SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board 
of Governors of the Federal Reserve System (Board), and the Federal 
Deposit Insurance Corporation (FDIC) (collectively, the Agencies) are 
amending their respective risk-based capital standards to incorporate a 
measure for market risk to cover all positions located in an 
institution's trading account and foreign exchange and commodity 
positions wherever located. The final rule implements an amendment to 
the Basle Capital Accord that sets forth a supervisory framework for 
measuring market risk. The effect of the final rule is that any bank or 
bank holding company (institution) regulated by the OCC, the Board, or 
the FDIC, with significant exposure to market risk must measure that 
risk using its own internal value-at-risk model, subject to the 
parameters contained in this final rule, and must hold a commensurate 
amount of capital.

DATES: Effective date: January 1, 1997.
    Compliance date: Mandatory compliance January 1, 1998.

FOR FURTHER INFORMATION CONTACT:
    OCC: Margot Schwadron, Financial Analyst, Roger Tufts, Senior 
Economic Advisor, or Christina Benson, Capital Markets Specialist, 
Office of the Chief National Bank Examiner (202/874-5070). For legal 
issues, Andrew Gutierrez, Attorney, or Ron Shimabukuro, Senior 
Attorney, Legislative and Regulatory Activities Division (202/874-
5090), Office of the Comptroller of the Currency, 250 E Street, SW, 
Washington, D.C. 20219.
    Board: Roger Cole, Deputy Associate Director (202/452-2618), James 
Houpt, Assistant Director (202/452-3358), Barbara Bouchard, Supervisory 
Financial Analyst (202/452-3072), Division of Banking Supervision and 
Regulation; or Stephanie Martin, Senior Attorney (202/452-3198), Legal 
Division. For the Hearing impaired only, Telecommunication Device for 
the Deaf (TDD), Dorothea Thompson (202/452-3544), Federal Reserve 
Board, 20th and C Streets, NW, Washington, D.C. 20551.
    FDIC: William A. Stark, Assistant Director (202/898-6972), Miguel 
Browne, Deputy Assistant Director (202/898-6789), Kenton Fox, Senior 
Capital Markets Specialist (202/898-7119), Division of Supervision; 
Jamey Basham, Counsel (202/898-7265), Legal Division, Federal Deposit 
Insurance Corporation, 550 17th Street, NW, Washington, D.C. 20429.

SUPPLEMENTARY INFORMATION:

I. Background

    The Agencies' risk-based capital standards are based upon 
principles contained in the July 1988 agreement entitled 
``International Convergence of Capital Measurement and Capital 
Standards'' (Accord). The Accord, developed by the Basle Committee on 
Banking Supervision (Committee) and endorsed by the central bank 
governors of the Group of Ten (G-10) countries,1 provides a 
framework for assessing an institution's capital adequacy by weighting 
its assets and off-balance-sheet exposures on the basis of counterparty 
credit risk. In April 1995, the Committee issued a consultative 
proposal to amend the Accord and require institutions to measure and 
hold capital to cover their exposure to market risk, specifically, 
market risk associated with foreign exchange and commodity positions, 
and with debt and equity positions located in the trading 
account.2
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    \1\ The G-10 countries are Belgium, Canada, France, Germany, 
Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom, 
and the United States. The Committee is comprised of representatives 
of the central banks and supervisory authorities from the G-10 
countries and Luxembourg. The Agencies each adopted risk-based 
capital standards implementing the Accord in 1989.
    \2\ Market risk consists of general market risk and specific 
risk. General market risk refers to changes in the market value of 
on-balance-sheet assets and liabilities and off-balance-sheet items 
resulting from broad market movements, such as changes in the 
general level of interest rates, equity prices, foreign exchange 
rates, and commodity prices. Specific risk refers to changes in the 
market value of individual positions due to factors other than broad 
market movements and includes such risks as the credit risk of an 
instrument's issuer.
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Market Risk Proposal

    On July 25, 1995, the Agencies published a joint proposal to amend 
their respective risk-based capital standards in accordance with the 
Committee's consultative proposal (60 FR 38082) (market risk proposal). 
Under the market risk proposal, an institution with significant trading 
activity must calculate a capital charge for market risk using either 
its own internal risk measurement model (internal models approach) or a 
risk-weighting process developed by the Committee (standardized 
approach). The market risk proposal requires an institution to 
integrate the market risk capital charge into its risk-based capital 
ratios used for supervisory purposes no later than year-end 1997.
    The proposed internal models approach requires an institution to 
employ an internal model to calculate daily value-at-risk (VAR) 
measures 3 for each of four risk categories: interest rates, 
equity prices, foreign exchange rates, and commodity prices, including 
related options in each category. For regulatory capital purposes, the 
market risk proposal requires an institution to calibrate VAR measures 
to a ten-day movement in rates and prices and a 99 percent confidence 
level. An institution must base its VAR measures upon rates and prices 
observed over a period of at least one year. In deriving the overall 
VAR measure, an institution could take into account historical 
correlations within a risk category (e.g., between interest rates), but 
not across risk categories (e.g., not between interest rates and equity 
prices); in other words, the overall VAR measure equals the sum of the 
VAR measures for each risk category. An institution's capital charge 
for general market risk equals the greater of (1) the previous day's 
overall VAR measure, or (2) the average of the preceding 60 days' 
overall VAR measures multiplied by a factor of three (the 
multiplication factor). Moreover, the market risk proposal requires an 
institution to hold additional capital for specific risk associated 
with debt and equity positions in the trading account to the extent 
that its internal model does not incorporate that risk.
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    \3\ The VAR measure represents an estimate of the amount by 
which an institution's positions in a risk category could decline 
due to general market movements during a given holding period, 
measured with a specified confidence level.
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    Under the market risk proposal, an institution's supervisor 
evaluates its internal modeling and risk management process to ensure 
that the institution is, in fact, using its internal model for risk management purposes, that 
the calculation of VAR for capital purposes conforms with the specified 
quantitative criteria, and that the risk management process meets 
certain qualitative criteria, such as requiring independent model 
validations 4 and having an independent risk management unit. The 
market risk proposal allows an institution's supervisor to increase its 
multiplication factor (which applies to the 60-day VAR average) if 
backtesting results suggest problems with the institution's internal 
model or risk management process.
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    \4\ The proposed qualitative criteria identify backtesting and 
stress testing as two model validation techniques. Backtests provide 
information about the accuracy of an internal model by comparing an 
institution's daily VAR measures to its corresponding daily trading 
profits and losses. Stress tests provide information about the 
impact of adverse market events on an institution's positions.
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    The standardized approach, the market risk proposal's alternative 
to the internal models approach, requires an institution to apply 
certain uniform techniques to calculate a capital charge for the 
general market risk of positions in the four risk categories, as well 
as for the specific risk of debt and equity positions located in the 
trading account. The total capital charge is the sum of the capital 
charges for each risk category.
    An institution supports its market risk capital charges using a 
combination of Tier 1 and Tier 2 capital instruments (as defined in the 
credit risk-based capital standards), as well as a proposed new type of 
capital (Tier 3). Generally, Tier 3 capital consists of short-term 
subordinated debt subject to certain criteria, including a lock-in 
provision that prevents the issuer from repaying the debt even at 
maturity if the issuer's risk-based capital ratio is less than 8.0 
percent following the payment.
    In December 1995, the G-10 Governors endorsed a final amendment to 
the Accord adopting, with some modification, the Committee's market 
risk consultative proposal. At that same time, the Committee issued 
supervisory guidance specifying the effect of backtesting results on an 
institution's multiplication factor.

