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• SUPPLEMENTARY INFORMATION:
• Table of Contents
• I. Introduction
• A. Objectives of Proposed Rule
• B. Overview of Proposed Rule
• C. List of Questions Asked and Comments Requested in This Preamble
• (1) Alternatives to Including Common Cooperative Equities in CET1 or Tier 2 Capital
• (2) Capital Treatment of MSAs
• (3) Accounting for Defined Benefit Pension Fund Assets
• (4) Third-Party Capital Limits
• (5) Risk-Weighting—Exposures to OFIs
• (6) Risk-Weighting—Exposures to Certain Electrical Cooperative Assets
• (7) Credit Conversion Factors for Off-Balance Sheet Items—Exposure Amount of a System Bank’s Commitment to an Association
• (8) System Institution Acting as Clearing Member
• (9) Collateralized Transactions—Own Estimate of Haircuts
• (10) Exposures to Asset-Backed Commercial Paper (ABCP) Programs
• (11) Disclosures
• D. Key Provisions of the Proposed Rule
• E. The History and Cooperative Structure of the Farm Credit System
• 1. Capital Structure of System Institutions
• 2. Member Stock—Association Level
• 3. Member Stock—System Bank Level
• 4. Allocated Equities
• 5. Unallocated Retained Earnings (URE) and URE Equivalents
• F. The FCA’s Current Capital Regulations
  
• G. Prior FCA Advance Notices of Proposed Rulemaking (ANPRMs) on the Basel Capital Standards
  
• II. Minimum Regulatory Capital Ratios, Additional Capital Requirements, and Overall Capital Adequacy
• A. Minimum Risk-Based Capital Ratios and Other Regulatory Capital Provisions
• B. Leverage Ratio
• C. Capital Conservation Buffer
• D. Supervisory Assessment of Overall Capital Adequacy
  
• III. Definition of Capital
• A. Capital Components and Eligibility Criteria for Regulatory Capital Instruments
• 1. Common Cooperative Equity Tier 1 (CET1) Capital
• a. Criteria
• b. Accumulated Other Comprehensive Income (AOCI) and Minority Interests
• 2. Additional Tier 1 (AT1) Capital
• a. Criteria
• b. FCA’s Current Capital Regulations
• 3. Tier 2 Capital
• 4. FCA Approval of Capital Elements
• 5. FCA Prior Approval Requirements for Cash Patronage, Dividends, and Redemptions; Safe Harbor
• B. Regulatory Adjustments and Deductions
• 1. Regulatory Deductions From CET1 Capital
• a. Goodwill and Other Intangibles (Other Than Mortgage Servicing Assets)
• b. Gain-on-Sale Associated With a Securitization Exposure
• c. Defined Benefit Pension Fund Net Assets
• d. A System Institution’s Allocated Equity Investment in Another System Institution
• e. “Haircut” Deduction for Redemption of Equities Included in CET1 Capital Less Than 10 Years After Issuance or Allocation
• 2. The Corresponding Deduction Approach for Purchased Equities
• 3. Netting of Deferred Tax Liabilities Against Deferred Tax Assets and Other Deductible Assets
• C. Limits on Inclusion of Third-Party Capital
• IV. Standardized Approach for Risk-Weighted Assets
• A. Calculation of Standardized Total Risk-Weighted Assets
• B. Risk-Weighted Assets for General Credit Risk
• 1. Exposures to Sovereigns
• 2. Exposures to Certain Supranational Entities and Multilateral Development Banks
• 3. Exposures to Government-Sponsored Enterprises
• 4. Exposures to Depository Institutions, Foreign Banks, and Credit Unions
• 5. Exposures to Public Sector Entities
• 6. Corporate Exposures
• 7. Residential Mortgage Exposures
• 8. High Volatility Commercial Real Estate Exposures
• 9. Past Due Exposures
• 10. Other Assets
• 11. Exposures to Other System Institutions
• 12. Risk-Weighting for Specialized Exposures
• C. Off-Balance Sheet Items
• 1. Credit Conversion Factors
• 2. Credit-Enhancing Representations and Warranties
• D. Over-the-Counter Derivative Contracts
• E. Cleared Transactions
• 1. Definition of Cleared Transaction
• 2. Risk Weighting for Cleared Transactions
• System Institution Client—Clearing Member(CM) Trade
• F. Credit Risk Mitigation
• 1. Guarantees and Credit Derivatives
• a. Eligibility Requirements
• b. Substitution Approach
• c. Maturity Mismatch Haircut
• d. Adjustment for Credit Derivatives Without Restructuring as a Credit Event
• e. Currency Mismatch Adjustment
• f. Multiple Credit Risk Mitigants
• 2. Collateralized Transactions
• a. Eligible Collateral
• b. Risk Management Guidance for Recognizing Collateral
• c. Simple Approach
• d. Collateral Haircut Approach
• e. Standard Supervisory Haircuts
• f. Own Estimates of Haircuts
• G. Unsettled Transactions
• H. Risk-Weighted Assets for Securitization Exposures
• 1. Overview of the Securitization Framework and Definitions
• 2. Operational Requirements
• a. Due Diligence Requirements
• b. Operational Requirements for Traditional Securitizations
• c. Operational Requirements for Synthetic Securitizations
• d. Clean-Up Calls
• 3. Risk-Weighted Asset Amounts for Securitization Exposures
• a. Exposure Amount of a Securitization Exposure
• b. Gains-On-Sale and Credit-Enhancing Interest-Only Strips
• c. Exceptions Under the Securitization Framework
• d. Overlapping Exposures
• e. Servicer Cash Advances
• f. Implicit Support
• 4. Simplified Supervisory Formula Approach
• 5. Gross-up Approach
• 6. Alternative Treatments for Certain Types of Securitization Exposures
• 7. Credit Risk Mitigation for Securitization Exposures
• 8. Nth-to-Default Credit Derivatives
• I. Equity Exposures
• 1. Definition of Equity Exposure and Exposure Measurement
• 2. Equity Exposure Risk Weights
• 3. 100-Percent Risk Weight
• 4. Hedged Transactions
• 5. Measures of Hedge Effectiveness
• 6. Equity Exposures to Investment Funds
• b. Simple Modified Look-Through Approach
• c. Alternative Modified Look-Through Approach
• V. Market Discipline and Disclosure Requirements
• A. Proposed Disclosure Requirements
• B. Location and Frequency of Disclosures
• C. Proprietary and Confidential Information
• D. Specific Public Disclosure Requirements
• VI. Conforming Changes
• VII. Proposed Timeframe for Implementation
• VIII. Abbreviations
• IX. Regulatory Flexibility Act
• Addendum: Discussion of This Proposed Rule
• Overview
• A. Capital Components
• 1. Common Equity Tier 1 Capital (CET1)
• 2. Additional Tier 1 Capital (AT1)
• 3. Tier 2 Capital
• 4. Regulatory Adjustments and Deductions
• 5. FCA Prior Approval of Cash Patronage Refunds, Cash Dividend Payments, and Allocated Equity Redemptions; “Safe Harbor” Treatment for Certain Such Payments
• 6. Capital Conservation Buffer
• B. Risk Weightings
• 1. Zero-Percent (0%) Risk-Weighted Exposures
• 2. Twenty-Percent (20%) Risk-Weighted Exposures
• 3. Fifty-Percent (50%) Risk-Weighted Exposures
• 4. One Hundred-Percent (100%) Risk-Weighted Exposures
• 5. One Hundred Fifty-Percent (150%) Risk-Weighted Exposures
• 6. Six Hundred-Percent (600%) Risk-Weighted Exposures
• 7. One Thousand Two Hundred Fifty-Percent (1,250%) Risk-Weighted Exposures
• 8. Past Due Exposures (90 Days or More Past Due or in Nonaccrual Status)
• 9. Conversion Factors for Off-Balance Sheet Items—§ 628.33
• 10. Over-the-Counter (OTC) Derivative Contracts—§ 628.34
• 11. Treatment of Cleared Transactions—§ 628.35
• 12. Treatment of Guarantees—§ 628.36
• 13. Treatment of Collateralized Transactions—§ 628.37
• 14. Unsettled Transactions—§ 628.38
• 15. Securitization Exposures—§§ 628.41-628.45
• 16. Equity Exposures—§§ 628.51-628.52
• 17. Equity Exposures to Investment Funds—§ 628.53
• 18. Foreign Exposures—§ 628.32(a), (d), and (e), and Tables 1, 2, 3, and 4
• 20. Disclosure Requirements—§§ 628.61-628.63 (Including Tables 1-10)
• List of Subjects
• PART 607—ASSESSMENT AND APPORTIONMENT OF ADMINISTRATIVE EXPENSES
• PART 614—LOAN POLICIES AND OPERATIONS
• PART 615—FUNDING AND FISCAL AFFAIRS, LOAN POLICIES AND OPERATIONS, AND FUNDING OPERATIONS
• Subpart K [Removed and reserved]
• PART 620—DISCLOSURE TO SHAREHOLDERS
• PART 628—CAPITAL ADEQUACY OF SYSTEM INSTITUTIONS
• Subpart A—General Provisions
• Subpart B—Capital Ratio Requirements and Buffers
• Subpart C—Definition of Capital
• Subpart D—Risk-Weighted Assets—Standardized Approach
• Risk-Weighted Assets for General Credit Risk
• Risk-Weighted Assets for Unsettled Transactions
• Risk-Weighted Assets for Securitization Exposures
• Risk-Weighted Assets for Equity Exposures
• Disclosures
• Subpart E—[Reserved]
• Subpart F—[Reserved]
• Subpart G—Transition Provisions
• Subpart A—General Provisions
• Subpart B—Capital Ratio Requirements and Buffers
• Subpart C—Definition of Capital
• Subpart D—Risk-Weighted Assets—Standardized Approach
• Risk-Weighted Assets for General Credit Risk
• Risk-Weighted Assets for Unsettled Transactions
• Risk-Weighted Assets for Securitization Exposures
• Risk-Weighted Assets for Equity Exposures
• Disclosures.
• Subpart E—[Reserved]
• Subpart F—[Reserved]
• Subpart G—Transition Provisions
• Footnotes

• Table 1—Summary of Key Provisions of the Tier 1/Tier 2 Capital Items and Standardized Approach Risk Weights
• Table 2—Capital Instrument Comparison
• Table 3—Risk Weights for Sovereign Exposures
• Table 4—Risk Weights for Exposures to Foreign Banks
• Table 5—Proposed Risk Weights for Exposures to Non-U.S. PSE General Obligations and Revenue Obligations
• Table 7—Risk Weights for Various Cleared Transactions
• Table 8—Standard Supervisory Market Price Volatility Haircuts¹
  
• Table 9—Proposed Risk Weights for Unsettled DvP and PvP Transactions
• Table 10—Simple Risk-Weight Approach (SRWA)
• Table 1—Risk Weights for Foreign Sovereign Exposures
• Table 2—Risk Weights for Exposures to Foreign Banks
• Table 3—Risk Weights for Foreign PSE General Obligations
• Table 4—Risk Weights for Foreign PSE Revenue Obligations
• Table 19—Summary Comparison of Current Risk-Weighting Rules Versus Proposed Risk-Weighting Rules
• Table 1 to § 628.11—Calculation of Maximum Payout Amount
• Table 1 to § 628.32—Risk Weights for Sovereign Exposures
• Table 2 to § 628.32—Risk Weights for Exposures to Foreign Banks
• Table 3 to § 628.32—Risk Weights for Non-U.S. PSE General Obligations
• Table 4 to § 628.32—Risk Weights for Non-U.S. PSE Revenue Obligations
• Table 1 to § 628.34—Conversion Factor Matrix for Derivative Contracts¹
  
• Table 1 to § 628.37—Standard Supervisory Market Price Volatility Haircut ¹
  
• Table 1 to § 628.38—Risk Weights for Unsettled DvP and PvP Transactions
• Table 1 to § 628.63—Scope of Application
• Table 2 to § 628.63—Capital Structure
• Table 3 to § 628.63—Capital Adequacy
• Table 4 to § 628.63—Capital Conservation Buffer
• Table 5 to § 628.63¹—Credit Risk: General Disclosures
• Table 6 to § 628.63—General Disclosure for Counterparty Credit Risk-Related Exposures
• Table 7 to § 628.63—Credit Risk Mitigation^{1
  2}
  
• Table 8 to § 628.63—Securitization¹
  
• Table 9 to § 628.63—Equities
• Table 10 to § 628.63—Interest Rate Risk for Non-Trading Activities
• Table 1 to § 628.300

You may send us comments by January 2, 2015.

For accuracy and efficiency reasons, please submit comments by email or through the FCA’s Web site. We do not accept comments submitted by facsimile (fax), as faxes are difficult for us to process in compliance with section 508 of the Rehabilitation Act. Please do not submit your comment multiple times via different methods. You may submit comments by any of the following methods:

• Email: Send us an email at reg-comm@fca.gov.
• FCA Web site:
  http://www.fca.gov. Select “Public Commenters,” then “Public Comments,” and follow the directions for “Submitting a Comment.”
• Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments.
• Mail: Barry F. Mardock, Deputy Director, Office of Regulatory Policy, Farm Credit Administration, 1501 Farm Credit Drive, McLean, VA 22102-5090.

You may review copies of all comments we receive at our office in McLean, Virginia, or from our Web site at http://www.fca.gov. Once you are in the Web site, select “Public Commenters,” then “Public Comments,” and follow the directions for “Reading Submitted Public Comments.” We will show your comments as submitted, but for technical reasons we may omit items such as logos and special characters. Identifying information you provide, such as phone numbers and addresses, will be publicly available. However, we will attempt to remove email addresses to help reduce Internet spam.

J.C. Floyd, Senior Capital Markets Specialist and FCA Examiner, Office of Examination, Farm Credit Administration, McLean, VA 22102-5090, (720) 213-0924, TTY (703) 883-4056; or Rebecca S. Orlich, Senior Counsel, or Jennifer A. Cohn, Senior Counsel, Office of General Counsel, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4020, TTY (703) 883-4056.

A. Objectives of Proposed Rule

The FCA’s objectives in proposing this rule are:

• To modernize capital requirements while ensuring that institutions continue to hold enough regulatory capital to fulfill their mission as a Government-sponsored enterprise (GSE);
• To ensure that the System’s capital requirements are comparable to the Basel III framework and the standardized approach that the Federal banking regulatory agencies have adopted, but also to ensure that the rules take into account the cooperative structure and the organization of the System;
• To make System regulatory capital requirements more transparent; and
• To meet the requirements of section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

B. Overview of Proposed Rule

The FCA is seeking public comment on a proposed rule that would revise our capital requirements governing System banks,¹
System associations, Farm Credit Leasing Services Corporation, and any other FCA-chartered institution the FCA determines should be subject to this rule (collectively, System institutions). The proposed rule, where appropriate, is comparable to the capital rules adopted in October 2013 and April 2014 by the Federal banking regulatory agencies²
for the banking organizations they regulate.³
Those rules follow the Basel Committee on Banking Supervision’s (BCBS or Basel Committee) document entitled “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (Basel III), including subsequent changes to the BCBS’s capital standards and BCBS consultative papers, and our proposed rule follows Basel III as appropriate for cooperatives.⁴

The FCA believes this proposed rule would improve the quality and quantity of System institutions’ capital and enhance risk sensitivity in calculating risk-weighted assets. It would also provide a more transparent picture of System institutions’ capital to the investment-banking sector, which could facilitate System institutions’ securities offerings to third-party investors. In addition, to comply with section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act),⁵
we propose alternatives to credit ratings for calculating risk-weighted assets for certain exposures that are currently based on the ratings of nationally recognized statistical rating organizations (NRSROs).

After the worldwide financial crisis that began in the past decade, the BCBS issued Basel III and has continued to issue additional standards, with the goal of strengthening the capital of financial organizations. The capital rules recently adopted by the Federal banking regulatory agencies reflect Basel III as well as aspects of Basel II and other BCBS standards. The provisions of the banking agencies’ rules that are not specifically included in the Basel III framework are generally consistent with the goals of the framework.

The FCA’s proposed rule is comparable to the standardized approach rules of the Federal banking regulatory agencies to the extent appropriate for the System’s cooperative structure and status as a GSE with a mission to provide a dependable source of credit and related services for agriculture and rural America. Like the banking agencies’ rules, the FCA’s proposed rule incorporates key aspects of the Basel III tier 1 and tier 2 framework and includes a leverage ratio as well as a capital conservation buffer to enhance the resilience of System institutions. The capital conservation buffer would be phased in over 3 years, but we are not proposing to incorporate any of the other transition periods in Basel III and the Federal regulatory banking agencies’ rules.

The proposed rule would impose some new patronage and redemption restrictions, including FCA prior approvals, on System institutions in order to ensure the stability and permanence of the capital includable in the tier 1 and tier 2 capital ratios, especially regarding the equities held by the cooperative members of the institutions (common cooperative equities). The proposed rule would also require additional recordkeeping and disclosures by System institutions. We believe that the benefits to the System of these proposed rules would more than outweigh the restrictions and additional responsibilities we would require.

The FCA also proposes changes to its risk-based capital rules for determining risk-weighted assets—that is, the calculation of the denominator of a System institution’s risk-based capital ratios. This proposed rule would eliminate the credit ratings of NRSROs from risk-weights for certain exposures, consistent with section 939A of the Dodd-Frank Act. As an alternative, FCA proposes to include methodologies for determining risk-weighted assets for exposures to sovereigns, foreign banks, and public sector entities, securitization exposures, and counterparty credit risk. The rule includes new risk weights for cleared transactions, guarantees including credit derivatives, collateralized financial transactions, unsettled transactions, and securitization exposures. In addition, there are proposed new disclosure requirements for all System banks related to regulatory capital instruments.

We generally do not propose risk weightings for exposures that System institutions have no authority to acquire.⁶
In some but not all cases, we discuss in this preamble this variance from the rules of the Federal banking regulatory agencies. In addition, we do not propose risk weightings for certain exposures that are both complex and unlikely; in the unlikely event that a System institution did acquire such an exposure, we would address it on a case-by-case basis using the reservation of authority that we propose. We generally discuss these exposures in this preamble.

We remind System institutions that the presence of a particular risk weighting does not itself provide authority for a System institution to have an exposure to that asset or item. System authorities to acquire exposures are contained in other provisions of our regulations and in the Farm Credit Act.

We are not proposing to adopt the “advanced approaches” regulatory capital rules because no System institution has the volume of assets or foreign exposures that would subject it to those approaches if it were regulated by a Federal banking regulatory agency.⁷
We also do not propose the market risk requirements, because no System institution has significant exposure to market risk, and we propose to require all System institutions to exclude Accumulated Other Comprehensive Income (AOCI) from regulatory capital.

We propose to place the tier 1 and tier 2 risk-weighted and leverage capital requirements in a new part 628 of FCA regulations in Title 12 of the Code of Federal Regulations. We would rescind the risk-weighting provisions in subpart H of part 615 and the core surplus, total surplus, and net collateral requirements in subpart K of part 615. We would retain in part 615 the requirements for the numerator of the permanent capital ratio, a measure that is mandated by the Farm Credit Act, but the risk weightings for the denominator of the permanent capital ratio would be the risk weightings in new part 628. We also propose conforming changes in several other FCA regulations.

In this proposed rule, we have used the general format and the section and paragraph numbering system of the Federal banking regulatory agencies’ rules to the extent possible. In many cases, we have retained the numbering system by reserving sections and paragraphs where we are not proposing parallel provisions. We have done so in order to facilitate the comparison of the proposal with the banking agencies’ rules.

C. List of Questions Asked and Comments Requested in This Preamble

We welcome comments on every aspect of this proposed regulation, but there are certain areas where we are specifically seeking comment. We ask specific questions in these areas throughout this preamble, but for the convenience of commenters we provide below a list all of our specific questions and requests for comment. We also ask generally for comments that suggest how we could simplify the rule while retaining the improved capital framework that is our goal.

(1) Alternatives to Including Common Cooperative Equities in CET1 or Tier 2 Capital

We seek comment on using alternative terms or conditions that FCA could apply to common cooperative equities. Is a 10-year revolvement cycle long enough to reduce the expectation of redemption and increase the permanence of such equity instruments so that they may be included in CET1 capital?

(2) Capital Treatment of MSAs

We seek comment on whether FCA should risk weight MSAs at 100 percent or require deduction of MSAs from CET1, as we propose to do for non-mortgage servicing rights. At the present time, FCA does not consider any type of servicing asset material to a System institution’s or the System’s consolidated balance sheet.

(3) Accounting for Defined Benefit Pension Fund Assets

Given System institutions’ differing methods of reporting defined benefit pension fund assets, what is the best way to require adjustments for defined benefit pension fund assets in the CET1 capital computation?

(4) Third-Party Capital Limits

We seek comment on alternative third-party limits to ensure that System institutions remain capitalized primarily by their member borrowers.

(5) Risk-Weighting—Exposures to OFIs

We seek comment on our proposed capital treatment of exposures to OFIs. Specifically, what factors or other information would be relevant if we consider assigning an intermediate risk-weight to a System institution’s exposure to an OFI, recognizing that the same exposure to the same OFI would receive a 100-percent risk weight from a banking organization regulated by a Federal banking regulatory agency?

(6) Risk-Weighting—Exposures to Certain Electrical Cooperative Assets

We seek comment as to whether we should retain this risk weighting [for exposures to certain electrical cooperative assets], being mindful of the Dodd-Frank Act section 939A requirement that we must eliminate the credit rating criteria.

(7) Credit Conversion Factors for Off-Balance Sheet Items—Exposure Amount of a System Bank’s Commitment to an Association

We invite comment on this determination [regarding our determination of the exposure amount of a System bank’s commitment to an association].

(8) System Institution Acting as Clearing Member

We invite comment as to whether we should adopt such provisions [contemplating that System institutions would act as clearing members].

(9) Collateralized Transactions—Own Estimate of Haircuts

We seek comment on whether we should adopt a regulation that would permit the use of an institution’s own estimates.

(10) Exposures to Asset-Backed Commercial Paper (ABCP) Programs

We seek comment as to whether we should include provisions in our risk-based capital rules regarding ABCP programs that are comparable to those adopted by the Federal banking regulatory agencies.

(11) Disclosures

We invite comment on the appropriate application of these proposed disclosure requirements to System banks.

D. Key Provisions of the Proposed Rule

E. The History and Cooperative Structure of the Farm Credit System

The System is a federally chartered network of four banks and 78 associations that are borrower-owned lending cooperatives, as well as their related service organizations.⁸
Cooperatives are organizations that are owned and controlled by their members who use the cooperatives’ products or services. The mission of the System is to provide sound and dependable credit to its member borrowers, who are American farmers, ranchers, producers or harvesters of aquatic products, their cooperatives, and certain farm-related businesses and rural utility cooperatives. The System was created by Congress in 1916 as a farm real estate lender and was the first GSE; in subsequent years, Congress expanded the System to include production credit, cooperative, rural housing, and other types of lending. The System’s enabling statute is the Farm Credit Act.⁹

System associations are direct retail lenders; Farm Credit Banks (FCBs) are primarily wholesale lenders to the associations, and the agricultural credit bank (CoBank or ACB) makes retail loans to cooperatives as well as wholesale loans to affiliated associations. Each System bank has a district, or lending territory, which includes the territories of the affiliated associations that it funds; CoBank, in addition, lends to cooperatives nationwide. There are generally two types of associations: Agricultural credit associations (ACAs) and Federal land credit associations (FLCAs). In general, ACAs make short, intermediate, and long-term operating loans, real estate mortgage loans, and rural housing loans.¹⁰
FLCAs make only long-term real estate mortgage and rural housing loans.

