Calculation of risk weights
Foreign sovereigns, foreign public sector entities and depository institutions
High volatility commercial real estate loans
Past due exposures
Conversion factors for off-balance sheet exposures
OTC derivatives contracts
Cleared derivatives and repo-style transactions
Treatment of guarantees (and credit derivatives) and collateral
The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) recently released three proposed rules and one final rule which would substantially revise the federal banking agencies' current capital rules.(1)
The proposals and the market risk rule are expected to be published in the Federal Register shortly and comments on the proposals are due by September 7 2012. The market risk rule will become effective on January 1 2013. The proposals would implement the regulatory capital reforms recommended in December 2010 by the Basel Committee on Banking Supervision (Basel III), as well as additional capital reforms required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The first proposal would revise the risk-based and leverage capital ratio minimum requirements and the definition of 'capital' (for further details please see "Federal banking agencies issue proposed capital reforms"). This update highlights some of the changes presented in the second proposal, Regulatory Capital Rules: Standardised Approach for Risk-weighted Assets; Market Discipline and Disclosure Requirements.
The standardised approach proposal would revise the agencies' general capital rules to increase their risk sensitivity by revising the methodology for computing a banking organisation's total risk-weighted assets (the denominator of the banking organisation's risk-based capital ratios). The changes proposed in the standardised approach proposal include:
- giving greater recognition to collateral and guarantees;
- replacing credit ratings-based measurements with non-ratings-based alternatives for determining creditworthiness, as required by the Dodd-Frank Act;
- revising the treatment of counterparty credit risk;
- establishing due diligence requirements for securitisation exposures;
- providing a more favourable capital treatment for transactions cleared through qualifying central counterparties; and
- introducing disclosure requirements for banking organisations with assets of $50 billion or more.
The standardised approach proposal would apply to the following:
- US federal and state-chartered banks and savings associations;
- US bank holding companies with more than $500 million in total consolidated assets; and
- US savings and loan holding companies regardless of asset size.
The proposed changes would take effect on January 1 2015, although banking organisations may choose to implement these changes sooner.
The current risk-based capital requirements categorise exposures into four risk-weighting categories - 0%, 20%, 50% and 100% - in calculating a banking organisation's total risk-weighted assets. The standardised approach proposal would replace those four discrete categories with a large range of possible risk-weighting categories, generally ranging from 0% to 1250%. A banking organisation's total risk-weighted assets would be the sum of:
- its risk-weighted assets for general credit risk, off-balance sheet items, over-the-counter (OTC) derivative contracts, transactions cleared through central counterparties, unsettled transactions, securitisation exposures and equity exposures; plus
- its risk-weighted assets for market risk calculated under the market risk rules (as amended by the market risk rule); less
- if applicable, the portion of its allowance for loan and lease losses that is not included in Tier 2 capital.
The standardised approach proposal would revise the risk-weight calculations for some exposures, including by increasing the risk weight for some higher-risk exposures, such as past-due loans. However, for most exposures no changes are proposed. In particular, the treatment of exposures to the US government, government-sponsored entities, US states and municipalities, most corporations and most consumer loans would remain unchanged.
Exposures to foreign sovereigns, foreign public sector entities and foreign banks would be risk weighted based on the country risk classification - as published by the Organisation for Economic Cooperation and Development - applicable to the foreign government or the home country of the foreign public sector entity or foreign bank. The risk weights for foreign sovereigns range from 0% to 150%. For foreign public sector entities and foreign banks, the range is from 20% to 150%. If the foreign government or home country does not have a country risk classification, the exposure would be assigned a risk weight of 100%. If the foreign government or home country defaults or has defaulted within the previous five years, the exposure to a foreign sovereign, foreign public sector entity or foreign bank would be assigned a risk weight of 150%.
Under the standardised approach proposal, one to four family residential mortgages would be separated into two risk categories based on certain product and underwriting characteristics. Traditional, first-lien mortgage loans that are prudently underwritten would be included in the first category. The second category would contain junior-lien and non-traditional mortgage products. The exposures would then be assigned a risk weight based on the category and the loan-to-value ratio of the exposure. The standardised approach proposal would not recognise private mortgage insurance in calculating the loan to value.
High volatility commercial real estate loan exposures would be assigned a 150% risk weight. A 'high volatility commercial real estate loan exposure' is defined as a credit facility that finances (or has financed) the acquisition, development or construction of real property, unless the facility finances one to four family residential properties or the facility finances commercial real estate projects that meet a loan-to-value cap or the borrower has contributed a certain amount of capital at a designated point in the transaction.
The standardised approach proposal would assign a 150% risk weight to loans and other exposures that are not guaranteed or secured and are 90 days or more past due. This requirement would not apply to one to four family residential exposures (which would be assigned to the second category and weighted accordingly) or sovereign exposures where the sovereign has experienced a sovereign default (which would be assigned a 150% risk weight immediately upon default).
Equity exposures would be assigned one of several risk-weight categories, based on the type of exposure and the type of issuer. The risk-weight categories range from 0% to 600%. For equity exposures to an investment fund, the standardised approach proposal permits a full look-through approach and two modified look-through approaches in calculating the risk weight of the exposure.
As in the current capital rules, a banking organisation would be required under the standardised approach proposal to calculate the exposure amount of an off-balance sheet exposure using a credit conversion factor. The proposal would broaden the scope of off-balance sheet items subject to regulatory capital and would increase the credit conversion factor in some instances. For example, the credit conversion factor for commitments with an original maturity of one year or less that are not unconditionally cancellable would be increased from 0% to 20%. A 100% credit conversion factor would apply to off-balance sheet guarantees, repurchase agreements, securities lending and borrowing transactions, financial standby letters of credit and forward agreements.