Backtesting Proposal

    On March 7, 1996, the Agencies published for public comment a joint 
proposal on backtesting (61 FR 9114) (backtesting proposal) that 
reflected the Committee's backtesting guidance. The backtesting 
proposal requires an institution to compare its daily net profits and 
losses for the most recent 250 business days to the corresponding daily 
VAR measures generated for internal risk management purposes, using a 
99 percent confidence level and a one-day period of rate and price 
movement. Each day for which a net trading loss exceeds the 
corresponding VAR measure is counted as an exception. An institution 
with five or more exceptions is presumed to have an inaccurate internal 
model and must increase its multiplication factor from three up to a 
maximum of four, depending on the number of exceptions. The backtesting 
proposal requires an institution to begin backtesting one year after it 
begins to calculate market risk capital charges. The delayed effective 
date for backtesting provides an institution with sufficient time to 
accumulate the required data for 250 business days.

II. Comment Summary

Market Risk Proposal

    Together, the Agencies received 33 public comments on the market 
risk proposal. Commenters strongly supported the proposed internal 
models approach.5 Most commenters believed that approach provides 
greater accuracy in measuring market risk than the standardized 
approach and creates incentives for institutions to continue improving 
their risk modeling and management techniques. Nevertheless, most 
commenters stated that the proposed modeling constraints were 
unnecessarily rigid and, especially when combined with the 
multiplication factor of three, result in excessive capital charges. 
The following discussion summarizes the responses to the Agencies' 
specific questions about the proposal.
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    \5\ Early versions of the Basle Committee's market risk 
amendment did not allow for the use of internal models to determine 
capital charges.
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General Topics
    The Agencies asked commenters about the proposed criteria for 
determining which institutions must calculate capital charges for 
market risk. As proposed, the rule applied to: (1) Any institution with 
total assets exceeding $5 billion and either trading activity totaling 
at least 3 percent of total assets or the notional amount of trading 
account derivative contracts in excess of $5 billion; and (2) any 
institution with total assets of $5 billion or less and trading 
activity representing at least 10 percent of total assets. Commenters 
generally agreed that an institution with significant exposure to 
market risk should hold capital against that exposure. However, some 
believed it inappropriate to use the notional amount of trading account 
derivative contracts as a criterion. Further, some objected to 
different criteria for institutions of different asset size.
    The Agencies asked about the burden associated with applying the 
market risk measure to both banks and bank holding companies and, with 
regard to bank holding companies, the burden associated with applying 
the measure both with and without Section 20 subsidiaries. The Agencies 
received mixed comments on the bank and bank holding company issue. 
Some believed the measure should apply only at the bank holding company 
level, pointing out that market risk usually is managed on a 
consolidated basis at the bank holding company level. Some favored 
applying the measure at the bank level. Others believed that an 
institution should have a choice, depending on how it manages risk. 
Most commenters discussing the Section 20 subsidiary issue supported 
applying the rule on a fully consolidated basis (i.e., including 
Section 20 subsidiaries).
    The Agencies also asked whether to allow an institution to choose 
either the standardized or internal models approaches, whether to allow 
an institution to combine the two approaches for different risk 
categories, and whether the two approaches result in similar capital 
charges. While some commenters supported the flexibility of choosing 
between the internal models and standardized approaches, those 
commenters who anticipated that they would be subject to the market 
risk capital requirements indicated that they intend to use only the 
internal models approach. Other commenters thought that a choice of 
approaches could be useful in certain situations, for example, when an 
institution suddenly meets the applicability criteria but does not have 
a completely developed internal model. Several commenters expressed 
concerns about the accuracy of the standardized approach and urged its 
elimination. The few commenters that addressed the question about 
combining the two approaches supported the flexibility that this could 
provide. A few commenters stated that capital charges would be higher 
under the internal models approach than under the standardized 
approach.6
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    \6\ The summary does not include comments on particular issues 
that might arise in applying the standardized approach (other than 
comments on specific risk) because, as discussed below, the Agencies 
have decided not to adopt the standardized approach in the final 
rule. Public comments are available from the Board's and OCC's 
Freedom of Information Office and the FDIC's Reading Room.