The System banks own the Federal Farm Credit Banks Funding Corporation (Funding Corporation), which is the fiscal agent for the banks and is responsible for issuing and marketing System-wide debt securities in domestic and global capital markets. The banks use the proceeds from the securities to fund their lending and other operations, and the banks are jointly and severally liable on the debt.

The FCA is the System’s independent Federal regulator that examines and regulates System institutions for safety and soundness and mission compliance. The Farm Credit System Insurance Corporation (FCSIC) is an independent, U.S. Government-controlled corporation whose purpose is to ensure the timely payment of principal and interest on insured System-wide debt obligations issued on behalf of the System banks. The members of the FCA Board also serve as the members of the FCSIC Board. The FCSIC administers a $3.5 billion Insurance Fund and collects insurance premiums from System banks.

1. Capital Structure of System Institutions

A System institution’s cooperative capital consists of member-borrower stock, allocated equities, and unallocated retained earnings. System institutions, like all businesses, need capital to absorb losses in times of financial adversity and provide a source of funds to stabilize earnings and finance growth. Capital also carries ownership rights of members, which reflect the System’s cooperative nature. Members, both past and current, helped build almost all the capital of System institutions.¹¹

Member stock and allocated equities are the common equity classes of System institutions. As discussed above, this proposed rule refers to member stock and allocated equity collectively as “common cooperative equity.” After the URE of an institution is depleted, all categories of common cooperative equities are subject to impairment before preferred stock and other non-cooperative equities of the institution are impaired. This impairment of common cooperative equities by category differs somewhat from the common stock of a joint-stock bank, whose common equities are all impaired on a pro rata basis. However, the FCA considers the impairment by category to be substantially the same, as the common cooperative equities protect other equities and obligations of the institution to the same extent common equities of a joint-stock bank protect non-common equities and obligations.

Table 2 compares the capital of System institutions, as cooperatives, and joint-stock companies.

2. Member Stock—Association Level

A retail borrower of a System association or of the ACB is required to purchase voting stock or non-voting participation certificates (depending on the status of the borrower
^[12]

) as a condition of obtaining a loan
^[13]

and becoming a member of the institution. For purposes of this discussion, the FCA uses the term “member stock” to refer to both voting stock and participation certificates.

Member stock is redeemable at book value, not to exceed par, only at the discretion of the association’s board of directors and subject to the association’s compliance with capital adequacy requirements. When these requirements are met, associations routinely retire member stock within some timeframe after the member has repaid the loan. System associations are authorized to pay dividends on member stock but do not currently do so.

Currently, all associations set their member stock purchase requirements at the Farm Credit Act’s minimum of the lesser of $1,000 or 2 percent of the loan amount,
^[14]

regardless of the member’s loan volume. Thus, while association stock purchased by borrowers embodies a key cooperative principle, it is not a significant source of association capital.

3. Member Stock—System Bank Level

By contrast, member stock purchased by associations in their affiliated System bank plays an important role in capitalizing System banks. Each System bank sets a “required investment” for its affiliated associations based on a percentage of each association’s loan volume funded by the bank. System bank advances fund the stock purchases, and the associations’ repayments of these advances reduce their retained earnings.
^[15]

As an association’s loan volume grows, the bank requires the association periodically to acquire additional stock to maintain the required stock investment. When an association’s loan volume decreases, the bank either pays a return on what the bank deems “excess” stock through an interest credit or an increased patronage refund distribution, or the bank retires such stock. Tying the amount of the required investment to the amount of the loan results in each association’s bearing the cost and risks of bank capital relative to the association’s share of bank debt, but this practice also makes the stock less permanent because the bank routinely issues or redeems the stock.

The ACB’s capitalization program sets a “targeted investment” for its members based on loan volume and allows its members to accumulate the targeted investment through the bank’s payment of stock patronage refunds, or to purchase stock to fulfill the entire investment requirement. The ACB’s affiliated associations have all chosen to meet the target through stock purchases rather than through accumulations of allocated equities.

4. Allocated Equities

As discussed above, some System institutions provide cooperative benefits to their borrowers by paying patronage refunds to their member borrowers based on net income. Patronage refunds may be paid in cash or allocated equities
^[16]

(stock or surplus) or a combination of both. When institutions pay patronage refunds as allocated equity, they actually retain the allocated equity thus effectively increasing a borrower’s equity investment in the institution. For tax purposes, a System institution that declares a patronage refund must provide the borrower with a written notice of allocation evidencing the amount paid in cash and the amount of allocated equity.
^[17]

In this context, FCA is describing allocated equities that the institution determines are subject to redemption. Those allocated equities that an institution determines are not subject to redemption will be discussed later.

Allocated equities have certain rights and features in common with member stock. Allocated equities are redeemable at book value, not to exceed face value, only at a board’s discretion and subject to compliance with regulatory and supervisory capital requirements.

5. Unallocated Retained Earnings (URE) and URE Equivalents

URE consists of current and retained earnings not allocated to a member or distributed through patronage refunds or dividends.
^[18]

It is free from any specific ownership claim or expectation of allocation, and it absorbs losses before other forms of surplus and stock. For the past two decades, System associations have retained their earnings primarily in the form of URE. One distinction between URE and allocated equity is whether the institution provides a written notice of allocation to the borrower. If the System institution does not provide a written notice of allocation to the borrower, the equity is URE. However, many System institutions keep “memo” records so that URE may be attributed to a borrower if liquidation occurs.
^[19]

In a liquidation, current and past members may have a fixed and limited claim on URE (except allocated equity not subject to retirement that is treated as URE under generally accepted accounting principles (GAAP)).

The FCA has considered certain nonqualified allocated equities to be the equivalent of URE when a System institution has provided a written notice of allocation to members stating the equities are not subject to redemption except upon liquidation or dissolution. To treat these nonqualified allocated equities as URE in the core surplus ratio, the FCA has required System institutions to adopt bylaw provisions that the nonqualified allocated equity cannot be:

• Redeemed other than in a liquidation or dissolution of the institution;
• Considered by the institution as satisfying any borrower requirement to capitalize the entity; and
• Offset against the specified borrower’s loan in the event of a loan loss on the specified borrower’s account.

F. The FCA’s Current Capital Regulations

The FCA currently has three risk-based minimum capital standards: (1) A 3.5-percent core surplus ratio (CSR); (2) a 7-percent total surplus ratio (TSR); and (3) a 7-percent permanent capital ratio (PCR).
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Congress added a definition of “permanent capital” to the Farm Credit Act in 1988 and required the FCA to adopt risk-based permanent capital standards for System institutions. The FCA adopted permanent capital regulations in 1988 and, in 1997, added core surplus and total surplus capital standards for banks and associations, as well as a non-risk-based net collateral ratio (NCR) for banks.
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Since then, we have made only minor changes to these regulations.

Permanent capital is defined in the Farm Credit Act to include current earnings, unallocated and allocated earnings,
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stock (other than stock retireable on repayment of the holder’s loan or at the discretion of the holder, and certain stock issued before October 1988), surplus less allowance for loan losses (ALL), and other debt or equity instruments that the FCA determines appropriate to be considered permanent capital. Allocated equities shared by a bank and each affiliated association—that is, equities that a bank has allocated to an affiliated association—appear on the books of both institutions but can be counted in only one institution’s permanent capital pursuant to a capital allotment agreement between the two institutions.

Core surplus is high-quality capital similar (but not identical) to Basel I’s tier 1 capital and generally consists of URE, certain allocated surplus, and noncumulative perpetual preferred stock. In calculating core surplus, an association must deduct its net investment in its affiliated bank; the bank may not include in its core surplus the equities it has issued or distributed to its affiliated associations. At least 1.5 percent of the minimum 3.5-percent core surplus requirement must consist of URE and noncumulative perpetual preferred stock. We did not include equities held by one System institution in another institution because we wanted institutions to have sufficient high-quality capital on a standalone basis in the event the other System institution became severely weakened.

Total surplus generally contains most of the components of permanent capital but excludes stock held by members as a condition of obtaining a loan and certain other instruments that are routinely and frequently retired by institutions.

G. Prior FCA Advance Notices of Proposed Rulemaking (ANPRMs) on the Basel Capital Standards

In October 2007, the FCA published an advance notice of proposed rulemaking (ANPRM) on the risk weighting of assets—the denominator in our risk-based core surplus, total surplus, and permanent capital ratios—a possible leverage ratio, and a possible early intervention framework.
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A comment letter we received in December 2008 from the Funding Corporation on behalf of the System focused primarily on the numerators of those regulatory capital ratios.
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The System urged us to replace the core surplus and total surplus capital standards with a “Tier 1/Tier 2” capital framework consistent with the Basel Accord (Basel I and Basel II) and the other Federal banking regulatory agencies’ guidelines. The comment letter stated that, “because the System’s growth has required the use of external equity capital, the System is in regular contact with the financial community, including rating agencies and investors. Obtaining capital at competitive terms, conditions, and rates requires these parties [to] understand the System’s and individual institution’s financial position, making consistency with approaches used by other regulators, rating agencies, and investment firms a requirement to enhance the capacity of the System to achieve its mission. For the System to achieve its mission, the System must be able to compete with other lenders. Therefore, FCA’s capital regulations must result in a regulatory framework that provides for a level playing field, in addition to safe and sound operations.” Furthermore, the System recommended that we replace our NCR, which is applicable only to banks, with a non-risk-based leverage ratio applicable to all System institutions.

In December 2009, the Basel Committee published a consultative document that proposed fundamental reforms to the current tier 1/tier 2 capital framework.
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The Basel Committee’s primary aims were to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, to mitigate spillover risk from the financial sector to the broader economy, and to increase bank transparency and disclosures. The FCA issued another ANPRM in July 2010 seeking comments on a tier 1/tier 2 regulatory capital structure that would be similar to the capital tiers delineated in the Basel consultative document and the then-existing guidelines of the Federal regulatory banking agencies. We received two comment letters, one from a System institution and one from a trade association on behalf of the System. Both commenters strongly supported the FCA’s adoption of a capital framework that was as similar as possible to the capital guidelines of the Federal regulatory banking agencies as revised to implement the Basel III standards. In particular, they asserted that consistency of FCA capital requirements with those of the Federal regulatory banking agencies and transparency would allow investors, shareholders, and others to better understand the financial strength and risk-bearing capacity of the System. The FCA decided to delay issuing a proposed rule until the Basel Committee had issued its new framework and the Federal regulatory banking agencies had proposed rules to implement that framework.

After soliciting comments on its December 2009 consultative document, the Basel Committee issued the new Basel III capital standards in December 2010 (revised June 2011). In 2012, the Federal regulatory banking agencies issued proposed rules to implement those standards and adopted final rules in October 2013 and April 2014.

The FCA agrees generally with the System’s position that a tier 1 and tier 2 regulatory capital framework comparable to Basel III and the Federal regulatory banking agencies’ new rules would be beneficial to System institutions, their members, the investment community, and other interested parties. It would also facilitate the issuance of equities and subordinated debt to third-party investors. In addition, we believe it necessary and appropriate to update the denominator risk weightings that have been revised based on the lessons learned in the 2008 global financial crisis.

When we adopted the core surplus, total surplus and the net collateral ratios in 1997, transparency to the investment community was not a significant consideration because the capital in the System institutions was held by or generated by their members. The goal of those regulations was to ensure that each System institution built sufficient high-quality capital, especially URE and URE equivalents, to serve the needs of all qualifying eligible borrowers and to withstand downturns in the agricultural sector as well as adversities at other System institutions. The FCA continues to believe a significant amount of URE and URE equivalents is necessary to achieve and maintain that goal but also believes common cooperative equities may be included in the higher quality capital measures to a larger extent than they are included in our current regulations. This position is based on a number of factors, including the reduction of the member stock requirement at most institutions to the statutory minimum and the institutions’ evolving allocated equity redemption practices.

Through the 1990s and to the present day, a strong agricultural economy together with sound business practices has enabled System institutions to build higher quality capital while at the same time growing the System’s total assets from $64.8 billion in 1993 to $260.8 billion at the end of 2013.

A. Minimum Risk-Based Capital Ratios and Other Regulatory Capital Provisions

The FCA is proposing the following minimum capital ratios: (1) A common cooperative equity tier 1 (CET1) capital ratio of 4.5 percent; (2) a tier 1 capital ratio of 6 percent; (3) a total capital ratio of 8 percent; and (4) a tier 1 capital leverage ratio of 5 percent, of which at least 1.5 percent must be composed of URE and URE equivalents. Tier 1 capital would equal the sum of CET1 and AT1 capital. Total capital would consist of CET1, AT1, and tier 2 capital. As noted above, the FCA’s existing core surplus, total surplus, and net collateral requirements would be rescinded, but the minimum permanent capital requirements would be retained.

In addition, each System institution would be subject to a capital conservation buffer in excess of the risk-based capital requirements that would impose limitations on its capital distributions and certain discretionary bonuses, as described in section C below. The capital conservation buffer would not be considered a minimum capital requirement.

The FCA will continue to hold each System institution accountable to maintain sufficient capital commensurate with the level and nature of the risks to which it is exposed. This may require capital significantly above the minimum requirements, depending on the institution’s activities and risk profile. Section D below describes the requirement for overall capital adequacy of System institutions and the supervisory assessment of an institution’s capital adequacy.

Consistent with the FCA’s authority under the Farm Credit Act and current capital regulations, proposed § 628.10(d) confirms FCA’s authority to require an institution to hold a different amount of regulatory capital from what would otherwise be required under the proposal, if we determine that the institution’s regulatory capital is not commensurate with its credit, operational, or other risks.

B. Leverage Ratio

The FCA is proposing a tier 1 leverage ratio for all System institutions of 5 percent, of which at least 1.5 percent of non-risk-weighted total assets must be URE and URE equivalents. This would replace the net collateral ratio requirement for System banks. System associations do not currently have a leverage ratio requirement. The proposed ratio differs from the Federal regulatory banking agencies’ leverage ratio in two respects: There is no minimum URE and URE equivalents requirement in their leverage ratio, and their minimum requirement is 4 percent.

A leverage ratio constrains the build-up of leverage in the System, which the risk-based regime is not designed to do. It reinforces the risk-based requirements with a non-risk-based backstop—that is, if the computation of the risk-weighted assets does not accurately reflect the true underlying risk inherent in a System institution, the leverage ratio serves as a floor that prevents the institution from decreasing its capital below a certain percentage of total assets. Furthermore, it represents a standardized measure that can be used to make comparison among System institutions over time.

The 5-percent leverage ratio takes into consideration the fact that System institutions are financially and operationally interconnected, member-owned cooperatives, and monoline lenders that currently provide credit to approximately 41 percent of the United States agriculture sector. They have a business model and risk profile that are substantially different from traditional banking organizations.

The higher 5-percent leverage ratio also helps to ensure that System institutions continue to have sufficient systemic loss-absorbing capital to withstand a severely adverse economic event while continuing to provide a steady flow of credit to U.S. agriculture in view of the System’s unique GSE mission.

For associations, the proposed 5-percent minimum leverage ratio would differ little from their proposed tier 1 risk-based capital requirement. Most associations’ on-balance sheet assets are risk weighted at 100 percent, and the associations do not have significant off-balance sheet items. This is not the case for System banks, however. While System banks do have off-balance sheet items that would have to be risk weighted—especially unfunded commitments in this proposal—the banks also have a large portion of instruments in the 20-percent risk-weighting category, primarily the direct loans to their affiliated associations, and the 0-percent risk-weighting category. We believe it is important for System banks to hold enough capital to protect against risks other than credit risk (e.g. interest rate risk, liquidity risk, premium risk, operational risk, etc.).

The 1.5-percent minimum URE and URE equivalents requirement is similar in some respects to our current requirement that at least 1.5 percent of an institution’s core surplus must consist of URE and URE equivalents and noncumulative perpetual preferred stock. For associations, the great majority of which have not issued noncumulative perpetual preferred stock, compliance with the proposed 1.5-percent URE and URE equivalents requirement would differ little from the compliance with their existing 1.5 percent of core surplus requirement. By contrast, all banks have noncumulative perpetual preferred stock outstanding that is included in their 1.5-percent core surplus requirement but would not be included in the proposed 1.5-percent URE and URE equivalents minimum standard. The FCA believes that it is especially important for System banks to hold sufficient URE and URE equivalents to cushion the third-party and common cooperative equities that make up the rest of tier 1 capital. URE and URE equivalents, when depleted, do not result in losses to a System’s institution’s members. URE protects against the interconnected risk that exists between System banks and associations; it protects association members against association losses, associations against bank losses, and the System against financial contagion. We are proposing to make the URE and URE equivalents a part of the leverage ratio because a URE minimum tied to risk-adjusted assets may not be sufficient for the banks, which have a greater disparity between risk-adjusted assets and total assets.

C. Capital Conservation Buffer

Consistent with Basel III and the Federal regulatory banking agencies’ rules, we are proposing a capital conservation buffer to enhance the resilience of System institutions throughout financial cycles. To avoid restrictions on cash payments for patronage, redemptions, and dividends (collectively, capital distributions) or discretionary executive bonuses, an institution’s risk-weighted regulatory capital ratios would have to be at least 2.5 percent above the minimums when the buffer is fully phased in. The buffer would provide an incentive for institutions to hold capital well above the minimum required levels to ensure that they would meet the regulatory minimums even during stressful conditions.

The capital conservation buffer would consist of tier 1 capital and would be the lowest of the following risk-weighted measures:

• The institution’s CET1 ratio minus its minimum CET1 ratio;
• The institution’s tier 1 ratio minus its minimum tier 1 ratio; and
• The institution’s total capital ratio minus its minimum total capital ratio.

If any of the institution’s risk-weighted ratios were at or below the minimum required ratios, the institution’s capital conservation buffer would be zero.

The maximum payout ratio would be the percentage of eligible retained income that a System institution would be allowed to pay out in capital distributions and discretionary bonuses during the current calendar quarter and would be determined by the amount of the capital conservation buffer held by the institution during the previous calendar quarter. Eligible retained income would be defined as the institution’s net income as reported in its quarterly call reports to the FCA for the four calendar quarters preceding the current calendar quarter, net of any capital distributions, certain discretionary bonus payments, and associated tax effects not already reflected in net income.

A System institution’s maximum payout amount for the current calendar quarter would be equal to its eligible retained income multiplied by the applicable maximum payout ratio in accordance with table 1 in § 628.11. An institution with a capital conservation buffer that is greater than 2.5 percent would not be subject to a maximum payout amount under this provision (although distributions without FCA prior approval may be restricted by other provisions in this proposed rule). If an institution’s CET1, tier 1, or total capital ratio is 2.5 percent or less above the minimum ratio, the maximum payout ratio would also decline. The institution would remain subject to payout restrictions until it raises its capital conservation buffer above 2.5 percent. In addition, a System institution would not generally be able to make capital distributions or pay discretionary bonuses during the current calendar quarter if its eligible retained income is negative and its capital conservation buffer is less than 2.5 percent as of the end of the previous quarter.

The capital conservation buffer is divided into quartiles, with greater restrictions on capital distributions and discretionary bonus payments as the capital conservation buffer falls closer to 0 percent. When the buffer is fully phased in, payouts would be restricted to 60 percent of eligible retained income if the buffer is above 1.875 percent but at or below 2.5 percent. When the buffer is above 1.25 percent but less than or equal to 1.875 percent, the payout would be restricted to 40 percent of eligible retained income. When the buffer is above 0.625 percent but equal to or below 1.25 percent, the payout would be restricted to 20 percent of eligible retained income. A capital conservation buffer of 0.625 percent or below would result in a 0-percent payout.

The FCA proposes to define a capital distribution as:

• A reduction of tier 1 capital through the repurchase or redemption of a tier 1 capital instrument or by other means, unless the redeemed capital is replaced in the same quarter by tier 1 qualifying capital;
• A reduction of tier 2 capital through the repurchase, or redemption prior to maturity, of a tier 2 capital instrument or by other means, unless the redeemed capital is replaced in the same quarter by qualifying tier 1 or tier 2 capital;
• A dividend declaration or payment on any tier 1 capital instrument;
• A dividend declaration or interest payment on any tier 2 capital instrument if the institution has full discretion to suspend such payments permanently or temporarily without triggering an event of default;
• A cash patronage refund declaration or payment;
• A patronage refund declaration in the form of allocated equities that do not qualify as tier 1 or tier 2 capital;
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  or

• Any similar transaction that the FCA determines to be in substance a distribution of capital.
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The FCA proposes to define a discretionary bonus payment as a payment made to a senior officer of a System institution, where:

• The System institution retains discretion whether to pay the bonus and how much to pay until it awards the payment to the senior officer;
• The System institution determines the amount of the bonus without prior promise to, or agreement with, the senior officer; and
• The senior officer has no express or implied contractual right to the bonus payment.

The term “senior officer” is already defined in § 619.9310 as “[t]he Chief Executive Officer, the Chief Operations Officer, the Chief Financial Officer, and the General Counsel, or persons in similar positions; and any other person responsible for a major policy-making function.”
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The purpose of limiting restrictions on discretionary bonus payments to senior officers is to focus these measures on the individuals within an institution who could expose the institution to the greatest risk. We note that the institution may otherwise be subject to limitations on capital distributions under other provisions in this rule. In addition, we retain authority to approve a capital distribution or bonus payment if we determine that the payment would not be contrary to the purposes of the capital conservation buffer or the safety and soundness of the institution.

D. Supervisory Assessment of Overall Capital Adequacy

System institutions should have internal processes to assess capital adequacy that reflect a full understanding of risks and to ensure sufficient capital is held. Our supervisory assessment of capital adequacy must take account of the internal processes for capital adequacy, as well as risks and other factors that can affect an institution’s financial condition, including the level and severity of problem assets and total surplus exposure to operational and interest rate risk. For this reason, a supervisory assessment of capital adequacy may differ significantly from conclusions that might be drawn solely from the level of the institution’s risk-based capital ratios.

The FCA expects System institutions generally to operate with capital levels well above the minimum risk-based ratios and to hold capital commensurate with the level and nature of the exposed risk. For example, System institutions that are growing or that anticipate growth in the near future should maintain strong capital levels substantially above the minimums and should not allow significant diminution of financial strength below such levels to fund their growth. System institutions with high levels of risk are also expected to operate with capital well above the minimum levels. The supervisory assessment also evaluates the quality and trends in an institution’s capital composition, including the share of common cooperative equities and URE and equivalents.

Section 628.10(d) of the proposal would maintain and reinforce these supervisory expectations by requiring that a System institution maintain capital commensurate with the level and nature of all risks to which it is exposed and that the institution have a process for assessing its overall capital adequacy in relation to its risk profile, as well as a comprehensive strategy for maintaining an appropriate level of capital.

The supervisory assessment may include such factors as whether the institution has merged recently, entered new activities, or introduced new products. It would also consider whether an institution is receiving special supervisory attention from FCA, has or is expected to have losses resulting in capital inadequacy, has significant exposure due to risks from concentrations in credit or nontraditional activities, or has significant exposure to interest rate risk, operational risk, or could be adversely affected by the activities or condition of an affiliated System institution.

The supervisory assessment would also evaluate the comprehensiveness and effectiveness of a System institution’s capital as required by §§ 615.5200 and 618.8440 of existing FCA regulations. We are proposing to revise § 615.5200 to require the planning to include the new ratios in this proposed rule. An effective capital planning process would require a System institution to assess its risk exposures, develop strategies for mitigating those risks, and set capital adequacy goals relative to its risks, and prospective economic conditions. Evaluation of an institution’s capital adequacy process would be commensurate with the institution’s size, sophistication, and risk profile.

