------------------------------------------------------------------------
    
        (ii) Term subordinated debt (and intermediate-term preferred 
    stock and related
    
    [[Page 47371]]
    
    surplus) included in Tier 2 capital (both allocated and excess) may 
    not exceed 50 percent of Tier 1 capital (both allocated and excess).
        (4) Numerator calculation. Add Tier 1 capital (both allocated 
    and excess), Tier 2 capital (both allocated and excess), and Tier 3 
    capital (allocated under paragraph (b)(2) of this section). The 
    resulting sum is the bank's risk-based capital ratio numerator.
    
    Section 4. Internal Models.
    
        (a) General. For risk-based capital purposes, a bank subject to 
    this appendix must use its internal model to measure its daily VAR, 
    in accordance with the requirements of this section.10 The 
    Federal Reserve may permit a bank to use alternative techniques to 
    measure the market risk of de minimis exposures so long as the 
    techniques adequately measure associated market risk.
    ---------------------------------------------------------------------------
    
        \10\ A bank's internal model may use any generally accepted 
    measurement techniques, such as variance-covariance models, 
    historical simulations, or Monte Carlo simulations. However, the 
    level of sophistication and accuracy of a bank's internal model must 
    be commensurate with the nature and size of its covered positions. A 
    bank that modifies its existing modeling procedures to comply with 
    the requirements of this appendix for risk-based capital purposes 
    should, nonetheless, continue to use the internal model it considers 
    most appropriate in evaluating risks for other purposes.
    ---------------------------------------------------------------------------
    
        (b) Qualitative requirements. A bank subject to this appendix 
    must have a risk management system that meets the following minimum 
    qualitative requirements:
        (1) The bank must have a risk control unit that reports directly 
    to senior management and is independent from business trading units.
        (2) The bank's internal risk measurement model must be 
    integrated into the daily management process.
        (3) The bank's policies and procedures must identify, and the 
    bank must conduct, appropriate stress tests and backtests.11 
    The bank's policies and procedures must identify the procedures to 
    follow in response to the results of such tests.
    ---------------------------------------------------------------------------
    
        \11\ Stress tests provide information about the impact of 
    adverse market events on a bank's covered positions. Backtests 
    provide information about the accuracy of an internal model by 
    comparing a bank's daily VAR measures to its corresponding daily 
    trading profits and losses.
    ---------------------------------------------------------------------------
    
        (4) The bank must conduct independent reviews of its risk 
    measurement and risk management systems at least annually.
        (c) Market risk factors. The bank's internal model must use risk 
    factors sufficient to measure the market risk inherent in all 
    covered positions. The risk factors must address interest rate 
    risk,12 equity price risk, foreign exchange rate risk, and 
    commodity price risk.
    ---------------------------------------------------------------------------
    
        \12\ For material exposures in the major currencies and markets, 
    modeling techniques must capture spread risk and must incorporate 
    enough segments of the yield curve--at least six--to capture 
    differences in volatility and less than perfect correlation of rates 
    along the yield curve.
    ---------------------------------------------------------------------------
    
        (d) Quantitative requirements. For regulatory capital purposes, 
    VAR measures must meet the following quantitative requirements:
        (1) The VAR measures must be calculated on a daily basis using a 
    99 percent, one-tailed confidence level with a price shock 
    equivalent to a ten-business day movement in rates and prices. In 
    order to calculate VAR measures based on a ten-day price shock, the 
    bank may either calculate ten-day figures directly or convert VAR 
    figures based on holding periods other than ten days to the 
    equivalent of a ten-day holding period (for instance, by multiplying 
    a one-day VAR measure by the square root of ten).
        (2) The VAR measures must be based on an historical observation 
    period (or effective observation period for a bank using a weighting 
    scheme or other similar method) of at least one year. The bank must 
    update data sets at least once every three months or more frequently 
    as market conditions warrant.
        (3) The VAR measures must include the risks arising from the 
    non-linear price characteristics of options positions and the 
    sensitivity of the market value of the positions to changes in the 
    volatility of the underlying rates or prices. A bank with a large or 
    complex options portfolio must measure the volatility of options 
    positions by different maturities.
        (4) The VAR measures may incorporate empirical correlations 
    within and across risk categories, provided that the bank's process 
    for measuring correlations is sound. In the event that the VAR 
    measures do not incorporate empirical correlations across risk 
    categories, then the bank must add the separate VAR measures for the 
    four major risk categories to determine its aggregate VAR measure.
        (e) Backtesting. (1) Beginning one year after a bank starts to 
    comply with this appendix, a bank must conduct backtesting by 
    comparing each of its most recent 250 business days' actual net 
    trading profit or loss 13 with the corresponding daily VAR 
    measures generated for internal risk measurement purposes and 
    calibrated to a one-day holding period and a 99 percent, one-tailed 
    confidence level.
    ---------------------------------------------------------------------------
    
        \13\ Actual net trading profits and losses typically include 
    such things as realized and unrealized gains and losses on portfolio 
    positions as well as fee income and commissions associated with 
    trading activities.
    ---------------------------------------------------------------------------
    
        (2) Once each quarter, the bank must identify the number of 
    exceptions, that is, the number of business days for which the 
    magnitude of the actual daily net trading loss, if any, exceeds the 
    corresponding daily VAR measure.
        (3) A bank must use the multiplication factor indicated in Table 
    1 of this appendix in determining its capital charge for market risk 
    under section 3(a)(2)(i)(B) of this appendix until it obtains the 
    next quarter's backtesting results, unless the Federal Reserve 
    determines that a different adjustment or other action is 
    appropriate.
    
         Table 1.--Multiplication Factor Based on Results of Backtesting    
    ------------------------------------------------------------------------
                                                              Multiplication
                      Number of exceptions                        factor    
    ------------------------------------------------------------------------
    4 or fewer..............................................          3.00  
    5.......................................................          3.40  
    6.......................................................          3.50  
    7.......................................................          3.65  
    8.......................................................          3.75  
    9.......................................................          3.85  
    10 or more..............................................          4.00  
    ------------------------------------------------------------------------
    
    Section 5. Specific Risk
    
        (a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of 
    this appendix, a bank's specific risk add-on equals the standard 
    specific risk capital charge calculated under paragraph (c) of this 
    section. If, however, a bank can demonstrate to the Federal Reserve 
    that its internal model measures the specific risk of covered debt 
    and/or equity positions and that those measures are included in the 
    VAR-based capital charge in section 3(a)(2)(i) of this appendix, 
    then the bank may reduce or eliminate its specific risk add-on under 
    this section. The determination as to whether a model incorporates 
    specific risk must be made separately for covered debt and equity 
    positions.
        (1) If a model includes the specific risk of covered debt 
    positions but not covered equity positions (or vice versa), then the 
    bank can reduce its specific risk charge for the included positions 
    under paragraph (b) of this section. The specific risk charge for 
    the positions not included equals the standard specific risk capital 
    charge under paragraph (c) of this section.
        (2) If a model addresses the specific risk of both covered debt 
    and equity positions, then the bank can reduce its specific risk 
    charge for both covered debt and equity positions under paragraph 
    (b) of this section. In this case, the comparison described in 
    paragraph (b) of this section must be based on the total VAR-based 
    figure for the specific risk of debt and equity positions, taking 
    into account any correlations that are built into the model.
        (b) VAR-based specific risk capital charge. In all cases where a 
    bank measures specific risk in its internal model, the total capital 
    charge for specific risk (i.e., the VAR-based specific risk capital 
    charge plus the specific risk add-on) must equal at least 50 percent 
    of the standard specific risk capital charge (this amount is the 
    minimum specific risk charge).
        (1) If the portion of a bank's VAR measure that is attributable 
    to specific risk (multiplied by the bank's multiplication factor if 
    required in section 3(a)(2) of this appendix) is greater than or 
    equal to the minimum specific risk charge, then the bank has no 
    specific risk add-on and its capital charge for specific risk is the 
    portion included in the VAR measure.
        (2) If the portion of a bank's VAR measure that is attributable 
    to specific risk (multiplied by the bank's multiplication factor if 
    required in section 3(a)(2) of this appendix) is less than the 
    minimum specific risk charge, then the bank's specific risk add-on 
    is the difference between the minimum specific risk charge and the 
    specific risk portion of the VAR measure (multiplied by the bank's 
    multiplication factor if required in section 3(a)(2) of this 
    appendix).
    
