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Trading and Capital-Markets Activities Manual

Trading Activities: Capital Adequacy
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

As with all risk-bearing activities, the risk exposures a banking organization assumes in its trading, derivative, and capital-markets activities should be fully supported by an adequate capital position. Accordingly, banking organizations should ensure that their capital positions are sufficiently strong to support all trading and capital-markets risks on a fully consolidated basis and that adequate capital is maintained in all affiliated entities engaged in these activities. Institutions with significant trading activities should have reasonable methods to measure the risks of their activities and allocate capital against the economic substance of those risks. To that extent, regulatory capital requirements should be viewed as minimum requirements, and those institutions exposed to a high or inordinate degree of risk or forms of risk that may not be fully addressed in regulatory requirements are expected to operate above minimum regulatory standards consistent with the economic substance of the risks entailed. 

As the baseline for capital-adequacy assessment, bank supervisors first consider an organization's risk-based capital ratio; that is, the ratio of qualifying capital to assets and off-balance-sheet items that have been ''risk weighted'' according to perceived credit risk. Supervisors also focus on the tier 1 leverage ratio to help assess capital adequacy. For banking organizations with significant trading activities, the risk-based capital ratio also takes into account an institution's exposure to market risk.1 

RISK-BASED CAPITAL MEASURE 

The principal objectives of the risk-based capital measure2 are to (1) make regulatory capital requirements generally sensitive to differences in risk profiles among banking organizations; (2) factor off-balance-sheet exposures into the assessment of capital adequacy; (3) minimize disincentives to holding liquid, low-risk assets; and (4) achieve greater consistency in the evaluation of the capital adequacy of major banks throughout the world. The risk-based capital measure focuses primarily on the credit risk associated with the nature of banking organizations' on- and off-balance-sheet exposures and on the type and quality of their capital. It provides a definition of capital and a framework for calculating risk-weighted assets by assigning assets and off-balance-sheet items to broad categories of credit risk. A banking organization's risk-based capital ratio is calculated by dividing its qualifying capital by its risk-weighted assets. The risk-based capital measure sets forth minimum supervisory capital standards that apply to all banking organizations on a consolidated basis. 

The risk-based capital ratio focuses principally on broad categories of credit risk. For most banking organizations, the ratio does not incorporate other risk factors that may affect the organization's financial condition. These factors may include overall interest-rate exposure; liquidity, funding, and market risks; the quality and level of earnings; investment or loan portfolio concentrations; the effectiveness of loan and investment policies; the quality of assets; and management's ability to monitor and control financial and operating risks. An overall assessment of capital adequacy must take into account these other factors and may differ significantly from conclusions that might be drawn solely from the level of an organization's risk-based capital ratio. 

Definition of Capital 

For risk-based capital purposes, a banking organization's capital consists of two major components: core capital elements (tier 1 capital) and supplementary capital elements (tier 2 capital). Core capital elements include common equity including capital stock, surplus, and undivided profits; qualifying non-cumulative perpetual preferred stock (or, for bank holding companies, cumulative perpetual preferred stock, the aggregate of which may not exceed 25 percent of tier 1 capital); and minority interest in the equity accounts of consolidated subsidiaries. Tier 1 capital is generally defined as the sum of core capital elements less goodwill, unrealized holding losses in the available-for-sale equity portfolio, and other intangible assets that do not qualify within capital, as well as any other investments in subsidiaries that the Federal Reserve determines should be deducted from tier 1 capital. Tier 1 capital represents the highest form of capital, namely permanent equity. Tier 2 capital consists of a limited amount of the allowance for loan and lease losses, perpetual preferred stock that does not qualify as tier 1 capital, mandatory convertible securities and other hybrid capital instruments, long-term preferred stock with an original term of 20 years or more, and limited amounts of term subordinated debt, intermediate-term preferred stock, and unrealized holding gains on qualifying equity securities. See section 3020.1, ''Assessment of Capital Adequacy,'' in the Commercial Bank Examination Manual for a complete definition of capital elements. 

Capital investments in unconsolidated banking and finance subsidiaries and reciprocal holdings of other banking organizations' capital instruments are deducted from an organization's capital. The sum of tier 1 and tier 2 capital less any deductions makes up total capital, which is the numerator of the risk-based capital ratio. 

In assessing an institution's capital adequacy, supervisors and examiners should consider the capacity of the institution's paid-in equity and other capital instruments to absorb economic losses. In this regard, it has been the Federal Reserve's long-standing view that common equity (that is, common stock and surplus and retained earnings) should be the dominant component of a banking organization's capital structure and that organizations should avoid undue reliance on non-common-equity capital elements. 3 Common equity allows an organization to absorb losses on an ongoing basis and is permanently available for this purpose. Further, this element of capital best allows organizations to conserve resources when they are under stress because it provides full discretion in the amount and timing of dividends and other distributions. Consequently, common equity is the basis on which most market judgments of capital adequacy are made. 

Consideration of the capacity of an institution's capital structure to absorb losses should also take into account how that structure could be affected by changes in the institution's performance. For example, an institution experiencing a net operating loss-perhaps because of realization of unexpected losses-will face not only a reduction in its retained earnings, but also possible constraints on its access to capital markets. These constraints could be exacerbated should conversion options be exercised to the detriment of the institution. A decrease in common equity, the key element of tier 1 capital, may have further unfavorable implications for an organization's regulatory capital position. The eligible amounts of most types of tier 1 preferred stock and tier 2 or tier 3 capital elements may be reduced, because current capital regulations limit the amount of these elements that can be included in regulatory capital to a maximum percentage of tier 1 capital. Such adverse magnification effects could be further accentuated should adverse events take place at critical junctures for raising or maintaining capital, for example, as limited-life capital instruments are approaching maturity or as new capital instruments are being issued. 