--------------------------------------------------------------------------- The Internal Models Approach
    The market risk proposal imposed several quantitative standards on 
VAR measures used for regulatory capital purposes. The Agencies asked 
about the potential burden associated with these standards and whether 
the resulting capital charge sufficiently covered market risk. 
Commenters overwhelmingly responded that the proposed modeling 
constraints were unnecessarily rigid and would result in an excessive 
capital charge. Many commenters suggested the Agencies allow an 
institution to use the same internal modeling parameters for regulatory 
capital purposes as for internal risk management.
    Modeling Constraints. With regard to the proposed modeling 
constraints, a few commenters supported basing capital charges on a 
ten-day period of rate and price movements. Others indicated that the 
period was too long, with most suggesting a one-day period. Some 
commenters objected to any specified period. Several commenters opposed 
the proposed 99 percent confidence level, noting that many institutions 
use lower confidence levels. Others supported the proposed level and 
still others suggested that regulators should not specify a confidence 
level.
    Many commenters strongly asserted that the proposed multiplication 
factor of three was too high and suggested, instead, a minimum factor 
of one. Most of these commenters believed that the proposal did not 
adequately explain the rationale for a multiplication factor greater 
than one. Several asked for clarification about how the Agencies will 
measure a model's accuracy and adjust an institution's multiplication 
factor. They advocated objective, well-defined criteria to ensure that 
the Agencies apply the rules consistently.
    Commenters strongly opposed the proposal's requirement that an 
institution aggregate VAR measures by simple summation across the risk 
categories. They asserted that ignoring the effects of cross 
correlation among risk categories overstates exposure and understates 
the merits of diversified portfolios.
    The Agencies asked whether to require an institution to calculate 
VARs using two observation periods. Specifically, the Agencies asked 
about the tradeoff between enhanced prudential coverage and additional 
burden associated with requiring an institution to make two VAR 
measures, one based on a short observation period and one based on a 
longer (over one year) period. Most commenters believed dual 
observation periods would result in unnecessary costs and operational 
burden. Commenters had varying opinions about the optimal length of 
time for an observation period. Some commenters suggested that the 
Agencies allow an institution to choose an appropriate observation 
period.
    Backtesting. The Agencies asked for comments about the potential 
burden associated with backtesting to evaluate the accuracy of an 
institution's internal model. Commenters generally viewed backtesting 
as a useful tool for model validation purposes. Most believed that 
backtesting should compare an institution's VAR calculated for internal 
risk management purposes (rather than for regulatory capital purposes) 
with actual profits and losses. A few commenters, noting the developing 
nature of backtesting generally, urged regulators not to prescribe 
specific regulations, guidelines, or methodologies for backtesting.
    The Agencies also asked for comment about the types of stress tests 
institutions should perform as part of their internal risk management 
process. Several commenters recognized generally the importance of 
stress testing. These and other commenters responded that the Agencies 
should allow an institution to choose its methodology. Other commenters 
questioned whether a stress testing requirement was necessary.
    Specific Risk. The Agencies noted that the internal models approach 
requires an institution to add a specific risk capital charge 
calculated using the standardized approach if its internal model does 
not adequately capture specific risk, and asked what modeling 
techniques the Agencies should consider when evaluating an 
institution's model for specific risk. While commenters generally 
agreed that an institution should integrate specific risk into its 
internal model, several objected to using capital charges calculated 
under the standardized approach as the benchmark for specific risk 
under the internal models approach. A few commenters asked for 
clarification about what constitutes sufficient integration of specific 
risk into a model to avoid the add-on capital charge. Some commenters 
noted that internal models that incorporate specific risk elements are 
still in the development stage, and stated that the Agencies should not 
include a specific risk requirement in the internal models approach.
    The Agencies asked whether they should specifically define the term 
``liquid and well-diversified,'' as applied to specific risk in 
equities, entitling an institution to a lower capital charge under the 
standardized approach. Commenters differed as to the appropriate degree 
of specificity. Some preferred a qualitative definition, as proposed, 
and others supported a more explicit and objective definition.
Other Issues
    Some commenters raised issues not directly addressed in the 
Agencies' specific questions on the market risk proposal. One commenter 
suggested that an institution could determine internally whether to 
classify a debt instrument as qualifying or non-qualifying for purposes 
of determining the applicable specific risk weight factor (qualifying 
instruments receive a lower specific risk charge than non-qualifying 
instruments). Another commenter recommended a zero percent specific 
risk charge for debt instruments issued by local and regional 
governments. Another recommended a zero percent specific risk charge 
for instruments tracking an equity index.
    Several commenters said that the proposed qualitative standards for 
an institution's risk management system were reasonable. One 
institution noted the qualitative standards provided a comprehensive 
set of guidelines. Some commenters questioned the marketability of 
short-term subordinated debt included as Tier 3 capital. A few 
commenters discussed the relationship between market risk and credit 
risk, with some arguing that when aggregating capital charges for 
credit and market risk the Agencies should permit an institution to 
recognize correlations between the two types of risk.