A. Capital Components and Eligibility Criteria for Regulatory Capital Instruments

1. Common Cooperative Equity Tier 1 (CET1) Capital

Under the proposed rule, a System institution’s CET1 would be the sum of URE and common cooperative equities, minus the regulatory adjustments and deductions described in § 628.22. We have adapted the criteria for the common cooperative equities in accordance with footnote 12 of Basel III, which states that the criteria for non-joint stock companies, including mutuals and cooperatives, should take into account their legal structure and constitution.
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The footnote provides that the CET1 criteria “should preserve the quality of the instruments by requiring that they are deemed fully equivalent to common shares . . . as regards loss absorption and do not possess features which could cause the condition of the [non-joint stock] bank to be weakened as a going concern during periods of market stress.” The Federal regulatory banking agencies’ rules have decided to apply the same criteria to the mutual financial institutions they regulate and to their joint-stock banking organizations.

Basel III established 14 criteria a banking organization must meet to include an instrument in CET1 capital; the Federal regulatory banking agencies’ rules have 13 criteria. These criteria are intended to ensure that the instrument will be available to absorb losses at the banking organization on a going-concern basis. Several of the criteria provide that the instrument must represent the most subordinated claim in liquidation, is entitled to a claim on residual assets proportional to its share of issued capital, and must take the first and proportionately greatest share of any losses as they occur.

Unlike joint-stock banks, System institutions have priorities of impairment among the various classes of member stock and allocated equities, and typically all current and former members are entitled to the residual assets, based on historic patronage, in a liquidation of the institution. However, all common cooperative equities are impaired and depleted before all other instruments. Therefore, we are replacing these criteria with criteria providing that the instrument must represent a claim subordinated to all other equities of an institution in a liquidation, and the holder receives payment only after all general creditors and debt holders are paid.

Another CET1 criterion of Basel III and the Federal regulatory banking agencies is that the banking organization does nothing to create an expectation at issuance that the instrument will be redeemed, nor do the statutory or contractual terms provide any feature that might give rise to such an expectation. In the System, institutions issue or distribute some common cooperative equities that are never retired and that do not give rise to redemption expectations by members. Other common cooperative equities, by contrast, are routinely and frequently redeemed. Through this practice, System institutions can create expectations on the part of their members that these purchased and allocated equities will be redeemed. Consequently, we believe that the “expectation” requirement of Basel III and the Federal regulatory banking agencies’ rules could reasonably be interpreted to disallow common cooperative equities redeemed by System institutions from CET1. However, it is important for the current members of a cooperative to provide capital to the cooperative and for current and former members of the cooperative eventually to receive a return of their capital. Therefore, we have decided to recognize this key cooperative principle by including in CET1 purchased and allocated equities that meet the requirements described below.

The FCA is proposing to include in CET1 an amount of member stock equal to the minimum stock purchase requirement set forth in the Farm Credit Act. That minimum amount is the lesser of $1,000 or 2 percent of the member’s loan or loans. The FCA has reviewed the 2013 regulatory technical standards of the European Banking Authority (EBA) regarding the standards for CET1 for cooperatives, mutuals, the other non-joint stock banks.
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European cooperative banks do not issue allocated equities; therefore, the technical regulations have little application to the treatment of System institutions’ allocated equities. However, we have adapted the EBA document’s treatment of minimum required amounts of purchased cooperative equities to allow System institutions to include purchased member stock in their CET1.

Purchased member capital is routinely funded directly or indirectly by European cooperative banks, and the same is true for System institutions. The CET1 criteria for Basel III and the Federal regulatory banking agencies’ rules do not permit joint-stock banks to include in CET1 any equities whose purchase is directly or indirectly funded by the bank. However, the EBA document permits cooperatives to include directly or indirectly funded member stock (called a subscription) if the amount of the subscription is not material, the purpose of the cooperative’s loan to the member is not the purchase of an institution’s capital instrument, and the member stock purchase is necessary in order for the beneficiary of the loan to become a member of the cooperative. The required minimum stock purchase requirements in System institutions mirror these characteristics.

Some countries in the European Union require the redemption of the member’s subscription when the member pays off the loan. That is not the case with respect to System institutions. They may, but are not required to, redeem the member’s required stock when a loan is paid. As a general matter, the FCA has not given favorable treatment to member stock in its capital regulations because of the widespread and routine redemptions of member stock when the member’s loan is paid off. Notwithstanding these concerns, because the repayment of the member’s loan reduces the level of assets that the System institution must capitalize and because of the similar characteristics with EBA provisions, we have determined that including an amount equal to the minimum stock purchase requirement appropriately recognizes the cooperative structure of the System and is acceptable from a safety and soundness standpoint. For this minimum amount of stock, the institution would not have to obtain the prior approval of the FCA before redeeming it and would not be required to keep it outstanding for a minimum period. In other words, the institution could redeem the member’s minimum required stock according to its current redemption practices.

The FCA is also proposing to include other member-purchased common cooperative equities and allocated equities of System institutions that adopt a capitalization bylaw providing that the institution will not redeem the equities for at least 10 years (for CET1 capital) and for at least 5 years (for tier 2 capital) after issuance or distribution, will not offset such equities against a member’s loan in default, and will not redeem the equities without the FCA’s prior approval unless the redemption falls within the “safe harbor” provision described below.

System institutions typically have allocated equity revolvement periods ranging from 4 to 10 years, and perhaps longer, for their allocated equities. We believe allocated equities with shorter revolvement periods have higher member expectations of redemption than allocated equities that are held longer. Such expectations may put stress on System institutions to continue to redeem equities even when the institution’s financial health is deteriorating. Institutions’ boards of directors generally prefer to revolve allocated equities on a regular basis. This aids in the capital planning process and can help manage the revolvement expectations of the members. While the regularity of redemptions results in a rise in member expectations, we believe a longer revolvement period has the effect of moderating these expectations—that is, if a member is not expecting equities allocated in 2015 to be redeemed before 2025, the member is less likely to count on the cash redemption of those equities in the member’s own capital planning. Therefore, we are retaining an “expectation” criterion similar to that in Basel III and the Federal regulatory banking agencies’ rules, but we are providing that equities held by an institution for at least 10 years will not be considered to create an expectation. Cash payment of patronage refunds, dividends, and redemption of allocated equities normally are paid from current year net income, and an institution must ensure it generates sufficient net income to cover these expected cash outlays from capital. A shorter revolvement or redemption cycle places more strain than a longer revolvement or redemption cycle on an institution’s ability to generate a return to stockholders and capitalize growth.

Under this proposal, all System institutions would be able to include an amount equal to the minimum stock purchase requirements of their members in CET1 capital, as well as purchased stock or allocated equities that the institution never retires. System institutions that have a member stock purchase requirement that is higher than the statutory minimum and that revolve allocated equities would be able to include all such equities in CET1 capital if they ensure that the purchased stock and allocated equities are not redeemed for at least 10 years. Member stock in excess of the statutory minimum and allocated equities that are retained for at least 5 years are includable in tier 2 capital; if retained for less than 5 years, such equities are not includable in tier 1 or tier 2.

a. Criteria

The FCA proposes to require that the common cooperative equities included in CET1 satisfy all the following criteria:

(1) The instrument is issued directly by the System institution and represents a claim subordinated to all preferred stock, all subordinated debt, and all liabilities in a receivership, insolvency, liquidation, or similar proceeding of the System institution;

(2) If the holder of the instrument is entitled to a claim on the residual assets of the System institution, the claim will be paid only after all general creditors, subordinated debt holders, and preferred stock claims have been satisfied in a receivership, insolvency, liquidation, or similar proceeding;

(3) The instrument has no maturity date, can be redeemed only at the discretion of the System institution and with the prior approval of FCA, and does not contain any term or feature that creates an incentive to redeem;

(4) The System institution did not create, through any action or communication, an expectation that it will buy back, cancel, revolve, or redeem the instrument, and the instrument does not include any term or feature that might give rise to such an expectation, except that the establishment of a revolvement period of 10 years or more, or the practice of revolving or redeeming the instrument no less than 10 years after issuance or allocation, will not be considered to create such an expectation;

(5) Any cash dividend payments on the instrument are paid out of the System institution’s net income or unallocated retained earnings, and are not subject to a limit imposed by the contractual terms governing the instrument;

(6) The System institution has full discretion at all times to refrain from paying any dividends without triggering an event of default, a requirement to make a payment-in-kind, or an imposition of any other restrictions on the System institution;

(7) Dividend payments and other distributions related to the instrument may be paid only after all legal and contractual obligations of the System institution have been satisfied, including payments due on more senior claims;

(8) The holders of the instrument bear losses as they occur before any losses are borne by holders of preferred stock claims on the System institution and holders of any other claims with priority over common cooperative equity instruments in a receivership, insolvency, liquidation, or similar proceeding;

(9) The instrument is classified as equity under GAAP;

(10) The System institution, or an entity that the System institution controls, did not purchase or directly or indirectly fund the purchase of the instrument, except that where there is an obligation for a member of the institution to hold an instrument in order to receive a loan or service from the System institution, an amount of that loan equal to the minimum borrower stock requirement under section 4.3A of the Farm Credit Act will not be considered as a direct or indirect funding where:

(a) The purpose of the loan is not the purchase of capital instruments of the System institution providing the loan; and

(b) The purchase or acquisition of one or more member equities of the institution is necessary in order for the beneficiary of the loan to become a member of the System institution;

(11) The instrument is not secured, not covered by a guarantee of the System institution, and is not subject to any other arrangement that legally or economically enhances the seniority of the instrument;

(12) The instrument is issued in accordance with applicable laws and regulations and with the institution’s capitalization bylaws;

(13) The instrument is reported on the System institution’s regulatory financial statements separately from other capital instruments; and

(14) The System institution’s capitalization bylaws provide that it will not redeem the instrument for a period of at least 10 years after issuance, or if allocated equities at least 10 years after allocation to a member, or reduce the original revolvement period to less than 10 years without the prior approval of the FCA, except that the minimum statutory borrower stock described under paragraph (b)(1)(x) of this section may be redeemed without a minimum period outstanding after issuance and without the prior approval of the FCA.

b. Accumulated Other Comprehensive Income (AOCI) and Minority Interests

The FCA is not proposing to include minority interests in CET1 or in any other component of regulatory capital because System institutions have few or no minority equity interests in unconsolidated subsidiaries.

The FCA is not proposing to include AOCI in CET1 capital, which is different from Basel III and the Federal banking regulatory agencies’ final rules. As a result, we are proposing no adjustments to CET1 for AOCI.

Under the FCA’s current risk-based capital rules, most of the components of AOCI included in GAAP equity are not included in a System institution’s regulatory capital. Under GAAP, AOCI includes unrealized gains and losses on certain assets and liabilities that are not included in net income. AOCI includes unrealized gains and losses on available-for-sale (AFS) securities; “other than temporary impairment on securities” reported as held to maturity (HTM) that are not credit related; cumulative gains and losses on cash-flow hedges; foreign currency translation adjustments; and amounts attributed to defined benefit post retirement plans resulting from the initial and subsequent application of the relevant GAAP standards that pertain to such plans.

The Federal banking regulatory agencies include in CET1 capital any net unrealized losses on AFS equity securities and any foreign currency translation adjustments. System institutions carry all equity investments in other System institutions at par or book value. Current investment regulations restrict equity investment outside the System. Therefore, it would be rare for a System institution to have any net unrealized losses or gains because of AFS equity securities. Only one System institution, CoBank, would have a need to hold foreign currency, and only in an amount to facilitate its lending activities. As a result, the FCA is not proposing to include any AOCI item in CET1 capital, as it does not believe AFS equity securities or foreign currency translation adjustments would ever be material to CET1 capital.

We note that, while the Federal regulatory banking agencies’ proposed rule would have required all banking organizations to include most elements of AOCI in CET1 capital, the agencies’ final rule permits banking organizations using the standardized approach to make a one-time election not to include most elements of AOCI in their regulatory capital. The preamble to the final rule states that the agencies received a significant number of comments expressing concern about the potential volatility of AOCI inclusion on a banking organization’s capital and made other assertions about the negative effect the proposed treatment would have on an organization’s ability to manage liquidity and interest rate risk. Under the FCA’s proposed AOCI treatment, the exclusion of AOCI from CET1 capital would be comparable to the AOCI exclusions of the banking organizations that make an election not to include AOCI in their CET1 capital.

We seek comment on using alternative terms or conditions that FCA could apply to common cooperative equities. Is a 10-year revolvement cycle long enough to reduce the expectation of redemption and increase the permanence of such equity instruments so that they may be included in CET1 capital?

2. Additional Tier 1 (AT1) Capital

The proposed criteria for AT1 are comparable to Basel III and the Federal regulatory banking agencies’ rules. AT1 would include primarily noncumulative perpetual preferred stock issued by System institutions and would be subject to certain adjustments and deductions. Qualifying instruments would primarily be stock issued by System banks to third-party investors, though all System institutions have authority to issue such stock. AT1 would not include common cooperative equities.

a. Criteria

The criteria for inclusion in AT1 capital are:

(1) The instrument is issued and paid-in;

(2) The instrument is subordinated to general creditors and subordinated debt holders of the System institution in a receivership, insolvency, liquidation, or similar proceeding;

(3) The instrument is not secured, not covered by a guarantee of the System institution and not subject to any other arrangement that legally or economically enhances the seniority of the instrument;

(4) The instrument has no maturity date and does not contain a dividend step-up or any other term or feature that creates an incentive to redeem;

(5) If callable by its terms, the instrument may be called by the System institution only after a minimum of 5 years following issuance, except that the terms of the instrument may allow it to be called earlier than 5 years upon the occurrence of a regulatory event that precludes the instrument from being included in AT1 capital, or a tax event. In addition:

(a) The System institution must receive prior approval from FCA to exercise a call option on the instrument.

(b) The System institution does not create at issuance of the instrument, through any action or communication, an expectation that the call option will be exercised.

(c) Prior to exercising the call option, or immediately thereafter, the System institution must either: Replace the instrument to be called with an equal amount of instruments that meet the criteria for a CET1 or AT1 capital instrument;
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or demonstrate to the satisfaction of FCA that following redemption, the System institution will continue to hold capital commensurate with its risk;

(6) Redemption or repurchase of the instrument requires prior approval from FCA;

(7) The System institution has full discretion at all times to cancel dividends or other distributions on the instrument without triggering an event of default, a requirement to make a payment-in-kind, or an imposition of other restrictions on the System institution except in relation to any distributions to holders of common cooperative equity instruments or other instruments that are pari passu with the instrument.

(8) Any distributions on the instrument are paid out of the System institution’s net income, unallocated retained earnings, or surplus related to other AT1 capital instruments and are not subject to a limit imposed by the contractual terms governing the instrument;

(9) The instrument does not have a credit-sensitive feature, such as a dividend rate that is reset periodically based in whole or in part on the System institution’s credit quality, but may have a dividend rate that is adjusted periodically independent of the System institution’s credit quality, in relation to general market interest rates or similar adjustments;

(10) The paid-in amount is classified as equity under GAAP;

(11) The System institution did not purchase or directly or indirectly fund the purchase of the instrument;

(12) The instrument does not have any features that would limit or discourage additional issuance of capital by the System institution, such as provisions that require the System institution to compensate holders of the instrument if a new instrument is issued at a lower price during a specified timeframe; and

(13) The System institution’s capitalization bylaws provide that it will not redeem the instrument without the prior approval of the FCA.

Notwithstanding the criteria for AT1 capital instruments referenced above, an instrument with terms that provide that the instrument may be called earlier than 5 years upon the occurrence of a rating agency event does not violate the minimum 5-year issuance requirement provided that the instrument was issued and included in a System institution’s core surplus capital prior to the effective date of the final rule, and that such instrument satisfies all other criteria under this § 628.20(c).

b. FCA’s Current Capital Regulations

Under the FCA’s current regulatory capital regulations, the outstanding noncumulative perpetual preferred stock issued by System institutions to third parties is included in core surplus and is included in the minimum required 1.5 percent of core surplus that is other than allocated equities routinely redeemed. Such preferred stock would continue to receive favorable regulatory capital treatment in tier 1 capital. However, consistent with the objective of Basel III and the Federal regulatory banking agencies’ rules that banking organizations’ common equities comprise at least 4.5 percent of risk-based capital, the preferred stock would not be included in CET1.

3. Tier 2 Capital

The FCA proposes to include in tier 2 capital the sum of tier 2 capital instruments that satisfy the applicable criteria, plus ALL up to 1.25 percent of risk-weighted assets, less any applicable adjustments and deductions. The criteria are similar to those in Basel III and the Federal regulatory banking agencies’ rules, except that common cooperative equities that are not includable in CET1 may be included in tier 2 if they meet the applicable criteria.

The criteria for instruments (plus related surplus) included in tier 2 capital are:

(1) The instrument is issued and paid-in, is a common cooperative equity, or is member equity purchased in accordance with § 628.20(d)(1)(viii) of the proposed rule;

(2) The instrument is subordinated to general creditors of the System institution;

(3) The instrument is not secured, not covered by a guarantee of the System institution and not subject to any other arrangement that legally or economically enhances the seniority of the instrument in relation to more senior claims;

(4) The instrument has a minimum original maturity of at least 5 years. At the beginning of each of the last 5 years of the life of the instrument, the amount that is eligible to be included in tier 2 capital is reduced by 20 percent of the original amount of the instrument (net of redemptions) and is excluded from regulatory capital when the remaining maturity is less than 1 year. In addition, the instrument must not have any terms or features that require, or create significant incentives for, the System institution to redeem the instrument prior to maturity;
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(5) The instrument, by its terms, may be called by the System institution only after a minimum of 5 years following issuance, except that the terms of the instrument may allow it to be called sooner upon the occurrence of an event that would preclude the instrument from being included in tier 2 capital, or a tax event. In addition:

(a) The System institution must receive the prior approval of FCA to exercise a call option on the instrument.

(b) The System institution does not create at issuance, through action or communication, an expectation the call option will be exercised.

(c) Prior to exercising the call option, or immediately thereafter, the System institution must either: Replace any amount called with an instrument that is of equal or higher quality regulatory capital under this section;
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or demonstrate to the satisfaction of FCA that following redemption, the System institution would continue to hold an amount of capital that is commensurate with its risk;

(6) The holder of the instrument must have no contractual right to accelerate payment of principal, dividends, or interest on the instrument, except in the event of a receivership, insolvency, liquidation, or similar proceeding of the System institution;

(7) The instrument has no credit-sensitive feature, such as a dividend or interest rate that is reset periodically based in whole or in part on the System institution’s credit standing, but may have a dividend rate that is adjusted periodically independent of the System institution’s credit standing, in relation to general market interest rates or similar adjustments;

(8) The System institution has not purchased and has not directly or indirectly funded the purchase of the instrument, except that where common cooperative equity instruments are held by a member of the institution in connection with a loan, and the institution funds the acquisition of such instruments, that loan shall not be considered as a direct or indirect funding where:

(a) The purpose of the loan is not the purchase of capital instruments of the System institution providing the loan;

(b) The purchase or acquisition of one or more capital instruments of the institution is necessary in order for the beneficiary of the loan to become a member of the System institution; and

(c) The capital instruments are in excess of the statutory minimum stock purchase amount;

(9) Redemption of the instrument prior to maturity or repurchase is at the discretion of the System institution and requires the prior approval of the FCA; and

(10) If the instrument is a common cooperative equity, the System institution’s capitalization bylaws provide that it will not, except with the prior approval of the FCA, redeem such equity included in tier 2 capital for a period of at least 5 years after allocating it to a member.

4. FCA Approval of Capital Elements

Proposed § 628.20(e) would require a System institution to obtain prior approval to include a new capital element in its CET1 capital, AT1 capital, or tier 2 capital unless the element is equivalent, in terms of capital quality and ability to absorb losses with respect to all material terms, to a regulatory element the FCA has already determined may be included in regulatory capital. After the FCA determines that an institution may include an element in regulatory capital, it will make its decision publicly available.

5. FCA Prior Approval Requirements for Cash Patronage, Dividends, and Redemptions; Safe Harbor

As described above, the proposed rule would require FCA prior approval for the redemption of equities included in tier 1 and tier 2, consistent with Basel III and the Federal regulatory banking agencies’ rules. The proposed rule would also require FCA prior approval of cash dividends and cash patronage, which is not a requirement of the Basel III framework but is a requirement imposed by statute or regulation on the federally chartered banking organizations regulated by the Federal regulatory banking agencies. In § 628.20(f), we are also proposing a “safe harbor” to permit institutions to pay cash dividends and patronage and to redeem equities with “deemed” FCA prior approval if the payments are within the specified parameters.

Before a Federal savings association declares a dividend, it must send a notice, or application for approval, of the action to the Office of the Comptroller of the Currency (OCC). Whether OCC approval is required or a mere notice will suffice depends on a number of factors. For example, an application for approval is required if the proposed declaration (together with all other capital distributions) for the applicable calendar year exceeds the savings association’s net income for the current year plus the retained net income for the 2 preceding years.
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A national bank must obtain OCC approval to declare a dividend if the total amount of all common and preferred dividends, including the proposed dividend, declared in any current year exceeds the total of the national bank’s net income of the current year to date, combined with the retained net income of the previous 2 years.
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The FCA’s proposed rule would not require System institutions to obtain prior approval to retire member stock up to an amount equal to the Farm Credit Act’s minimum member stock requirement of $1,000 or 2 percent of the loan, whichever is less. In addition, subject to any restrictions on cash payouts under the capital conservation buffer provision in § 628.11, the proposed safe harbor would provide that FCA prior approval is deemed to be granted for cash distributions to pay dividends, patronage, or revolvements and redemptions of common cooperative equities provided that:

• For revolvements or redemptions of common cooperative equities included in CET1 capital, such equities were issued or distributed at least 10 years ago;
• For revolvements or redemptions of common cooperative equities included in tier 2 capital, such equities were issued or distributed at least 5 years ago;
• After such cash distributions, the dollar amount of the System institution’s CET1 capital equals or exceeds the dollar amount of CET1 capital on the same date in the previous calendar year; and
• After such cash distributions, the System institution continues to comply with all regulatory capital requirements and supervisory or enforcement actions.

System institutions do not generally have to obtain FCA prior approval before paying patronage or dividends or redeeming equities under current regulations, nor does the Farm Credit Act require prior approval. However, it is a fundamental principle of the regulatory capital requirements for U.S. banking organizations regulated by the Federal regulatory banking agencies. In order for the regulatory capital framework that applies to System institutions to be comparable to the regulatory capital framework that applies to U.S. banking organizations, we believe it is necessary to include these prior approval requirements in our proposed rule. We believe that, most of the time, most System institutions will be able to pay cash patronage and dividends and redeem equities to the same extent that they do currently.

B. Regulatory Adjustments and Deductions

1. Regulatory Deductions From CET1 Capital

Under the proposal, a System institution must deduct from CET1 capital the items described in § 628.22 of the proposed rule. A System institution would exclude these deductions from its total risk-weighted assets and leverage exposure. These deductions are:

a. Goodwill and Other Intangibles (Other Than Mortgage Servicing Assets)

Consistent with Basel III and the Federal regulatory banking agencies’ rules, the FCA proposes to exclude goodwill and other intangible assets from regulatory capital because of the uncertainty that a System institution may realize value from these assets under adverse financial conditions. An institution would deduct goodwill and “non-mortgage” servicing assets, net of associated deferred tax liabilities (DTLs), from CET1 capital. (The FCA’s current capital regulations require goodwill to be deducted from regulatory capital.) While intangible assets include mortgage servicing assets (MSAs), the MSAs are subject to a different treatment from other intangible assets under Basel III and the Federal banking regulatory agencies’ rules. In Basel III and the agencies’ rules, the MSAs, along with two other items—significant investments in the common shares of unconsolidated financial institutions and deferred tax assets (DTAs) that arise from temporary differences—are given limited recognition in a banking organization’s CET1, with recognition capped at 10 percent of CET1 for each item (i.e., a “threshold deduction” of 10 percent). There is also a threshold deduction of 15 percent on the aggregate of the three items, and any included MSAs are risk weighted at 250 percent.