Risk-Weighted Assets 

Each asset and off-balance-sheet item is assigned to one of four broad risk categories based on the obligor or, if relevant, the guarantor or type of collateral. The risk categories are zero, 20, 50, and 100 percent. The standard risk category, which includes the majority of items, is 100 percent. The appropriate dollar value of the amount in each category is multiplied by the risk weight associated with that category. The weighted values are added together and the resulting sum is the organization's risk-weighted assets, the denominator of the risk-based capital ratio.4 

Off-balance-sheet items are incorporated into the risk-based capital ratio by first being converted into a ''credit-equivalent'' amount. To accomplish this, the face amount of the item is multiplied by a credit conversion factor (zero, 20, 50, or 100 percent). The credit-equivalent amount is then assigned to a risk category in the same manner as on-balance-sheet items. For over-the-counter derivative transactions, the credit-equivalent amount is determined by multiplying the notional principal amount of the underlying contract by a credit-conversion factor and adding the resulting product (which is an estimate of potential future exposure) to the positive mark-to-market value of the contract (which is the current exposure). A contract with a negative mark-to-market value is treated as having a current exposure of zero. (See ''Credit-Equivalent Computations for Derivative Contracts'' below.) 

The primary determinant of the appropriate risk category for a particular off-balance-sheet item is the obligor. Collateral or guarantees may be used to a limited extent to assign an item to a lower risk category than would be available to the obligor. The forms of collateral generally recognized for risk-based capital purposes are cash on deposit in the lending institution; securities issued or guaranteed by central governments of the Organization for Economic Cooperation and Development (OECD) countries,5 U.S. government agencies, or U.S. government-sponsored agencies; and securities issued by multilateral lending institutions or regional development banks in which the U.S. government is a shareholder or contributing member. The only guarantees recognized are those provided by central or state and local governments of the OECD countries, U.S. government agencies, U.S. government-sponsored agencies, multilateral lending institutions or regional development banks in which the United States is a shareholder or contributing member, U.S. depository institutions, and foreign banks. 

Banking organizations are expected to meet a minimum ratio of capital to risk-weighted assets of 8 percent, with at least 4 percent taking the form of tier 1 capital. Organizations that do not meet the minimum ratios, or that are considered to lack sufficient capital to support their activities, are expected to develop and implement capital plans acceptable to the Federal Reserve for achieving adequate levels of capital. 

TIER 1 LEVERAGE RATIO 

The principal objective of the tier 1 leverage measure is to place a constraint on the maximum degree to which a banking organization can leverage its equity capital base.6 A banking organization's tier 1 leverage ratio is calculated by dividing its tier 1 capital by its average total consolidated assets. Generally, average total consolidated assets are defined as the quarterly average total assets reported on the organization's most recent regulatory reports of financial condition, less goodwill, certain other intangible assets, investments in subsidiaries or associated companies, and certain excess deferred-tax assets that are dependent on future taxable income. 

The Federal Reserve has adopted a minimum tier 1 leverage ratio of 3 percent for the most highly rated banks. A state member bank operating at or near this level is expected to have well-diversified risk, including no undue interest-rate-risk exposure; excellent asset quality; high liquidity; good earnings; and in general be considered a strong banking organization rated a composite 1 under the CAMELS rating system for banks. Other state member banks are expected to have a minimum tier 1 leverage ratio of 4 percent. Bank holding companies rated a composite 1 under the BOPEC rating system and those that have implemented the Board's risk-based capital measure for market risk must maintain a minimum tier 1 leverage ratio of 3 percent. Other bank holding companies are expected to have a minimum tier 1 leverage ratio of 4 percent. In all cases, banking organizations should hold capital commensurate with the level and nature of all risks to which they are exposed.
 
1. The market-risk capital rules are mandatory for certain banking organizations with significant exposure to market risk beginning no later than January 1, 1998. See ''Market-Risk Measure,'' below. 
2. The risk-based capital measure is based on a framework developed jointly by supervisory authorities from the G-10 countries. The Federal Reserve implemented the risk-based measure in January 1989. This section provides a brief overview of the current risk-based capital measure. More detailed discussions can be found in the Federal Reserve's Commercial Bank Examination Manual. Specific guidelines for calculating the risk-based capital ratio are found in Regulation H (12 CFR 208, appendixes A and E) for state member banks and in Regulation Y (12 CFR 225, appendixes A and E) for bank holding companies.
3. The Basel Committee on Banking Supervision affirmed this view in a release issued in October 1998, which stated that common shareholders' funds are the key element of capital. 
4. See the Commercial Bank Examination Manual for a complete discussion of risk-weighted assets. 
5. OECD countries are defined to include all full members of the Organization for Economic Cooperation and Development regardless of entry date, as well as countries that have concluded special lending arrangements with the International Monetary Fund (IMF) associated with the IMF's General Arrangements to Borrow, but excludes any country that has rescheduled its external sovereign debt within the previous five years. As of May 1999, the OECD countries were Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. Saudi Arabia has concluded special lending arrangements with the IMF associated with the IMF's General Arrangements to Borrow. 
6. The tier 1 leverage measure, intended to be a supplement to the risk-based capital measure, was adopted by the Federal Reserve in 1990. Guidelines for calculating the tier 1 leverage ratio are found in Regulation H (12 CFR 208, appendix B) for state member banks and in Regulation Y (12 CFR 225, appendix D) for bank holding companies. 