Backtesting Proposal

    Together, the Agencies received 17 public comments on the 
backtesting proposal. Commenters to that proposal generally supported 
backtesting as a useful component of risk management. Several expressed 
concern that the proposal was unnecessarily rigid, noting that 
backtesting techniques are evolving, and suggested that the Agencies 
reexamine backtesting prior to implementation of the final rule. A few 
commenters questioned linking backtesting results to capital 
requirements. Some commenters expressed the view that the Agencies 
should take into account the severity of an exception, not just the 
number of exceptions. Other commenters believed that the Agencies 
should base capital requirements on an overall evaluation of an 
institution's risk management process and not merely on the number of 
exceptions. A few commenters suggested that the Agencies retain the flexibility to adjust the multiplication factor below three if an 
institution's model exhibits superior performance.
    Among other specific questions, the Agencies asked about the merits 
and problems associated with backtesting hypothetical trading outcomes 
(profits and losses) versus backtesting actual trading outcomes.7 
Almost all commenters supported using actual trading outcomes for 
backtesting purposes rather than hypothetical outcomes. One commenter 
supported giving an institution the option of what type of outcomes it 
will backtest. Commenters who supported using actual trading outcomes 
believed that these results appropriately included such factors as 
gains and losses from trading activity, fee income, net interest 
income, and management responses to changing portfolio conditions. 
Commenters who objected to using hypothetical results noted that costs 
associated with creating and operating a system for determining 
hypothetical results were significant. Other commenters discussed the 
potential burden of requiring an institution to calculate daily profits 
and losses with an unreasonable degree of exactness. They noted that 
global VARs are calculated by simulating changes in all market factors 
and calculating resulting changes in portfolio values. They suggested 
letting an institution estimate daily profit and losses using a 
consistent, reasonable methodology.
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    \7\ Generally, hypothetical outcomes are trading outcomes that 
would result if the trading position as of the end of one business 
day went unchanged during the next business day. Hypothetical 
outcomes differ from actual outcomes because of the effects of such 
items as changes in portfolio composition over the holding period, 
fee income, commissions, and income from trading.
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    The Agencies asked for comment on what types of events or regime 
shifts (i.e., dramatic changes in market conditions that result in 
numerous exceptions in a short period of time for the same reason) 
might generate exceptions that do not warrant an increase in an 
institution's multiplication factor. Several commenters asserted that 
the Agencies should not list the types of regime shifts in advance. Two 
commenters suggested that the Agencies should treat any market-wide or 
asset-class event affecting a large number of institutions as a regime 
shift. Commenters suggested the following examples of regime shifts: 
sudden abnormal changes in interest or exchange rates, major political 
events, and natural disasters. Some commenters suggested that the 
Agencies should take into account an institution's reaction to 
unanticipated trading results, such as how it adapts its internal model 
to take into account changed conditions. A few commenters stated the 
Agencies should not penalize an institution for exceptions after it 
adjusts its model.
    The Agencies asked about the proposed sample size of 250 
independent observations. While several commenters on this question 
responded that the proposed sample size was appropriate, some believed 
that an institution should have flexibility to increase or decrease the 
sample size. A few commenters asserted that all institutions should use 
the same sample size.
    Finally, the Agencies asked whether to require an institution to 
backtest against its VAR measures generated for internal risk 
management purposes, or against VAR measures calculated for market risk 
capital requirements. Most commenters supported the former approach.

III. Final Rule

    The Agencies believe it is important for an institution with 
significant market risk to measure its exposure and hold commensurate 
amounts of capital. The Agencies support the market risk amendment to 
the Accord and are now issuing uniform market risk standards that will 
implement that amendment for institutions regulated by the Agencies. 
The final rule incorporates a measure for exposure to market risk into 
the Agencies' credit risk-based capital standards. By January 1, 1998, 
an institution that meets the applicability criteria must use its 
internal model to measure its exposure to market risk and hold capital 
in support of that exposure. The Agencies concur with commenters that 
an institution with significant exposure to market risk can most 
accurately measure that risk using detailed information available to 
the institution about its particular portfolio processed by its own 
risk measurement model. The final rule does not include the proposed 
standardized approach for measuring general market risk. The final rule 
does retain, however, the standardized approach methodologies for 
determining capital charges for specific risk, which an institution 
must use as the basis for its specific risk charge for debt and equity 
positions in its trading account.
    The final rule supplements the existing credit risk-based capital 
standards by requiring an affected institution to adjust its risk-based 
capital ratio to reflect market risk. Specifically, an institution must 
adjust its risk-based capital ratio to take into account the general 
market risk of all positions located in its trading account and of 
foreign exchange and commodity positions, wherever located. 
Additionally, the institution must account for the specific risk of 
debt and equity positions located in its trading account. The positions 
covered by this final rule (except for foreign exchange positions 
outside the trading account and over-the-counter (OTC) derivatives) are 
excluded from the credit risk capital charge. Foreign exchange 
positions outside the trading account and OTC derivatives are subject 
to the market risk capital charge, as well as the credit risk capital 
charge.
    Thus, the minimum capital charge for an institution that meets the 
applicability criteria is its credit risk capital charge as calculated 
under the Agencies' credit risk-based capital standards (excluding the 
positions previously noted) plus its measure for market risk as 
calculated under this final rule. The institution's risk-based capital 
ratio adjusted for market risk is its risk-based capital ratio for 
purposes of prompt corrective action and other statutory and regulatory 
purposes.
    Subject to supervisory approval that its internal model and risk 
management processes meet the final rule's regulatory criteria, an 
institution may choose to comply with the final rule as early as 
January 1, 1997. Any institution that voluntarily complies with the 
final rule prior to January 1, 1998, must comply with all of its 
provisions, except for the backtesting provisions, which apply one year 
after the institution begins to comply with the other provisions of the 
final rule.

Institutions Subject to the Final Rule (Section 1(b))

    The Agencies agree with commenters that all institutions with 
significant market risk, regardless of size, should measure their 
exposure and hold appropriate levels of capital. Thus, the Agencies 
have revised the applicability criteria to eliminate the differential 
criteria based on total asset size. The Agencies believe that the 
capital requirements are appropriate both for an institution whose 
trading activity is large relative to its total assets, and for an 
institution with a substantial volume of trading activity.
    The final rule applies to any bank or bank holding company whose 
trading activity equals 10 percent or more of its total assets, or 
whose trading activity equals $1 billion or more.8 For purposes of these criteria, an institution's trading activity is defined as the 
sum of its trading assets and trading liabilities as reported in its 
most recent Consolidated Report of Condition and Income (Call Report) 
for a bank, or its most recent Y-9C Report for a bank holding company. 
Total assets means quarter-end total assets as most recently reported 
by the institution.
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    \8\ The Federal Reserve agrees with commenters that since market 
risk usually is managed on a consolidated basis at the bank holding 
company level, market risk should be measured at that level for 
risk-based capital purposes. Thus, the final rule applies to bank 
holding companies on a fully consolidated basis. In addition, 
because the Accord applies to internationally active banks, the 
final rule applies to consolidated banks. The Agencies may monitor 
the market risk exposure of institutions on a non-consolidated basis 
to ensure that significant imbalances within an organization do not 
avoid supervision.
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    In addition, on a case-by-case basis, an Agency may require an 
institution that does not meet the applicability criteria to comply 
with the final rule if the Agency deems it necessary for safety and 
soundness purposes, or may exclude an institution that meets the 
applicability criteria. For example, an Agency may require an 
institution with trading activity less than $1 billion and less than 10 
percent of total assets, but with significant foreign exchange exposure 
outside of its trading account to comply with the provisions of the 
final rule. On the other hand, an Agency may exempt an institution with 
trading activity that exceeds 10 percent of its total assets as a 
result of accounting, operational, or similar considerations, provided 
this does not raise safety and soundness concerns.
    An institution that does not meet the applicability criteria may, 
subject to supervisory approval, comply voluntarily with the market 
risk rule, but only if it complies with all of the final rule's 
provisions (e.g., the backtesting requirements, after accumulating 
sufficient trading outcomes).