    [[Page 47372]]
    
        (c) Standard specific risk capital charge. The standard specific 
    risk capital charge equals the sum of the components for covered 
    debt and equity positions as follows:
        (1) Covered debt positions. (i) For purposes of this section 5, 
    covered debt positions means fixed-rate or floating-rate debt 
    instruments located in the trading account and instruments located 
    in the trading account with values that react primarily to changes 
    in interest rates, including certain non-convertible preferred 
    stock, convertible bonds, and instruments subject to repurchase and 
    lending agreements. Also included are derivatives (including written 
    and purchased options) for which the underlying instrument is a 
    covered debt instrument that is subject to a non-zero specific risk 
    capital charge.
        (A) For covered debt positions that are derivatives, a bank must 
    risk-weight (as described in paragraph (c)(1)(iii) of this section) 
    the market value of the effective notional amount of the underlying 
    debt instrument or index portfolio. Swaps must be included as the 
    notional position in the underlying debt instrument or index 
    portfolio, with a receiving side treated as a long position and a 
    paying side treated as a short position; and
        (B) For covered debt positions that are options, whether long or 
    short, a bank must risk-weight (as described in paragraph 
    (c)(1)(iii) of this section) the market value of the effective 
    notional amount of the underlying debt instrument or index 
    multiplied by the option's delta.
        (ii) A bank may net long and short covered debt positions 
    (including derivatives) in identical debt issues or indices.
        (iii) A bank must multiply the absolute value of the current 
    market value of each net long or short covered debt position by the 
    appropriate specific risk weighting factor indicated in Table 2 of 
    this appendix. The specific risk capital charge component for 
    covered debt positions is the sum of the weighted values.
    
      Table 2.--Specific Risk Weighting Factors for Covered Debt Positions  
    ------------------------------------------------------------------------
                                                                   Weighting
                                             Remaining maturity      factor 
                  Category                     (contractual)          (in   
                                                                    percent)
    ------------------------------------------------------------------------
    Government..........................  N/A....................       0.00
    Qualifying..........................  6 months or less.......       0.25
                                          Over 6 months to 24           1.00
                                           months.                          
                                          Over 24 months.........       1.60
    Other...............................  N/A....................       8.00
    ------------------------------------------------------------------------
    
        (A) The government category includes all debt instruments of 
    central governments of OECD-based countries 14 including bonds, 
    Treasury bills, and other short-term instruments, as well as local 
    currency instruments of non-OECD central governments to the extent 
    the bank has liabilities booked in that currency.
    ---------------------------------------------------------------------------
    
        \14\ Organization for Economic Cooperation and Development 
    (OECD)-based countries is defined in appendix A of this part.
    ---------------------------------------------------------------------------
    
        (B) The qualifying category includes debt instruments of U.S. 
    government-sponsored agencies, general obligation debt instruments 
    issued by states and other political subdivisions of OECD-based 
    countries, multilateral development banks, and debt instruments 
    issued by U.S. depository institutions or OECD-banks that do not 
    qualify as capital of the issuing institution.15 This category 
    also includes other debt instruments, including corporate debt and 
    revenue instruments issued by states and other political 
    subdivisions of OECD countries, that are:
    ---------------------------------------------------------------------------
    
        \15\ U.S. government-sponsored agencies, multilateral 
    development banks, and OECD banks are defined in appendix A of this 
    part.
    ---------------------------------------------------------------------------
    
        (1) Rated investment-grade by at least two nationally recognized 
    credit rating services;
        (2) Rated investment-grade by one nationally recognized credit 
    rating agency and not rated less than investment-grade by any other 
    credit rating agency; or
        (3) Unrated, but deemed to be of comparable investment quality 
    by the reporting bank and the issuer has instruments listed on a 
    recognized stock exchange, subject to review by the Federal Reserve.
        (C) The other category includes debt instruments that are not 
    included in the government or qualifying categories.
        (2) Covered equity positions. (i) For purposes of this section 
    5, covered equity positions means equity instruments located in the 
    trading account and instruments located in the trading account with 
    values that react primarily to changes in equity prices, including 
    voting or non-voting common stock, certain convertible bonds, and 
    commitments to buy or sell equity instruments. Also included are 
    derivatives (including written and purchased options) for which the 
    underlying is a covered equity position.
        (A) For covered equity positions that are derivatives, a bank 
    must risk weight (as described in paragraph (c)(2)(iii) of this 
    section) the market value of the effective notional amount of the 
    underlying equity instrument or equity portfolio. Swaps must be 
    included as the notional position in the underlying equity 
    instrument or index portfolio, with a receiving side treated as a 
    long position and a paying side treated as a short position; and
        (B) For covered equity positions that are options, whether long 
    or short, a bank must risk weight (as described in paragraph 
    (c)(2)(iii) of this section) the market value of the effective 
    notional amount of the underlying equity instrument or index 
    multiplied by the option's delta.
        (ii) A bank may net long and short covered equity positions 
    (including derivatives) in identical equity issues or equity indices 
    in the same market.16
    ---------------------------------------------------------------------------
    
        \16\ A bank may also net positions in depository receipts 
    against an opposite position in the underlying equity or identical 
    equity in different markets, provided that the bank includes the 
    costs of conversion.
    ---------------------------------------------------------------------------
    
        (iii)(A) A bank must multiply the absolute value of the current 
    market value of each net long or short covered equity position by a 
    risk weighting factor of 8.0 percent, or by 4.0 percent if the 
    equity is held in a portfolio that is both liquid and well-
    diversified.17 For covered equity positions that are index 
    contracts comprising a well-diversified portfolio of equity 
    instruments, the net long or short position is multiplied by a risk 
    weighting factor of 2.0 percent.
    ---------------------------------------------------------------------------
    
        \17\ A portfolio is liquid and well-diversified if: (1) It is 
    characterized by a limited sensitivity to price changes of any 
    single equity issue or closely related group of equity issues held 
    in the portfolio; (2) the volatility of the portfolio's value is not 
    dominated by the volatility of any individual equity issue or by 
    equity issues from any single industry or economic sector; (3) it 
    contains a large number of individual equity positions, with no 
    single position representing a substantial portion of the 
    portfolio's total market value; and (4) it consists mainly of issues 
    traded on organized exchanges or in well-established over-the-
    counter markets.
    ---------------------------------------------------------------------------
    
        (B) For covered equity positions from the following futures-
    related arbitrage strategies, a bank may apply a 2.0 percent risk 
    weighting factor to one side (long or short) of each position with 
    the opposite side exempt from charge, subject to review by the 
    Federal Reserve:
        (1) Long and short positions in exactly the same index at 
    different dates or in different market centers; or
        (2) Long and short positions in index contracts at the same date 
    in different but similar indices.
        (C) For futures contracts on broadly-based indices that are 
    matched by offsetting positions in a basket of stocks comprising the 
    index, a bank may apply a 2.0 percent risk weighting factor to the 
    futures and stock basket positions (long and short), provided that 
    such trades are deliberately entered into and separately controlled, 
    and that the basket of stocks comprises at least 90 percent of the 
    capitalization of the index.
        (iv) The specific risk capital charge component for covered 
    equity positions is the sum of the weighted values.
    
    PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL 
    (REGULATION Y)
    
        1. The authority citation for part 225 continues 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.
    
        2. Appendix A is amended in the introductory text, by adding a new 
    paragraph after the second undesignated paragraph to read as follows:
    
    Appendix A to Part 225--Capital Adequacy Guidelines for Bank Holding 
    Companies: Risk-Based Measure
    
    * * * * *
        In addition, when certain organizations that engage in trading 
    activities calculate their risk-based capital ratio under this 
    appendix A, they must also refer to appendix E of this part, which 
    incorporates capital charges for certain market risks into the risk-
    based capital ratio. When calculating their risk-based capital ratio 
    under this appendix A, such organizations are required to refer to
    
    [[Page 47373]]
    
    appendix E of this part for supplemental rules to determine 
    qualifying and excess capital, calculate risk-weighted assets, 
    calculate market risk equivalent assets, and calculate risk-based 
    capital ratios adjusted for market risk.
    * * * * *
        3. A new appendix E is added to read as follows:
    
    Appendix E to Part 225--Capital Adequacy Guidelines for Bank Holding 
    Companies: Market Risk Measure
    
    Section 1. Purpose, Applicability, Scope, and Effective Date
    
        (a) Purpose. The purpose of this appendix is to ensure that bank 
    holding companies (organizations) with significant exposure to 
    market risk maintain adequate capital to support that 
    exposure.1 This appendix supplements and adjusts the risk-based 
    capital ratio calculations under appendix A of this part with 
    respect to those organizations.
    ---------------------------------------------------------------------------
    
        \1\ This appendix is based on a framework developed jointly by 
    supervisory authorities from the countries represented on the Basle 
    Committee on Banking Supervision and endorsed by the Group of Ten 
    Central Bank Governors. The framework is described in a Basle 
    Committee paper entitled ``Amendment to the Capital Accord to 
    Incorporate Market Risk,'' January 1996.
    ---------------------------------------------------------------------------
    
        (b) Applicability. (1) This appendix applies to any bank holding 
    company whose trading activity 2 (on a worldwide consolidated 
    basis) equals:
    ---------------------------------------------------------------------------
    
        \2\ Trading activity means the gross sum of trading assets and 
    liabilities as reported in the bank holding company's most recent 
    quarterly Y-9C Report.
    ---------------------------------------------------------------------------
    
        (i) 10 percent or more of total assets; 3 or
    ---------------------------------------------------------------------------
    
        \3\ Total assets means quarter-end total assets as reported in 
    the bank holding company's most recent Y-9C Report.
    ---------------------------------------------------------------------------
    
        (ii) $1 billion or more.
        (2) The Federal Reserve may additionally apply this appendix to 
    any bank holding company if the Federal Reserve deems it necessary 
    or appropriate for safe and sound banking practices.
        (3) The Federal Reserve may exclude a bank holding company 
    otherwise meeting the criteria of paragraph (b)(1) of this section 
    from coverage under this appendix if it determines the organization 
    meets such criteria as a consequence of accounting, operational, or 
    similar considerations, and the Federal Reserve deems it consistent 
    with safe and sound banking practices.
        (c) Scope. The capital requirements of this appendix support 
    market risk associated with an organization's covered positions.
        (d) Effective date. This appendix is effective as of January 1, 
    1997. Compliance is not mandatory until January 1, 1998. Subject to 
    supervisory approval, a bank holding company may opt to comply with 
    this appendix as early as January 1, 1997.4
    ---------------------------------------------------------------------------
    
        \4\ A bank holding company that voluntarily complies with the 
    final rule prior to January 1, 1998, must comply with all of its 
    provisions.
    ---------------------------------------------------------------------------
    
    Section 2. Definitions
    
        For purposes of this appendix, the following definitions apply:
        (a) Covered positions means all positions in an organization's 
    trading account, and all foreign exchange 5 and commodity 
    positions, whether or not in the trading account.6 Positions 
    include on-balance-sheet assets and liabilities and off-balance-
    sheet items. Securities subject to repurchase and lending agreements 
    are included as if still owned by the lender.
    ---------------------------------------------------------------------------
    
        \5\ Subject to supervisory review, a bank may exclude structural 
    positions in foreign currencies from its covered positions.
        \6\ The term trading account is defined in the instructions to 
    the Call Report.
    ---------------------------------------------------------------------------
    
        (b) Market risk means the risk of loss resulting from movements 
    in market prices. Market risk consists of general market risk and 
    specific risk components.
        (1) General market risk means changes in the market value of 
    covered positions resulting from broad market movements, such as 
    changes in the general level of interest rates, equity prices, 
    foreign exchange rates, or commodity prices.
        (2) Specific risk means changes in the market value of specific 
    positions due to factors other than broad market movements and 
    includes such risk as the credit risk of an instrument's issuer.
        (c) Tier 1 and Tier 2 capital are defined in appendix A of this 
    part.
        (d) Tier 3 capital is subordinated debt that is unsecured; is 
    fully paid up; has an original maturity of at least two years; is 
    not redeemable before maturity without prior approval by the Federal 
    Reserve; includes a lock-in clause precluding payment of either 
    interest or principal (even at maturity) if the payment would cause 
    the issuing organization's risk-based capital ratio to fall or 
    remain below the minimum required under appendix A of this part; and 
    does not contain and is not covered by any covenants, terms, or 
    restrictions that are inconsistent with safe and sound banking 
    practices.
        (e) Value-at-risk (VAR) means the estimate of the maximum amount 
    that the value of covered positions could decline due to market 
    price or rate movements during a fixed holding period within a 
    stated confidence level, measured in accordance with section 4 of 
    this appendix.
    
    Section 3. Adjustments to the Risk-Based Capital Ratio Calculations
    
        (a) Risk-based capital ratio denominator. An organization 
    subject to this appendix shall calculate its risk-based capital 
    ratio denominator as follows:
        (1) Adjusted risk-weighted assets. Calculate adjusted risk-
    weighted assets, which equals risk-weighted assets (as determined in 
    accordance with appendix A of this part) excluding the risk-weighted 
    amounts of all covered positions (except foreign exchange positions 
    outside the trading account and over-the-counter derivative 
    positions).7
    ---------------------------------------------------------------------------
    
        \7\ Foreign exchange positions outside the trading account and 
    all over-the-counter derivative positions, whether or not in the 
    trading account, must be included in adjusted risk weighted assets 
    as determined in appendix A of this part.
    ---------------------------------------------------------------------------
    
        (2) Measure for market risk. Calculate the measure for market 
    risk, which equals the sum of the VAR-based capital charge, the 
    specific risk add-on (if any), and the capital charge for de minimis 
    exposures (if any).
        (i) VAR-based capital charge. The VAR-based capital charge 
    equals the higher of:
        (A) The previous day's VAR measure; or
        (B) The average of the daily VAR measures for each of the 
    preceding 60 business days multiplied by three, except as provided 
    in section 4(e) of this appendix;
        (ii) Specific risk add-on. The specific risk add-on is 
    calculated in accordance with section 5 of this appendix; and
        (iii) Capital charge for de minimis exposure. The capital charge 
    for de minimis exposure is calculated in accordance with section 
    4(a) of this appendix.
        (3) Market risk equivalent assets. Calculate market risk 
    equivalent assets by multiplying the measure for market risk (as 
    calculated in paragraph (a)(2) of this section) by 12.5.
        (4) Denominator calculation. Add market risk equivalent assets 
    (as calculated in paragraph (a)(3) of this section) to adjusted 
    risk-weighted assets (as calculated in paragraph (a)(1) of this 
    section). The resulting sum is the organization's risk-based capital 
    ratio denominator.
        (b) Risk-based capital ratio numerator. An organization subject 
    to this appendix shall calculate its risk-based capital ratio 
    numerator by allocating capital as follows:
        (1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital 
    equal to 8.0 percent of adjusted risk-weighted assets (as calculated 
    in paragraph (a)(1) of this section).8
    ---------------------------------------------------------------------------
    
        \8\ An institution may not allocate Tier 3 capital to support 
    credit risk (as calculated under appendix A of this part).
    ---------------------------------------------------------------------------
    
        (2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3 
    capital equal to the measure for market risk as calculated in 
    paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3 
    capital allocated for market risk must not exceed 250 percent of 
    Tier 1 capital allocated for market risk. (This requirement means 
    that Tier 1 capital allocated in this paragraph (b)(2) must equal at 
    least 28.6 percent of the measure for market risk.)
        (3) Restrictions. (i) The sum of Tier 2 capital (both allocated 
    and excess) and Tier 3 capital (allocated in paragraph (b)(2) of 
    this section) may not exceed 100 percent of Tier 1 capital (both 
    allocated and excess).9
    ---------------------------------------------------------------------------
    
        \9\ Excess Tier 1 capital means Tier 1 capital that has not been 
    allocated in paragraphs (b)(1) and (b)(2) of this section. Excess 
    Tier 2 capital means Tier 2 capital that has not been allocated in 
    paragraph (b)(1) and (b)(2) of this section, subject to the 
    restrictions in paragraph (b)(3) of this section.
    ---------------------------------------------------------------------------
    
        (ii) Term subordinated debt (and intermediate-term preferred 
    stock and related surplus) included in Tier 2 capital (both 
    allocated and excess) may not exceed 50 percent of Tier 1 capital 
    (both allocated and excess).
        (4) Numerator calculation. Add Tier 1 capital (both allocated 
    and excess), Tier 2 capital (both allocated and excess), and Tier 3 
    capital (allocated under paragraph (b)(2) of this section). The 
    resulting sum is the organization's risk-based capital ratio 
    numerator.
    