CREDIT-EQUIVALENT COMPUTATIONS FOR DERIVATIVE CONTRACTS

Applicable Derivative Contracts 

Credit-equivalent amounts are computed for each of the following off-balance-sheet contracts: 

interest-rate contracts 
- single-currency interest-rate swaps 
- basis swaps 
- forward rate agreements 
- interest-rate options purchased (including caps, collars, and floors purchased)  - any other instrument linked to interest rates that gives rise to similar credit risks    (including when-issued securities and forward forward deposits accepted) 

exchange-rate contracts 
- cross-currency interest-rate swaps 
- forward foreign-exchange-rate contracts 
- currency options purchased 
- any other instrument linked to exchange rates that gives rise to similar credit risks 

equity derivative contracts 
- equity-linked swaps 
- equity-linked options purchased 
- forward equity-linked contracts 
- any other instrument linked to equities that gives rise to similar credit risks 

commodity (including precious metal) derivative contracts 
- commodity-linked swaps 
- commodity-linked options purchased 
- forward commodity-linked contracts 
- any other instrument linked to commodities that gives rise to similar credit risks 

credit derivatives 
- credit-default swaps 
- total-rate-of-return swaps 
- other types of credit derivatives 

Exceptions 

Exchange-rate contracts with an original maturity of 14 or fewer calendar days and derivative contracts traded on exchanges that require daily receipt and payment of cash variation margin may be excluded from the risk-based ratio calculation. Gold contracts are accorded the same treatment as exchange-rate contracts except that gold contracts with an original maturity of 14 or fewer calendar days are included in the risk-based ratio calculation. Over-the-counter options purchased are included and treated in the same way as other derivative contracts. 

Calculation of Credit-Equivalent Amounts 

The credit-equivalent amount of a derivative contract (excluding credit derivatives) that is not subject to a qualifying bilateral netting contract is equal to the sum of-

  the current exposure (sometimes referred to as the replacement cost) of the contract and 
  an estimate of the potential future credit exposure of the contract. 

The current exposure is determined by the mark-to-market value of the contract. If the mark-to-market value is positive, then the current exposure is equal to that mark-to-market value. If the mark-to-market value is zero or negative, then the current exposure is zero. Mark-to-market values are measured in dollars, regardless of the currency or currencies specified in the contract, and should reflect changes in the relevant rates, as well as in counterparty credit quality. 

The potential future credit exposure of a contract, including a contract with a negative mark-to-market value, is estimated by multiplying the notional principal amount of the contract by a credit-conversion factor. Banking organizations should use, subject to examiner review, the effective rather than the apparent or stated notional amount in this calculation. The conversion factors (in percent) are in table 1. The Board has noted that these conversion factors, which are based on observed volatilities of the particular types of instruments, are subject to review and modification in light of changing volatilities or market conditions. 




For a contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so that the market value of the contract is zero, the remaining maturity is equal to the time until the next reset date. For an interest-rate contract with a remaining maturity of more than one year that meets these criteria, the minimum conversion factor is 0.5 percent. 

For a contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments in the contract. A derivative contract not included in the definitions of interest-rate, exchange-rate, equity, or commodity contracts is subject to the same conversion factors as a commodity, excluding precious metals. 

No potential future credit exposure is calculated for a single-currency interest-rate swap in which payments are made based on two floating-rate indexes, so-called floating/floating or basis swaps. The credit exposure on these contracts is evaluated solely on the basis of their mark-to-market values. 

Examples of the calculation of credit-equivalent amounts for selected instruments are in table 2.



Avoidance of Double Counting 

In certain cases, credit exposures arising from derivative contracts may be reflected, in part, on the balance sheet. To avoid double counting these exposures in the assessment of capital adequacy and, perhaps, assigning inappropriate risk weights, examiners may need to exclude counterparty credit exposures arising from the derivative instruments covered by the guidelines from balance-sheet assets when calculating a banking organization's risk-based capital ratios. This exclusion will eliminate the possibility that an organization could be required to hold capital against both an off-balance-sheet and on-balance-sheet amount for the same item. This treatment is not accorded to margin accounts and accrued receivables related to interest-rate and exchange-rate contracts. 

The aggregate on-balance-sheet amount excluded from the risk-based capital calculation is equal to the lower of- 

  each contract's positive on-balance-sheet amount or 
  its positive market value included in the off-balance-sheet risk-based capital calculation. 

For example, a forward contract that is marked to market will have the same market value on the balance sheet as is used in calculating the credit-equivalent amount for off-balance-sheet exposures under the guidelines. Therefore, the on-balance-sheet amount is not included in the risk-based capital calculation. When either the contract's on-balance-sheet amount or its market value is negative or zero, no deduction from on-balance-sheet items is necessary for that contract. 

If the positive on-balance-sheet asset amount exceeds the contract's market value, the excess (up to the amount of the on-balance-sheet asset) should be included in the appropriate risk-weight category. For example, a purchased option will often have an on-balance-sheet amount equal to the fee paid until the option expires. If that amount exceeds market value, the excess of carrying value over market value would be included in the appropriate risk-weight category for purposes of the on-balance-sheet portion of the calculation. 