Covered Positions (Section 2(a))

    An institution subject to the final rule must hold capital to 
support its exposure to general market risk arising from fluctuations 
in interest rates, equity prices, foreign exchange rates, and commodity 
prices and its exposure to specific risk associated with certain debt 
and equity positions. Covered positions include all positions in an 
institution's trading account and foreign exchange and commodity 
positions throughout the institution (whether or not in the trading 
account).
    For market risk capital purposes, an institution's trading account 
is defined in the instructions to the Call Report. For example, the 
trading account includes on- and off-balance-sheet positions in 
financial instruments acquired with the intent to resell in order to 
profit from short-term price or rate movements (or other price or rate 
variations). An institution may include in its measure for general 
market risk certain non-trading account instruments that it 
deliberately uses to hedge trading positions. Those instruments are not 
subject to a specific risk capital charge, but instead, remain subject 
to the credit risk capital requirements. An institution may not include 
items in, or exclude items from, its trading account to manipulate 
associated capital charges. All positions included in the trading 
account must be marked to market and reflected in an institution's 
earnings statement.
    The market risk capital charge applies to all of an institution's 
foreign exchange and commodities positions. An institution's foreign 
exchange positions include, for each currency, such items as its net 
spot position (including ordinary assets and liabilities denominated in 
a foreign currency), forward positions, guarantees that are certain to 
be called and likely to be unrecoverable, and any other items that 
react primarily to changes in exchange rates. An institution may, 
subject to supervisory approval, exclude from the market risk measure 
any structural positions in foreign currencies. For this purpose, 
structural positions include transactions designed to hedge an 
institution's capital ratios against the effect of adverse exchange 
rate movements on (1) subordinated debt, equity, or minority interests 
in consolidated subsidiaries and capital assigned to foreign branches 
that are denominated in foreign currencies, and (2) any positions 
related to unconsolidated subsidiaries and other items that are 
deducted from an institution's capital when calculating its capital 
base. An institution's commodity positions include all positions that 
react primarily to changes in commodity prices.

Adjustment to the Risk-Based Capital Ratio Calculation (Section 3)

    An institution subject to the final rule must measure its market 
risk and hold capital on a daily basis to maintain an overall minimum 
8.0 percent ratio of total qualifying capital to risk-weighted assets 
adjusted for market risk.
Risk-Based Capital Ratio Denominator (Section 3(a))
    An institution's risk-based capital ratio denominator equals its 
adjusted risk-weighted assets plus its market risk equivalent assets. 
Adjusted risk-weighted assets are risk-weighted assets, as determined 
under the credit risk-based capital standards, less the risk-weighted 
amounts of all covered positions other than foreign exchange positions 
outside the trading account and OTC derivatives. Covered positions 
(except for foreign exchange positions outside the trading account and 
OTC derivatives) are no longer subject to a credit risk capital charge. 
An institution's market risk equivalent assets equals the measure for 
market risk, as determined under this final rule, multiplied by 12.5 
(the reciprocal of the minimum 8.0 percent capital ratio).
Measure for Market Risk (Section 3(a)(2))
    The measure for market risk consists of an institution's VAR-based 
capital charge plus an add-on capital charge for specific risk.\9\ The 
VAR-based capital charge is the larger of either (1) the average VAR 
measure for the last 60 business days, calculated under the regulatory 
criteria and increased by a multiplication factor of between three and 
four; or (2) the previous day's VAR, calculated under the regulatory 
criteria but without the multiplication factor. An institution's 
multiplication factor is three unless its backtesting results indicate 
that a higher factor is appropriate or unless the institution's 
supervisor determines that another action is appropriate.
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    \9\ The final rule also provides that, on a case-by-case basis, 
an Agency may permit an institution to measure de minimis exposures 
to market risk using other techniques, provided the exposure is 
truly de minimis, the associated risk is adequately measured, and 
integration of the exposure into the institution's internal model 
would impose an unnecessary regulatory burden.
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    The Agencies believe this comparative approach will result in an 
institution holding capital sufficient to cover peak levels of market 
volatility. While the Agencies acknowledge some commenters' concerns 
that a multiplication factor of three (or higher) imposes excessive 
capital charges, the Agencies believe that adjustments in the final 
rule to the internal models approach (e.g., requiring only a single 
observation period and recognizing cross correlations among risk 
categories) result in capital charges that are appropriate, given 
existing industry practices. As institutions implement the final rule, 
the Agencies will monitor resulting capital charges, will continue to 
evaluate the appropriateness of the multiplication factor, and may 
consider further refinements or adjustments to the final rule. Risk-Based Capital Ratio Numerator (Section 3(b))
    An institution's risk-based capital ratio numerator consists of a 
combination of core (Tier 1) capital, supplemental (Tier 2) capital\10\ 
and a third tier of capital (Tier 3), which consists of short-term 
subordinated debt that meets certain conditions. Specifically, Tier 3 
capital must have an original maturity of at least two years; it must 
be unsecured and fully paid up; it must be subject to a lock-in clause 
that prevents the issuer from repaying the debt even at maturity if the 
issuer's capital ratio is, or with repayment would become, less than 
the minimum 8.0 percent risk-based capital ratio; it must not be 
redeemable before maturity without the prior approval of the 
institution's supervisor; and it must not contain or be covered by any 
covenants, terms, or restrictions that may be inconsistent with safe 
and sound banking practices. An institution may use Tier 3 capital only 
to meet market risk capital requirements.
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    \10\ Tier 1 and Tier 2 capital components are discussed in the 
Agencies' credit risk capital standards. Generally, Tier 1 includes 
common stockholder's equity, noncumulative perpetual preferred 
stock, and minority equity interests in consolidated subsidiaries, 
less goodwill and other deductions. Bank holding companies may 
include certain amounts of cumulative perpetual preferred stock in 
Tier 1. Tier 2 includes the allowance for loan and lease losses, 
other preferred stock, and subordinated debt with an original 
average maturity of at least five years.
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    To determine its risk-based capital ratio numerator, an institution 
should first allocate Tier 1 and Tier 2 capital equal to 8.0 percent of 
its risk-weighted assets (adjusted for the positions that are no longer 
subject to the credit risk rules). Next, the institution should 
allocate Tier 1, Tier 2, and Tier 3 capital to support its measure for 
market risk. The risk-based capital ratio numerator (i.e., total 
qualifying capital), is the sum of Tier 1 capital (whether or not 
allocated for credit risk or market risk), Tier 2 capital (whether or 
not allocated for credit risk or market risk and subject to certain 
limits), and Tier 3 capital (allocated for market risk and subject to 
certain limits).
    The Agencies continue to believe that Tier 1 capital should 
constitute a substantial proportion of an institution's total capital. 
Thus, the final rule includes the existing credit risk-based capital 
constraints that at least 50 percent of an institution's total 
qualifying capital must be Tier 1 capital, and that term subordinated 
debt (and intermediate-term preferred stock and related surplus) may 
not exceed 50 percent of Tier 1 capital. In addition, the sum of Tier 2 
and Tier 3 capital allocated for market risk must not exceed 250 
percent of Tier 1 capital allocated for market risk. This requirement 
means that an institution must support at least 28.6 percent of its 
measure for market risk with Tier 1 capital.

