Banking and Finance Law Daily Wrap Up, CAPITAL AND BASEL ACCORDS—Fed adopts changes to market risk regulations, (Dec 6, 2013)

By John M. Pachkowski, J.D.

The Federal Reserve Board has adopted a final rule that makes technical changes to its market risk capital rule so as to align it with the Basel III revised capital framework adopted by the agency earlier this year.

The final rule addresses recent changes to the Country Risk Classifications (CRCs) published by the Organization for Economic Cooperation and Development (OECD), which are referenced in the Fed’s market risk rule. The final rule also clarifies the treatment of certain traded securitization positions; makes a technical amendment to the definition of covered position; and clarifies the timing of the required market risk disclosures.

The final rule will be effective April 1, 2014; however, any bank holding company or state member bank subject to the market risk rule may elect to adopt the requirements in the final rule before the effective date.

Sovereign debt positions. The final rule maps the risk weights to CRCs in a manner consistent with the Basel II standardized approach, which provides risk weights for exposures to foreign sovereigns based on CRCs. This final rule amends the Fed’s market risk rule to allow exposures to OECD member countries that are covered positions and that no longer receive a CRC or continue to receive a zero percent specific risk-weighting factor, except in cases of default by the sovereign entity. The final rule, as well as the current rule, defines default by a sovereign entity as noncompliance by the sovereign entity with its external debt service obligations or the inability or unwillingness of a sovereign government to service an existing loan according to its original terms, as evidenced by failure to pay principal and interest timely and fully, arrearages, or restructuring. A default includes a voluntary or involuntary restructuring that results in a sovereign not servicing an existing obligation in accordance with the obligation’s original terms.

Securitization positions. A banking organization subject to the market risk rule generally must assign a 100 percent specific risk-weighting factor to its securitization positions or apply the so-called Simplified Supervisory Formula Approach (SSFA), which takes into account the nature and quality of the underlying collateral of the securitization and was designed to apply relatively higher capital requirements to the more risky junior tranches of a securitization that are the first to absorb losses and relatively lower requirements to the most senior positions.

The final rule clarifies the treatment of certain securitization positions under the SSFA with regard to determining the delinquency of the underlying exposures, namely the “W” parameter, which increases the capital requirements for a securitization exposure when delinquencies in the underlying assets of the securitization grow. Under the market risk rule, the parameter W equals the ratio of: (1) the sum of the dollar amounts of any underlying exposures of the securitization that meet certain criteria to (2) the balance, measured in dollars, of underlying exposures.

The final rule clarifies that parameter W excludes loans with contractual provisions that allow deferral of principal and interest on federally-guaranteed student loans, in accordance with the terms of those guarantee programs, or on consumer loans including non-federally-guaranteed student loans, provided that such payments are deferred pursuant to provisions included in the contract at the time funds are disbursed that provide for periods of deferral that are not initiated based on changes in the creditworthiness of the borrower. The Fed notes that this clarification avoids regulatory disincentives for banking organizations to invest in securitizations, particularly securitizations of federally-guaranteed student loans, where the underlying exposures include provisions that allow for the deferral of certain payments for non-credit related reasons. This clarification is consistent with the approach the Board finalized in the new capital framework.

Covered position. The final rule also provides a technical amendment to the definition of “covered position.” In the current market risk rule, the covered position definition excludes equity positions that are not publicly traded. The Fed has refined this exclusion such that a covered position may include a position in an investment company, as defined in and registered with the Securities and Exchange Commission under the Investment Company Act of 1940, or its non-U.S. equivalent, provided that all the underlying equities held by the investment company are publicly traded. The Fed believes that a “look-through” approach is appropriate in these circumstances because of the liquidity of the underlying positions, so long as the other conditions of a covered position are satisfied. This modification to the definition of “covered position” is consistent with the approach the Board finalized in the new capital framework.

Timing of market risk disclosures. The final rule also amends the market risk rule regarding the timing of market risk disclosures by clarifying when a banking organization subject to the market risk rule must make its required market risk disclosures. The amendments align with the Fed’s new capital framework and are consistent with the expectation that public disclosures should be made in a timely manner. The final rule provides that a banking organization must provide timely quantitative disclosures after each calendar quarter. In addition, the final rule clarifies that a banking organization is required to provide timely qualitative disclosures at least annually, after the end of the fourth calendar quarter, provided any significant changes must be disclosed in the interim.

Basel III framework. The Fed also made minor modifications to its Basel III revised capital framework to clarify the criteria for subordinated debt instruments that may be counted as tier 2 capital. The Fed also corrected an incorrect citation.

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