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Subject: Risk-based Capital; Market Risk
Date: September 6, 1996
To: Chief Executive Officers of all National Banks, Department and Division Heads, and all Examining Personnel
Description: Final Rule
The attached final rule on market risk was published in the Federal Register on September 6, 1996. The rule was issued jointly by the OCC, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (agencies). The final rule amends the risk-based capital guidelines to incorporate a measure for market risk. A bank subject to this rule must measure the market risk of the debt and equity positions located in its trading account and of the foreign exchange and commodity positions throughout the bank. The rule is consistent with the amendment to the Capital Accord adopted by the Basel Committee on Banking Supervision. If a bank is subject to this rule, its trading account debt and equity positions and its commodity positions will no longer be included in the capital calculation for credit risk. The existing counterparty credit risk-based capital requirements for off-balance sheet transactions will, however, continue to apply to all banks.
The OCC intends to apply the rule to a limited group of national banks with significant trading activity. Specifically, the rule will apply to banks that meet one of the following two criteria:
Additionally, the final rule provides the agencies with flexibility to exempt from the rule banks that meet either of these two criteria. It also allows the agencies to apply the rule on a case-by-case basis to any bank with significant market risk exposure but which is not captured by the above criteria.
Identified banks must comply with the rule by January 1, 1998; however, a bank may choose to comply on January 1, 1997, with prior approval from the OCC.
Measure for Market Risk
The rule requires an identified bank to measure its market risk using its own internal value-at-risk (VAR) model and hold capital for that risk. The VAR model must incorporate risk factors that address the potential change in value due to movements in interest rates, equity and commodity prices and foreign exchange rates. The VAR measure must be calculated daily based on a 99 percent confidence level, a 10-day price shock, and a minimum historical observation period of one year. A bank's measure for market risk exposure will be a VAR measure plus a specific risk add-on. The VAR measure is calculated as the larger of the previous day's VAR measure or the average daily VAR for the preceding 60 business days multiplied by a factor of 3. The specific risk add-on is described below.
Specific risk refers to the changes in the market value of individual positions due to factors other than broad market movements. The final rule requires that a bank's market risk measure include the amount of specific risk associated with individual trading account debt and equity positions. A bank can determine the specific risk add-on either from its internal model or the specific risk weighting factors contained in the rule (standard specific risk charge). A bank may use the specific risk amount calculated by its VAR model as long as that amount is at least 50 percent of the standard specific risk charge. If the internal model generated figure is less than 50 percent of the standard specific risk charge, the bank must add to its VAR measure so that its total specific risk amount is 50 percent of the standard specific risk charge. If a bank's internal model does not measure specific risk, than 100 percent of the standard specific risk charge must be added to the VAR measure.
An institution subject to this rule must 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. The rule permits banks to use a new category of capital, Tier 3 capital, for a portion of its market risk requirement. Tier 3 capital is subordinated debt that meets certain conditions. It must have an original maturity of at least two years and be unsecured and fully paid up. Additionally, to qualify as Tier 3 capital, the subordinated debt must be subject to a lock-in clause which prohibits repayment even at maturity if the bank's resulting capital ratio would fall below the 8.0 percent minimum. The preamble to the rule outlines in detail the capital calculation.
The rule requires banks to conduct quarterly backtesting of their VAR models. A bank must compare its daily VAR measure calibrated to a one-day holding period and a 99 percent confidence level to its actual daily trading profit or loss for the preceding 250 business days. The bank must count the number of times during that period that its actual trading loss exceeds the VAR measure; each occurrence is called an "exception." If the number of exceptions during the 250 day period is five or more, the bank must increase its multiplication factor according to the table contained in the rule. However, exceptions may be excluded if they are the result of such occurrences as sudden abnormal changes in interest rates or exchange rates, major political events or natural disasters.
The final rule outlines qualitative requirements that a bank's internal model and risk management process must meet. The bank must have a risk control unit that is independent from its trading unit and conduct appropriate stress tests of its internal model. The bank also must conduct independent reviews of its model at least annually.
Implementation of the Market Risk Rule
In the coming months, the Office of the Chief National Bank Examiner will provide guidance on the many implementation issues of this rule including determination of a bank's status with respect to the requirements of the rule, evaluation of a bank's internal model and its risk management process, and exclusion of a backtesting exception.
For further information about the final rule, contact the Office of the Chief National Bank Examiner at (202) 874-5070.
Jimmy F. Barton