The FCA is not proposing to implement the threshold deductions for these three items. We believe that no System institution’s MSAs would meet the 10- and 15-percent thresholds. The proposed rule would require System institutions to assign a risk weight to MSAs of 100 percent, as they do in current FCA regulations. Traditionally, System institutions follow the make-and-hold philosophy when it comes to its loan assets. As a result, only a few System institutions have sold loans to Farmer Mac or other parties for securitization. Should the levels of MSAs held by System institutions increase significantly in the future, the FCA may reconsider the appropriateness of this proposed treatment.

The FCA is not proposing the threshold deduction in Basel III and the Federal regulatory banking agencies’ rules for investments in other financial institutions because it is proposing that System institutions deduct their investments in other System institutions from their regulatory capital, as described below. Other equity investments will be risk weighted according to § 628.51.

We do not believe DTAs that are risk weighted in this section would represent material items on a System institution’s balance sheet because of System institutions’ tax status. The FCBs and FLCAs are exempt from Federal, state, municipal, and local taxation.
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Most other System institutions’ net income arises from both non-taxable and taxable sources. The production and cooperative lending business lines are taxable, but the ACB and taxable System associations may reduce taxes by following Subchapter T provisions of the Internal Revenue Code. Therefore, we do not expect large amounts of DTAs and deferred tax liabilities (DTLs) on a System institution’s balance sheet. Should the levels of DTAs held by System institutions increase significantly in the future, the FCA may reconsider the appropriateness of this proposed treatment.

We seek comment on whether FCA should risk weight MSAs at 100 percent or require deduction of MSAs from CET1, as we propose to do for non-mortgage servicing rights. At the present time, FCA does not consider any type of servicing asset material to a System institution’s or the System’s consolidated balance sheet.

b. Gain-on-Sale Associated With a Securitization Exposure

A System institution would deduct from CET1 capital any after-tax gain-on-sale associated with a securitization exposure. Under GAAP, any gain-on-sale from a traditional securitization would increase a System institution’s CET1 capital. However, if a System institution received cash from the sale of the securitization exposure and the MSA, it would not deduct such amount from its CET1 capital. Any sale of loans to a securitization structure that creates a gain may include an MSA that also meets the proposed definition of “gain-on-sale.” A System institution must exclude any portion of a gain-on-sale reported as an MSA on FCA’s Call Report.

c. Defined Benefit Pension Fund Net Assets

A System institution must deduct from CET1 capital a defined benefit pension fund asset (an overfunded pension), net of any associated DTLs, because of the uncertainty of realizing any of the value from such assets. This proposed rule recognizes under GAAP the amount of a defined benefit pension fund liabilities (an underfunded pension) on the balance sheet of the institution, would be the same amount included as CET1 capital. Therefore, a System institution must not increase its CET1 capital by the derecognition of these defined pension fund liabilities.

Currently, FCA regulations do not require the deduction of the defined benefit pension fund net assets in the regulatory capital calculations. Additionally, our call report does not collect defined benefit pension fund assets. To implement this regulation, FCA will develop a call report schedule and require each System institution to report its individual yearend transactions for defined benefit pension assets on their individual call report schedule. At this time, some System institutions report their yearend transactions for defined benefit pension assets on their institution-only shareholder reports. Others, however, collectively report their yearend transactions for defined benefit pension assets in the district-wide shareholder report.

Comparable to Basel III, a System institution would not be required to deduct defined benefit pension fund assets to which the System institution has unrestricted and unfettered access. In this case, the System institution would assign risk weights to such assets as if the institution directly owned them. Under this proposal, unrestricted and unfettered access would mean that an institution is not required to request and receive specific approval from pension beneficiaries each time it would access funds in the plan.

Any portion of the defined benefit pension fund net assets not deducted by an institution must be risk-weighted as if the System institution directly held a proportional ownership share of each exposure in the defined benefit pension fund. For example, assume that: (1) The institution has a defined benefit pension fund net asset of $10; and (2) the institution has unfettered and unrestricted access to the assets of the defined benefit pension fund. Also, assume that 20 percent of the defined benefit pension fund is risk-weighted at 100 percent and 80 percent is risk-weighted at 300 percent. The institution would risk weight $2 at 100 percent and $8 at 300 percent. This treatment would be consistent with the full look-through approach described in § 628.53(b) of the proposed rule.

Given System institutions’ differing methods of reporting defined benefit pension fund assets, what is the best way to require adjustments for defined benefit pension fund assets in the CET1 capital computation?

d. A System Institution’s Allocated Equity Investment in Another System Institution

The proposed rule would require a System institution to deduct any allocated equity investment in another System institution
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from its CET1 capital pursuant to § 628.22(a). Later in this preamble, we will discuss deducting a System institution’s purchased investment in another System institution using the corresponding deduction approach in § 628.22(c). Other equity exposures are covered in § 628.52.

The FCA is proposing a different equity elimination method from the Federal banking regulatory agencies’ rules. We believe the method proposed is more conservative than the banking agencies’ rules but is more appropriate for System institutions and is consistent with the principles of Basel III. It is also simpler to calculate. System associations, as members of a cooperative network, have equity investments in their affiliated banks. System institutions also have equity investments in other System institutions but few outside the System. As we have discussed earlier in the preamble, the investments that System institutions have in other System institutions are counted in their GAAP financial statements as equity of the issuing or allocating institution and as assets of the recipient institution. The FCA continues to believe, as we have stated numerous times previously, that equities should be counted in the regulatory capital of the institution that has control of the equities. The allocating institutions alone have discretion whether to allocate equities and when, if ever, to distribute those equities. Therefore, under this proposal, the allocating institutions would include in their CET1 capital the equities they have allocated to their members, provided those equities meet the criteria for inclusion in CET1 capital. The institutions that have received allocated equities from other institutions must deduct those equities from their CET1 capital.

Under the proposed rule, System institutions will be able to include allocated equities in CET1 capital that are excluded from core surplus under current regulations. The proposed deductions apply only to investments in other System institutions because, for the most part, our investment regulations restrict equity investments outside the System.

e. “Haircut” Deduction for Redemption of Equities Included in CET1 Capital Less Than 10 Years After Issuance or Allocation

Section 628.22(f) of the proposed rule would provide that, if a System institution redeems equities included in CET1 capital that the institution issued or allocated less than 10 years before, and the institution did not receive prior FCA approval, the institution must exclude 30 percent of the remaining purchased and allocated equities otherwise includable in CET1 capital. That amount must be excluded from CET1 for the next 3 years; during those 3 years the amount excluded from CET1 may be included in tier 2 capital if it otherwise qualifies for tier 2 capital. This haircut would not be imposed on allocated equities that are URE equivalents unless such equities redeemed without FCA approval were URE equivalents, nor would it be imposed for redemptions of a member’s minimum borrower stock requirement.

The FCA is proposing this deduction to ensure proper management by System institutions of their members’ expectations of redemption and also to ensure that institutions are vigilant in their recordkeeping of the issuance and allocation dates of CET1 capital. For most System institutions that redeem equities on a regular basis, the 10-year minimum retention requirement will result in a longer revolvement period, especially for allocated equities, and will likely require some member education about the longer period. It is important that members know they cannot reasonably expect redemption of the equities that their institution includes in CET1 capital in a shorter timeframe than 10 years.

2. The Corresponding Deduction Approach for Purchased Equities

Section 628.22(c) of this proposal incorporates the Basel III corresponding deduction approach for a System institution’s purchased equity investment in another System institution. The corresponding deduction approach does not apply to allocated equity investments in another System institution. Under the proposal, a System institution would be required to deduct an amount from the same component of capital for which the underlying instrument would qualify as if the System institution had issued the instrument itself. If a System institution did not have a sufficient amount of the specific component of regulatory capital for the entire deduction, then it would deduct the remaining portion from the next higher (more subordinated) capital component. Should a System institution not have enough AT1 capital to satisfy the required deduction, the shortfall would be deducted from CET1 capital elements.

3. Netting of Deferred Tax Liabilities Against Deferred Tax Assets and Other Deductible Assets

In this proposed rule, FCA would simplify the netting of DTLs against DTAs and other deductible assets for deductions of DTAs. This proposal differs from the Federal banking regulatory agencies’ final rules for deductions of DTAs. For System institutions, this proposal also represents a change from our existing DTAs deduction regulation. Under the proposal, System institutions would adjust CET1 capital under § 628.22(b) of the proposed rule net of any associated deferred tax effects. In addition, System institutions would deduct from CET1 capital elements under § 628.22(a) and (c) of the proposed rule net of associated DTLs, pursuant to § 628.22(e).

Currently System institution deduct DTAs according to § 615.5209 of FCA regulations. A System institution must deduct an amount of DTAs from its assets and its total capital that is equal to the greater of the two following conditions: (1) An amount of DTAs that is dependent on future income; or (2) an amount of DTAs that is dependent on future income in excess of 10 percent of the amount of core surplus.
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For this proposed regulation, FCA categorized DTAs into three types. First, there are DTAs that arise from temporary differences that a System institution could realize through a net loss carryback.
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Since System institutions have recognized or projected to realize these temporary differences in current income, a System institution would assign these DTAs a risk weight of 100 percent. Second, there are DTAs that arise from temporary differences that a System institution could not realize through net loss carryback.
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And third, there are DTAs that arise from operating loss and tax credit carryforwards.
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A System institution would deduct the latter two DTAs subject to § 628.22(c).

Under the proposal, System institutions making regulatory capital deductions under § 628.22 would net DTLs against assets to which they are associated (other than DTAs). Should the asset to which the DTL is associated become impaired or derecognized under GAAP, the System institution would extinguish the DTL. Likewise, System institutions may only use the same DTL once for netting purposes. This practice is consistent with the netting DTLs against goodwill.

System institutions would net DTLs against DTAs that arise from temporary differences that a System institution could not realize through net loss carrybacks,
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and DTAs that arise from operating loss and tax credit carryforwards
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provided certain conditions exist: (1) A System institution would net only DTLs and DTAs related to taxes levied by the same taxation authority and eligible for offsetting by that authority; and (2) the amount of DTLs that a System institution would be able to net against DTAs that arise from loss carryforwards,
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and against DTAs arising from temporary differences that could not be realized through loss carrybacks,
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would be allocated in proportion to the amount of DTAs that arise from loss carryforwards
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and of DTAs arising from temporary differences that could not be realized through net operating loss carrybacks.
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GAAP requires quarterly adjustment for some DTA and DTL items, such as DTAs and DTLs associated with certain gains and losses included in AOCI. Therefore, the FCA expects System institutions to use for regulatory capital calculations the DTA and DTL amounts reported in the regulatory reports. The proposed rule does not require System institutions to perform these calculations more often than would be required to meet quarterly regulatory reporting requirements.

The FCA would allow System institutions to treat future taxes payable included in valuing a leveraged lease portfolio as a reversing taxable temporary difference available to support recognizing DTAs.
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The proposed rule allows a System institution to use the DTLs embedded in the carrying value of a leveraged lease to reduce the amount of DTAs consistent with § 628.22(e).

The FCA recognizes that, if the tax laws of the relevant state and local jurisdictions do not differ significantly from Federal income tax laws, then under GAAP the calculation of deferred tax expense can be made in the aggregate considering the combination of Federal, state, and local income tax rates. The rate used should consider whether amounts paid in one jurisdiction are deductible in another jurisdiction. For example, since state and local taxes are deductible for Federal income tax purposes, the aggregate combined rate would generally be (1) The Federal income tax rate plus (2) the state and local tax rates, minus (3) the Federal tax effect of the deductibility of the state and local taxes at the Federal tax rate. In addition, for financial reporting purposes, consistent with GAAP, the FCA allows System institutions to offset DTAs (net of valuation allowance) and DTLs related to a particular tax jurisdiction. Moreover, for regulatory reporting purposes, consistent with GAAP, the FCA requires separate calculations of income taxes, both current and deferred amounts, for each tax jurisdiction. Accordingly, System institutions must calculate DTAs and DTLs on a state-by-state basis for financial reporting purposes under GAAP and for regulatory reporting purposes.

Under the proposed rule, a System institution must assign a risk weight of 100 percent under § 628.30 for DTAs that arise from temporary differences that a System institution may realize through net operating loss carrybacks. By this proposal, the FCA would allow System institutions to include in regulatory capital some or all of their DTAs resulting from timing differences that are realizable through net operating loss carrybacks. In this regard, we believe the proposed rule strikes an appropriate balance between prudential concerns and practical considerations about the ability of System institutions to realize DTAs.

C. Limits on Inclusion of Third-Party Capital

The proposed rule would impose limits on System institution issuances of third-party capital—that is, capital issued to entities that are not System institutions or members of System institutions—in regulatory capital.
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The FCA currently imposes limits on the inclusion of third-party capital in core surplus, total surplus, and net collateral on a case-by-case basis in connection with our clearance of disclosure documents and regulatory capital determinations. The FCA has imposed this restriction to ensure that cooperative ownership continues to predominate in all System institutions, in order to maintain the status of the System as a member-controlled GSE that is owned by and primarily benefits its members.

The proposed rule would provide that third-party capital when issued, together with any already outstanding third-party capital in tier 1 capital, may be included in tier 1 capital in an amount up to 33 percent of all other tier 1 capital (i.e., 25 percent of all tier 1 capital including third-party capital). It may be included in total capital in an amount equal to the lesser of 40 percent of total capital or 100 percent of tier 1 capital.

The two formulas are:

1. ALTPC = min (40 percent TC, 100 percent T1),

We seek comment on alternative third-party limits to ensure that System institutions remain capitalized primarily by their member borrowers.

A. Calculation of Standardized Total Risk-Weighted Assets

Similar to the FCA’s current risk-based capital rules, under this proposal a System institution would calculate its total risk-weighted assets by adding together its on- and off-balance sheet risk-weighted asset amounts and making any relevant adjustments to incorporate required capital deductions.
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Risk-weighted asset amounts generally would be determined by assigning on-balance sheet assets to broad risk-weight categories according to the counterparty or, if relevant, the guarantor or collateral. Similarly, risk-weighted asset amounts for off-balance sheet items would be calculated using a two-step process: (1) Multiplying the amount of the off-balance sheet exposure
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by a credit conversion factor (CCF) to determine a credit equivalent amount; and (2) assigning the credit equivalent amount to a relevant risk-weight category.

A System institution would determine its standardized total risk-weighted assets by calculating the sum of its risk-weighted assets for general credit risk, cleared transactions, unsettled transactions, securitization exposures, and equity exposures, each as defined below, less the System institution’s allowance for loan losses (ALL) that is not included in tier 2 capital (as described in § 628.20 of the proposal). The sections below describe in more detail how a System institution would determine the risk-weighted asset amounts for its exposures.

B. Risk-Weighted Assets for General Credit Risk

Under this proposed rule, total risk-weighted assets for general credit risk is the sum of the risk-weighted asset amounts as calculated under § 628.31(a) of the proposal. As proposed, general credit risk exposures would include a System institution’s on-balance sheet exposures (other than cleared transactions, securitization exposures, and equity exposures, each as defined in § 628.2 of the proposed rule), exposures to over-the-counter (OTC) derivative contracts, off-balance sheet commitments, trade and transaction-related contingencies, guarantees, repo-style transactions, financial standby letters of credit, forward agreements, or other similar transactions. Proposed § 628.32 describes the risk weights that would apply to sovereign exposures; exposures to certain supranational entities and multilateral development banks (MDBs); exposures to Government-sponsored enterprises (GSEs); exposures to depository institutions, foreign banks, and credit unions (including certain exposures to other financing institutions (OFIs) owned or controlled by these entities); exposures to public sector entities (PSEs); corporate exposures (including certain exposures to OFIs); residential mortgage exposures; high volatility commercial real estate (HVCRE) exposures; past due exposures; other assets (including cash, gold bullion, certain MSAs and DTAs); and loans from System banks to associations.

Generally, the exposure amount for the on-balance sheet component of an exposure would be the System institution’s carrying value for the exposure as determined under generally accepted accounting principles (GAAP). Because all System institutions use GAAP to prepare their financial statements and regulatory reports, we believe that using GAAP to determine the amount and nature of an exposure provides a consistent framework that System institutions can easily apply. Using GAAP for this purpose would reduce the potential burden that could otherwise result from requiring System institutions to comply with a separate set of accounting and measurement standards for risk-based capital calculation purposes under non-GAAP standards, such as regulatory accounting practices or legal classification standards.

For purposes of the definition of exposure amount for available-for-sale (AFS) or held-to-maturity (HTM) debt securities and AFS preferred stock not classified as equity under GAAP, the exposure amount is the System institution’s carrying value (including net accrued but unpaid interest and fees) for the exposure, less any net unrealized gains, and plus any net unrealized losses. For purposes of the definition of exposure amount for AFS preferred stock classified as an equity security under GAAP, the exposure amount is the System institution’s carrying value (including net accrued but unpaid interest and fees) for the exposure, less any net unrealized gains that are reflected in such carrying value but excluded from the System institution’s regulatory capital.
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In most cases, the exposure amount for an off-balance sheet component of an exposure would typically be determined by multiplying the notional amount of the off-balance sheet component by the appropriate CCF as determined under § 628.33 of the proposed rule. The exposure amount for an OTC derivative contract or cleared transaction that is a derivative would be determined under § 628.34 of the proposed rule, whereas exposure amounts for collateralized OTC derivative contracts, collateralized cleared transactions that are derivatives, repo-style transactions, and eligible margin loans would be determined under § 628.37 of the proposal.

1. Exposures to Sovereigns

Under the proposal, a sovereign would be defined as a central government (including the U.S. Government) or an agency, department, ministry, or central bank of a central government (for the U.S. Government, the central bank is the Federal Reserve). The FCA proposes to retain the current rules’ risk weights for exposures to and claims directly and unconditionally guaranteed by the U.S. Government or its agencies.
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Accordingly, exposures to the U.S. Government, the Federal Reserve, or a U.S. Government agency, and the portion of an exposure that is directly and unconditionally guaranteed by the U.S. Government, the Federal Reserve, or a U.S. Government agency would receive a 0-percent risk weight.
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Consistent with the current risk-based capital rules, the portion of a deposit insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA) would also be assigned a 0- percent risk weight.

An exposure conditionally guaranteed by the U.S. Government, the Federal Reserve, or a U.S. Government agency would receive a 20-percent risk weight.
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This would include an exposure that is conditionally guaranteed by the FDIC or the NCUA.

The FCA’s existing risk-based capital rules generally assign risk weights to direct exposures to sovereigns and exposures directly guaranteed by sovereigns based on whether the sovereign is a member of the Organization for Economic Cooperation and Development (OECD) and, as applicable, whether the exposure is unconditionally or conditionally guaranteed by the sovereign.
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The OECD assigns Country Risk Classifications (CRCs) to many countries as an assessment of their credit risk. CRCs are used to set interest rate charges for transactions covered by the OECD arrangement on export credits. The OECD uses a scale of 0 to 7 with 0 being the lowest possible risk and 7 being the highest possible risk. The OECD no longer assigns CRCs to certain high-income countries that are members of the OECD and that have previously received a CRC of 0. These countries exhibit a similar degree of country risk as that of a jurisdiction with a CRC of 0.
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Under the proposed rule, the risk weight for exposures to countries with CRCs would be determined based on the CRCs. Exposures to OECD member countries that do not have CRCs would be risk-weighted at 0-percent. Exposures to non-OECD members with no CRC would be risk-weighted at 100-percent.
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The OECD regularly updates CRCs and makes the assessments publicly available on its Web site. Accordingly, the FCA believes that the CRC approach should not represent undue burden to System institutions.

The FCA believes that use of CRCs in the proposal is permissible under section 939A of the Dodd-Frank Act and that section 939A was not intended to apply to assessments of creditworthiness by organizations such as the OECD. Section 939A is part of Subtitle C of Title IX of the Dodd-Frank Act, which, among other things, enhances regulation by the U.S. Securities and Exchange Commission (SEC) of credit rating agencies, including Nationally Recognized Statistical Rating Organizations (NRSROs) registered with the SEC. Section 939A requires agencies to remove references to credit ratings and NRSROs from Federal regulations. In the introductory “findings” section to Subtitle C, which is entitled “Improvements to the Regulation of Credit Ratings Agencies,” Congress characterized credit rating agencies as organizations that play a critical “gatekeeper” role in the debt markets and perform evaluative and analytical services on behalf of clients, and whose activities are fundamentally commercial in character.
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Furthermore, the legislative history of section 939A focuses on the conflicts of interest of credit rating agencies in providing credit ratings to their clients, and the problem of government “sanctioning” of the credit rating agencies’ credit ratings by having them incorporated into Federal regulations. The OECD is not a commercial entity that produces credit assessments for fee-paying clients, nor does it provide the sort of evaluative and analytical services as credit rating agencies. Additionally, the FCA notes that the use of the CRCs is limited in the proposal. The FCA considers CRCs to be a reasonable alternative to credit ratings for sovereign exposures and the proposed CRC methodology to be more granular and risk sensitive than the current risk-weighting methodology based solely on OECD membership.

The FCA also proposes to require a System institution to apply a 150-percent risk weight to sovereign exposures immediately upon determining that an event of sovereign default has occurred or if an event of sovereign default has occurred during the previous 5 years. Sovereign default would be defined as a noncompliance by a sovereign 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 or interest fully and on a timely basis, arrearages, or restructuring. A default would include a voluntary or involuntary restructuring that results in a sovereign not servicing an existing obligation in accordance with the obligation’s original terms.

2. Exposures to Certain Supranational Entities and Multilateral Development Banks

Under the FCA’s existing risk-based capital rules, exposures to certain supranational entities and multilateral development banks (MDBs) receive a 20-percent risk weight. Consistent with the Basel framework’s treatment of exposures to supranational entities, the FCA proposes to apply a 0-percent risk weight to exposures to the Bank for International Settlements, the European Central Bank, the European Commission, and the International Monetary Fund.

Similarly, the FCA proposes to apply a 0-percent risk weight to exposures to an MDB. The proposal would define an MDB to include the International Bank for Reconstruction and Development, the Multilateral Investment Guarantee Agency, the International Finance Corporation, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, the European Bank for Reconstruction and Development, the European Investment Bank, the European Investment Fund, the Nordic Investment Bank, the Caribbean Development Bank, the Islamic Development Bank, the Council of Europe Development Bank, and any other multilateral lending institution or regional development bank in which the U.S. Government is a shareholder or contributing member or which the FCA determines poses comparable credit risk.

The FCA believes this treatment is appropriate in light of the generally high-credit quality of MDBs, their strong shareholder support, and a shareholder structure comprised of a significant proportion of sovereign entities with strong creditworthiness. Exposures to regional development banks and multilateral lending institutions that are not covered under the definition of MDB generally would be treated as corporate exposures and would receive a 100-percent risk weight.

3. Exposures to Government-Sponsored Enterprises

The System is a GSE, and the definition of GSE adopted by the Federal banking regulatory agencies includes the System in their definition of GSE.
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Those agencies view the System, and the other GSEs, as potential counterparties to the entities that they regulate. In contrast, we regulate System institutions rather than viewing them as potential counterparties. It is too confusing for the System to be included in a definition that is intended to refer to counterparties. Accordingly, we propose for the purpose of these capital regulations at part 628 to exclude institutions of the System (other than the Federal Agricultural Mortgage Corporation (Farmer Mac)) from the definition of GSE.
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Throughout these capital regulations, we will refer to System institutions specifically as necessary.