    Section 4. Internal Models
    
        (a) General. For risk-based capital purposes, a bank holding 
    company subject to this appendix must use its internal model to 
    measure its daily VAR, in accordance with
    
    [[Page 47374]]
    
    the requirements of this section.10 The Federal Reserve may 
    permit an organization to use alternative techniques to measure the 
    market risk of de minimis exposures so long as the techniques 
    adequately measure associated market risk.
    ---------------------------------------------------------------------------
    
        \10\ An organization's internal model may use any generally 
    accepted measurement techniques, such as variance-covariance models, 
    historical simulations, or Monte Carlo simulations. However, the 
    level of sophistication and accuracy of an organization's internal 
    model must be commensurate with the nature and size of its covered 
    positions. An organization that modifies its existing modeling 
    procedures to comply with the requirements of this appendix for 
    risk-based capital purposes should, nonetheless, continue to use the 
    internal model it considers most appropriate in evaluating risks for 
    other purposes.
    ---------------------------------------------------------------------------
    
        (b) Qualitative requirements. A bank holding company subject to 
    this appendix must have a risk management system that meets the 
    following minimum qualitative requirements:
        (1) The organization must have a risk control unit that reports 
    directly to senior management and is independent from business 
    trading units.
        (2) The organization's internal risk measurement model must be 
    integrated into the daily management process.
        (3) The organization's policies and procedures must identify, 
    and the organization must conduct, appropriate stress tests and 
    backtests.11 The organization's policies and procedures must 
    identify the procedures to follow in response to the results of such 
    tests.
    ---------------------------------------------------------------------------
    
        \11\ Stress tests provide information about the impact of 
    adverse market events on a bank's covered positions. Backtests 
    provide information about the accuracy of an internal model by 
    comparing an organization's daily VAR measures to its corresponding 
    daily trading profits and losses.
    ---------------------------------------------------------------------------
    
        (4) The organization must conduct independent reviews of its 
    risk measurement and risk management systems at least annually.
        (c) Market risk factors. The organization's internal model must 
    use risk factors sufficient to measure the market risk inherent in 
    all covered positions. The risk factors must address interest rate 
    risk,12 equity price risk, foreign exchange rate risk, and 
    commodity price risk.
    ---------------------------------------------------------------------------
    
        \12\ For material exposures in the major currencies and markets, 
    modeling techniques must capture spread risk and must incorporate 
    enough segments of the yield curve--at least six--to capture 
    differences in volatility and less than perfect correlation of rates 
    along the yield curve.
    ---------------------------------------------------------------------------
    
        (d) Quantitative requirements. For regulatory capital purposes, 
    VAR measures must meet the following quantitative requirements:
        (1) The VAR measures must be calculated on a daily basis using a 
    99 percent, one-tailed confidence level with a price shock 
    equivalent to a ten-business day movement in rates and prices. In 
    order to calculate VAR measures based on a ten-day price shock, the 
    organization may either calculate ten-day figures directly or 
    convert VAR figures based on holding periods other than ten days to 
    the equivalent of a ten-day holding period (for instance, by 
    multiplying a one-day VAR measure by the square root of ten).
        (2) The VAR measures must be based on an historical observation 
    period (or effective observation period for an organization using a 
    weighting scheme or other similar method) of at least one year. The 
    organization must update data sets at least once every three months 
    or more frequently as market conditions warrant.
        (3) The VAR measures must include the risks arising from the 
    non-linear price characteristics of options positions and the 
    sensitivity of the market value of the positions to changes in the 
    volatility of the underlying rates or prices. An organization with a 
    large or complex options portfolio must measure the volatility of 
    options positions by different maturities.
        (4) The VAR measures may incorporate empirical correlations 
    within and across risk categories, provided that the organization's 
    process for measuring correlations is sound. In the event that the 
    VAR measures do not incorporate empirical correlations across risk 
    categories, then the organization must add the separate VAR measures 
    for the four major risk categories to determine its aggregate VAR 
    measure.
        (e) Backtesting. (1) Beginning one year after a bank holding 
    company starts to comply with this appendix, it must conduct 
    backtesting by comparing each of its most recent 250 business days' 
    actual net trading profit or loss 13 with the corresponding 
    daily VAR measures generated for internal risk measurement purposes 
    and calibrated to a one-day holding period and a 99th percentile, 
    one-tailed confidence level.
    ---------------------------------------------------------------------------
    
        \13\ Actual net trading profits and losses typically include 
    such things as realized and unrealized gains and losses on portfolio 
    positions as well as fee income and commissions associated with 
    trading activities.
    ---------------------------------------------------------------------------
    
        (2) Once each quarter, the organization must identify the number 
    of exceptions, that is, the number of business days for which the 
    magnitude of the actual daily net trading loss, if any, exceeds the 
    corresponding daily VAR measure.
        (3) A bank holding company must use the multiplication factor 
    indicated in Table 1 of this appendix in determining its capital 
    charge for market risk under section 3(a)(2)(i)(B) of this appendix 
    until it obtains the next quarter's backtesting results, unless the 
    Federal Reserve determines that a different adjustment or other 
    action is appropriate.
    
         Table 1.--Multiplication Factor Based on Results of Backtesting    
    ------------------------------------------------------------------------
                                                              Multiplication
                      Number of exceptions                        factor    
    ------------------------------------------------------------------------
    4 or fewer..............................................          3.00  
    5.......................................................          3.40  
    6.......................................................          3.50  
    7.......................................................          3.65  
    8.......................................................          3.75  
    9.......................................................          3.85  
    10 or more..............................................          4.00  
    ------------------------------------------------------------------------
    
    Section 5. Specific Risk
    
        (a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of 
    this appendix, a bank holding company's specific risk add-on equals 
    the standard specific risk capital charge calculated under paragraph 
    (c) of this section. If, however, an organization can demonstrate to 
    the Federal Reserve that its internal model measures the specific 
    risk of covered debt and/or equity positions and that those measures 
    are included in the VAR-based capital charge in section 3(a)(2)(i) 
    of this appendix, then it may reduce or eliminate its specific risk 
    add-on under this section. The determination as to whether a model 
    incorporates specific risk must be made separately for covered debt 
    and equity positions.
        (1) If a model includes the specific risk of covered debt 
    positions but not covered equity positions (or vice versa), then the 
    organization can reduce its specific risk charge for the included 
    positions under paragraph (b) of this section. The specific risk 
    charge for the positions not included equals the standard specific 
    risk capital charge under paragraph (c) of this section.
        (2) If a model addresses the specific risk of both covered debt 
    and equity positions, then the organization can reduce its specific 
    risk charge for both covered debt and equity positions under 
    paragraph (b) of this section. In this case, the comparison 
    described in paragraph (b) of this section must be based on the 
    total VAR-based figure for the specific risk of debt and equity 
    positions, taking account of any correlations that are built into 
    the model.
        (b) VAR-based specific risk capital charge. In all cases where a 
    bank holding company measures specific risk in its internal model, 
    the total capital charge for specific risk (i.e., the VAR-based 
    specific risk capital charge plus the specific risk add-on) must 
    equal at least 50 percent of the standard specific risk capital 
    charge (this amount is the minimum specific risk charge).
        (1) If the portion of an organization's VAR measure that is 
    attributable to specific risk (multiplied by the organization's 
    multiplication factor if required in section 3(a)(2) of this 
    appendix) is greater than or equal to the minimum specific risk 
    charge, then the organization has no specific risk add-on and its 
    capital charge for specific risk is the portion included in the VAR 
    measure.
        (2) If the portion of an organization's VAR measure that is 
    attributable to specific risk (multiplied by the organization's 
    multiplication factor if required in section 3(a)(2) of this 
    appendix) is less than the minimum specific risk charge, then the 
    organization's specific risk add-on is the difference between the 
    minimum specific risk charge and the specific risk portion of the 
    VAR measure (multiplied by the multiplication factor if required in 
    section 3(a)(2) of this appendix).
        (c) Standard specific risk capital charge. The standard specific 
    risk capital charge equals the sum of the components for covered 
    debt and equity positions as follows:
        (1) Covered debt positions. (i) For purposes of this section 5, 
    covered debt positions means fixed-rate or floating-rate debt 
    instruments located in the trading account or instruments located in 
    the trading account with values that react primarily to changes in 
    interest rates, including certain non-
    