Internal Models (Section 4)

    The Agencies recognize that institutions can and will use different 
assumptions and modeling techniques and that such differences often 
reflect distinct business strategies and approaches to risk management. 
For example, an institution may calculate VAR using internal models 
based on variance-covariance matrices, historical simulations, Monte 
Carlo simulations, or other statistical approaches. In all cases, 
however, the model must cover the institution's material risks.\11\ 
While the Agencies are not specifying modeling parameters for internal 
risk management purposes, the final rule does include minimum 
qualitative requirements for internal risk management processes, as 
well as certain quantitative requirements for the parameters and 
assumptions for internal models used to measure market risk exposure 
for regulatory capital purposes.
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    \11\ For an institution using an externally developed or 
outsource risk measurement model, the model may be used for risk-
based capital purposes provided it complies with the requirements of 
the final rule, management fully understands the model, the model is 
integrated into the institution's daily risk management, and the 
institution's overall risk management process is sound.
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Qualitative Requirements (Section 4(b))
    The qualitative requirements reiterate several basic components of 
sound risk management. For example, one of the final rule's qualitative 
requirements is that an institution must have a risk control unit that 
reports directly to senior management and that is independent from 
business trading functions. The Agencies expect that a risk control 
unit will conduct regular backtests to evaluate the model's accuracy 
and stress tests to identify the impact of adverse market events on the 
institution's portfolio.
    The other qualitative requirements in the final rule are also 
elements of sound risk management practices. For example, an 
institution must have an internal model that is integrated into its 
daily management, must have policies and procedures for conducting 
appropriate stress tests and backtests and for responding to the 
results of those tests, and must conduct independent reviews of its 
risk measurement and management systems at least annually.
    The Agencies agree with commenters that an institution should 
develop and use stress tests appropriate to its particular situation. 
Thus, the final rule does not require specific stress test 
methodologies. The Agencies expect an institution to conduct stress 
tests that are rigorous and comprehensive and that cover a range of 
factors that could create extraordinary losses in a trading portfolio, 
or make the control of risk in a portfolio difficult. The Agencies 
believe stress tests should be both qualitative and quantitative, 
should incorporate both market risk and liquidity aspects of market 
disturbances, and should reflect the impact of an event on positions 
with linear and non-linear price characteristics. Where stress tests 
reveal a particular vulnerability, the institution should take 
effective steps to appropriately manage those risks.
    An institution's independent review of its risk management process 
should include both the activities of business trading units and the 
risk control unit. For example, the Agencies expect that an 
institution's review would include assessing whether its risk 
management system is fully integrated into the daily management process 
and whether its risk management system is adequately documented. The 
review should evaluate the organizational structure of the risk control 
unit and analyze the approval process for risk pricing models and 
valuation systems. The review should also consider the scope of market 
risks captured by the risk measurement model, the accuracy and 
completeness of position data, the verification of the consistency, 
timeliness, and reliability of data sources used to run the internal 
model, the accuracy and appropriateness of volatility and correlation 
assumptions, and the validity of valuation and risk transformation 
calculations.
Market Risk Factors (Section 4(c))
    The final rule provides that an institution's internal model must 
use risk factors that address market risk associated with interest 
rates, equity prices, exchange rates, and commodity prices, including 
the market risk associated with options in each of these risk 
categories. Although an institution has discretion to use market risk 
factors that it has determined affect the value of its positions and 
the risks to which it is exposed, the Agencies expect an institution to 
use sufficient risk factors to cover the risks inherent in its 
portfolio. For example, the Agencies believe that interest rate risk factors 
should correspond to interest rates in each currency in which the 
institution has interest-rate-sensitive positions. The risk measurement 
system should model the yield curve using one of a number of generally 
accepted approaches, such as by estimating forward rates or zero coupon 
yields, and should incorporate risk factors to capture spread risk. The 
yield curve should be divided into various maturity segments to capture 
variation in the volatility of rates along the yield curve. For 
material exposures to interest rate movements in the major currencies 
and markets, modeling techniques should capture at least six segments 
of the yield curve.
    The risk measurement system should incorporate risk factors 
corresponding to individual foreign currencies in which the 
institution's positions are denominated, to each of the equity markets 
in which the institution has significant positions (at a minimum, a 
risk factor should capture market-wide movements in equity prices), and 
to each of the commodity markets in which the institution has 
significant positions. Risk factors should measure the volatilities of 
rates and prices underlying option positions. An institution with a 
large or complex options portfolio should measure the volatilities of 
options positions by different maturities. The sophistication and 
nature of the modeling techniques should correspond to the level of the 
institution's exposure.
Quantitative Requirements (Section 4(d))
    While an institution has flexibility in developing the precise 
nature of its model for internal risk management purposes, the Agencies 
continue to believe that when determining capital charges for exposure 
to market risk an institution's VAR measures should meet certain 
quantitative requirements. Such requirements are designed to ensure 
that an institution with significant market risk holds prudential 
levels of capital and that capital charges are sufficiently consistent 
across institutions with similar exposures. The Agencies have 
considered commenters' concerns that the proposed modeling constraints, 
when combined, would result in excessive capital charges. The Agencies 
believe that certain of the proposed constraints, such as a 99 percent 
(one-tailed) confidence level and a ten-day movement in rates and 
prices, are appropriate and therefore they have been retained in the 
final rule. However, the Agencies agree with commenters that other 
proposed or considered requirements are not necessary. For example, the 
Agencies have determined that a dual observation period would 
unnecessarily increase regulatory burden without providing a 
substantial benefit. Thus, the final rule employs a single observation 
period.
    The Agencies also agree with commenters that, for regulatory 