Netting of Swaps and Similar Contracts 

Netting refers to the offsetting of positive and negative mark-to-market values in the determination of a current exposure to be used in the calculation of a credit-equivalent amount. Any legally enforceable form of bilateral netting (that is, netting with a single counterparty) of derivative contracts is recognized for purposes of calculating the credit-equivalent amount provided that- 

  the netting is accomplished under a written netting contract that creates a single legal obligation, covering all included individual contracts, with the effect that the organization would have a claim to receive, or an obligation to receive or pay, only the net amount of the sum of the positive and negative mark-to-market values on included individual contracts if a counterparty, or a counterparty to whom the contract has been validly assigned, fails to perform due to default, insolvency, liquidation, or similar circumstances; 
  the banking organization obtains written and reasoned legal opinions that in the event of a legal challenge-including one resulting from default, insolvency, liquidation, or similar circumstances-the relevant court and administrative authorities would find the banking organization's exposure to be such a net amount under- 

-the law of the jurisdiction in which the counterparty is chartered or the equivalent location in the case of non-corporate entities, and if a branch of the counterparty is involved, then also under the law of the jurisdiction in which the branch is located; -the law that governs the individual contracts covered by the netting contract; and -the law that governs the netting contract; 

  the banking organization establishes and maintains procedures to ensure that the legal characteristics of netting contracts are kept under review in light of possible changes in relevant law; and 
  the banking organization maintains documentation in its files that is adequate to support the netting of rate contracts, including a copy of the bilateral netting contract and necessary legal opinions.

A contract containing a walkaway clause is not eligible for netting for purposes of calculating the credit-equivalent amount. 

By netting individual contracts for the purpose of calculating credit-equivalent amounts of derivative contracts, a banking organization represents that it has met the requirements of the risk-based measure of the capital adequacy guidelines for bank holding companies and that all the appropriate documents are in the organization's files and available for inspection by the Federal Reserve. The Federal Reserve may determine that a banking organization's files are inadequate or that a netting contract, or any of its underlying individual contracts, may not be legally enforceable. If such a determination is made, the netting contract may be disqualified from recognition for risk-based capital purposes, or underlying individual contracts may be treated as though they are not subject to the netting contract. 

The credit-equivalent amount of contracts that are subject to a qualifying bilateral netting contract is calculated by adding- 

  the current exposure of the netting contract (net current exposure) and 
  the sum of the estimates of the potential future credit exposures on all individual contracts subject to the netting contract (gross potential future exposure) adjusted to reflect the effects of the netting contract.

The net current exposure of the netting contract is determined by summing all positive and negative mark-to-market values of the individual contracts included in the netting contract. If the net sum of the mark-to-market values is positive, then the current exposure of the netting contract is equal to that sum. If the net sum of the mark-to-market values is zero or negative, then the current exposure of the netting contract is zero. The Federal Reserve may determine that a netting contract qualifies for risk-based capital netting treatment even though certain individual contracts may not qualify. In these instances, the non-qualifying contracts should be treated as individual contracts that are not subject to the netting contract. 

Gross potential future exposure or Agross is calculated by summing the estimates of potential future exposure for each individual contract subject to the qualifying bilateral netting contract. The effects of the bilateral netting contract on the gross potential future exposure are recognized through the application of a formula that results in an adjusted add-on amount (Anet). The formula, which employs the ratio of net current exposure to gross current exposure (NGR), is expressed as: 

Anet = (0.4 Agross) + 0.6(NGR Agross) 

The NGR may be calculated in accordance with either the counterparty-by-counterparty approach or the aggregate approach. Under the counterparty-by-counterparty approach, the NGR is the ratio of the net current exposure for a netting contract to the gross current exposure of the netting contract. The gross current exposure is the sum of the current exposures of all individual contracts subject to the netting contract. Net negative mark-to-market values for individual netting contracts with the same counterparty may not be used to offset net positive mark-to-market values for other netting contracts with the same counterparty. 

Under the aggregate approach, the NGR is the ratio of the sum of all the net current exposures for qualifying bilateral netting contracts to the sum of all the gross current exposures for those netting contracts (each gross current exposure is calculated in the same manner as in the counterparty-by-counterparty approach). Net negative mark-to-market values for individual counterparties may not be used to offset net positive current exposures for other counterparties. 


A banking organization must consistently use either the counterparty-by-counterparty approach or the aggregate approach to calculate the NGR. Regardless of the approach used, the NGR should be applied individually to each qualifying bilateral netting contract to determine the adjusted add-on for that netting contract. 

In the event a netting contract covers contracts that are normally excluded from the risk-based ratio calculation-for example, exchange-rate contracts with an original maturity of 14 or fewer calendar days or instruments traded on exchanges that require daily payment of cash variation margin-an institution may elect to either include or exclude all mark-to-market values of such contracts when determining net current exposure, provided the method chosen is applied consistently. 

Examiners are to review the netting of off-balance-sheet derivative contractual arrangements used by banking organizations when calculating or verifying risk-based capital ratios to ensure that the positions of such contracts are reported gross unless the net positions of those contracts reflect netting arrangements that comply with the netting requirements listed previously. 