The FCA is proposing to assign a 20-percent risk weight to exposures to GSEs that are not equity exposures and a 100-percent risk weight to preferred stock issued by a GSE.
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This risk weighting would represent a change to the FCA’s existing risk-based capital rules, which currently allow a System institution to apply a 20-percent risk weight to GSE preferred stock.
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4. Exposures to Depository Institutions, Foreign Banks, and Credit Unions

The FCA’s existing risk-based capital rules assign a 20-percent risk weight to all exposures to U.S. depository institutions and foreign banks incorporated in an OECD country. Short-term exposures to foreign banks incorporated in a non-OECD country receive a 20-percent risk weight and long-term exposures to such entities receive a 100-percent risk weight.

Under the proposal, exposures to U.S. depository institutions and credit unions would be assigned a 20-percent risk weight.
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This risk weight would apply to a System bank exposure to an OFI that is owned and controlled by a U.S. or state depository institution or credit union that guarantees the exposure. If the OFI exposure did not satisfy these requirements, it would be assigned a 100-percent risk weight as a corporate exposure pursuant to § 628.32(f)(2).

Our existing OFI rules assign a 20-percent risk weight to a claim on an OFI that is an OECD bank or is owned and controlled by an OECD bank that guarantees the claim or if the OFI or its parent has a sufficiently high credit rating.
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Our proposal would impose the same risk weight for OFI exposures of the same nature, except that we propose to eliminate the credit rating alternative in accordance with section 939A of the Dodd-Frank Act.

Under this proposal, an exposure to a foreign bank would receive a risk weight one category higher than the risk weight assigned to a direct exposure to the foreign bank’s home country, based on the assignment of risk weights by CRC, as discussed above.
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Exposures to a foreign bank in a country that does not have a CRC but that is a member of the OECD would receive a 20-percent risk weight. A System institution would assign a 100-percent risk weight to an exposure to a foreign bank in a non-OECD member country that does not have a CRC, except that the institution could assign a 20-percent risk weight to self-liquidating, trade-related contingent items that arise from the movement of goods and that have a maturity of 3 months or less.

A System institution would be required to assign a 150-percent risk weight to an exposure to a foreign bank immediately upon determining that an event of sovereign default has occurred in the bank’s home country, or if an event of sovereign default has occurred in the foreign bank’s home country during the previous 5 years.

Both the Basel capital framework and our existing regulation treat exposures to securities firms that meet certain requirements like exposures to depository institutions.
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However, like the Federal banking regulatory agencies, the FCA no longer believes that the risk profile of these firms is sufficiently similar to depository institutions to justify that treatment. Accordingly, the FCA proposes to require System institutions to treat exposures to securities firms as corporate exposures, with a 100-percent risk weight.

5. Exposures to Public Sector Entities

The FCA’s existing risk-based capital rules assign a 20-percent risk weight to general obligations of states and other political subdivisions of OECD countries.
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Exposures that rely on repayment from specific projects (for example, revenue bonds) are assigned a risk weight of 50 percent. Other exposures to state and political subdivisions of OECD countries (including industrial revenue bonds) and exposures to political subdivisions of non-OECD countries receive a risk weight of 100 percent. The risk weights assigned to revenue obligations are higher than the risk weight assigned to general obligations because repayment of revenue obligations depends on specific projects, which present more risk relative to a general repayment obligation of a state or political subdivision of a sovereign.

The FCA is proposing to apply the same risk weights to exposures to U.S. states and municipalities as the existing risk-based capital rules apply. Under the proposal, these political subdivisions would be included in the definition of “public sector entity” (PSE). Consistent with both the current rules and the Basel capital framework, the FCA proposes to define a PSE as a state, local authority, or other governmental subdivision below the level of a sovereign. This definition would include U.S. states and municipalities and would not include government-owned commercial companies that engage in activities involving trade, commerce, or profit that are generally conducted or performed in the private sector.

Under the proposal, a System institution would assign a 20-percent risk weight to a general obligation exposure to a PSE that is organized under the laws of the United States or any state or political subdivision thereof and a 50-percent risk weight to a revenue obligation exposure to such a PSE. A general obligation would be defined as a bond or similar obligation that is backed by the full faith and credit of a PSE. A revenue obligation would be defined as a bond or similar obligation that is an obligation of a PSE, but which the PSE is committed to repay with revenues from a specific project financed rather than general tax funds.

Similar to the Basel framework’s use of home country risk weights to assign a risk weight to a PSE exposure, the FCA proposes to require a System institution to apply a risk weight to an exposure to a non-U.S. PSE based on (1) The CRC applicable to the PSE’s home country or, if the home country has no CRC, whether it is a member of the OECD, and (2) whether the exposure is a general obligation or a revenue obligation, in accordance with Table 5.

The risk weights assigned to revenue obligations would be higher than the risk weights assigned to a general obligation issued by the same PSE, as set forth, for non-U.S. PSEs, in Table 5. Similar to exposures to a foreign bank, exposures to a non-U.S. PSE in a country that does not have a CRC rating would receive a 100-percent risk weight. Exposures to a non-U.S. PSE in a country that has defaulted on any outstanding sovereign exposure or that has defaulted on any sovereign exposure during the previous 5 years would receive a 150-percent risk weight. Table 5 illustrates the proposed risk weights for exposures to non-U.S. PSEs.

The FCA proposes to allow a System institution to apply a risk weight to an exposure to a non-U.S. PSE according to the risk weight that the foreign banking organization supervisor allows to be assigned to it. In no event, however, may the risk weight for an exposure to a non-U.S. PSE be lower than the risk weight assigned to direct exposures to that PSE’s home country.

6. Corporate Exposures

Under the FCA’s existing risk-based capital rules, credit exposures to companies that are not depository institutions or securitization vehicles generally are assigned to the 100-percent risk weight category. A 20-percent risk weight is assigned to claims on, or guaranteed by, a securities firm incorporated in an OECD country that satisfies certain conditions.

The proposed requirements would be generally consistent with the existing risk-based capital rules and require System institutions to assign a 100-percent risk weight to all corporate exposures. The proposal would define a corporate exposure as an exposure to a company that is not an exposure to a sovereign, the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, an MDB, a depository institution, a foreign bank, or a credit union, a PSE, a GSE, a residential mortgage exposure, an HVCRE exposure, a cleared transaction, a securitization exposure, an equity exposure, or an unsettled transaction. This definition captures all exposures that are not otherwise included in another specific exposure category and is not limited to exposures to corporations.

Accordingly, this category would include borrower loans such as agricultural loans and consumer loans, regardless of the corporate form of the borrower, unless those loans qualify for different risk weights (such as a 50-percent risk weight for residential mortgage exposures) under other provisions. This category would also include premises, fixed assets, and other real estate owned.

Because they are corporate exposures, this category includes all OFI exposures that do not qualify for the 20-percent depository institution risk weight provided in § 628.32(d) and discussed above. Our existing rules also contain a default 100-percent risk weight category.
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But our existing regulations also contain an intermediate, 50-percent risk weight category for claims on OFIs that do not satisfy the requirements for a 20-percent risk weight but that otherwise meet similar capital, risk identification and control, and operational standards or that carry an investment grade credit rating.
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Only if an OFI does not satisfy these standards does a claim on it receive a 100-percent risk weighting.

This 50-percent risk weighting for what would otherwise be a corporate exposure is inconsistent with our treatment of other corporate exposures. In addition, the Federal banking regulatory agencies would assign a 100-percent risk weight to these exposures. Accordingly, we propose to eliminate the 50-percent risk weight for OFIs and to assign a 100-percent risk weight to exposures to OFIs that do not satisfy the requirements for a 20-percent risk weight because they are not depository institutions.

We seek comment on our proposed capital treatment of exposures to OFIs. Specifically, what factors or other information would be relevant if we consider assigning an intermediate risk weight to a System institution’s exposure to an OFI, recognizing that the same exposure to the same OFI would receive a 100-percent risk weight from a banking organization regulated by a Federal banking regulatory agency?

In contrast to the FCA’s existing risk-based capital rules, all securities firms would be subject to the same treatment as corporate exposures.

7. Residential Mortgage Exposures

The FCA’s existing risk-based capital rules assign “qualified residential loans” to the 50-percent risk-weight category.
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Qualified residential loans include both rural home loans authorized under § 613.3030 and single-family residential loans to bona fide farmers, ranchers, and producers and harvesters of aquatic products. Qualified residential loans must have been approved in accordance with prudent underwriting standards suitable for residential property and must not be past due 90 days or more or carried in nonaccrual status.
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If the loan does not satisfy these safety and soundness standards, or the property is not characteristic of residential property, the loan receives a 100-percent risk weight.

In general, although our rule is structured differently, our existing safety and soundness standards are very similar to the risk-weighting requirements of the Federal banking regulatory agencies for residential mortgage exposures.
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The major differences between the two sets of rules are the FCA’s criteria regarding the characteristics of residential property, which the Federal banking regulatory agencies do not have.

In the interest of consistency, we now propose to structure our rule the same way as the Federal banking regulatory agencies do. Moreover, we propose to adopt the safety and soundness standards of the Federal banking regulatory agencies. As mentioned above, and as discussed below, although these standards are already very similar, there would be a few changes to our rule. Finally, while we would retain two of our existing requirements regarding the characteristics of residential property, we propose to eliminate the rest of these requirements as unnecessary and burdensome.
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We would define a residential mortgage exposure as an exposure (other than a securitization exposure or equity exposure) that is primarily secured by a first or subsequent lien on one-to-four family residential property, provided that the dwelling (including attached components such as garages, porches, and decks) represents at least 50 percent of the total appraised value of the collateral secured by the first or subsequent lien.
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The proposed rule would assign a residential mortgage exposure to the 50-percent risk-weight category if the property is either owner-occupied or rented
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and if the exposure was made in accordance with prudent underwriting standards suitable for residential property, including standards relating to the loan amount as a percentage of the appraised value of the property;
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is not 90 days or more past due or carried in non-accrual status; and is not restructured or modified.
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A System institution must assign a 100-percent risk weight to all residential mortgage exposures that do not satisfy the criteria for a 50-percent risk weight.

The proposed rule would maintain the current risk-based capital treatment for residential mortgage exposures that are guaranteed by the U.S. Government or U.S. Government agencies. Accordingly, residential mortgage exposures that are unconditionally guaranteed by the U.S. Government or a U.S. Government agency would receive a 0-percent risk weight, and residential mortgage exposures that are conditionally guaranteed by the U.S. Government or a U.S. Government agency would receive a 20-percent risk weight.

Under the proposal, a residential mortgage exposure may be assigned to the 50-percent risk-weight category only if it is not restructured or modified. We believe this new restriction on System institution risk weighting, which the Federal banking regulatory agencies adopted, is appropriate based on risk.

However, a residential mortgage exposure modified or restructured on a permanent or trial basis solely pursuant to the U.S. Treasury’s Home Affordable Mortgage Program (HAMP) would not be considered to be restructured or modified and would continue to receive a 50-percent risk weighting. Treating mortgage loans modified pursuant to HAMP in this manner is appropriate in light of the special and unique incentive features of HAMP, and the fact that the program is offered by the U.S. Government to achieve the public policy objective of promoting sustainable loan modifications for homeowners at risk of foreclosure in a way that balances the interests of borrowers, servicers, and lenders.
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System institutions should be mindful that the residential mortgage market is likely to change in the future, in part because of regulations the CFPB is adopting to improve the quality of mortgage underwriting and to reduce the associated credit risk and in part for market-driven or other reasons. The FCA may propose changes in the treatment of residential mortgage exposures in the future. If so, we intend to take into consideration structural and product market developments, other relevant regulations, and potential issues with implementation across various product types.

8. High Volatility Commercial Real Estate Exposures

Certain acquisition, development, and construction (ADC) loans (which are a subset of commercial real estate exposures) present particular risks and warrant the holding of additional capital beyond the 100-percent risk weight that would otherwise apply. Accordingly, the FCA is proposing a 150-percent risk weight for these HVCRE exposures.

The proposed definition of HVCRE would be a credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction of real property. The financing of four kinds of property is excluded from this definition:

• One-to-four family residential properties;
• Real property that the FCA has authorized as an investment pursuant to § 615.5140(e) (this provision authorizes System institutions to purchase and hold investments as approved by the FCA);
• The purchase or development of agricultural land, which includes all land known to be used or usable for agricultural purposes (such as crop and livestock production), provided that the valuation of the agricultural land is based on its value for agricultural purposes and the valuation does not take into consideration any potential use of the land for non-agricultural commercial development or residential development; or
• Commercial real estate projects that meet certain prudential criteria, including with respect to the LTV ratio and capital contributions or expense contributions of the borrower.

A commercial real estate loan that is not an HVCRE exposure, including permanent financing after the life of the ADC project concludes, would be treated as a corporate exposure.

There may be overlap between HVCRE exposures and exposures to land in transition—agricultural land in the path of development. FCA Bookletter BL-058 (BL-058) explains that while System institutions may finance land in transition, they may not provide development financing that converts agricultural land to non-agricultural land, except in very rare instances. BL-058 provides guidance on how a System institution making a loan to purchase or refinance land in transition should ensure compliance with the FCA’s eligibility and scope of financing regulations. System institutions contemplating land in transition financing must review and understand BL-058 and must ensure they are in full compliance with all FCA regulations in that area.

9. Past Due Exposures

Under the FCA’s existing risk-based capital rules, the risk weight of a loan does not change if the loan becomes past due, with the exception of certain residential mortgage loans. The FCA believes, however, that a higher risk weight is appropriate for past due exposures (such as past due agricultural or other borrower loans) to reflect the increased risk associated with such exposures.

To reflect the impaired credit quality of such exposures, the FCA proposes to require a System institution to assign a risk weight of 150 percent to an exposure that is not guaranteed or is not secured by financial collateral (and that is not a sovereign exposure or a residential mortgage exposure) if it is 90 days or more past due or recognized as nonaccrual.
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We believe this risk weight is appropriate and that any increased capital burden, potential rise in procyclicality, or impact on lending associated with the increased risk weight is justified given the overall objective of capturing the risk associated with the impaired credit quality of these exposures.

Moreover, the increased risk weight would not double-count the risk of a past due exposure, even though the ALL would already be reflected in the risk-based capital numerator, because the ALL is intended to cover estimated, incurred losses as of the balance sheet date, not unexpected losses. The higher risk weight on past due exposures would ensure sufficient regulatory capital for the increased probability of unexpected losses on these exposures.

A System institution would be permitted to assign a risk weight to the portion of a past due exposure that is collateralized by financial collateral or that is guaranteed if the financial collateral, guarantee, or credit derivative meets the proposed requirements for recognition described in § 628.36 and § 628.37.
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10. Other Assets

Generally consistent with our existing risk-based capital rules, the FCA proposes the risk weights described below for the following exposures:

(1) A 0-percent risk weight to cash owned and held in all offices of the System institution, in transit, or in accounts at a depository institution or a Federal Reserve Bank; to gold bullion held in a depository institution’s vaults on an allocated basis to the extent gold bullion assets are offset by gold bullion liabilities; and to exposures that arise from the settlement of cash transactions (such as equities, fixed income, spot foreign exchange and spot commodities) with a central counterparty where there is no assumption of ongoing counterparty credit risk by the central counterparty after settlement of the trade;

(2) A 20-percent risk weight to cash items in the process of collection; and

(3) A 100-percent risk weight to DTAs arising from temporary differences that a System institution could realize through net operating loss carrybacks;

(4) A 100-percent risk weight to all MSAs; and

(5) A 100-percent risk weight to all assets not specifically assigned a different risk weight under this proposed rule (other than exposures that would be deducted from tier 1 or tier 2 capital pursuant to proposed § 628.22).

As discussed above, the FCA is proposing, unlike the Federal banking regulatory agencies, to deduct from capital all DTAs, other than those arising from temporary differences that a System institution could realize through net operating loss carrybacks. In addition, because System institutions have such little exposure to MSAs, we are proposing to simplify the capital treatment as adopted by the Federal banking regulatory agencies. Accordingly, we are proposing to risk weight DTAs and MSAs as stated above and to eliminate the capital treatment, including the 250-percent risk weight, adopted by the Federal banking regulatory agencies.
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11. Exposures to Other System Institutions

We propose to retain the existing 20-percent risk weight for loans from System banks to associations (direct loans).

Under proposed § 628.22(c), all equities (including preferred stock) a System institution has invested in another System institution would be deducted from the investing institution’s regulatory capital, and therefore we do not propose a risk weighting for these exposures. These exposures would include an association’s investment in its System bank, a System bank’s purchase of nonvoting stock or participation certificates of an affiliated association pursuant to § 615.5171, and the purchase of a System association’s preferred stock by a System bank, association, or service corporation pursuant to § 615.5175.

In the past, System institutions (generally System banks) have entered into loss-sharing agreements with other System institutions (generally, affiliated associations) under § 614.4340. In the future, if System institutions enter into a loss-sharing agreement, the FCA would assign a risk weight for any associated exposures at that time, using our reservation of authority.

12. Risk-Weighting for Specialized Exposures

By FCA Bookletter BL-052, dated January 25, 2006, the FCA permitted loans recorded before January 1, 2006 that are supported by Tobacco Buyout assignments to be risk weighted at 20 percent.
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These loans mature no later than 2015. Although we do not propose to include it in this rule, the FCA intends to continue to permit a 20-percent risk weight for these loans. If necessary, we will issue revised guidance on this capital treatment when we adopt our final capital rule.

By FCA Bookletter BL-053, dated February 27, 2007, the FCA permitted System institutions to assign a lower risk than would otherwise apply to certain electrical cooperative assets, based on the unique characteristics and lower risk profile of this industry segment. Exposures to certain electrical cooperative assets that satisfy specified conditions receive a 50-percent rather than a 100-percent risk weight. Furthermore, exposures to these assets receive a 20-percent risk weight if the assets have a AAA or AA credit rating.

We do not propose this favorable risk weighting for these assets in this rule, but we seek comment as to whether we should retain this risk weighting, being mindful of the Dodd-Frank Act section 939A requirement that we must eliminate the credit rating criteria. If we do retain this capital treatment, we will issue revised guidance on the risk weighting when we adopt our final capital rule.

C. Off-Balance Sheet Items

1. Credit Conversion Factors

Under this proposed rule, as under our existing risk-based capital rules, a System institution would calculate the exposure amount of an off-balance sheet item by multiplying the off-balance sheet component, which is usually the contractual amount, by the applicable credit conversion factor (CCF). This treatment would apply to off-balance sheet items, such as commitments (including a System bank’s commitment to an association, discussed below), contingent items, guarantees, certain repo-style transactions, financial standby letters of credit, and forward agreements.

We propose to determine the exposure amount of a System bank’s commitment to an association as the difference between the association’s maximum credit limit with the System bank (as established by the general financing agreement or promissory note, as required by § 614.4125(d)) and the amount the association has borrowed from the System bank. For example, if a System bank has a $100 maximum credit limit to an association and the association has $80 outstanding on its direct note, the System bank’s exposure amount on its commitment would be $20.

Determining a System bank’s exposure amount in this manner would result in what could be viewed as double counting of commitment exposures (although, as discussed below, we disagree). Continuing the example above, the association that has borrowed $80 from its System bank could have $60 in outstanding loans to its borrowers and $15 in commitments to its borrowers.
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The System bank would be required to hold capital against its $20 commitment exposure amount, and the association would be required to hold capital against its $15 commitment exposure amount, which it would fund by drawing on its commitment with the System bank.

We do not believe this treatment results in double counting commitment exposures. This treatment is consistent with the way we treat loan exposures; we require a System bank to hold capital against the outstanding balance of its loan to an association, and we also require an association to hold capital against its loans to borrowers (even though the association’s loaned funds come from its loan with the System bank). As with loan exposures, we believe that there are separate risks involved in System bank commitment exposures and association commitment exposures.
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Accordingly, we do not propose to net association commitments against System bank commitments. We invite comment on this determination.

Similar to the current risk-based capital rules, a System institution would apply a 0-percent CCF to the unused portion of commitments that are unconditionally cancelable by the institution. For purposes of this proposed rule, a commitment would mean any legally binding arrangement that obligates a System institution to extend credit or to purchase assets. Unconditionally cancelable would mean a commitment that a System institution may, at any time, with or without cause, refuse to extend credit under the commitment (to the extent permitted under applicable law). In the case of an operating line of credit, a System institution would be deemed able to unconditionally cancel the commitment if it can, at its option, prohibit additional extensions of credit, reduce the credit line, and terminate the commitment to the full extent permitted by applicable law. If a System institution provides a commitment that is structured as a syndication, it would only be required to calculate the exposure amount for its pro rata share of the commitment.

The FCA proposes to maintain the current 20-percent CCF for self-liquidating, trade-related contingencies with an original maturity of 14 months or less.
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In addition, the FCA proposes to increase the CCF from 0 percent to 20 percent for commitments with an original maturity of 14 months or less that are not unconditionally cancelable by a System institution.

As under our existing risk-based capital rules, a System institution would apply a 50-percent CCF to commitments with an original maturity of more than 14 months that are not unconditionally cancelable by the institution and to transaction-related contingent items, including performance bonds, bid bonds, warranties, and performance standby letters of credit.

Under this proposed rule, a System institution would be required to apply a 100-percent CCF to off-balance sheet guarantees, repurchase agreements, credit-enhancing representations and warranties that are not securitization exposures, securities lending and borrowing transactions, financial standby letters of credit, forward agreements, and other similar exposures. The off-balance sheet component of a repurchase agreement would equal the sum of the current fair values of all positions the System institution has sold subject to repurchase. The off-balance sheet component of a securities lending transaction would be the sum of the current fair values of all positions the System institution has lent under the transaction. For securities borrowing transactions, the off-balance sheet component would be the sum of the current fair values of all non-cash positions the institution has posted as collateral under the transaction. In certain circumstances, a System institution may instead determine the exposure amount of the transaction as described in § 628.37 of the proposed rule.

In contrast to our existing risk-based capital rules, which require capital for securities lending and borrowing transactions and repurchase agreements only if they generate an on-balance sheet exposure, the proposed rule would require a System institution to hold risk-based capital against all repo-style transactions (that is, repurchase agreements, reverse repurchase agreements, securities lending transactions, and securities borrowing transactions), regardless of whether they generate on-balance sheet exposures, as described in § 628.37 of the proposed rule. For example, capital is required against the cash receivable that a System institution generates when it borrows a security and posts cash collateral to obtain the security. We propose this approach because System institutions face counterparty credit risk when engaging in repo-style transactions, even if those transactions do not generate on-balance sheet exposures, and thus these transactions should not be exempt from risk-based capital requirements.

2. Credit-Enhancing Representations and Warranties

Consistent with our existing risk-based capital rules, under the proposed rule a System institution would be subject to a risk-based capital requirement when it provides credit-enhancing representations and warranties on assets sold or otherwise transferred to third parties, as such positions are considered recourse arrangements.
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A System institution would be required to hold capital only for the maximum contractual amount of its exposure under the representations and warranties, not against the value of the underlying loan. Moreover, a System institution would have to hold capital for the life of a credit-enhancing representation and warranty, but not after its expiration, regardless of the maturity of the underlying loan.

D. Over-the-Counter Derivative Contracts

Under the proposed rule, a System institution is required to hold risk-based capital for counterparty credit risk for an OTC derivative contract. As defined in proposed § 628.2, a derivative contract is a financial contract whose value is derived from the values of one or more underlying assets, reference rates, or indices of asset values or reference rates. A derivative contract includes interest rate, exchange rate, equity, commodity, credit, and any other derivative contract that poses similar counterparty credit risks. Derivative contracts also include unsettled securities, commodities, and foreign exchange transactions with a contractual settlement or delivery lag that is longer than the lesser of the market standard for the particular instrument or 5 business days. This applies, for example, to mortgage-backed securities (MBS) transactions that the GSEs conduct in the To-Be-Announced market.

Under the proposed rule, an OTC derivative contract does not include a derivative contract that is a cleared transaction, which is subject to a specific treatment as described elsewhere in this preamble.