    [[Page 47375]]
    
    convertible preferred stock, convertible bonds, and instruments 
    subject to repurchase and lending agreements. Also included are 
    derivatives (including written and purchased options) for which the 
    underlying instrument is a covered debt instrument that is subject 
    to a non-zero specific risk capital charge.
        (A) For covered debt positions that are derivatives, an 
    organization must risk-weight (as described in paragraph (c)(1)(iii) 
    of this section) the market value of the effective notional amount 
    of the underlying debt instrument or index portfolio. Swaps must be 
    included as the notional position in the underlying debt instrument 
    or index portfolio, with a receiving side treated as a long position 
    and a paying side treated as a short position; and
        (B) For covered debt positions that are options, whether long or 
    short, an organization must risk-weight (as described in paragraph 
    (c)(1)(iii) of this section) the market value of the effective 
    notional amount of the underlying debt instrument or index 
    multiplied by the option's delta.
        (ii) An organization may net long and short covered debt 
    positions (including derivatives) in identical debt issues or 
    indices.
        (iii) An organization must multiply the absolute value of the 
    current market value of each net long or short covered debt position 
    by the appropriate specific risk weighting factor indicated in Table 
    2 of this appendix. The specific risk capital charge component for 
    covered debt positions is the sum of the weighted values.
    
      Table 2.--Specific Risk Weighting Factors for Covered Debt Positions  
    ------------------------------------------------------------------------
                                                                   Weighting
                                             Remaining maturity      factor 
                  Category                     (contractual)          (in   
                                                                    percent)
    ------------------------------------------------------------------------
    Government..........................  N/A....................       0.00
    Qualifying..........................  6 months or less.......       0.25
                                          Over 6 months to 24           1.00
                                           months.                          
                                          Over 24 months.........       1.60
    Other...............................  N/A....................       8.00
    ------------------------------------------------------------------------
    
        (A) The government category includes all debt instruments of 
    central governments of OECD-based countries 14 including bonds, 
    Treasury bills, and other short-term instruments, as well as local 
    currency instruments of non-OECD central governments to the extent 
    the organization has liabilities booked in that currency.
    ---------------------------------------------------------------------------
    
        \14\ Organization for Economic Cooperation and Development 
    (OECD)-based countries is defined in appendix A of this part.
    ---------------------------------------------------------------------------
    
        (B) The qualifying category includes debt instruments of U.S. 
    government-sponsored agencies, general obligation debt instruments 
    issued by states and other political subdivisions of OECD-based 
    countries, multilateral development banks, and debt instruments 
    issued by U.S. depository institutions or OECD banks that do not 
    qualify as capital of the issuing institution.15 This category 
    also includes other debt instruments, including corporate debt and 
    revenue instruments issued by states and other political 
    subdivisions of OECD countries, that are:
    ---------------------------------------------------------------------------
    
        \15\ U.S. government-sponsored agencies, multilateral 
    development banks, and OECD banks are defined in appendix A of this 
    part.
    ---------------------------------------------------------------------------
    
        (1) Rated investment-grade by at least two nationally recognized 
    credit rating services;
        (2) Rated investment grade by one nationally recognized credit 
    rating agency and not rated less than investment grade by any other 
    credit rating agency; or
        (3) Unrated, but deemed to be of comparable investment quality 
    by the reporting organization and the issuer has instruments listed 
    on a recognized stock exchange, subject to review by the Federal 
    Reserve.
        (C) The other category includes debt instruments that are not 
    included in the government or qualifying categories.
        (2) Covered equity positions. (i) For purposes of this section 
    5, covered equity positions means equity instruments located in the 
    trading account and instruments located in the trading account with 
    values that react primarily to changes in equity prices, including 
    voting or non-voting common stock, certain convertible bonds, and 
    commitments to buy or sell equity instruments. Also included are 
    derivatives (including written or purchased options) for which the 
    underlying is a covered equity position.
        (A) For covered equity positions that are derivatives, an 
    organization must risk weight (as described in paragraph (c)(2)(iii) 
    of this section) the market value of the effective notional amount 
    of the underlying equity instrument or equity portfolio. Swaps must 
    be included as the notional position in the underlying equity 
    instrument or index portfolio, with a receiving side treated as a 
    long position and a paying side treated as a short position; and
        (B) For covered equity positions that are options, whether long 
    or short, an organization must risk weight (as described in 
    paragraph (c)(2)(iii) of this section) the market value of the 
    effective notional amount of the underlying equity instrument or 
    index multiplied by the option's delta.
        (ii) An organization may net long and short covered equity 
    positions (including derivatives) in identical equity issues or 
    equity indices in the same market.16
    ---------------------------------------------------------------------------
    
        \16\ An organization may also net positions in depository 
    receipts against an opposite position in the underlying equity or 
    identical equity in different markets, provided that the 
    organization includes the costs of conversion.
    ---------------------------------------------------------------------------
    
        (iii)(A) An organization must multiply the absolute value of the 
    current market value of each net long or short covered equity 
    position by a risk weighting factor of 8.0 percent, or by 4.0 
    percent if the equity is held in a portfolio that is both liquid and 
    well-diversified.17 For covered equity positions that are index 
    contracts comprising a well-diversified portfolio of equity 
    instruments, the net long or short position is to be multiplied by a 
    risk weighting factor of 2.0 percent.
    ---------------------------------------------------------------------------
    
        \17\ A portfolio is liquid and well-diversified if: (1) it is 
    characterized by a limited sensitivity to price changes of any 
    single equity issue or closely related group of equity issues held 
    in the portfolio; (2) the volatility of the portfolio's value is not 
    dominated by the volatility of any individual equity issue or by 
    equity issues from any single industry or economic sector; (3) it 
    contains a large number of individual equity positions, with no 
    single position representing a substantial portion of the 
    portfolio's total market value; and (4) it consists mainly of issues 
    traded on organized exchanges or in well-established over-the-
    counter markets.
    ---------------------------------------------------------------------------
    
        (B) For covered equity positions from the following futures-
    related arbitrage strategies, an organization may apply a 2.0 
    percent risk weighting factor to one side (long or short) of each 
    equity position with the opposite side exempt from charge, subject 
    to review by the Federal Reserve:
        (1) Long and short positions in exactly the same index at 
    different dates or in different market centers; or
        (2) Long and short positions in index contracts at the same date 
    in different but similar indices.
        (C) For futures contracts on broadly-based indices that are 
    matched by offsetting positions in a basket of stocks comprising the 
    index, an organization may apply a 2.0 percent risk weighting factor 
    to the futures and stock basket positions (long and short), provided 
    that such trades are deliberately entered into and separately 
    controlled, and that the basket of stocks comprises at least 90 
    percent of the capitalization of the index.
        (iv) The specific risk capital charge component for covered 
    equity positions is the sum of the weighted values.
    
        By order of the Board of Governors of the Federal Reserve 
    System, August 29, 1996.
    William W. Wiles,
    Secretary of the Board.
    
    Federal Deposit Insurance Corporation
    
    12 CFR CHAPTER III
    
        For the reasons indicated in the preamble, the FDIC Board of 
    Directors hereby amends part 325 of chapter III of title 12 of the Code 
    of Federal Regulations as follows.
    