CAPITAL TREATMENT OF CREDIT DERIVATIVES 

Credit derivatives are off-balance-sheet arrangements that allow one party (the beneficiary) to transfer credit risk of a reference asset-which the beneficiary may or may not own-to another party (the guarantor). Many banks increasingly use these instruments to manage their overall credit-risk exposure. In general, credit derivatives have three distinguishing features: 

1. the transfer of the credit risk associated with a reference asset through contingent payments based on events of default and, usually, the prices of instruments before, at, and shortly after default (reference assets are most often traded sovereign and corporate debt instruments or syndicated bank loans) 

2. the periodic exchange of payments or the payment of a premium rather than the payment of fees customary with other off-balance-sheet credit products, such as letters of credit 

3. the use of an International Swap Derivatives Association (ISDA) master agreement and the legal format of a derivatives contract 

For risk-based capital purposes, total-rate-of-return swaps and credit-default swaps generally should be treated as off-balance-sheet direct credit substitutes.7 The notional amount of a contract should be converted at 100 percent to determine the credit-equivalent amount to be included in the risk-weighted assets of a guarantor. 8 A bank that provides a guarantee through a credit derivative transaction should assign its credit exposure to the risk category appropriate to the obligor of the reference asset or any collateral. On the other hand, a bank that owns the underlying asset upon which effective credit protection has been acquired through a credit derivative may, under certain circumstances, assign the unamortized portion of the underlying asset to the risk category appropriate to the guarantor (for example, the 20 percent risk category if the guarantor is an OECD bank).9 

Whether the credit derivative is considered an eligible guarantee for purposes of risk-based capital depends on the degree of credit protection actually provided, which may be limited depending on the terms of the arrangement. For example, a relatively restrictive definition of a default event or a materiality threshold that requires a comparably high percentage of loss to occur before the guarantor is obliged to pay could effectively limit the amount of credit risk actually transferred in the transaction. If the terms of the credit derivative arrangement significantly limit the degree of risk transference, then the beneficiary bank cannot reduce the risk weight of the ''protected'' asset to that of the guarantor. On the other hand, even if the transfer of credit risk is limited, a banking organization providing limited credit protection through a credit derivative should hold appropriate capital against the underlying exposure while the organization is exposed to the credit risk of the reference asset. 

Banking organizations providing a guarantee through a credit derivative may mitigate the credit risk associated with the transaction by entering into an offsetting credit derivative with another counterparty, a so-called ''back-to-back'' position. Organizations that have entered into such a position may treat the first credit derivative as guaranteed by the offsetting transaction for risk-based capital purposes. Accordingly, the notional amount of the first credit derivative may be assigned to the risk category appropriate to the counterparty providing credit protection through the offsetting credit derivative arrangement (for example, to the 20 percent risk category if the counterparty is an OECD bank). 

In some instances, the reference asset in the credit derivative transaction may not be identical to the underlying asset for which the beneficiary has acquired credit protection. For example, a credit derivative used to offset the credit exposure of a loan to a corporate customer may use a publicly traded corporate bond of the customer as the reference asset, whose credit quality serves as a proxy for the on-balance-sheet loan. In such a case, the underlying asset will still generally be considered guaranteed for capital purposes as long as both the underlying asset and the reference asset are obligations of the same legal entity and have the same level of seniority in bankruptcy. In addition, banking organizations offsetting credit exposure in this manner would be obligated to demonstrate to examiners that there is a high degree of correlation between the two instruments; the reference instrument is a reasonable and sufficiently liquid proxy for the underlying asset so that the instruments can be reasonably expected to behave similarly in the event of default; and, at a minimum, the reference asset and underlying asset are subject to mutual cross-default provisions. A banking organization that uses a credit derivative which is based on a reference asset that differs from the protected underlying asset must document the credit derivative being used to offset credit risk and must link it directly to the asset or assets whose credit risk the transaction is designed to offset. The documentation and the effectiveness of the credit derivative transaction are subject to examiner review. Banking organizations providing credit protection through such arrangements must hold capital against the risk exposures that are assumed. 

Some credit derivative transactions provide credit protection for a group or basket of reference assets and call for the guarantor to absorb losses on only the first asset in the group that defaults. Once the first asset in the group defaults, the credit protection for the remaining assets covered by the credit derivative ceases. If examiners determine that the credit risk for the basket of assets has effectively been transferred to the guarantor and the beneficiary banking organization owns all of the reference assets included in the basket, then the beneficiary may assign the asset with the smallest dollar amount in the group-if less than or equal to the notional amount of the credit derivative-to the risk category appropriate to the guarantor. Conversely, a banking organization extending credit protection through a credit derivative on a basket of assets must assign the contract's notional amount of credit exposure to the highest risk category appropriate to the assets in the basket. In addition to holding capital against credit risk, a bank that is subject to the market-risk rule (see below) must hold capital against market risk for credit derivatives held in its trading account. (For a description of market-risk capital requirements, see SR-97-18). 

7. Unlike total-rate-of-return swaps and credit-default swaps, credit-linked notes are on-balance-sheet assets or liabilities. A guarantor bank should assign the on-balance-sheet amount of the credit-linked note to the risk category appropriate to either the issuer or the reference asset, whichever is higher. For a beneficiary bank, cash consideration received in the sale of the note may be considered as collateral for risk-based capital purposes. 
8. A guarantor bank that has made cash payments representing depreciation on reference assets may deduct such payments from the notional amount when computing credit-equivalent amounts for capital purposes. 
9. In addition to holding capital against credit risk, a bank that is subject to the market-risk rule (see ''Market-Risk Measure,'' below) must hold capital against market risk for credit derivatives held in its trading account. 