To determine the risk-weighted asset amount for an OTC derivative contract under the proposed rule, a System institution would first determine its exposure amount for the contract and then apply to that amount a risk weight based on the counterparty, eligible guarantor, or recognized collateral.

For a single OTC derivative contract that is not subject to a qualifying master netting agreement (as defined further below in this section), the proposed rule would require the exposure amount to be the sum of: (1) The System institution’s current credit exposure, which would be the greater of the fair value or 0; and (2) potential future exposure (PFE), which would be calculated by multiplying the notional principal amount of the OTC derivative contract by the appropriate conversion factor, in accordance with Table 6 below.

Under the proposed rule, the conversion factor matrix would include the categories of OTC derivative contracts as illustrated in Table 6. For an OTC derivative contract that does not fall within one of the specified categories in Table 6, the proposed rule would require PFE to be calculated using the “other” conversion factor.

For multiple OTC derivative contracts subject to a qualifying master netting agreement, a System institution would calculate the exposure amount by adding the net current credit exposure and the adjusted sum of the PFE amounts for all OTC derivative contracts subject to the qualifying master netting agreement. Under the proposed rule, the net current credit exposure would be the greater of 0 and the net sum of all positive and negative fair values of the individual OTC derivative contracts subject to the qualifying master netting agreement. The adjusted sum of the PFE amounts would be calculated as described in § 628.34(a)(2)(ii) of the proposed rule.

Under the proposed rule, to recognize the netting benefit of multiple OTC derivative contracts, the contracts would have to be subject to a qualifying master netting agreement. The proposed rule would define a qualifying master netting agreement as any written, legally enforceable netting agreement that creates a single legal obligation for all individual transactions covered by the agreement upon an event of default (including receivership, insolvency, liquidation, or similar proceeding) provided that certain conditions set forth in § 628.3 of the proposed rule are met.
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These conditions include requirements with respect to the System institution’s right to terminate the contract and liquidate collateral and meeting certain standards with respect to legal review of the agreement to ensure it meets the criteria in the definition.

The required legal review must be sufficient so that the System institution may conclude with a well-founded basis that, among other things, the contract would be found legal, binding, and enforceable under the law of the relevant jurisdiction and that the contract meets the other requirements of the definition. In some cases, the legal review requirement could be met by reasoned reliance on a commissioned legal opinion or an in-house counsel analysis.

In other cases, for example, those involving certain unfamiliar derivative transactions or derivative counterparties in jurisdictions where a System institution has little experience, the institution would be expected to obtain an explicit, written legal opinion from external or internal legal counsel addressing the particular situation.

Under the proposed rule, if an OTC derivative contract is collateralized by financial collateral,
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a System institution would first have to determine the exposure amount of the OTC derivative contract as described in this section of the preamble. Next, to recognize the credit risk mitigation benefits of the financial collateral, a System institution could use the simple approach for collateralized transactions as described in § 628.37(b) of the proposed rule. Alternatively, if the financial collateral is marked-to-market on a daily basis and subject to a daily margin maintenance requirement, a System institution could adjust the exposure amount of the contract using the collateral haircut approach described in § 628.37(c) of the proposed rule.

Similarly, if a System institution purchased a credit derivative that would be recognized under § 628.36 of the proposed rule as a credit risk mitigant, it would not be required to compute a separate counterparty credit risk capital requirement for the credit derivative, provided it does so consistently for all such credit derivative contracts. Further, where these credit derivative contracts are subject to a qualifying master netting agreement, the System institution would be required to either include them all or exclude them all from any measure used to determine the counterparty credit risk exposure to all relevant counterparties for risk-based capital purposes.

Under the proposed rule, a System institution would have to treat an equity derivative contract as an equity exposure and compute its risk-weighted asset amount according to the simple risk-weight approach (SRWA) described in § 628.52. If the System institution risk weighted a contract under the SRWA described in § 628.52, it could choose not to hold risk-based capital against the counterparty risk of the equity contract, so long as it made this choice for all such contracts. Where the OTC equity contracts are subject to a qualified master netting agreement, a System institution would either include or exclude all of the contracts from any measure used to determine counterparty credit risk exposures.
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If a System provided protection through a credit derivative, it would have to treat the credit derivative as an exposure to the underlying reference asset and compute a risk-weighted asset amount for the credit derivative under § 628.32 of the proposed rule. The System institution would not be required to compute a counterparty credit risk capital requirement for the credit derivative, as long as it did so consistently for all such OTC credit derivative contracts. Further, where these credit derivative contracts are subject to a qualifying master netting agreement, the System institution would either have to include all or exclude all such credit derivatives from any measure used to determine counterparty credit risk exposure to all relevant counterparties for risk-based capital purposes.

Under the proposed rule, the risk weight for OTC derivative transactions is not subject to any specific ceiling, consistent with the Basel capital framework.

E. Cleared Transactions

Like the BCBS and the Federal banking regulatory agencies, the FCA supports incentives designed to encourage clearing of derivative and repo-style transactions
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through a central counterparty (CCP) wherever possible in order to promote transparency, multilateral netting, and robust risk management practices. Although there are some risks associated with CCPs, as discussed below, we believe that CCPs generally help improve the safety and soundness of the derivatives and repo-style transactions markets through the multilateral netting of exposures, establishment, and enforcement of collateral requirements, and the promotion of market transparency.

1. Definition of Cleared Transaction

Under the proposal, a System institution would be required to hold risk-based capital for all of its cleared transactions. In any such transaction, the System institution would act as a clearing member client (defined as a party to a cleared transaction associated with a CCP in which a clearing member acts either as a financial intermediary with respect to the party or guarantees the performance of the party to the CCP).
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The proposed rule would define a cleared transaction as an exposure associated with an outstanding derivative contract or repo-style transaction that a System institution or clearing member has entered into with a CCP (that is, a transaction that a CCP has accepted).
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Cleared transactions would include the following: (1) A transaction between a clearing member client System institution and a clearing member where the clearing member acts as a financial intermediary on behalf of the client and enters into an offsetting transaction with a CCP; and (2) a transaction between a clearing member client System institution and a CCP where a clearing member guarantees the performance of the client to the CCP. Such transactions would also have to satisfy additional criteria provided in § 628.3 of the proposed rule, including bankruptcy remoteness of collateral, transferability criteria, and portability of the clearing member client’s position.

Derivative transactions that are not cleared transactions because they do not meet all the criteria would be OTC derivative transactions. For example, if a transaction submitted to a CCP is not accepted by a CCP because the terms of the transaction submitted by the clearing members do not match or because other operational issues were identified by the CCP, the transaction would not meet the definition of a cleared transaction and would be an OTC derivative transaction. If the counterparties to the transaction resolved the issues and resubmitted the transaction and it was accepted, the transaction would then be a cleared transaction.

2. Risk Weighting for Cleared Transactions

Under the proposed rule, to determine the risk-weighted asset amount for a cleared transaction, a clearing member client System institution would multiply the trade exposure amount for the cleared transaction by the appropriate risk weight, determined as described below. The trade exposure amount would be calculated as follows:

(1) For a cleared transaction that is either a derivative contract or a netting set of derivative contracts, the trade exposure amount would equal the exposure amount for the derivative contract or netting set of derivative contracts, calculated using the current exposure method (CEM) for OTC derivative contracts (described in § 628.34 of the proposed rule), plus the fair value of the collateral posted by the clearing member client System institution and held by the CCP or clearing member in a manner that is not bankruptcy remote;
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and

(2) For a cleared transaction that is a repo-style transaction or a netting set of repo-style transactions, the trade exposure amount would equal the exposure amount calculated under the collateral haircut approach (described in § 628.37(c) of the proposed rule) plus the fair value of the collateral posted by the clearing member client System institution that is held by the CCP or clearing member in a manner that is not bankruptcy remote.

The trade exposure amount would not include any collateral posted by a clearing member client System institution that is held by a custodian in a manner that is bankruptcy remote from the CCP, clearing member, other counterparties of the clearing member, and the custodian itself. In addition to the capital requirement for the cleared transaction, the System institution would remain subject to a capital requirement for any collateral provided to a CCP, a clearing member, or a custodian in connection with a cleared transaction in accordance with § 628.32 of the proposal.

The risk weight for a cleared transaction would depend on whether the CCP is a qualifying CCP (QCCP). Central counterparties that are designated financial market utilities (FMUs) and foreign entities regulated and supervised in a manner equivalent to designated FMUs would be QCCPs. In addition, a CCP could be a QCCP if it were in sound financial condition and met certain standards that are set forth in the proposed QCCP definition.

A System institution that is a clearing member client would apply a 2-percent risk weight to its trade exposure amount to a QCCP only if:

(1) The collateral posted by the clearing member client System institution to the QCCP or clearing member is subject to an arrangement that prevents any losses to the clearing member client due to the joint default or a concurrent insolvency, liquidation, or receivership proceeding of the clearing member and any other clearing member clients of the clearing member; and

(2) The clearing member client System institution has conducted sufficient legal review to conclude with a well-founded basis (and maintains sufficient written documentation of that legal review) that in the event of a legal challenge (including one resulting from default or a liquidation, insolvency, or receivership proceeding) the relevant court and administrative authorities would find the arrangements to be legal, valid, binding, and enforceable under the law of the relevant jurisdiction.

If the criteria above are not met, a clearing member client System institution would apply a risk weight of 4 percent to the trade exposure amount.

For a cleared transaction with a CCP that is not a QCCP, a clearing member client System institution would risk weight the trade exposure amount to the CCP according to the treatment for the CCP under § 628.32 of the proposal (generally 100 percent). Collateral posted by a clearing member client System institution that is held by a custodian in a manner that is bankruptcy remote from the CCP, clearing member, and other clearing member clients of the clearing member would not be subject to a capital requirement for counterparty credit risk.

The diagrams below demonstrate the various potential transactions and exposure treatment in the proposed rule. Table 7 sets out how the transactions illustrated in the diagrams below are risk-weighted under the proposed rule.

In the diagram, “T” refers to a transaction, and the arrow indicates the direction of the exposure. The diagram describes the appropriate risk weight treatment for exposures from the perspective of a System institution entering into cleared transactions as a client of a clearing member (T ₁ and T ₂). Table 7 shows for each trade whom the exposure is to, a description of the type of trade, and the risk weight that would apply based on the risk of the counterparty.

System Institution Client—Clearing Member(CM) Trade

• Financial Intermediary with offsetting transaction to QCCP

• Agency with guarantee of client performance

F. Credit Risk Mitigation

System institutions use a number of techniques to mitigate credit risks. For example, a System institution may collateralize exposures with cash or securities; a third party may guarantee an exposure; a System institution may buy a credit derivative to offset an exposure’s credit risk; or a System institution may net exposures with a counterparty under a netting agreement. This section of the preamble describes how the proposed rule would allow System institutions to recognize the risk-mitigation effects of guarantees, credit derivatives, and collateral for risk-based capital purposes.

Under the proposed rule, a System institution generally would be able to use a substitution approach to recognize the credit risk mitigation effect of an eligible guarantee from an eligible guarantor and the simple approach to recognize the effect of collateral. To recognize credit risk mitigants, a System institution would have to implement operational procedures and risk-management processes that ensure that all documentation used in collateralizing or guaranteeing a transaction is legal, valid, binding, and enforceable under applicable law in the relevant jurisdictions. A System institution would be expected to conduct sufficient legal review to reach a well-founded conclusion that the documentation meets this standard as well as conduct additional reviews as necessary to ensure continuing enforceability.

Although the use of credit risk mitigants may reduce or transfer credit risk, it simultaneously may increase other risks, including operational, liquidity, or market risk. Accordingly, a System institution would be expected to employ robust procedures and processes to control risks, including roll-off and concentration risks, and monitor and manage the implications of using credit risk mitigants for the institution’s overall credit risk profile.

1. Guarantees and Credit Derivatives

a. Eligibility Requirements

Our existing risk-based capital rules generally recognize third-party guarantees provided by central governments, GSEs, PSEs in the OECD countries, multilateral lending institutions and regional development banking organizations, U.S. depository institutions, foreign banks, and qualifying securities firms in OECD countries.
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The FCA proposes to revise this listing of eligible guarantors to expressly include sovereigns, the Bank for International Settlements, the International Monetary Fund, the European Central Bank, the European Commission, Federal Home Loan Banks (FHLB), Federal Agricultural Mortgage Corporation (Farmer Mac), MDBs, depository institutions, bank holding companies, savings and loan holding companies, credit unions, and foreign banks. Entities not expressly included in the above list would be eligible guarantors if they have issued and outstanding unsecured debt securities without credit enhancement that are investment grade, if their creditworthiness is not positively correlated with the credit risk of the exposures for which it has provided guarantees, and if they meet certain other requirements.
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Guarantees and credit derivatives would be required to meet specific eligibility requirements to be recognized for credit risk mitigation purposes. Under the proposal, an eligible guarantee would be defined as a guarantee from an eligible guarantor that is written and meets certain standards and conditions, including with respect to its enforceability. An eligible credit derivative would be defined as a credit derivative in the form of a credit default swap (CDS), n^th-to-default swap, total return swap, or any other form of credit derivative approved by the FCA, provided that the instrument meets the standards and conditions set forth in the proposed definition. See the proposed definitions of “eligible guarantee” and “eligible credit derivative” in § 628.2 of the proposed rule.

Under this proposed rule, a System institution would be permitted to recognize the credit risk mitigation benefits of an eligible credit derivative that hedges an exposure that is different from the credit derivative’s reference exposure used for determining the derivative’s cash settlement value, deliverable obligation, or occurrence of a credit event if:

(1) The reference exposure ranks pari passu with or is subordinated to the hedged exposure;

(2) The reference exposure and the hedged exposure are to the same legal entity; and

(3) Legally enforceable cross-default or cross-acceleration clauses are in place to assure payments under the credit derivative are triggered when the issuer fails to pay under the terms of the hedged exposure.

When a System institution has a group of hedged exposures with different residual maturities that are covered by a single eligible guarantee or eligible credit derivative, the System institution would treat each hedged exposure as if it were fully covered by a separate eligible guarantee or eligible credit derivative.

b. Substitution Approach

Under the proposed substitution approach, if the protection amount (as defined below) of an eligible guarantee or eligible credit derivative is greater than or equal to the exposure amount of the hedged exposure, a System institution would substitute the risk weight applicable to the guarantor or credit derivative protection provider for the risk weight assigned to the hedged exposure.

If the protection amount of the eligible guarantee or eligible credit derivative is less than the exposure amount of the hedged exposure, a System institution would treat the hedged exposure as two separate exposures (protected and unprotected) to recognize the credit risk mitigation benefit of the guarantee or credit derivative. In such cases, a System institution would calculate the risk-weighted asset amount for the protected exposure under § 628.36 of the proposed rule (using a risk weight applicable to the guarantor or credit derivative protection provider and an exposure amount equal to the protection amount of the guarantee or credit derivative). The System institution would calculate its risk-weighted asset amount for the unprotected exposure under § 628.32 of the proposed rule (using the risk weight assigned to the exposure and an exposure amount equal to the exposure amount of the original hedged exposure minus the protection amount of the guarantee or credit derivative).

The protection amount of an eligible guarantee or eligible credit derivative would mean the effective notional amount of the guarantee or credit derivative reduced to reflect any maturity mismatch, lack of restructuring coverage, or currency mismatch as described below. The effective notional amount for an eligible guarantee or eligible credit derivative would be the lesser of the contractual notional amount of the credit risk mitigant or the exposure amount of the hedged exposure, multiplied by the percentage coverage of the credit risk mitigant. For example, the effective notional amount of a guarantee that covers, on a pro rata basis, 40 percent of any losses on a $100 bond would be $40.

c. Maturity Mismatch Haircut

Under the proposed requirements, a System institution that recognizes an eligible guarantee or eligible credit derivative would have to adjust the effective notional amount of the credit risk mitigant to reflect any maturity mismatch between the hedged exposure and the credit risk mitigant. A maturity mismatch occurs when the residual maturity of a credit risk mitigant is less than that of the hedged exposure(s).
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The residual maturity of a hedged exposure would be the longest possible remaining time before the obligated party of the hedged exposure is scheduled to fulfill its obligation on the hedged exposure. A System institution would be required to take into account any embedded options that may reduce the term of the credit risk mitigant so that the shortest possible residual maturity for the credit risk mitigant would be used to determine the potential maturity mismatch. If a call is at the discretion of the protection provider, the residual maturity of the credit risk mitigant would be at the first call date. If the call is at the discretion of the System institution purchasing the protection, but the terms of the arrangement at origination of the credit risk mitigant contain a positive incentive for the institution to call the transaction before contractual maturity, the remaining time to the first call date would be the residual maturity of the credit risk mitigant. Under this proposed rule, a System institution would be permitted to recognize a credit risk mitigant with a maturity mismatch only if its original maturity is greater than or equal to 1 year and the residual maturity is greater than 3 months.

Assuming that the credit risk mitigant may be recognized, a System institution would be required to apply the following adjustment to reduce the effective notional amount of the credit risk mitigant to recognize the maturity mismatch:

P _m= E × [(t −0.25)/(T −0.25)],

d. Adjustment for Credit Derivatives Without Restructuring as a Credit Event

Under the proposal, a System institution that seeks to recognize an eligible credit derivative that does not include a restructuring of the hedged exposure as a credit event under the derivative would have to reduce the effective notional amount of the credit derivative recognized for credit risk mitigation purposes by 40 percent. For purposes of the proposed credit risk mitigation framework, a restructuring would involve forgiveness or postponement of principal, interest, or fees that result in a credit loss event (that is, a charge-off, specific provision, or other similar debit to the profit and loss account). In these instances, the System institution would be required to apply the following adjustment to reduce the effective notional amount of the credit derivative: P _r= P _M× 0.60,

e. Currency Mismatch Adjustment

Under this proposal, if a System institution recognizes an eligible guarantee or eligible credit derivative that is denominated in a currency different from that in which the hedged exposure is denominated, the institution would apply the following formula to the effective notional amount of the guarantee or credit derivative:

P _c= P _r× (1 − H _fx),

A System institution would be required to use a standard supervisory haircut of 8 percent for H
_fx (based on a 10-business day holding period and daily marking-to-market and remargining). The System institution is required to scale the haircut up using the square root of time formula if the institution revalues the guarantee or credit derivative less frequently than once every 10 business days. The applicable haircut H
_M is calculated using the following square root of time formula:

f. Multiple Credit Risk Mitigants

If multiple credit risk mitigants cover a single exposure, a System institution would be able to disaggregate the exposure into portions covered by each credit risk mitigant (for example, the portion covered by each guarantee) and calculate separately a risk-based capital requirement for each portion. In addition, when a single credit risk mitigant covers multiple exposures, a System institution would have to treat each hedged exposure as covered by a single risk mitigant and must calculate separate risk-weighted asset amounts for each exposure using the substitution approach described in § 628.36(c) of the proposed rule.

2. Collateralized Transactions

a. Eligible Collateral

We propose to recognize a range of financial collateral as credit risk mitigants that may reduce the risk-based capital requirements associated with a collateralized transaction, similar to the Basel capital framework and the rules of the Federal banking regulatory agencies.

As proposed, financial collateral would mean collateral in the form of:

(1) Cash on deposit at a depository institution, or Federal Reserve Bank (including cash held for the System institution by a third-party custodian or trustee);

(2) Gold bullion;

(3) Short- and long-term debt securities that are not resecuritization exposures
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and that are investment grade;

(4) Equity securities that are publicly traded;

(5) Convertible bonds that are publicly traded; or

(6) Money market fund shares and other mutual fund shares if a price for the shares is publicly quoted daily.
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With the exception of cash on deposit at a depository institution, or Federal Reserve Bank, the System institution would also be required to have a perfected, first-priority security interest or, outside of the United States, the legal equivalent thereof, notwithstanding the prior security interest of any custodial agent. A System institution would be permitted to recognize partial collateralization of an exposure.

Under this proposed rule, a System institution would be able to recognize the risk-mitigating effects of financial collateral using the simple approach, described below, where: (1) The collateral is subject to a collateral agreement for at least the life of the exposure; (2) the collateral is revalued at least every 6 months; and (3) the collateral (other than gold) and the exposure are denominated in the same currency. For repo-style transactions, eligible margin loans, collateralized derivative contracts, and single-product netting sets of such transactions, a System institution could alternatively use the collateral haircut approach described below. A System institution would be required to use the same approach for similar exposures or transactions.

b. Risk Management Guidance for Recognizing Collateral

Before a System institution recognized collateral for credit risk mitigation purposes, it would have to: (1) Conduct sufficient legal review to ensure, at the inception of the collateralized transaction and on an ongoing basis, that all documentation used in the transaction is binding on all parties and legally enforceable in all relevant jurisdictions; (2) consider the correlation between risk of the underlying direct exposure and collateral risk in the transaction; and (3) fully take into account the time and cost needed to realize the liquidation proceeds and the potential for a decline in collateral value over this time period.

A System institution also would have to ensure that the legal mechanism under which the collateral is pledged or transferred provides the institution the right to liquidate or take legal possession of the collateral in a timely manner in the event of the default, insolvency, or bankruptcy (or other defined credit event) of the counterparty and, where applicable, the custodian holding the collateral.

In addition, a System institution would have to ensure that it has:

(1) Taken all steps necessary to fulfill any legal requirements to secure its interest in the collateral so that it has and maintains an enforceable security interest;

(2) Set up and implemented clear and robust procedures to comply with any legal conditions required for declaring the default of the borrower and prompt liquidation of the collateral in the event of default;

(3) Established and implemented procedures and practices for conservatively estimating, on a regular ongoing basis, the fair value of the collateral, taking into account factors that could affect that value (for example, the liquidity of the market for the collateral and obsolescence or deterioration of the collateral); and

(4) Established systems in place for promptly requesting and receiving additional collateral for transactions whose terms require maintenance of collateral values at specified thresholds.

c. Simple Approach

Under the proposed simple approach, the collateralized portion of the exposure would receive the risk weight applicable to the collateral. The collateral would be required to meet the definition of financial collateral. For repurchase agreements, reverse repurchase agreements, and securities lending and borrowing transactions, the collateral would be the instruments, gold, and cash that a System institution has borrowed, purchased subject to resale, or taken as collateral from the counterparty under the transaction. As noted above, in all cases:

(1) The collateral would have to be subject to a collateral agreement for at least the life of the exposure;

(2) The System institution would be required to revalue the collateral at least every 6 months; and

(3) The collateral (other than gold) and the exposure would be required to be denominated in the same currency.

Generally, the risk weight assigned to the collateralized portion of the exposure would be no less than 20 percent. However, OTC derivative contracts that are marked-to-fair value on a daily basis and subject to a daily margin maintenance agreement could receive:

(1) A 0-percent risk weight to the extent that they are collateralized by cash on deposit; or

(2) A 10-percent risk weight to the extent that the contracts are collateralized by an exposure to a sovereign that qualifies for a 0-percent risk weight under § 628.32 of the proposal.

In addition, a System institution may assign a 0-percent risk weight to the collateralized portion of an exposure where:

(i) The financial collateral is cash on deposit; or

(ii) The financial collateral is an exposure to a sovereign that qualifies for a 0-percent risk weight under § 628.32 of the proposal and the System institution has discounted the fair value of the collateral by 20 percent.

d. Collateral Haircut Approach

The proposed rule would permit a System institution to use a collateral haircut approach to recognize the credit risk mitigation benefits of financial collateral that secures an eligible margin loan, a repo-style transaction, collateralized derivative contract, or single-product netting set of such transactions.

To apply the collateral haircut approach, a System institution would determine the exposure amount and the relevant risk weight for the counterparty or guarantor.