    PART 325--[AMENDED]
    
        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, 4808; 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. Appendix A to part 325 is amended in the introductory text, by 
    adding a new paragraph after the third undesignated paragraph to read 
    as follows:
    
    Appendix A to Part 325--Statement of Policy on Risk-Based Capital
    
    * * * * *
        In addition, when certain banks that engage in trading 
    activities calculate their risk-based capital ratio under this 
    appendix A, they must also refer to appendix C of this
    
    [[Page 47376]]
    
    part, which incorporates capital charges for certain market risks 
    into the risk-based capital ratio. When calculating their risk-based 
    capital ratio under this appendix A, such banks are required to 
    refer to appendix C of this part for supplemental rules to determine 
    qualifying and excess capital, calculate risk-weighted assets, 
    calculate market risk equivalent assets and add them to risk-
    weighted assets, and calculate risk-based capital ratios as adjusted 
    for market risk.
    * * * * *
        3. A new appendix C is added to part 325 to read as follows:
    
    Appendix C to Part 325--Risk-Based Capital for State Non-Member 
    Banks; Market Risk
    
    Section 1. Purpose, Applicability, Scope, and Effective Date
    
        (a) Purpose. The purpose of this appendix is to ensure that 
    banks with significant exposure to market risk maintain adequate 
    capital to support that exposure.1 This appendix supplements 
    and adjusts the risk-based capital ratio calculations under appendix 
    A of this part with respect to those banks.
    ---------------------------------------------------------------------------
    
        \1\ This appendix is based on a framework developed jointly by 
    supervisory authorities from the countries represented on the Basle 
    Committee on Banking Supervision and endorsed by the Group of Ten 
    Central Bank Governors. The framework is described in a Basle 
    Committee paper entitled ``Amendment to the Capital Accord to 
    Incorporate Market Risk,'' January 1996.
    ---------------------------------------------------------------------------
    
        (b) Applicability. (1) This appendix applies to any insured 
    state nonmember bank whose trading activity 2 (on a worldwide 
    consolidated basis) equals:
    ---------------------------------------------------------------------------
    
        \2\ Trading activity means the gross sum of trading assets and 
    liabilities as reported in the bank's most recent quarterly 
    Consolidated Report of Condition and Income (Call Report).
    ---------------------------------------------------------------------------
    
        (i) 10 percent or more of total assets; 3 or
    ---------------------------------------------------------------------------
    
        \3\ Total assets means quarter-end total assets as reported in 
    the bank's most recent Call Report.
    ---------------------------------------------------------------------------
    
        (ii) $1 billion or more.
        (2) The FDIC may additionally apply this appendix to any insured 
    state nonmember bank if the FDIC deems it necessary or appropriate 
    for safe and sound banking practices.
        (3) The FDIC may exclude an insured state nonmember bank 
    otherwise meeting the criteria of paragraph (b)(1) of this section 
    from coverage under this appendix if it determines the bank meets 
    such criteria as a consequence of accounting, operational, or 
    similar considerations, and the FDIC deems it consistent with safe 
    and sound banking practices.
        (c) Scope. The capital requirements of this appendix support 
    market risk associated with a bank's covered positions.
        (d) Effective date. This appendix is effective as of January 1, 
    1997. Compliance is not mandatory until January 1, 1998. Subject to 
    supervisory approval, a bank may opt to comply with this appendix as 
    early as January 1, 1997.4
    ---------------------------------------------------------------------------
    
        \4\ A bank that voluntarily complies with the final rule prior 
    to January 1, 1998, must comply with all of its provisions.
    ---------------------------------------------------------------------------
    
    Section 2. Definitions
    
        For purposes of this appendix, the following definitions apply:
        (a) Covered positions means all positions in a bank's trading 
    account, and all foreign exchange 5 and commodity positions, 
    whether or not in the trading account.6 Positions include on-
    balance-sheet assets and liabilities and off-balance-sheet items. 
    Securities subject to repurchase and lending agreements are included 
    as if they are still owned by the lender.
    ---------------------------------------------------------------------------
    
        \5\ Subject to FDIC review, a bank may exclude structural 
    positions in foreign currencies from its covered positions.
        \6\ The term trading account is defined in the instructions to 
    the Call Report.
    ---------------------------------------------------------------------------
    
        (b) Market risk means the risk of loss resulting from movements 
    in market prices. Market risk consists of general market risk and 
    specific risk components.
        (1) General market risk means changes in the market value of 
    covered positions resulting from broad market movements, such as 
    changes in the general level of interest rates, equity prices, 
    foreign exchange rates, or commodity prices.
        (2) Specific risk means changes in the market value of specific 
    positions due to factors other than broad market movements and 
    includes such risk as the credit risk of an instrument's issuer.
        (c) Tier 1 and Tier 2 capital are defined in appendix A of this 
    part.
        (d) Tier 3 capital is subordinated debt that is unsecured; is 
    fully paid up; has an original maturity of at least two years; is 
    not redeemable before maturity without prior approval by the FDIC; 
    includes a lock-in clause precluding payment of either interest or 
    principal (even at maturity) if the payment would cause the issuing 
    bank's risk-based capital ratio to fall or remain below the minimum 
    required under appendix A of this part; and does not contain and is 
    not covered by any covenants, terms, or restrictions that are 
    inconsistent with safe and sound banking practices.
        (e) Value-at-risk (VAR) means the estimate of the maximum amount 
    that the value of covered positions could decline during a fixed 
    holding period within a stated confidence level, measured in 
    accordance with section 4 of this appendix.
    
    Section 3. Adjustments to the Risk-Based Capital Ratio 
    Calculations.
    
        (a) Risk-based capital ratio denominator. A bank subject to this 
    appendix shall calculate its risk-based capital ratio denominator as 
    follows:
        (1) Adjusted risk-weighted assets. Calculate adjusted risk-
    weighted assets, which equals risk-weighted assets (as determined in 
    accordance with appendix A of this part), excluding the risk-
    weighted amounts of all covered positions (except foreign exchange 
    positions outside the trading account and over-the-counter 
    derivative positions).7
    ---------------------------------------------------------------------------
    
        \7\ Foreign exchange positions outside the trading account and 
    all over-the-counter derivative positions, whether or not in the 
    trading account, must be included in adjusted risk weighted assets 
    as determined in appendix A of this part.
    ---------------------------------------------------------------------------
    
        (2) Measure for market risk. Calculate the measure for market 
    risk, which equals the sum of the VAR-based capital charge, the 
    specific risk add-on (if any), and the capital charge for de minimis 
    exposures (if any).
        (i) VAR-based capital charge. The VAR-based capital charge 
    equals the higher of:
        (A) The previous day's VAR measure; or
        (B) The average of the daily VAR measures for each of the 
    preceding 60 business days multiplied by three, except as provided 
    in section 4(e) of this appendix;
        (ii) Specific risk add-on. The specific risk add-on is 
    calculated in accordance with section 5 of this appendix; and
        (iii) Capital charge for de minimis exposure. The capital charge 
    for de minimis exposure is calculated in accordance with section 
    4(a) of this appendix.
        (3) Market risk equivalent assets. Calculate market risk 
    equivalent assets by multiplying the measure for market risk (as 
    calculated in paragraph (a)(2) of this section) by 12.5.
        (4) Denominator calculation. Add market risk equivalent assets 
    (as calculated in paragraph (a)(3) of this section) to adjusted 
    risk-weighted assets (as calculated in paragraph (a)(1) of this 
    section). The resulting sum is the bank's risk-based capital ratio 
    denominator.
        (b) Risk-based capital ratio numerator. A bank subject to this 
    appendix shall calculate its risk-based capital ratio numerator by 
    allocating capital as follows:
        (1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital 
    equal to 8.0 percent of adjusted risk-weighted assets (as calculated 
    in paragraph (a)(1) of this section).8
    ---------------------------------------------------------------------------
    
        \8\ A bank may not allocate Tier 3 capital to support credit 
    risk (as calculated under appendix A of this part).
    ---------------------------------------------------------------------------
    
        (2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3 
    capital equal to the measure for market risk as calculated in 
    paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3 
    capital allocated for market risk must not exceed 250 percent of 
    Tier 1 capital allocated for market risk. (This requirement means 
    that Tier 1 capital allocated in this paragraph (b)(2) must equal at 
    least 28.6 percent of the measure for market risk.)
        (3) Restrictions. (i) The sum of Tier 2 capital (both allocated 
    and excess) and Tier 3 capital (allocated in paragraph (b)(2) of 
    this section) may not exceed 100 percent of Tier 1 capital (both 
    allocated and excess).9
    ---------------------------------------------------------------------------
    
        \9\ Excess Tier 1 capital means Tier 1 capital that has not been 
    allocated in paragraphs (b)(1) and (b)(2) of this section. Excess 
    Tier 2 capital means Tier 2 capital that has not been allocated in 
    paragraph (b)(1) and (b)(2) of this section, subject to the 
    restrictions in paragraph (b)(3) of this section.
    ---------------------------------------------------------------------------
    
        (ii) Term subordinated debt (and intermediate-term preferred 
    stock and related surplus) included in Tier 2 capital (both 
    allocated and excess) may not exceed 50 percent of Tier 1 capital 
    (both allocated and excess).
        (4) Numerator calculation. Add Tier 1 capital (both allocated 
    and excess), Tier 2 capital (both allocated and excess), and Tier 3 
    capital (allocated under paragraph (b)(2) of this section). The 
    resulting sum is the bank's risk-based capital ratio numerator.
    