CAPITAL TREATMENT OF SYNTHETIC COLLATERALIZED LOAN OBLIGATIONS 

Credit derivatives can be used to synthetically replicate collateralized loan obligations (CLOs). Banking organizations can use CLOs and their synthetic variants to manage their balance sheets and, in some instances, transfer credit risk to the capital markets. These transactions allow economic capital to be allocated more efficiently, resulting in, among other things, improved shareholders' returns. A CLO is an asset-backed security that is usually supported by a variety of assets, including whole commercial loans, revolving credit facilities, letters of credit, banker's acceptances, or other asset-backed securities. In a typical CLO transaction, the sponsoring banking organization transfers the loans and other assets to a bankruptcy-remote special-purpose vehicle (SPV), which then issues asset-backed securities consisting of one or more classes of debt. The CLO enables the sponsoring institution to reduce its leverage and risk-based capital requirements, improve its liquidity, and manage credit concentrations. 

The first synthetic CLO issued in 1997 used credit-linked notes (CLNs).10 Rather than transferring assets to the SPV, the sponsoring bank issued CLNs to the SPV, individually referencing the payment obligation of a particular company or ''reference obligor.'' In that particular transaction, the notional amount of the CLNs issued equaled the dollar amount of the reference assets the sponsor was hedging on its balance sheet. Since that time, other structures have evolved that also use credit-default swaps to transfer credit risk and create different levels of risk exposure, but that hedge only a portion of the notional amount of the overall reference portfolio. In most traditional CLO structures, assets are actually transferred into the SPV. In synthetic securitizations, the underlying exposures that make up the reference portfolio remain in the institution's banking book. The credit risk is transferred into the SPV through credit-default swaps or CLNs. In this way, the institution is able to avoid sensitive client-relationship issues arising from loan-transfer notification requirements, loan-assignment provisions, and loan-participation restrictions. Client confidentiality also can be maintained. 

Under the risk-based capital guidelines, corporate credits are typically assigned to the 100 percent risk category and are assessed 8 percent capital. In the case of high-quality investment-grade corporate exposures, the 8 percent capital requirement may exceed the economic capital that a bank sets aside to cover the credit risk of the transaction. Clearly, one of the motivations behind CLOs and other securitizations is to more closely align the sponsoring institution's regulatory capital requirements with the economic capital required by the market. The introduction of synthetic CLOs has raised questions about their treatment for purposes of calculating the leverage and risk-based capital ratios of the Federal Reserve and other banking agencies.11 In this regard, supervisors and examiners should consider the capital treatment of synthetic CLOs from the perspective of both investors and sponsoring banking organizations for three types of transactions: (1) the sponsoring banking organization, through a synthetic CLO, hedges the entire notional amount of a reference asset portfolio; (2) the sponsoring banking organization hedges a portion of the reference portfolio and retains a high-quality, senior risk position that absorbs only those credit losses in excess of the junior-loss positions; and (3) the sponsoring banking organization retains a subordinated position that absorbs first losses in a reference portfolio. Each of these transactions is explained more fully below. 

Entire Notional Amount of the Reference Portfolio Hedged 

In a synthetic securitization that hedges the entire notional amount of the reference portfolio, an SPV acquires the credit risk on a reference portfolio by purchasing CLNs issued by the sponsoring banking organization. The SPV funds the purchase of the CLNs by issuing a series of notes in several tranches to third-party investors. The investor notes are in effect collateralized by the CLNs. Each CLN represents one obligor and the bank's credit-risk exposure to that obligor, which may take the form of, for example, bonds, commitments, loans, and counterparty exposures. Since the note-holders are exposed to the full amount of credit risk associated with the individual reference obligors, all of the credit risk of the reference portfolio is shifted from the sponsoring bank to the capital markets. The dollar amount of notes issued to investors equals the notional amount of the reference portfolio. If there is a default of any obligor linked to a CLN in the SPV, the institution will call the individual note and redeem it based on the repayment terms specified in the note agreement. The term of each CLN is set such that the credit exposure to which it is linked matures before the maturity of the CLN. This ensures that the CLN will be in place for the full term of the exposure to which it is linked. 

An investor in the notes issued by the SPV is exposed to the risk of default of the underlying reference assets, as well as to the risk that the sponsoring institution will not repay principal at the maturity of the notes. Because of the linkage between the credit quality of the sponsoring institution and the issued notes, a downgrade of the sponsor's credit rating most likely will result in the notes also being downgraded. Thus, a banking organization investing in this type of synthetic CLO should assign the notes to the higher of the risk categories appropriate to the underlying reference assets or the issuing entity. 

For purposes of risk-based capital, the sponsoring banking organizations may treat the cash proceeds from the sale of CLNs that provide protection against underlying reference assets as cash collateralizing these assets.12 This treatment would permit the reference assets, if carried on the sponsoring institution's books, to be assigned to the zero percent risk category to the extent that their notional amount is fully collateralized by cash. This treatment may be applied even if the cash collateral is transferred directly into the general operating funds of the institution and is not deposited in a segregated account. The synthetic CLO would not confer any bene-fits to the sponsoring banking organization for purposes of calculating its tier 1 leverage ratio because the reference assets remain on the organization's balance sheet.

10. CLNs are obligations whose principal repayment is conditioned upon the performance of a referenced asset or portfolio. The assets' performance may be based on a variety of measures, such as movements in price or credit spread, or the occurrence of default. 
11. For more information, see SR-99-32, ''Capital Treatment for Synthetic Collateralized Obligations.'' 
12. The CLNs should not contain terms that would significantly limit the credit protection provided against the underlying reference assets, for example, a materiality threshold that requires a relatively high percentage of loss to occur before CLN payments are adversely affected, or a strucEagle Tradersg of CLN post-default payments that does not adequately pass through credit-related losses on the reference assets to investors in the CLNs.