The exposure amount for an eligible margin loan, repo-style transaction, collateralized derivative contract, or a netting set of such transactions is equal to the greater of 0 or the sum of the following three quantities:

(1) The value of the exposure less the value of the collateral. For eligible margin loans, repo-style transactions and netting sets thereof, the value of the exposure is the sum of the current fair values of all instruments, gold, and cash the System institution has lent, sold subject to repurchase, or posted as collateral to the counterparty under the transaction or netting set. For collateralized OTC derivative contracts and netting sets thereof, the value of the exposure is the exposure amount that is calculated under § 628.34 of the proposal. The value of the collateral would equal the sum of the current fair values of all instruments, gold and cash the System institution has borrowed, purchased subject to resale, or taken as collateral from the counterparty under the transaction or netting set;

(2) The absolute value of the net position in a given instrument or in gold (where the net position in a given instrument or in gold equals the sum of the current fair values of the instrument or gold the System institution has lent, sold subject to repurchase, or posted as collateral to the counterparty minus the sum of the current fair values of that same instrument or gold that the System institution has borrowed, purchased subject to resale, or taken as collateral from the counterparty) multiplied by the market price volatility haircut appropriate to the instrument or gold; and

(3) The absolute values of the net position of instruments and cash in a currency that is different from the settlement currency (where the net position in a given currency equals the sum of the current fair values of any instruments or cash in the currency the System institution has lent, sold subject to repurchase, or posted as collateral to the counterparty minus the sum of the current fair values of any instruments or cash in the currency the System institution has borrowed, purchased subject to resale, or taken as collateral from the counterparty) multiplied by the haircut appropriate to the currency mismatch.

For purposes of the collateral haircut approach, a given instrument would include, for example, all securities with the same Committee on Uniform Securities Identification Procedures (CUSIP) number and would not include securities with different CUSIP numbers, even if issued by the same issuer with the same maturity date.

e. Standard Supervisory Haircuts

Under this proposed rule, a System institution would apply a haircut for price market volatility and foreign exchange rates, determined using standard supervisory market price volatility haircuts and a standard haircut for exchange rates.

The standard supervisory market price volatility haircuts would set a specified market price volatility haircut for various categories of financial collateral. These standard haircuts are based on the 10-business-day holding period for eligible margin loans and derivative contracts. For repo-style transactions, a System institution would multiply the standard supervisory haircuts by the square root of1/2to scale them for a holding period of 5 business days.

The FCA proposes standard supervisory market price volatility haircuts in accordance with Table 8 below. These haircuts reflect the collateral’s credit quality and an appropriate differentiation based on the collateral’s residual maturity.

A System institution would be required to use an 8-percent haircut for each currency mismatch for transactions subject to a 10-day holding period, as adjusted for different required holding periods.

The proposed rule would require that a System institution increase the standard supervisory haircut for transactions involving large netting sets. During the financial crisis, many financial institutions experienced significant delays in settling or closing out collateralized transactions, such as repo-style transactions and collateralized OTC derivatives. Accordingly, for netting sets where:

(1) The number of trades exceeds 5,000 at any time during the quarter;
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(2) One or more trades involves illiquid collateral posted by the counterparty; or

(3) The netting set includes any OTC derivatives that cannot be easily replaced, this proposed rule would require a System institution to assume a holding period of 20 business days for the collateral under the collateral haircut approach. The formula and methodology for increasing the haircut to reflect this longer holding period is described in § 628.37(c) of the proposed rule. A System institution is not required to adjust the holding period upward for cleared transactions. When determining whether collateral is illiquid or an OTC derivative cannot be easily replaced for these purposes, a System institution should assess whether, during a period of stressed market conditions, it could obtain multiple price quotes within 2 days or less for the collateral or OTC derivative that would not move the market or represent a market discount (in the case of collateral) or a premium (in the case of an OTC derivative.)

In addition, the proposed rule would require a System institution to increase the holding period for a netting set if over the two previous quarters more than two margin disputes on a netting set have occurred that lasted longer than the holding period.

Margin disputes may occur when the System institution and its counterparty do not agree on the value of collateral or on the eligibility of the collateral provided. Margin disputes also can occur when the System institution and its counterparty disagree on the amount of margin that is required, which could result from differences in the valuation of a transaction, or from errors in the calculation of the net exposure of a portfolio, for instance, if a transaction is incorrectly included or excluded from the portfolio.

The determination as to whether a dispute constitutes a margin dispute for purposes of this rule would depend on whether resolution of the dispute occurs within the time period required under an agreement. Where a dispute is subject to a recognized industry dispute resolution protocol, the dispute period would be considered to begin after a third-party dispute resolution mechanism has failed.

A System institution would not be required to adjust the holding period upward for cleared transactions.

f. Own Estimates of Haircuts

Unlike the Federal banking regulatory agencies, the FCA does not propose to permit System institutions to calculate market price volatility and foreign exchange volatility using their own internal estimates. We believe, due to the complexity of developing and using these estimates, that no System institution is likely to use its own estimates of haircuts. We seek comment on whether we should adopt a regulation that would permit the use of an institution’s own estimates. We note that even if we do not adopt such a provision, we would be able to permit a System institution to use its own estimates in the future on a case-by-case basis, using standards similar to those contained in the final rule of the Federal banking regulatory agencies.
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G. Unsettled Transactions

The FCA proposes to provide for a separate risk-based capital requirement for transactions involving securities, foreign exchange instruments, and commodities that have a risk of delayed settlement or delivery. The proposed capital requirement would not, however, apply to certain types of transactions, including:

(1) Cleared transactions that are marked-to-market daily and subject to daily receipt and payment of variation margin;

(2) Repo-style transactions, including unsettled repo-style transactions;

(3) One-way cash payments on OTC derivative contracts; or

(4) Transactions with a contractual settlement period that is longer than the normal settlement period (which the proposal defines as the lesser of the market standard for the particular instrument or 5 business days).
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Under the proposal, in the case of a system-wide failure of a settlement, clearing system, or central counterparty, the FCA may waive risk-based capital requirements for unsettled and failed transactions until the situation is rectified.

This rule proposes separate treatments for delivery-versus-payment (DvP) and payment-versus-payment (PvP) transactions with a normal settlement period, and non-DvP/non-PvP transactions with a normal settlement period. A DvP transaction would refer to a securities or commodities transaction in which the buyer is obligated to make payment only if the seller has made delivery of the securities or commodities and the seller is obligated to deliver the securities or commodities only if the buyer has made payment. A PvP transaction would mean a foreign exchange transaction in which each counterparty is obligated to make a final transfer of one or more currencies only if the other counterparty has made a final transfer of one or more currencies.

A System institution would be required to hold risk-based capital against a DvP or PvP transaction with a normal settlement period if the institution’s counterparty has not made delivery or payment within 5 business days after the settlement date. The System institution would determine its risk-weighted asset amount for such a transaction by multiplying the positive current exposure of the transaction for the institution by the appropriate risk weight in Table 9. The positive current exposure from an unsettled transaction of a System institution would be the difference between the transaction value at the agreed settlement price and the current market price of the transaction, if the difference results in a credit exposure of the institution to the counterparty.

A System institution would hold risk-based capital against any non-DvP/non-PvP transaction with a normal settlement period if the institution delivered cash, securities, commodities, or currencies to its counterparty but has not received its corresponding deliverables by the end of the same business day. The System institution would continue to hold risk-based capital against the transaction until it has received the corresponding deliverables. From the business day after the System institution has made its delivery until 5 business days after the counterparty delivery is due, the institution would calculate the risk-weighted asset amount for the transaction by risk weighting the current fair value of the deliverables owed to the institution, using the risk weight appropriate for an exposure to the counterparty in accordance with § 628.32. If a System institution has not received its deliverables by the 5th business day after the counterparty delivery due date, the institution would assign a 1,250-percent risk weight to the current fair value of the deliverables owed.

H. Risk-Weighted Assets for Securitization Exposures

Under the FCA’s existing risk-based capital rules, a System institution may use external ratings issued by NRSROs to assign risk weights to certain recourse obligations, residual interests, direct credit substitutes, and asset-backed securities (ABS) and MBS. We propose to significantly revise the risk-based capital framework for securitization exposures. These proposed revisions include removing references to and reliance on credit ratings to determine risk weights for these exposures and using alternative standards of creditworthiness, as required by section 939A of the Dodd-Frank Act. In addition, we propose to update the terminology for the securitization framework, include a definition of a securitization exposure that encompasses a wider range of exposures with similar risk characteristics, and implement new due diligence requirements for securitization exposures.

1. Overview of the Securitization Framework and Definitions

The proposed securitization framework is designed to address the credit risk of exposures that involve the tranching of the credit risk of one or more underlying financial exposures.
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The proposed rule would define a securitization exposure as an on- or off-balance sheet credit exposure (including credit-enhancing representations and warranties) that arises from a traditional or synthetic securitization (including a resecuritization), or an exposure that directly or indirectly references a securitization exposure.

A traditional securitization would be defined, in part, as a transaction in which credit risk of one or more underlying exposures has been transferred to one or more third parties (other than through the use of credit derivatives or guarantees), where the credit risk associated with the underlying exposures has been separated into at least two tranches reflecting different levels of seniority. The proposed definition includes certain other conditions, such as requiring all or substantially all of the underlying exposures to be financial exposures.

Both the designation of exposures as securitization exposures (or resecuritization exposures, as described below) and the calculation of risk-based capital requirements for securitization exposures under the proposed rule are guided by the economic substance of a transaction rather than its legal form. Provided there is tranching of credit risk, securitization exposures could include, among other things, ABS and MBS, loans, lines of credit, liquidity facilities, financial standby letters of credit, credit derivatives and guarantees, loan servicing assets, servicer cash advance facilities, reserve accounts, credit-enhancing representations and warranties, and credit-enhancing interest-only strips (CEIOs). Securitization exposures would also include assets sold with retained tranches.

Requiring all or substantially all of the underlying exposures of a securitization to be financial exposures creates an important boundary between the general credit risk framework and the securitization framework. Examples of financial exposures include loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, MBS, other debt securities, or equity securities. Based on their cash flow characteristics, for purposes of this proposal, asset classes such as lease residuals and royalty income would also be considered financial assets.

The securitization framework is designed to address the tranching of the credit risk of financial exposures and is not designed, for example, to apply to tranched credit exposures to commercial or industrial companies or nonfinancial assets or to amounts deducted from capital in § 628.22 of the proposal. In other words, a loan backed by nonfinancial assets (such as facilities, objects, or commodities that are being financed), even if the credit exposure is tranched, would not be a securitization exposure.

Under the proposal, an operating entity would not fall under the definition of a traditional securitization (even if substantially all of its assets are financial exposures). For purposes of the proposed definition of a traditional securitization, operating entities generally would refer to companies that are established to conduct business with clients with the intention of earning a profit in their own right and that generally produce goods or provide services beyond the business of investing, reinvesting, holding, or trading in financial assets.
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Under the proposal, a System institution’s equity investment in an operating entity generally would be an equity exposure.
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However, investment firms that generally do not produce goods or provide services beyond the business of investing, reinvesting, holding, or trading in financial assets, would not be operating entities for purposes of this proposal and would not qualify for this general exclusion from the definition of traditional securitization.

Paragraph (10) of the proposed definition of traditional securitization (in § 628.2) would specifically exclude exposures to investment funds (as defined in the proposed rule), collective investment funds, and pension plans (both terms as defined in relevant regulations set forth in the proposed definition); and exposures that are registered with the SEC under the Investment Company Act of 1940 or foreign equivalents. These specific exemptions serve to narrow the potential scope of the securitization framework. These entities and transactions are exempted because they are regulated and subject to strict leverage requirements. The capital requirements for an extension of credit to, or an equity holding in, these entities and transactions are more appropriately calculated under the rules for corporate and equity exposures.

To address the treatment of investment firms that are not specifically excluded from the securitization framework, the proposed rule provides discretion to the FCA to exclude from the definition of a traditional securitization those transactions in which the underlying exposures are owned by an investment firm that exercises substantially unfettered control over the size and composition of its assets, liabilities, and off-balance sheet exposures.

In determining whether to exclude an investment firm from the securitization framework, the FCA would consider a number of factors, including the assessment of the transaction’s leverage, risk profile, and economic substance. This supervisory exclusion would give the FCA discretion to distinguish structured finance transactions, to which the securitization framework was designed to apply, from those of flexible investment firms such as certain hedge funds and private equity funds.

Only investment firms that can easily change the size and composition of their capital structure, as well as the size and composition of their assets and off-balance sheet exposures, would be eligible for the exclusion from the definition of traditional securitization under this provision. The FCA does not consider managed collateralized debt obligation vehicles, structured investment vehicles, and similar structures, which allow considerable management discretion regarding asset composition but are subject to substantial restrictions regarding capital structure, to have substantially unfettered control. Thus, such transactions would meet the definition of traditional securitization.

The line between securitization exposures and non-securitization exposures may be difficult to draw in some circumstances. In addition to the supervisory exclusion from the definition of traditional securitization described above, the FCA may expand the scope of the securitization framework to include other transactions if doing so is justified by the economics of the transaction. Similar to the analysis for excluding an investment firm from treatment as a traditional securitization, the FCA would consider the economic substance, leverage, and risk profile of transactions to ensure the appropriate risk-based capital treatment. The FCA would consider a number of factors when assessing the economic substance of a transaction including, for example, the amount of equity in the structure, overall leverage (whether on- or off-balance sheet), whether redemption rights attach to the equity investor, and the ability of the junior tranches to absorb losses without interrupting contractual payments to more senior tranches.

Under the proposal, a synthetic securitization would mean a transaction in which:

(1) All or a portion of the credit risk of one or more underlying exposures is retained or transferred to one or more third parties through the use of one or more credit derivatives or guarantees (other than a guarantee that transfers only the credit risk of an individual retail exposure);

(2) The credit risk associated with the underlying exposures has been separated into at least two tranches reflecting different levels of seniority;

(3) Performance of the securitization exposures depends upon the performance of the underlying exposures; and

(4) All or substantially all of the underlying exposures are financial exposures (such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, MBS, other debt securities, or equity securities).

Mortgage-backed pass-through securities (for example, those guaranteed by Freddie Mac or Fannie Mae) that feature various maturities but do not involve tranching of credit risk would not meet the proposed definition of a securitization exposure. Only those MBS that involve tranching of credit risk would be securitization exposures.

This proposed rule would define a resecuritization exposure as an on- or off-balance sheet exposure to a resecuritization; or an exposure that directly or indirectly references a resecuritization exposure. A resecuritization would mean a securitization which has more than one underlying exposure and in which one or more of the underlying exposures is a securitization exposure. A resecuritization would not include exposures comprised of a single asset that has been retranched, such as a resecuritization of a real estate mortgage investment conduit (Re-REMIC). A resecuritization also would not include pass-through securities that have been pooled together and effectively reissued as tranched securities, because the pass-through securities do not tranche credit protection and would therefore not be considered securitization exposures.

In their rules, the Federal banking regulatory agencies excluded certain exposures to asset-backed commercial paper (ABCP) programs from the definition of resecuritization exposure. Their rules defined an ABCP program as a program established primarily for the purpose of issuing commercial paper that is investment grade and backed by underlying exposures held in a bankruptcy-remote special purpose entity. The System has access to the capital markets through the Funding Corporation; we believe it unlikely that a System institution would establish an ABCP program, because if the Funding Corporation’s ability to issue debt ever was impeded, we believe the ability of an ABCP program to issue commercial paper would face the same difficulties. Accordingly, in the interest of simplifying our regulations where possible, we propose to make no reference to ABCP programs. We seek comment as to whether we should include provisions in our risk-based capital rules regarding ABCP programs that are comparable to those adopted by the Federal banking regulatory agencies.

2. Operational Requirements

a. Due Diligence Requirements

The FCA, like the Federal banking regulatory agencies, notes that during the recent financial crisis, many banking organizations relied exclusively on NRSRO ratings and did not perform their own credit analysis of the securitization exposures.
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As the Federal banking regulatory agencies have required in their rules, we propose that System institutions satisfy specific due diligence requirements for securitization exposures. Specifically, a System institution would be required to demonstrate, to the FCA’s satisfaction, a comprehensive understanding of the features of a securitization exposure that would materially affect the exposure’s performance. The System institution’s analysis would be required to be commensurate with the complexity of the exposure and the materiality of the exposure in relation to capital of the institution. On an on-going basis (no less frequently than quarterly), the System institution would be required to evaluate, review, and update as appropriate the analysis required under § 628.41(c)(1) of the proposed rule for each securitization exposure. The pre- and periodic post-acquisition analysis of the exposure’s risk characteristics would have to consider:

(1) Structural features of the securitization that would materially affect the performance of the exposure, for example, the contractual cash flow waterfall, waterfall-related triggers, credit enhancements, liquidity enhancements, fair value triggers, the performance of organizations that service the position, and deal-specific definitions of default;

(2) Relevant information regarding the performance of the underlying credit exposure(s), for example, the percentage of loans 30, 60, and 90 days past due; default rates; prepayment rates; loans in foreclosure; property types; occupancy; average credit score or other measures of creditworthiness; average LTV ratio; and industry and geographic diversification data on the underlying exposure(s);

(3) Relevant market data on the securitization, for example, bid-ask spread, most recent sales price and historical price volatility, trading volume, implied market rating, and size, depth and concentration level of the market for the securitization; and

(4) For resecuritization exposures, performance information on the underlying securitization exposures, for example, the issuer name and credit quality, and the characteristics and performance of the exposures underlying the securitization exposures.

If the System institution is not able to meet these due diligence requirements and demonstrate a comprehensive understanding of a securitization exposure to the FCA’s satisfaction, the institution would be required to assign a risk weight of 1,250 percent to the exposure.

b. Operational Requirements for Traditional Securitizations

In a traditional securitization, an originating banking organization typically transfers a portion of the credit risk of underlying exposures (such as loans) to third parties by selling those exposures to a third party (which could include, but is not limited to, a securitization special purpose entity).
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The proposed rule would define “originating System institution,” with respect to a securitization, as a System institution that directly or indirectly originated the underlying exposures included in a securitization.
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Under the proposed rule, a System institution that transfers exposures it has originated or purchased to a third party in connection with a traditional securitization can exclude the underlying exposures from the calculation of risk-weighted assets only if each of the following conditions are met: (1) The exposures are not reported on the System institution’s consolidated balance sheet under GAAP; (2) the System institution has transferred to one or more third parties credit risk associated with the underlying exposures; and (3) any clean-up calls relating to the securitization are eligible clean-up calls (as discussed below).

An originating System institution that meets these conditions must hold risk-based capital against any credit risk it retains or acquires in connection with the securitization. An originating System institution that fails to meet these conditions is required to hold risk-based capital against the transferred exposures as if they had not been securitized and must deduct from CET1 capital any after-tax gain-on-sale resulting from the transaction.

In addition, if a securitization: (1) Includes one or more underlying exposures in which the borrower is permitted to vary the drawn amount within an agreed limit under a line of credit; and (2) contains an early amortization provision, the originating System institution is required to hold risk-based capital against the transferred exposures as if they had not been securitized and deduct from CET1 capital any after-tax gain-on-sale resulting from the transaction.
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We believe that this treatment is appropriate given the lack of risk transference in securitizations of revolving underlying exposures with early amortization provisions.

c. Operational Requirements for Synthetic Securitizations

System institutions are authorized to use synthetic securitizations as risk management tools to reduce their overall credit risk exposure relating to certain referenced loan pools. The use of synthetic securitizations enables System institutions to increase their risk-based capital ratios without moving assets off their balance sheets.

For synthetic securitizations, an originating System institution would recognize for risk-based capital purposes the use of a credit risk mitigant to hedge underlying exposures only if each of the conditions in the proposed definition of “synthetic securitization” is satisfied.

Failure to meet these operational requirements for a synthetic securitization would prevent a System institution that has purchased tranched credit protection referencing one or more of its exposures from using the proposed securitization framework with respect to the reference exposures and would require the institution to hold risk-based capital against the underlying exposures as if they had not been synthetically securitized.

A System institution that holds a synthetic securitization as a result of purchasing credit protection may use the securitization framework to determine the risk-based capital for its exposure. Alternatively, it may instead choose to disregard the credit protection and use the general risk weights under § 628.32.

A System institution that provides tranched credit protection in the form of a synthetic securitization or credit protection to a synthetic securitization must use the securitization framework to compute risk-based capital requirements for its exposures to the synthetic securitization even if the originating System institution fails to meet one or more of the operational requirements for a synthetic securitization.

d. Clean-Up Calls

To satisfy the operational requirements for securitizations and enable an originating System institution to exclude the underlying exposures from the calculation of its risk-based capital requirements, any clean-up call associated with a securitization would need to be an eligible clean-up call. The proposal would define a clean-up call as a contractual provision that permits an originating System institution or servicer to call securitization exposures before their stated maturity or call date. In the case of a traditional securitization, a clean-up call generally is accomplished by repurchasing the remaining securitization exposures once the amount of underlying exposures or outstanding securitization exposures falls below a specified level. In the case of a synthetic securitization, the clean-up call may take the form of a clause that extinguishes the credit protection once the amount of underlying exposures has fallen below a specified level.

Under the proposal, an eligible clean-up call would be a clean-up call that:

(1) Is exercisable solely at the discretion of the originating System institution or servicer;

(2) Is not structured to avoid allocating losses to securitization exposures held by investors or otherwise structured to provide credit enhancement to the securitization (for example, to purchase non-performing underlying exposures); and

(3) For a traditional securitization, is only exercisable when 10 percent or less of the principal amount of the underlying exposures or securitization exposures (determined as of the inception of the securitization) is outstanding; or, for a synthetic securitization, is only exercisable when 10 percent or less of the principal amount of the reference portfolio of underlying exposures (determined as of the inception of the securitization) is outstanding.

Where a securitization SPE is structured as a master trust, a clean-up call with respect to a particular series or tranche issued by the master trust would meet criterion (3) of the definition of “eligible clean-up call” as long as the outstanding principal amount in that series was 10 percent or less of its original amount at the inception of the series.

3. Risk-Weighted Asset Amounts for Securitization Exposures

Under the proposed securitization framework, a System institution generally would calculate a risk-weighted asset amount for a securitization exposure by applying either: (1) The simplified supervisory formula approach (SSFA), described elsewhere in this preamble; or (2) a gross-up approach. A System institution would be required to apply either the gross-up approach or the SSFA consistently across all of its securitization exposures. However, a System institution could choose to apply a 1,250-percent risk weight to any securitization exposure. While the FCA does not propose to restrict the ability of System institutions to switch from the SSFA to the gross-up approach, we do not anticipate there should be a need for frequent changes in methodology by an institution absent significant change in the nature of its securitization activities, and we would expect institutions would be able to provide the FCA’s Office of Examination, upon request, with their rationale for changing methodologies.

The SSFA may be somewhat complex for some System institutions to use, although it might also result in lower risk-weighting requirements. The gross-up approach may involve less operational burden, but it may also result in higher risk-weighting requirements.
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The proposal provides for alternative treatment of securitization exposures to certain gains-on-sale and CEIO exposures. Specifically, the proposed rule would include a minimum 100-percent risk weight for interest-only MBS and exceptions to the securitization framework for certain small business loans and certain derivatives as described below. A System institution could use the securitization credit risk mitigation rules to adjust the capital requirement under the securitization framework for an exposure to reflect certain collateral, credit derivatives, and guarantees, as described in more detail below.

a. Exposure Amount of a Securitization Exposure

Under this proposal, the exposure amount of an on-balance sheet securitization exposure that is not a repo-style transaction, eligible margin loan, OTC derivative contract or derivative that is a cleared transaction would generally be the System institution’s carrying value of the exposure. The exposure amount of an on-balance sheet securitization exposure that is an available-for-sale debt security or an available-for-sale debt security transferred to held-to-maturity would be the System institution’s carrying value (including net accrued but unpaid interest and fees), less any net unrealized gains on the exposure and plus any net unrealized losses on the exposure.