capital purposes, an institution should be permitted to use models that 
recognize cross correlations among risk categories. The final rule 
permits an institution to recognize cross correlations. The Agencies 
believe this revision eliminates a significant source of rigidity in 
the market risk proposal and should result in internal modeling for 
capital purposes that is more consistent with observed industry 
practice. The Agencies also believe this revision will appropriately 
recognize and reward portfolio diversification. These adjustments to 
the quantitative requirements are consistent with the final amendment 
to the Accord.
    The final rule contains the following quantitative requirements for 
an institution's VAR measures, upon which regulatory capital 
requirements are based:
    (1) VAR measures must be computed each business day based on a 99 
percent (one-tailed) confidence level of estimated maximum loss.
    (2) VAR measures must be based on a price shock equivalent to a 
ten-day movement in rates or prices. An institution may adjust VAR 
measures (including VAR measures for options) based on shorter periods 
to a ten-day standard (e.g., by multiplying by the square root of 
time).12 The Agencies do not believe that a price or rate movement 
period less than ten days is sufficient to reflect the risk associated 
with options positions (or other instruments with non-linear price 
characteristics), but recognize that it may be overly burdensome for an 
institution to apply a ten-day price or rate movement to such positions 
at this time. The Agencies expect an institution with concentrations of 
options to make substantive progress in developing a modeling system 
that measures the non-linear price characteristics of options positions 
(or other instruments with non-linear price characteristics), over a 
full ten-day period.
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    \12\ For example, under certain statistical assumptions, an 
institution can estimate the ten-day price volatility of an 
instrument by multiplying the volatility calculated on one-day 
changes by the square root of ten (approximately 3.16).
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    (3) Internal models must include the non-linear price 
characteristics of options positions and the sensitivity of the market 
value of those positions to changes in the volatility of the option's 
underlying rates and prices.
    (4) VAR measures must be based on a minimum historical observation 
period of at least one year for estimating future price and rate 
changes. A model that uses a weighting scheme or other method for the 
historical observation period must use an effective observation period 
of at least one year. That is, the weighted average time lag of the 
individual observations must be at least six months, the figure that 
would prevail in an equally weighted one-year observation period.
    (5) An institution must update its model data at least once every 
three months and more frequently if market conditions warrant.
    (6) VAR measures may incorporate empirical correlations (calculated 
from historical data on rates and prices) both within broad risk 
categories and across broad risk categories, subject to agreement by 
the institution's supervisor that the model's system for measuring such 
correlation is sound. If an institution's model does not incorporate 
empirical correlations across risk categories, then the bank must 
calculate the VAR measures used for regulatory capital purposes by 
summing the separate VAR measures for the four broad risk categories 
(i.e., interest rates, equity prices, foreign exchange rates, and 
commodity prices).
    The Agencies believe that, taken together, the modeling parameters 
are appropriate for regulatory capital purposes and also that they are 
compatible, as much as practicable, with existing modeling procedures. 
During the examination process, the Agencies will review an 
institution's risk management process and internal model to ensure that 
the model processes all relevant data and that modeling and risk 
management practices conform to the parameters and requirements of the 
final rule.13
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    \13\ When reviewing an institution's internal model for risk-
based capital purposes, the Agencies may consider reports and 
opinions about the accuracy of the model that have been generated by 
external auditors or qualified consultants.
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Backtesting (Section 4(e))

    The Agencies have considered commenters' responses to the 
backtesting proposal. The Agencies believe backtesting can be a useful 
tool for internal model validation, and have determined to include the 
backtesting provisions in the final rule, as proposed. An institution 
subject to the final rule must perform backtests of its VAR measures as 
calculated for internal risk management purposes. The backtests must 
compare daily VAR measures calibrated to a one-day movement in rates and prices and a 99 percent 
(one-tailed) confidence level against the institution's actual daily 
net trading profit or loss (trading outcome) for each of the preceding 
250 business days. The backtests must be performed once each 
quarter.14 Net trading outcomes include such items as fees and 
commissions associated with trading activities, as well as changes in 
market valuations associated with changing portfolio positions.
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    \14\ An institution's obligation to backtest for regulatory 
capital purposes does not arise until the institution has been 
subject to the final rule for 250 business days (approximately one 
year) and, thus, has accumulated the requisite number of 
observations to be used in backtesting.
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    An institution must identify the number of occurrences when its net 
trading loss (if any) for a particular day exceeds the corresponding 
daily VAR measure. In general, an institution's multiplication factor 
increases incrementally beginning with five or more exceptions during 
the previous 250 business days, and rises to a multiplication factor of 
four for an institution with 10 or more exceptions during the period. 
While the number of exceptions creates a presumption as to an 
institution's multiplication factor, the institution's supervisor may 
make other adjustments to the multiplication factor or may take other 
appropriate actions. For example, the supervisor may exclude exceptions 
that result from regime shifts, such as sudden abnormal changes in 
interest rates or exchange rates, major political events, or natural 
disasters. The supervisor may also consider such other factors as the 
magnitude of an exception (that is, the extent of the difference 
between the VAR measure and the actual trading loss), and an 
institution's reaction in response to an exception.
    The Agencies recognize that backtesting is evolving and acknowledge 
commenters' concerns that it may not be appropriate to penalize an 
institution by applying a higher multiplication factor if the 
institution has refined the accuracy of its model in response to an 
exception or has taken other action to improve its risk management 
processes. The Agencies emphasize that they will implement the 
backtesting requirements of the final rule with significant flexibility 
and examiner judgment. The Agencies will continue to monitor industry 
progress in developing backtesting methodologies and may consider 
adjusting the backtesting requirements in the near future.