High-Quality, Senior Risk Position in the Reference Portfolio Retained 

In some synthetic CLOs, the sponsoring banking organization uses a combination of credit-default swaps and CLNs to essentially transfer the credit risk of a designated portfolio of its credit exposures to the capital markets. This type of transaction allows the sponsoring institution to allocate economic capital more efficiently and to significantly reduce its regulatory capital requirements. In this structure, the sponsoring banking organization purchases default protection from an SPV for a specifically identified portfolio of banking-book credit exposures, which may include letters of credit and loan commitments. The credit risk on the identified reference portfolio (which continues to remain in the sponsor's banking book) is transferred to the SPV through the use of credit-default swaps. In exchange for the credit protection, the sponsoring institution pays the SPV an annual fee. The default swaps on each of the obligors in the reference portfolio are structured to pay the average default losses on all senior unsecured obligations of defaulted borrowers. To support its guarantee, the SPV sells CLNs to investors and uses the cash proceeds to purchase Treasury notes from the U.S. government. The SPV then pledges the Treasuries to the sponsoring banking organization to cover any default losses.13 The CLNs are often issued in multiple tranches of differing seniority and in an aggregate amount that is significantly less than the notional amount of the reference portfolio. The amount of notes issued typically is set at a level sufficient to cover some multiple of expected losses, but well below the notional amount of the reference portfolio being hedged.

There may be several levels of loss in this type of synthetic securitization. The first-loss position may be a small cash reserve, sufficient to cover expected losses, that accumulates over a period of years and is funded from the excess of the SPV's income (that is, the yield on the Treasury securities plus the credit-default-swap fee) over the interest paid to investors on the notes. The investors in the SPV assume a second-loss position through their investment in the SPV's senior and junior notes, which tend to be rated AAA and BB, respectively. Finally, the sponsoring banking organization retains a high-quality, senior risk position that would absorb any credit losses in the reference portfolio that exceed the first- and second-loss positions. Typically, no default payments are made until the maturity of the overall transaction, regardless of when a reference obligor defaults. While operationally important to the sponsoring banking organization, this feature has the effect of ignoring the time value of money. Thus, when the reference obligor defaults under the terms of the credit derivative and the reference asset falls significantly in value, the sponsoring banking organization should, in accordance with generally accepted accounting principles, make appropriate adjustments in its regulatory reports to reflect the estimated loss relating to the time value of money. 

For risk-based capital purposes, banking organizations investing in the notes must assign them to the risk weight appropriate to the underlying reference assets.14 A banking organization sponsoring such a transaction must include in its risk-weighted assets its retained senior exposures in the reference portfolio, to the extent these are held in its banking book. The portion of the reference portfolio that is collateralized by the pledged Treasury securities may be assigned a zero percent risk weight. The remainder of the portfolio should be risk weighted according to the obligor of the exposures, unless certain stringent minimum conditions are met. When the sponsoring institution has virtually eliminated its credit-risk exposure to the reference portfolio through the issuance of CLNs, and when the other stringent minimum requirements are met, the institution may assign the uncollateralized portion of its retained senior position in the reference portfolio to the 20 percent risk weight. To the extent that the reference portfolio includes loans and other balance-sheet assets in the banking book, a banking organization that sponsors this type of synthetic securitization would not realize any benefits with respect to the determination of its leverage ratio. 

The stringent minimum requirements, which are discussed more fully in the annex to SR-99-32, include (1) the probability of loss on the retained senior position is extremely low due to the high credit quality of the reference portfolio and the amount of prior credit protection; 2) market discipline is injected into the process through the sale of CLNs into the market, the most senior of which must be rated AAA by a nationally recognized credit rating agency; and 3) the sponsoring institution performs rigorous and robust stress testing and demonstrates that the level of credit enhancement is sufficient to protect itself from losses under scenarios appropriate to the specific transaction. The Federal Reserve may impose other requirements as deemed necessary to ensure that the sponsoring institution has virtually eliminated all of its credit exposure. Furthermore, supervisors and examiners retain the discretion to increase the risk-based capital requirement assessed against the retained senior exposure in these structures, if the underlying asset pool deteriorates significantly. 

Based on a qualitative review, Federal Reserve staff will determine on a case-by-case basis whether the senior retained portion of a sponsoring banking organization's synthetic securitization qualifies for the 20 percent risk weight. The sponsoring institution must be able to demonstrate that virtually all of the credit risk of the reference portfolio has been transferred from the banking book to the capital markets. As is the case with organizations engaging in more traditional securitization activities, examiners must carefully evaluate whether the institution is fully capable of assessing the credit risk it retains in its banking book and whether it is adequately capitalized given its residual risk exposure. Supervisors will require the sponsoring organization to maintain higher levels of capital if it is not deemed to be adequately capitalized given the retained residual risks. In addition, an institution sponsoring synthetic securitizations must adequately disclose to the marketplace the effect of the transaction on its risk profile and capital adequacy. A failure on the part of the sponsoring banking organization to require the investors in the CLNs to absorb the credit losses that they contractually agreed to assume may be considered an unsafe and unsound banking practice. In addition, this failure generally would constitute ''implicit recourse'' or support to the transaction that would result in the sponsoring banking organization losing the preferential capital treatment on its retained senior position. 