The standardised approach proposal would revise the treatment of OTC derivative contracts in several ways, including by:
- revising the definition of an 'OTC derivative contract';
- applying a revised conversion factor matrix for calculating the potential future exposure;
- revising the criteria for recognising the netting benefits of qualifying master netting agreements and of collateral; and
- deleting the current 50% risk-weight cap.
The standardised approach proposal introduces a specific capital treatment for exposures to central counterparties, including certain transactions conducted through clearing members by banking organisations that are not themselves clearing members of a central counterparty. In contrast to the current risk-based capital rules - which permit a banking organisation to exclude certain derivative contracts traded on an exchange from the risk-based capital calculation - the standardised approach proposal would require a banking organisation to hold risk-based capital for an outstanding derivative contract or repo-style transaction that has been entered into with all central counterparties, including exchanges. Derivative transactions that are not cleared transactions (including because they are not accepted by a central counterparty) would be OTC derivative transactions.
The standardised approach proposal would define a 'securitisation exposure' as:
- an on or off-balance sheet credit exposure (including credit-enhancing representations and warranties) that arises from a traditional or synthetic securitisation (including a resecuritisation); or
- an exposure that directly or indirectly references a securitisation exposure described
The proposal would also introduce due diligence requirements for banking organisations that own, originate or purchase securitisation exposures and introduce a new definition of 'securitisation exposure'. If a banking organisation cannot demonstrate to the satisfaction of its primary federal regulator a comprehensive understanding of the features of a securitisation exposure that would materially affect its performance (based on an analysis that is commensurate with the complexity of the exposure and the materiality of the exposure in relation to capital), the exposure would be assigned a risk weight of 1250%.
The proposal proposes no changes to the treatment of securitisation exposures guaranteed by the US government or government-sponsored entities. In particular, Ginnie Mae securities will receive a 0% risk weight to the extent they are unconditionally guaranteed. Securities guaranteed by Fannie Mae and Freddie Mac will receive a 20% risk weight. Fannie Mae and Freddie Mac non-credit enhancing interest-only securities receive a 100% risk weight.
Under the standardised approach proposal, a banking organisation would deduct any after-tax gain-on-sale of a securitisation. Credit-enhancing interest-only strips would be assigned a 1250% risk weight and non-credit enhancing interest-only mortgage-backed securities would be assigned a 100% risk weight.
Only those mortgage-backed securities that involve tranching of credit risk would meet the proposed definition of a 'securitisation exposure'. Thus, mortgage-backed pass-through securities would not meet the proposed definition.
For privately issued mortgage securities and all other securitisation exposures, a banking organisation would generally calculate risk weights for securitisation exposures using either the simplified supervisory formula approach adopted as part of the market risk rule or - if the banking organisation is not subject to the market risk rule - a gross-up approach based on the subordination of the securitisation exposure as provided under the current capital rules.
The method chosen would have to be used uniformly for all securitisation exposures. Banking organisations could also choose to apply a 1250% risk weight to any securitisation exposure. In addition, the standardised approach proposal provides for alternative treatment of securitisation exposures to asset-backed commercial paper liquidity facilities. The proposed requirements, similar to the general risk-based capital rules, would include exceptions for interest-only mortgage-backed securities, certain statutorily exempted assets and certain derivatives. In all cases, the minimum risk weight for securitisation exposures would be 20%.
The standardised approach proposal provides for a separate risk-based capital requirement for transactions involving securities, foreign exchange instruments and commodities that have a risk of delayed settlement or delivery. However, the proposed capital requirement would not apply to certain types of transaction, including cleared transactions that are marked-to-market daily and subject to daily receipt and payment of variation margin. The proposal contains separate treatments for delivery-versus-payment and payment-versus-payment transactions with a normal settlement period, and non-delivery-versus-payment and non-payment-versus-payment transactions with a normal settlement period.
The standardised approach proposal would increase the recognition of guarantees, credit derivatives and collateral. It would expand the scope of eligible guarantors to include, for example, investment-grade corporate entities, subject to certain limitations. The proposal would provide certain adjustments for maturity mismatches and currency mismatches. It would also expand the definition of financial collateral to include, among other things, investment-grade corporate debt securities and publicly traded equity securities and convertible bonds. With the exception of cash on deposit, a banking organisation would be required to have a perfected, first-priority security interest in collateral.
The standardised approach proposal would introduce both qualitative and quantitative disclosure requirements relating the regulatory capital for US top-tier US banking organisations with $50 billion or more in total consolidated assets that are not subject to the advanced approaches. The proposed disclosure requirements generally are consistent with the disclosure requirements of Basel III.
For further information on this topic please contact William S Eckland, Joel Feinberg or Amber Tofilon at Sidley Austin LLP by telephone (+1 202 736 8000), fax (+1 202 736 8711) or email (firstname.lastname@example.org, email@example.com or firstname.lastname@example.org).
(1) The Federal Reserve press release is available at www.federalreserve.gov/newsevents/press/bcreg/20120612a.htm. The OCC press release can be found at www.occ.treas.gov/news-issuances/news-releases/2012/nr-ia-2012-88.htmland the FDIC press release is available at www.fdic.gov/news/news/press/2012/pr12068.html.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.