Specific Risk (Section 5)

    The Agencies agree with the provisions in the final amendment to 
the Accord that require an institution to hold capital in support of 
the specific risk associated with debt and equity positions in an 
institution's trading account. Thus, the final rule provides that an 
institution must measure and hold capital in support of specific risk 
associated with those positions. The capital charge for specific risk 
is determined either by an institution's internal model or by the 
standardized risk measurement techniques specified by the Agencies (the 
standardized approach).
Standardized Approach
    Under the standardized approach, the specific risk charge for debt 
positions is calculated by multiplying the current market value of each 
net long or short position in a trading account debt instrument by the 
appropriate specific risk weighting factor as set forth in the final 
rule, based on the identity of the obligor, and in the case of some 
instruments such as corporate debt, on the credit rating and remaining 
maturity of the instrument. An institution must risk weight derivatives 
(e.g., swaps, futures, forwards, or options on certain debt 
instruments) according to the relevant underlying instrument. For 
example, for a forward contract, an institution must risk weight the 
market value of the effective notional amount of the underlying 
instrument (or index portfolio). An institution may net long and short 
positions in identical debt instruments with exactly the same issuer, 
coupon, currency, and maturity. An institution may also offset a 
matched position in a derivative instrument and its corresponding 
underlying instrument. The specific risk weighting factor for debt 
instruments of OECD 15 central governments is zero percent. Other 
debt instruments with qualifying ratings (essentially investment grade 
corporate securities) receive risk weights ranging from 0.25 percent to 
1.6 percent, depending on remaining maturity. Nonqualifying debt 
instruments receive a risk weight of 8.0 percent.
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    \15\ The Organization for Economic Cooperation and Development 
(OECD) is defined in the credit risk-based capital standards.
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    The specific risk charge for equity positions is based on an 
institution's gross equity position for each national market. The gross 
equity position is defined as the sum of all long and short equity 
positions, including positions arising from derivatives such as equity 
swaps, forwards, futures, and options. An institution must risk weight 
the current market value of each gross equity position by the 
appropriate factor. An institution must risk weight derivatives 
according to the relevant underlying equity instrument. An institution 
may net long and short positions in identical equity issues or indices 
in each national market. An institution may also offset a matched 
position in a derivative instrument and its corresponding underlying 
instrument.
    The specific risk charge is 8.0 percent of the gross equity 
position, unless the institution's portfolio is both liquid and well-
diversified, in which case the capital charge is 4.0 percent. A 
portfolio is liquid and well-diversified if: (1) it is characterized by 
a limited sensitivity to price changes of any single equity or closely 
related group of equity issues held in a portfolio; (2) the volatility 
of the portfolio's value is not dominated by the volatility of any 
individual equity issue or by equity issues from any single industry or 
economic sector; (3) it contains a large number of individual equity 
positions, with no single position representing a substantial portion 
of the portfolio's total market value; and (4) it consists mainly of 
issues traded on organized exchanges or in well-established over-the-
counter markets.
    For positions in an index comprising a diversified portfolio of 
equities, the specific risk charge is 2.0 percent of the net long or 
short position in the index. In addition, a 2.0 percent specific risk 
charge applies to only one side (long or short) in the case of certain 
futures-related arbitrage strategies (for instance, long and short 
positions in the same index at different dates or different market 
centers, and long and short positions at the same date in different, 
but similar indices). Finally, under certain conditions, futures 
positions on a broadly-based index that are matched against positions 
in the equities comprising the index are subject to a specific risk 
charge of 2.0 percent against each side of the transaction.
Internal Models Approach
    The final rule permits an institution to use its internal model to 
determine capital charges for specific risk if it can demonstrate to 
its supervisor that the modeling process adequately addresses elements 
of specific risk for debt and/or equity positions. In particular, an 
institution may use the model-based estimates of specific risk in place 
of the standardized capital charge. However, if the specific risk 
component of the institution's VAR measure (when multiplied by the 
backtesting multiplication factor, with respect to a 60-day average VAR figure) is not equal to at least 50 percent of the 
specific risk charge resulting from the standardized calculation, then 
the institution has a specific risk add-on in the amount of the 
difference. For example, if the standardized approach indicates a 
specific risk charge of $100, but the institution's 60-day average VAR 
figure includes only $10 for specific risk, then the institution has a 
specific risk add-on of $20 (that is, 50 percent of $100 minus three 
times $10). However, if the 60-day average VAR figure includes $20 from 
specific risk, then the institution would have no specific risk add-on 
because the VAR-based charge (three times $20) exceeds 50 percent of 
$100.
    An institution (in conjunction with its supervisor) must separately 
determine whether its model incorporates specific risk for debt 
positions and equity positions. For instance, if the model addresses 
the specific risk of debt positions but not equity positions, then the 
institution can use the model-based specific risk charge (subject to 
the limitations described earlier) for debt positions, but must use the 
full standard specific risk charge for equity positions. If, however, 
the model addresses the specific risk of both debt and equity 
positions, then the institution must make the comparison based on the 
total spe