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6000 - Bank Holding Company Act
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
{{10-31-08 p.6120.28-A}}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.
(b) Applicability. (1) This appendix applies to any
bank holding company whose trading
activity 2
(on a worldwide consolidated basis) equals:
(i) 10 percent or more of total
assets, 3
or
(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
{{2-28-06 p.6120.29}}
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.
(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 event and default risk as well as idiosyncratic variations.
(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
and receivables arising from the posting of cash collateral that is
associated with securities borrowing transactions to the extent the
receivables are collateralized by the market value of the borrowed
securities, provided that the following conditions are met:
(i) The transaction is based on securities includable in the
trading book that are liquid and readily marketable,
(ii) The transaction is marked to market daily,
(iii) The transaction is subject to daily margin maintenance
requirements, and
(iv)(A) The transaction is a securities contract for the purposes
of section 555 of the Bankruptcy Code (11 U.S.C. 555), a qualified
financial contract for the purposes of section 11(e)(8) of the Federal
Deposit Insurance Act (12 U.S.C.
1821(e)(8)), or a netting contract between or among financial
institutions for the purposes of sections 401--407 of the Federal
Deposit Insurance Corporation Improvement Act of 1991
(12 U.S.C. 4401--4407), or the
Board's Regulation EE (12 CFR Part 231); or
{{2-28-06 p.6120.30}}
(B) If the transaction does not meet the criteria set forth in
paragraph (iv)(A) of this section, then either:
(1) The banking organization has conducted sufficient
legal review to reach a well-founded conclusion that:
(i) The securities borrowing agreement executed in
connection with the transaction provides the bank the right to
accelerate, terminate, and close-out on a net basis all transactions
under the agreement and to liquidate or set off collateral promptly
upon an event of counterparty default, including in a bankruptcy,
insolvency, or other similar proceeding of the counterparty; and
(ii) Under applicable law of the relevant
jurisdiction, its rights under the agreement are legal, valid, binding,
and enforceable and any exercise of rights under the agreement will not
be stayed or avoided; or
(2) The transaction is either overnight or
unconditionally cancelable at any time by the bank, and the bank has
conducted sufficient legal review to reach a well-founded conclusion
that:
(i) The securities borrowing agreement executed in
connection with the transaction provides the bank the right to
accelerate, terminate, and close-out on a net basis all transactions
under the agreement and to liquidate or set off collateral promptly
upon an event of counterparty default; and
(ii) Under the law governing the agreement, its rights
under the agreement are legal, valid, binding, and enforceable.
(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. 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
(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
(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).
{{2-28-06 p.6120.30-A}}
(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 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.
(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.
{{4-30-99 p.6120.31}}
(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.
(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
weighing scheme or other similar method) of at least one a 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.
(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 measures.
(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.
{{4-30-99 p.6120.32}}
Table 1.—Multiplication Factor Based on Results of
Backtesting
| Number
of exceptions |
Multiplicationfactor |
|---|
| 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) Modeled specific risk. A bank holding company may
use its internal model to measure specific risk. If the organization
has demonstrated to the Federal Reserve that its internal model
measures the specific risk, including event and default risk as well as
idiosyncratic variation, of covered debt and equity positions and
includes the specific risk measures in the VAR-based capital charge in
section 3(a)(2)(i) of this appendix, then the organization has no
specific risk add-on for purposes of section 3(a)(2)(ii) of this
appendix. The model should explain the historical price variation in
the trading portfolio and capture concentration, both magnitude and
changes in composition. The model should also be robust to an adverse
environment and have been validated through backtesting which assesses
whether specific risk is being accurately captured.
(b) Partially modeled specific risk. (1) A bank holding
company that incorporates specific risk in its internal model but fails
to demonstrate to the Federal Reserve that its internal model
adequately measures all aspects of specific risk for covered debt and
equity positions, including event and default risk, as provided by
section 5(a) of this appendix, must calculate its specific risk add-on
in accordance with one of the following methods:
(i) If the model is susceptible to valid separation of the VAR
measure into a specific risk portion and a general market risk portion,
then the specific risk add-on is equal to the previous day's specific
risk portion.
(ii) If the model does not separate the VAR measure into a
specific risk portion and a general market risk portion, then the
specific risk add-on is the sum of the previous day's VAR measures for
subportfolios of covered debt and equity positions that contain
specific risk.
(2) If a bank holding company models the specific risk of covered
debt positions but not covered equity positions (or vice versa), then
the bank holding company may determine its specific risk charge for the
included positions under section 5(a) or 5(b)(1) of this appendix, as
appropriate. The specific risk charge for the positions not included
equals the standard specific risk capital charge under paragraph (c) of
this section.
(c) Specific risk not modeled. If a bank holding company
does not model specific risk in accordance with section 5(a) or 5(b) of
this appendix, then the organization's specific risk capital charge
shall equal the standard specific risk capital charge, calculated 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-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
{{2-28-06 p.6120.33}}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
| Category |
Remaining
maturity(contractual) |
Weighting factor(in
percent) |
|---|
| Government |
N/A |
0.00 |
| Qualifying |
6
months or less |
0.25 |
|
Over 6 months to 24
months |
1.00 |
|
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.
(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:
(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
{{2-28-06 p.6120.34}}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
(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.
(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.
[Codified to 12 C.F.R. Part 225, Appendix E]
[Appendix E added at 61 Fed. Reg. 47373, September 6,
1996, effective January 1, 1997; amended at 62 Fed. Reg. 68608,
December 30, 1997, effective December 31, 1997; 64 Fed. Reg. 19038,
April 19, 1999, effective July 1, 1999; 65 Fed. Reg. 75859, December 5,
2000, effective January 4, 2001; 69 Fed. Reg. 44921, July 28, 2004; 71
Fed. Reg. 8937, February 22, 2006]
1This 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 Risks," January 1996. Also see modifications issued in
September 1997. Go Back to Text
2Trading activity means the gross sum of trading assets and
liabilities as reported in the bank holding company's most recent
quarterly Y--9C Report. Go Back to Text
3Total assets means quarter-end total assets as reported in the
bank holding company's most recent Y--9C Report. Go Back to Text
4A bank holding company that voluntarily complies with the
final rule prior to January 1, 1998, must comply with all of its
provisions. Go Back to Text
5Subject to supervisory review, a bank may exclude structural
positions in foreign currencies from its covered positions. Go Back to Text
6The term trading account is defined in the instructions to the
Call Report. Go Back to Text
7Foreign exchange positions outside the trading account and all
over-the-counter derivative positions, whether or not in the trading
account, must be included in the adjusted risk weighted assets as
determined in appendix A of this part. Go Back to Text
8An institution may not allocate Tier 3 capital to support
credit risk (as calculated under appendix A of this part). Go Back to Text
9Excess 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. Go Back to Text
10An 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 risk for other purposes. Go Back to Text
11Stress 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. Go Back to Text
12For 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. Go Back to Text
13Actual 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. Go Back to Text
14Organization for Economic Cooperation and Development
(OECD)-based countries is defined in appendix A of this part. Go Back to Text
15U.S. government-sponsored agencies, multilateral development
banks, and OECD banks are defined in appendix A of this part. Go Back to Text
16An 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. Go Back to Text
17A 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 market. Go Back to Text
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