    Section 4. Internal Models
    
        (a) General. For risk-based capital purposes, a bank subject to 
    this appendix
    
    [[Page 47377]]
    
    must use its internal model to measure its daily VAR, in accordance 
    with the requirements of this section.10 The FDIC may permit a 
    bank to use alternative techniques to measure the market risk of de 
    minimis exposures so long as the techniques adequately measure 
    associated market risk.
    ---------------------------------------------------------------------------
    
        \10\ A bank's internal model may use any generally accepted 
    measurement techniques, such as variance-covariance models, 
    historical simulations, or Monte Carlo simulations. However, the 
    level of sophistication and accuracy of a bank's internal model must 
    be commensurate with the nature and size of its covered positions. A 
    bank that modifies its existing modeling procedures to comply with 
    the requirements of this appendix for risk-based capital purposes 
    should, nonetheless, continue to use the internal model it considers 
    most appropriate in evaluating risks for other purposes.
    ---------------------------------------------------------------------------
    
        (b) Qualitative requirements. A bank subject to this appendix 
    must have a risk management system that meets the following minimum 
    qualitative requirements:
        (1) The bank must have a risk control unit that reports directly 
    to senior management and is independent from business trading units.
        (2) The bank's internal risk measurement model must be 
    integrated into the daily management process.
        (3) The bank's policies and procedures must identify, and the 
    bank must conduct, appropriate stress tests and backtests.11 
    The bank's policies and procedures must identify the procedures to 
    follow in response to the results of such tests.
    ---------------------------------------------------------------------------
    
        \11\ Stress tests provide information about the impact of 
    adverse market events on a bank's covered positions. Backtests 
    provide information about the accuracy of an internal model by 
    comparing a bank's daily VAR measures to its corresponding daily 
    trading profits and losses.
    ---------------------------------------------------------------------------
    
        (4) The bank must conduct independent reviews of its risk 
    measurement and risk management systems at least annually.
        (c) Market risk factors. The bank's internal model must use risk 
    factors sufficient to measure the market risk inherent in all 
    covered positions. The risk factors must address interest rate 
    risk,12 equity price risk, foreign exchange rate risk, and 
    commodity price risk.
    ---------------------------------------------------------------------------
    
        \12\ For material exposures in the major currencies and markets, 
    modeling techniques must capture spread risk and must incorporate 
    enough segments of the yield curve--at least six--to capture 
    differences in volatility and less than perfect correlation of rates 
    along the yield curve.
    ---------------------------------------------------------------------------
    
        (d) Quantitative requirements. For regulatory capital purposes, 
    VAR measures must meet the following quantitative requirements:
        (1) The VAR measures must be calculated on a daily basis using a 
    99 percent, one-tailed confidence level with a price shock 
    equivalent to a ten-business day movement in rates and prices. In 
    order to calculate VAR measures based on a ten-day price shock, the 
    bank may either calculate ten-day figures directly or convert VAR 
    figures based on holding periods other than ten days to the 
    equivalent of a ten-day holding period (for instance, by multiplying 
    a one-day VAR measure by the square root of ten).
        (2) The VAR measures must be based on an historical observation 
    period (or effective observation period for a bank using a weighting 
    scheme or other similar method) of at least one year. The bank must 
    update data sets at least once every three months or more frequently 
    as market conditions warrant.
        (3) The VAR measures must include the risks arising from the 
    non-linear price characteristics of options positions and the 
    sensitivity of the market value of the positions to changes in the 
    volatility of the underlying rates or prices. A bank with a large or 
    complex options portfolio must measure the volatility of options 
    positions by different maturities.
        (4) The VAR measures may incorporate empirical correlations 
    within and across risk categories, provided that the bank's process 
    for measuring correlations is sound. In the event that the VAR 
    measures do not incorporate empirical correlations across risk 
    categories, then the bank must add the separate VAR measures for the 
    four major risk categories to determine its aggregate VAR measure.
        (e) Backtesting. (1) Beginning one year after a bank starts to 
    comply with this appendix, a bank must conduct backtesting by 
    comparing each of its most recent 250 business days' actual net 
    trading profit or loss 13 with the corresponding daily VAR 
    measures generated for internal risk measurement purposes and 
    calibrated to a one-day holding period and a 99 percent, one-tailed 
    confidence level.
    ---------------------------------------------------------------------------
    
        \13\ Actual net trading profits and losses typically include 
    such things as realized and unrealized gains and losses on portfolio 
    positions as well as fee income and commissions associated with 
    trading activities.
    ---------------------------------------------------------------------------
    
        (2) Once each quarter, the bank must identify the number of 
    exceptions, that is, the number of business days for which the 
    magnitude of the actual daily net trading loss, if any, exceeds the 
    corresponding daily VAR measure.
        (3) A bank must use the multiplication factor indicated in Table 
    1 of this appendix in determining its capital charge for market risk 
    under section 3(a)(2)(i)(B) of this appendix until it obtains the 
    next quarter's backtesting results, unless the FDIC determines that 
    a different adjustment or other action is appropriate.
    
         Table 1.--Multiplication Factor Based on Results of Backtesting    
    ------------------------------------------------------------------------
                                                              Multiplication
                      Number of exceptions                        factor    
    ------------------------------------------------------------------------
    4 or fewer..............................................          3.00  
    5.......................................................          3.40  
    6.......................................................          3.50  
    7.......................................................          3.65  
    8.......................................................          3.75  
    9.......................................................          3.85  
    10 or more..............................................          4.00  
    ------------------------------------------------------------------------
    
    Section 5. Specific Risk
    
        (a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of 
    this appendix, a bank's specific risk add-on equals the standard 
    specific risk capital charge calculated under paragraph (c) of this 
    section. If, however, a bank can demonstrate to the FDIC that its 
    internal model measures the specific risk of covered debt and/or 
    equity positions and that those measures are included in the VAR-
    based capital charge in section 3(a)(2)(i) of this appendix, then 
    the bank may reduce or eliminate its specific risk add-on under this 
    section. The determination as to whether a model incorporates 
    specific risk must be made separately for covered debt and equity 
    positions.
        (1) If a model includes the specific risk of covered debt 
    positions but not covered equity positions (or vice versa), then the 
    bank can reduce its specific risk charge for the included positions 
    under paragraph (b) of this section. The specific risk charge for 
    the positions not included equals the standard specific risk capital 
    charge under paragraph (c) of this section.
        (2) If a model addresses the specific risk of both covered debt 
    and equity positions, then the bank can reduce its specific risk 
    charge for both covered debt and equity positions under paragraph 
    (b) of this section. In this case, the comparison described in 
    paragraph (b) of this section must be based on the total VAR-based 
    figure for the specific risk of debt and equity positions, taking 
    into account any correlations that are built into the model.
        (b) VAR-based specific risk capital charge. In all cases where a 
    bank measures specific risk in its internal model, the total capital 
    charge for specific risk (i.e., the VAR-based specific risk capital 
    charge plus the specific risk add-on) must equal at least 50 percent 
    of the standard specific risk capital charge (this amount is the 
    minimum specific risk charge).
        (1) If the portion of a bank's VAR measure that is attributable 
    to specific risk (multiplied by the bank's multiplication factor if 
    required in section 3(a)(2) of this appendix) is greater than or 
    equal to the minimum specific risk charge, then the bank has no 
    specific risk add-on and its capital charge for specific risk is the 
    portion included in the VAR measure.
        (2) If the portion of a bank's VAR measure that is attributable 
    to specific risk (multiplied by the bank's multiplication factor if 
    required in section 3(a)(2) of this appendix) is less than the 
    minimum specific risk charge, then the bank's specific risk add-on 
    is the difference between the minimum specific risk charge and the 
    specific risk portion of the VAR measure (multiplied by the bank's 
    multiplication factor if required in section 3(a)(2) of this 
    appendix).
        (c) Standard specific risk capital charge. The standard specific 
    risk capital charge equals the sum of the components for covered 
    debt and equity positions as follows:
        (1) Covered debt positions. (i) For purposes of this section 5, 
    covered debt positions means fixed-rate or floating-rate debt 
    instruments located in the trading account and instruments located 
    in the trading account with values that react primarily to changes 
    in interest rates, including certain non-convertible preferred 
    stock, convertible bonds, and instruments subject to repurchase and 
    lending agreements. Also included are derivatives (including written 
    and purchased options) for which the underlying instrument is a 
    covered debt instrument that is subject to a non-zero specific risk 
    capital charge.
        (A) For covered debt positions that are derivatives, a bank must 
    risk-weight (as
    