If an organization sponsoring a synthetic securitization does not meet the stringent minimum criteria outlined in SR-99-32, it still may reduce the risk-based capital requirement on the senior risk position retained in the banking book by transferring the remaining credit risk to a third-party OECD bank through the use of a credit derivative. Provided the credit derivative transaction qualifies as a guarantee under the risk-based capital guidelines, the risk weight on the senior position may be reduced from 100 percent to 20 percent. Institutions may not enter into non-substantive transactions that transfer banking-book items into the trading account to obtain lower regulatory capital requirements.15

13. The names of corporate obligors included in the reference portfolio may be disclosed to investors in the CLNs. 
14. Under this type of transaction, if a structure exposes investing banking organizations to the creditworthiness of a substantive issuer (for example, the sponsoring institution), then the investing institutions should assign the notes to the higher of the risk categories appropriate to the underlying reference assets or the sponsoring institution. 
15. For instance, a lower risk weight would not be applied to a non-substantive transaction in which the sponsoring institution enters into a credit derivative to pass the credit risk of the senior retained portion held in its banking book to an OECD bank, and then enters into a second credit derivative transaction with the same OECD bank in which it reassumes into its trading account the credit risk initially transferred. 
16. Because the credit risk of the senior position is not transferred to the capital markets but, instead, remains with the intermediary bank, the sponsoring banking organization should ensure that its counterparty is of high credit quality, for example, at least investment grade.

Retention of a First-Loss Position 

In certain synthetic transactions, the sponsoring banking organization may retain the credit risk associated with a first-loss position and, through the use of credit-default swaps, pass the second and senior-loss positions to a third-party entity, most often an OECD bank. The third-party entity, acting as an intermediary, enters into offsetting credit-default swaps with an SPV, thus transferring its credit risk associated with the second-loss position to the SPV.16 As described in the second transaction type described above, the SPV then issues CLNs to the capital markets for a portion of the reference portfolio and purchases Treasury collateral to cover some multiple of expected losses on the underlying exposures. 

Two alternative approaches could be used to determine how the sponsoring banking organization should treat the overall transaction for risk-based capital purposes. The first approach employs an analogy to the low-level capital rule for assets sold with recourse. Under this rule, a transfer of assets with recourse that is contractually limited to an amount less than the effective risk-based capital requirements for the transferred assets is assessed a total capital charge equal to the maximum amount of loss possible under the recourse obligation. If this rule was applied to a sponsoring banking organization retaining a one percent first-loss position on a synthetically securitized portfolio that would otherwise be assessed 8 percent capital, the organization would be required to hold dollar-for-dollar capital against the one percent first loss risk position. The sponsoring institution would not be assessed a capital charge against the second and senior risk positions.17 

The second approach employs a literal reading of the capital guidelines to determine the sponsoring banking organization's risk-based capital charge. In this instance, the one percent first-loss position retained by the sponsoring institution would be treated as a guarantee, that is, a direct credit substitute, which would be assessed an 8 percent capital charge against its face value of one percent. The second-loss position, which is collateralized by Treasury securities, would be viewed as fully collateralized and subject to a zero percent capital charge. The senior-loss position guaranteed by the intermediary bank would be assigned to the 20 percent risk category appropriate to claims guaranteed by OECD banks.18 It is possible that this approach may result in a higher risk-based capital requirement than the dollar-for-dollar capital charge imposed by the first approach- depending on whether the reference portfolio consists primarily of loans to private obligors, or undrawn long-term commitments. These commitments generally have an effective risk-based capital requirement that is one-half the requirement for loans, since they are converted to an on-balance-sheet credit-equivalent amount using the 50 percent conversion factor. If the reference pool consists primarily of drawn loans to commercial obligors, then the capital requirement on the senior-loss position would be significantly higher than if the reference portfolio contained only undrawn long-term commitments. As a result, the capital charge for the overall transaction could be greater than the dollar-for-dollar capital requirement set forth in the first approach. 

Sponsoring institutions are required to hold capital against a retained first-loss position in a synthetic securitization. The capital should equal the higher of the two capital charges resulting from the sponsoring institution's application of the first and second approaches outlined above. Further, although the sponsoring banking organization retains only the credit-risk associated with the first-loss position, it still should continue to monitor all the underlying credit exposures of the reference portfolio to detect any changes in the credit-risk profile of the counterparties. This is important to ensure that the institution has adequate capital to protect against unexpected losses. Examiners should determine whether the sponsoring bank has the capability to assess and manage the retained risk in its credit portfolio after the synthetic securitization is completed. For risk-based capital purposes, banking organizations investing in the notes must assign them to the risk weight appropriate to the underlying reference assets.19 

17. A banking organization that sponsors this type of synthetic securitization would not realize any benefits in the determination of its leverage ratio since the reference assets themselves remain on the sponsoring institution's balance sheet. 
18. If the intermediary is a banking organization, then it could place both sets of credit-default swaps in its trading account and, if subject to the Federal Reserve's market-risk capital rules, use its general market-risk model and, if approved, specific-risk model to calculate the appropriate risk-based capital requirement. If the specific-risk model has not been approved, then the sponsoring banking organization would be subject to the standardized specific-risk capital charge. 
19. Under this type of transaction, if a structure exposes investing banking organizations to the creditworthiness of a substantive issuer (for example, the sponsoring institution), then the investing institutions should assign the notes to the higher of the risk categories appropriate to the underlying reference assets or the sponsoring institution.

Continue to ASSESSING CAPITAL ADEQUACY AT LARGE, COMPLEX BANKING ORGANIZATIONS 

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