    [[Page 47378]]
    
    described in paragraph (c)(1)(iii) of this section) the market value 
    of the effective notional amount of the underlying debt instrument 
    or index portfolio. Swaps must be included as the notional position 
    in the underlying debt instrument or index portfolio, with a 
    receiving side treated as a long position and a paying side treated 
    as a short position; and
        (B) For covered debt positions that are options, whether long or 
    short, a bank must risk-weight (as described in paragraph 
    (c)(1)(iii) of this section) the market value of the effective 
    notional amount of the underlying debt instrument or index 
    multiplied by the option's delta.
        (ii) A bank may net long and short covered debt positions 
    (including derivatives) in identical debt issues or indices.
        (iii) A bank must multiply the absolute value of the current 
    market value of each net long or short covered debt position by the 
    appropriate specific risk weighting factor indicated in Table 2 of 
    this appendix. The specific risk capital charge component for 
    covered debt positions is the sum of the weighted values.
    
      Table 2.--Specific Risk Weighting Factors for Covered Debt Positions  
    ------------------------------------------------------------------------
                                                                   Weighting
                  Category                  Remaining maturity    factor (in
                                              (contractual)        percent) 
    ------------------------------------------------------------------------
    Government.........................  N/A....................        0.00
    Qualifying.........................  6 months or less.......        0.25
                                         Over 6 months to 24            1.00
                                          months.                           
                                         Over 24 months.........        1.60
    Other..............................  N/A....................        8.00
    ------------------------------------------------------------------------
    
        (A) The government category includes all debt instruments of 
    central governments of OECD-based countries 14 including bonds, 
    Treasury bills, and other short-term instruments, as well as local 
    currency instruments of non-OECD central governments to the extent 
    the bank has liabilities booked in that currency.
    ---------------------------------------------------------------------------
    
        \14\  Organization for Economic Cooperation and Development 
    (OECD)-based countries is defined in appendix A of this part.
    ---------------------------------------------------------------------------
    
        (B) The qualifying category includes debt instruments of U.S. 
    government-sponsored agencies, general obligation debt instruments 
    issued by states and other political subdivisions of OECD-based 
    countries, multilateral development banks, and debt instruments 
    issued by U.S. depository institutions or OECD-banks that do not 
    qualify as capital of the issuing institution.15 This category 
    also includes other debt instruments, including corporate debt and 
    revenue instruments issued by states and other political 
    subdivisions of OECD countries, that are:
    ---------------------------------------------------------------------------
    
        \15\  U.S. government-sponsored agencies, multilateral 
    development banks, and OECD banks are defined in appendix A of this 
    part.
    ---------------------------------------------------------------------------
    
        (1) Rated investment-grade by at least two nationally recognized 
    credit rating services;
        (2) Rated investment-grade by one nationally recognized credit 
    rating agency and not rated less than investment-grade by any other 
    credit rating agency; or
        (3) Unrated, but deemed to be of comparable investment quality 
    by the reporting bank and the issuer has instruments listed on a 
    recognized stock exchange, subject to review by the FDIC.
        (C) The other category includes debt instruments that are not 
    included in the government or qualifying categories.
        (2) Covered equity positions. (i) For purposes of this section 
    5, covered equity positions means equity instruments located in the 
    trading account and instruments located in the trading account with 
    values that react primarily to changes in equity prices, including 
    voting or non-voting common stock, certain convertible bonds, and 
    commitments to buy or sell equity instruments. Also included are 
    derivatives (including written and purchased options) for which the 
    underlying is a covered equity position.
        (A) For covered equity positions that are derivatives, a bank 
    must risk weight (as described in paragraph (c)(2)(iii) of this 
    section) the market value of the effective notional amount of the 
    underlying equity instrument or equity portfolio. Swaps must be 
    included as the notional position in the underlying equity 
    instrument or index portfolio, with a receiving side treated as a 
    long position and a paying side treated as a short position; and
        (B) For covered equity positions that are options, whether long 
    or short, a bank must risk weight (as described in paragraph 
    (c)(2)(iii) of this section) the market value of the effective 
    notional amount of the underlying equity instrument or index 
    multiplied by the option's delta.
        (ii) A bank may net long and short covered equity positions 
    (including derivatives) in identical equity issues or equity indices 
    in the same market.16
    ---------------------------------------------------------------------------
    
        \16\ A bank may also net positions in depository receipts 
    against an opposite position in the underlying equity or identical 
    equity in different markets, provided that the bank includes the 
    costs of conversion.
    ---------------------------------------------------------------------------
    
        (iii)(A) A bank must multiply the absolute value of the current 
    market value of each net long or short covered equity position by a 
    risk weighting factor of 8.0 percent, or by 4.0 percent if the 
    equity is held in a portfolio that is both liquid and well-
    diversified.17 For covered equity positions that are index 
    contracts comprising a well-diversified portfolio of equity 
    instruments, the net long or short position is multiplied by a risk 
    weighting factor of 2.0 percent.
    ---------------------------------------------------------------------------
    
        \17\ A portfolio is liquid and well-diversified if: (1) it is 
    characterized by a limited sensitivity to price changes of any 
    single equity issue or closely related group of equity issues held 
    in the portfolio; (2) the volatility of the portfolio's value is not 
    dominated by the volatility of any individual equity issue or by 
    equity issues from any single industry or economic sector; (3) it 
    contains a large number of individual equity positions, with no 
    single position representing a substantial portion of the 
    portfolio's total market value; and (4) it consists mainly of issues 
    traded on organized exchanges or in well-established over-the-
    counter markets.
    ---------------------------------------------------------------------------
    
        (B) For covered equity positions from the following futures-
    related arbitrage strategies, a bank may apply a 2.0 percent risk 
    weighting factor to one side (long or short) of each position with 
    the opposite side exempt from charge, subject to review by the FDIC:
        (1) Long and short positions in exactly the same index at 
    different dates or in different market centers; or
        (2) Long and short positions in index contracts at the same date 
    in different but similar indices.
        (C) For futures contracts on broadly-based indices that are 
    matched by offsetting positions in a basket of stocks comprising the 
    index, a bank may apply a 2.0 percent risk weighting factor to the 
    futures and stock basket positions (long and short), provided that 
    such trades are deliberately entered into and separately controlled, 
    and that the basket of stocks comprises at least 90 percent of the 
    capitalization of the index.
        (iv) The specific risk capital charge component for covered 
    equity positions is the sum of the weighted values.
    
        By Order of the Board of Directors.
    
        Dated at Washington, D.C., this 13th day of August, 1996.
    
    Federal Deposit Insurance Corporation.
    Jerry L. Langley,
    Executive Secretary.
    [FR Doc. 96-22546 Filed 9-5-96; 8:45 am]
    BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P
    
    
    

Document Information

Published:
09/06/1996
Department:
Federal Deposit Insurance Corporation
Entry Type:
Rule
Action:
Joint final rule.
Document Number:
96-22546
Pages:
47358-47378 (21 pages)
Docket Numbers:
Docket No. 96-18, Regulations H and Y, Docket No. R-0884
RINs:
1557-AB14: Capital Rules, 3064-AB64: Capital Maintenance; Risk-Based Capital Standards: Market Risk
RIN Links:
https://www.federalregister.gov/regulations/1557-AB14/capital-rules, https://www.federalregister.gov/regulations/3064-AB64/capital-maintenance-risk-based-capital-standards-market-risk
PDF File:
96-22546.pdf
CFR: (2)
12 CFR 3.6
12 CFR 208.13