The exposure amount of an off-balance sheet securitization exposure that is not a repo-style transaction, an eligible margin loan, an OTC derivative contract (other than a credit derivative), or a derivative that is a cleared transaction (other than a credit derivative) would be the notional amount of the exposure. The proposed treatment for OTC credit derivatives is described in more detail below.
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Under the proposed rule, the exposure amount of a securitization exposure that is a repo-style transaction, eligible margin loan, an OTC derivative contract (other than a purchased credit derivative), or derivative that is a cleared transaction (other than a purchased credit derivative) would be the exposure amount of the transaction as calculated in § 628.34 or § 628.37, as applicable.

b. Gains-On-Sale and Credit-Enhancing Interest-Only Strips

Under this proposed rule, a System institution would deduct from CET1 capital any after-tax gain-on-sale resulting from a securitization and would apply a 1,250-percent risk weight to the portion of a CEIO that does not constitute an after-tax gain-on-sale.

c. Exceptions Under the Securitization Framework

We propose several exceptions to the general provisions in the securitization framework. First, a System institution would be required to assign a risk weight of at least 100 percent to an interest-only MBS. The FCA believes that a minimum risk weight of 100 percent is prudent in light of the uncertainty implied by the substantial price volatility of these securities. Second, as in the capital regulations of the Federal banking regulatory agencies, a special set of rules would apply to securitizations of small business loans and leases on personal property transferred with retained contractual exposure by System institutions. Finally, if a securitization exposure is an OTC derivative contract or derivative contract that is a cleared transaction (other than a credit derivative) that has a first priority claim on the cash flows from the underlying exposures (notwithstanding amounts due under interest rate or currency derivative contracts, fees due, or other similar payments), a System institution may choose to set the risk-weighted asset amount of the exposure equal to the amount of the exposure.

d. Overlapping Exposures

This proposed rule includes provisions to limit the double counting of risks in situations involving overlapping securitization exposures. If a System institution has multiple securitization exposures that provide duplicative coverage to the underlying exposures of a securitization the institution would not be required to hold duplicative risk-based capital against the overlapping position. Instead, the System institution would apply to the overlapping position the applicable risk-based capital treatment under the securitization framework that results in the highest risk-based capital requirement.

e. Servicer Cash Advances

A traditional securitization typically employs a servicing banking organization (which could be a System institution) that, on a day-to-day basis, collects principal, interest, and other payments from the underlying exposures of the securitization and forwards such payments to the securitization SPE or to investors in the securitization. Servicing banking organizations often provide a facility to the securitization under which the servicing banking organization may advance cash to ensure an uninterrupted flow of payments to investors in the securitization, including advances made to cover foreclosure costs or other expenses to facilitate the timely collection of the underlying exposures. These servicer cash advance facilities are securitization exposures.

Under the proposed rule, a System institution would either apply the SSFA or the gross-up approach, as described below, or a 1,250-percent risk weight to a servicer cash advance facility exposure. The treatment of the undrawn portion of the facility would depend on whether the facility is an eligible servicer cash advance facility. An eligible servicer cash advance facility would be defined as a servicer cash advance facility in which:

(1) The servicer is entitled to full reimbursement of advances, except that a servicer may be obligated to make non-reimbursable advances for a particular underlying exposure if any such advance is contractually limited to an insignificant amount of the outstanding principal balance of that exposure;

(2) The servicer’s right to reimbursement is senior in right of payment to all other claims on the cash flows from the underlying exposures of the securitization; and

(3) The servicer has no legal obligation to, and does not make, advances to the securitization if the servicer concludes the advances are unlikely to be repaid.

Under the proposal, a System institution that is a servicer under an eligible servicer cash advance facility would not be required to hold risk-based capital against potential future cash advanced payments that it may be required to provide under the contract governing the facility. A System institution that is a servicer under a non-eligible servicer cash advance facility would be required to hold risk-based capital against the amount of all potential future cash advance payments that it may be contractually required to provide during the subsequent 12-month period under the contract governing the facility.

f. Implicit Support

This proposed rule would require a System institution that provides support to a securitization in excess of its predetermined contractual obligation (implicit support) to include in risk-weighted assets all of the underlying exposures associated with the securitization as if the exposures had not been securitized, and deduct from CET1 any after-tax gain-on-sale resulting from the securitization. In addition, the System institution would have to disclose publicly (i) that it has provided implicit support to the securitization, and (ii) the risk-based capital impact to the institution of providing such implicit support. Under the proposed reservations of authority, the FCA also could require the System institution to hold risk-based capital against all the underlying exposures associated with some or all the institution’s other securitizations as if the exposures had not been securitized, and to deduct from CET1 any after-tax gain-on-sale resulting from such securitizations.

4. Simplified Supervisory Formula Approach

This rule proposes a SSFA as one option for assigning risk weights to securitization exposures.
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The proposed SSFA starts with a baseline derived from the capital requirements that apply to all exposures underlying a securitization and then assigns risk weights based on the subordination level of an exposure. The proposed SSFA would 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 exposures.

The SSFA methodology would apply a 1,250-percent risk weight to securitization exposures that absorb losses up to the amount of capital that would be required for the underlying exposures if those exposures were held directly by a System institution. In addition, the FCA is proposing a supervisory risk-weight floor, or minimum risk weight, of 20 percent for each securitization exposure. This floor is prudent given the performance of many securitization structures during the recent crisis.

At the inception of a securitization, the SSFA would require more capital on a transaction-wide basis than would be required if the underlying assets had not been securitized. That is, if the System institution held every tranche of a securitization, its overall capital charge would be greater than if the institution held the underlying assets in portfolio. This overall outcome is important in reducing the likelihood of regulatory capital arbitrage through securitizations.

Data used by a System institution to determine SSFA parameters would have to be the most currently available data. For exposures that feature payments on a monthly or quarterly basis, the data would have to be no more than 91 calendar days old.

To use the SSFA, a System institution would have to obtain or determine the weighted-average risk weight of the underlying exposures (K
_G), as well as the attachment and detachment points for the System institution’s position within the securitization structure. “K
_G” would be calculated using the risk-weighted asset amounts and would be expressed as a decimal value between 0 and 1 (that is, an average risk weight of 100 percent would mean that K _G would equal 0.08). The System institution could recognize the relative seniority of the exposure, as well as all cash funded enhancements, in determining attachment and detachment points. In addition, a System institution would have to determine the credit performance of the underlying exposures.

To make the SSFA more risk sensitive and forward-looking, the parameter K
_G would be modified based on delinquencies among the underlying assets of the securitization. The resulting adjusted parameter is labeled K
A. K
A is set equal to the weighted average of the K
_G value and a fixed parameter equal to 0.5.

Under the proposal, the W parameter would equal the ratio of the sum of the dollar amounts of any underlying exposures of the securitization that are 90 days or more past due, subject to a bankruptcy or insolvency proceeding, in the process of foreclosure, held as real estate owned, in default, or have contractually deferred interest for 90 days or more divided by the ending balance, measured in dollars, of the underlying exposures.

The numerator of parameter W explicitly excludes loans with deferral of principal or interest for: (1) Federally guaranteed student loans, in accordance with the terms of those programs; or (2) 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 period(s) of deferral that are not initiated based on changes in the creditworthiness of the borrower. Moreover, the calculation of parameter W includes all underlying exposures of a securitization transaction.

The entire specification of the SSFA in the proposed rule is as follows:

K
SSFA is the risk-based capital requirement for the securitization exposure and is a function of three variables, labeled a, u, and 1. The constant e is the base of the natural logarithms (which is approximately equal to 2.71828). The variables a, u, and 1, and have the following definitions:

The values of A and D denote the attachment and detachment points, respectively, for the tranche. Specifically, A is the attachment point for the tranche that contains the securitization exposure and represents the threshold at which credit losses will first be allocated to the exposure. This input is the ratio, as expressed as a decimal value between 0 and 1, of the dollar amount of the securitization exposures that are subordinated to the tranche that contains the securitization exposure held by the System institution to the current dollar amount of all underlying exposures.

Parameter D is the detachment point for the tranche that contains the securitization exposure and represents the threshold at which credit losses of principal allocated to the securitization exposure would result in a total loss of principal. This input, which is a decimal value between 0 and 1, equals the value of A plus the ratio of the dollar amount of the exposures that are pari passu with the System institution’s securitization exposure (that is, have equal seniority with respect to credit risk) to the current dollar amount of all underlying exposures. The SSFA specification is completed by the constant term p, which is set equal to 0.5 for securitization exposures that are not resecuritizations, or 1.5 for resecuritization exposures, and the variable K
A, which is described above.

When parameter D for a securitization exposure is less than or equal to K
A, the exposure must be assigned a risk weight of 1,250 percent. When parameter A for a securitization exposure is greater than or equal to K
A, the risk weight of the exposure, expressed as a percent, would equal K
SSFA times 1,250. When parameter A is less than K
A and D is greater than K
_A, the applicable risk weight is a weighted average of 1,250 percent and 1,250 percent times K
SSFA. The risk weight would be determined according to the following formula:

For resecuritizations, System institutions must use the SSFA to measure the underlying securitization exposure’s contribution to K
G. For example, consider a hypothetical securitization tranche that has an attachment point at 0.06 and a detachment point at 0.07. Then assume that 90 percent of the underlying pool of assets of the resecuritization were mortgage loans that qualified for a 50-percent risk weight and that the remaining 10 percent of the pool was a tranche of a separate securitization (where the underlying 7 exposures consisted of mortgages that also qualified for a 50-percent weight). An exposure to this hypothetical tranche would meet the definition of a resecuritization exposure. Next, assume that the attachment point A of the securitization that is the 10-percent share of the resecuritization is 0.06 and the detachment point D is 0.08. Finally, assume that none of the underlying mortgage exposures of either the hypothetical tranche or the underlying securitization exposure meet the proposed definition of “delinquent.”

The value of K
G for the resecuritization exposure would equal the weighted average of the two distinct K
G values. For the mortgages that qualify for the 50-percent risk weight and represent 90 percent of the resecuritization, K
G equals 0.04 (that is, 50 percent of the 8-percent risk-based capital standard).

To calculate the value of K
G, securitization a System institution would use the attachment and detachment points of 0.06 and 0.08, respectively. Applying those input parameters to the SSFA (together with p= 0.5 and K
G= 0.04) results in a K
G, securitization equal to 0.2325.

Substituting this value into the equation yields:

This value of 0.05925 for K
G, resecuritization, would then be used in the calculation of the risk-based capital requirement for the tranche of the resecuritization (where A= 0.06, B= 0.07, p= 1.5). The result is a risk-weight of 1,172 percent for the tranche that runs from 0.06 to 0.07. Given that the attachment point is very close to the value of K
G, resecuritization, the capital charge is nearly equal to the maximum risk weight of 1,250 percent.

To apply the securitization framework to a single tranched exposure that has been re-tranched, such as some Re-REMICs, a System institution must apply the SSFA or gross-up approach to the retranched exposure as if it were still part of the structure of the original securitization transaction. Therefore, a System institution implementing the SSFA or the gross-up approach would calculate parameters for those approaches that would treat the retranched exposure as if it were still embedded in the original structure of the transaction while still recognizing any added credit enhancement provided by retranching. For example, under the SSFA a System institution would calculate the approach using hypothetical attachment and detachment points that reflect the seniority of the retranched exposure within the original deal structure, as well as any additional credit enhancement provided by retranching of the exposure. Parameters that depend on pool-level characteristics, such as the W parameter under the SSFA, would be calculated based on the characteristics of the total underlying exposures of the initial securitization transaction, not just the retranched exposure.

5. Gross-up Approach

As an alternative to the SSFA, System institutions may assign risk-weighted asset amounts to securitization exposures by implementing the gross-up approach described in § 628.43 of the proposal. If a System institution chooses to apply the gross-up approach, it would be required to apply this approach to all of its securitization exposures, except as otherwise provided for certain securitization exposures under §§ 628.44 and 628.45 of the proposal.

The gross-up approach assigns risk-weighted asset amounts based on the full amount of the credit-enhanced assets for which the System institution directly or indirectly assumes credit risk. To calculate risk-weighted assets under the gross-up approach, a System institution would determine four inputs: the pro rata share A, the exposure amount C, the enhanced amount B, and the applicable risk weight RW. The pro rata share A is the par value of the System institution’s exposure X as a percentage of the par value of the tranche Y in which the securitization exposure resides A =x/y. The enhanced amount B is the value of all the tranches that are more senior to the tranche in which the exposure resides. The applicable risk weight RW is the weighted-average risk weight of the underlying exposures in the securitization (for example, 100 percent for a corporate exposure).

Under the gross-up approach, a System institution would be required to calculate the credit equivalent amount CEA, which equals the sum of (1) the exposure of the System institution’s securitization exposure and (2) the pro rata share multiplied by the enhanced amount CEA = C + (A × B). To calculate risk-weighted assets RWA for a securitization exposure under the gross-up approach, a System institution would be required to assign the applicable risk weight to the gross-up credit equivalent amount RWA = RW × CEA. As noted above, in all cases, the minimum risk weight for securitization exposures would be 20 percent.

6. Alternative Treatments for Certain Types of Securitization Exposures

Under the proposed rule, a System institution generally would assign a 1,250-percent risk weight to all securitization exposures to which the institution does not apply the SSFA or the gross-up approach. However, the proposed rule provides alternative treatments for certain types of securitization exposures described below, provided that the System institution knows the composition of the underlying exposures at all times.

7. Credit Risk Mitigation for Securitization Exposures

Under the proposed rule, the treatment of credit risk mitigation for securitization exposures would differ slightly from the treatment for other exposures. To recognize the risk-mitigating effects of financial collateral or an eligible guarantee or an eligible credit derivative from an eligible guarantor, a System institution that purchased credit protection would use the approaches for collateralized transactions under § 628.37 of the proposed rule or the substitution treatment for guarantees and credit derivatives described in § 628.36 of the proposed rule.

In cases of maturity or currency mismatches, or, if applicable, lack of a restructuring event trigger, the institution would have to make any applicable adjustments to the protection amount of an eligible guarantee or credit derivative as required by § 628.36 for any hedged securitization exposure. In addition, for synthetic securitizations, when an eligible guarantee or eligible credit derivative covers multiple hedged exposures that have different residual maturities, the System institution would have to use the longest residual maturity of any of the hedged exposures as the residual maturity of all the hedged exposures. A System institution would not be required to compute a counterparty credit risk capital requirement for the credit derivative provided that this treatment is applied consistently for all of its OTC credit derivatives.

A System institution that purchases an OTC credit derivative (other than an nth-to-default credit derivative) that is recognized as a credit risk mitigant for a securitization exposure would not be required to compute a separate counterparty credit risk capital requirement provided that the institution makes this choice consistently for all such credit derivatives. The System institution would have to either include all or exclude all such credit derivatives that are subject to a qualifying master netting agreement from any measure used to determine counterparty credit risk exposure to all relevant counterparties for risk-based capital purposes.

If a System institution could not, or chose not to, recognize a credit derivative that is a securitization exposure as a credit risk mitigant, the institution would have to determine the exposure amount of the credit derivative under the treatment for OTC derivatives in § 628.34. If the System institution purchased the credit protection from a counterparty that is a securitization, the institution would have to determine the risk weight for counterparty credit risk according to the securitization framework. If the System institution purchased credit protection from a counterparty that is not a securitization, the institution would have to determine the risk weight for counterparty credit risk according to general risk weights under § 628.32. A System institution that believes it is authorized to and wishes to provide protection in the form of a guarantee or credit derivative (other than an nth-to-default credit derivative) that covers the full amount or a pro rata share of a securitization exposure’s principal and interest should seek guidance from the FCA on risk weighting and other issues. We do not propose the capital treatment adopted by the Federal banking regulatory agencies, because we would want the opportunity to fully consider any contemplated transaction before assigning a risk weighting.

8. Nth-to-Default Credit Derivatives

A System institution that believes it is authorized to and wishes to provide credit protection through an nth-to-default credit derivative or second-or-subsequent-to default credit derivative should seek guidance from the FCA on risk weighting and other issues. As with the capital treatment for providing credit protection discussed above, we do not propose the capital treatment adopted by the Federal banking regulatory agencies for these derivatives, because we would want the opportunity to fully consider any contemplated transaction before assigning a risk weighting.

A System institution could obtain credit protection on a group of underlying exposures through a first-to-default credit derivative. Provided the rules of recognition for guarantees and credit derivatives under § 628.36(b) were met, the System institution would determine its risk-based capital requirement for the underlying exposures as if the institution synthetically securitized the underlying exposure with the smallest risk-weighted asset amount and had obtained no credit risk mitigant on the other underlying exposures. A System institution would calculate a risk-based capital requirement for counterparty credit risk according to § 628.34 for a first-to-default credit derivative that does not meet the rules of recognition of § 628.36(b).

A System institution could obtain credit protection on a group of underlying exposures through a nth-to-default credit derivative. Provided the rules of recognition of § 628.36(b) (other than a first-to-default credit derivative) were met, the System institution could recognize the credit risk mitigation benefits of the derivative only if the institution also had obtained credit protection on the same underlying exposures in the form of first-through-(n-1)-to-default credit derivatives; or if n-1 of the underlying exposures had already defaulted. If a System institution satisfied these requirements, the institution would determine its risk-based capital requirement for the underlying exposures as if the institution had only synthetically securitized the underlying exposure with the nth smallest risk-weighted asset amount and had obtained no credit risk mitigant on the other underlying exposures. For a nth-to-default credit derivative that did not meet the rules of recognition of § 628.36(b), a System institution would calculate a risk-based capital requirement for counterparty credit risk according to the treatment of OTC derivatives under § 628.34.

I. Equity Exposures

As discussed above, all equities (including preferred stock) issued by other System institutions would be deducted from capital under § 628.22. Accordingly, we do not propose a risk weighting for these equity exposures. These intra-System equity exposures would include an association’s investment in its System bank, a System bank’s purchase of nonvoting stock or participation certificates of an affiliated association pursuant to § 615.5171, and the purchase of a System institution’s preferred stock by a System bank, association, or service corporation pursuant to § 615.5175.

Generally, System institutions have limited non-System equity exposures. A System institution could, however, acquire limited non-System equity exposures in several ways, including by investing in rural business investment companies (RBICs), by making other equity investments that the FCA approves,
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and by foreclosing on equity exposures previously pledged as collateral.

This proposal would significantly revise our existing risk-based capital rules’ treatment for non-System equity exposures. In particular, the proposed rule would require a System institution to apply the Simple Risk-Weight Approach (SRWA) for equity exposures that are not exposures to an investment fund and apply certain look-through approaches to assign risk-weighted asset amounts to equity exposures to an investment fund. These approaches are discussed in detail below.

1. Definition of Equity Exposure and Exposure Measurement

Under the proposed rule, a System institution would be required to determine the adjusted carrying value for each non-System equity exposure based on the approaches described below:

(1) For an equity exposure classified as HTM
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the adjusted carrying value would be a System institution’s carrying value of the exposure;

(2) For an equity exposure classified as AFS, the adjusted carrying value of the exposure would be the System institution’s carrying value of the exposure less any net unrealized gains on the exposure that are reflected in the carrying value but excluded from the System institution’s regulatory capital components;

(3) For a commitment to acquire an equity exposure that is unconditional, the adjusted carrying value would be the effective notional principal amount of the exposure multiplied by a 100-percent conversion factor;

(4) For a commitment to acquire an equity exposure that is conditional, the adjusted carrying value would be the effective notional principal amount of the commitment multiplied by a conversion factor. For a commitment with an original maturity of 14 months or less, the conversion factor would be 20 percent, and for a commitment with an original maturity greater than 14 months, the conversion factor would be 50 percent; and

(5) For the off-balance sheet component of an equity exposure that is not an equity commitment, the adjusted carrying value would be the effective notional principal amount of the exposure. The size of the exposure would be equivalent to a hypothetical on-balance sheet position in the underlying equity instrument that would evidence the same change in fair value (measured in dollars) for a given small change in the price of the underlying equity instrument, minus the adjusted carrying value of the on-balance sheet component of the exposure.

The concept of the effective notional principal amount of the off-balance sheet portion of an equity exposure is included to provide a uniform method for System institutions to measure the on-balance sheet equivalent of an off-balance sheet exposure. For example, if the value of a derivative contract referencing the common stock of company X changes the same amount as the value of 150 shares of common stock of company X, for a small change (for example, 1.0 percent) in the value of the common stock of company X, the effective notional principal amount of the derivative contract is the current value of 150 shares of common stock of company X, regardless of the number of shares the derivative contract references. The adjusted carrying value of the off-balance sheet component of the derivative is the current value of 150 shares of common stock of company X minus the adjusted carrying value of any on-balance sheet amount associated with the derivative.

2. Equity Exposure Risk Weights

Under the proposed SRWA for equity exposures, a System institution would determine the risk-weighted asset amount for an equity exposure, other than an equity exposure to an investment fund, under § 628.52 of the proposed rule. A System institution would calculate risk-weighted asset amounts under § 628.52 by multiplying the adjusted carrying value of the equity exposure, or the effective and ineffective portions of a hedge pair as described below, by the lowest applicable risk weight in § 628.52. A System institution would determine the risk-weighted asset amount for an equity exposure to an investment fund under § 628.53 of the proposal. A System institution would sum risk-weighted asset amounts for all of its equity exposures to calculate its aggregate risk-weighted asset amount for its equity exposures.

The proposed SRWA risk weights are summarized below in Table 10.

3. 100-Percent Risk Weight

Under this proposed rule, a System institution would apply a 100-percent risk weight to the following equity exposures:

• An equity exposure that the FCA has authorized pursuant to § 615.5140(e) for a purpose other than those specified in § 615.5132(a) (for System banks) or § 615.5142 (for associations), unless the equity exposure is assigned a different risk weight under this section.
• The effective portion of a hedge pair; and
• Non-significant equity exposures.

Hedged transactions are discussed later in this preamble; the other two equity exposures are discussed in this section.

Section § 615.5132(a) of the FCA’s regulations authorizes System banks to invest in eligible securities (equity securities are not eligible) for the purposes of complying with liquidity requirements, managing surplus short-term funds, and managing interest rate risk. Section § 615.5142 authorizes associations to invest in eligible securities (again, equity securities are not eligible) for the purposes of reducing interest rate risk and managing surplus short-term funds. Section 615.5140(e) authorizes System banks and associations, with our approval, to purchase and hold investments that are not otherwise eligible (such as equity investments) or that would be held for a purpose not specified by regulation.

Under proposed § 628.52, equity investments that the FCA approves for a purpose other than those specified in § 615.5132(a) (for System banks) or § 615.5142 (for associations) would be risk weighted at 100 percent, unless the investments would qualify for a different risk weight (for example, 0 percent or 20 percent) under this section.

Under the proposed rule, a 100-percent risk weight would also apply to certain non-System equity exposures deemed non-significant. The following equity exposures, to the extent that their aggregate adjusted carrying value of does not exceed 10 percent of the System institution’s total capital (tier 1 and tier 2), would be deemed non-significant:
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• Equity exposures to unconsolidated unincorporated business entities and equity exposures held through consolidated unincorporated business entities, as authorized by subpart J of part 611;
• Equity exposures that the FCA has authorized pursuant to § 615.5140(e) for a purpose specified in § 615.5132(a) (for System banks) or § 615.5142 (for associations), unless the equity exposures are assigned a different risk weight under this section; and
• Equity exposures to an unconsolidated rural business investment company and equity exposures held through a consolidated rural business investment company described in 7 U.S.C. 2009cc et seq.
• Equity exposures to foreclosed collateral; these exposures could be either publicly traded or non-publicly traded.
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To compute the aggregate adjusted carrying value of a System institution’s equity exposures for determining their non-significance, this proposal provides that the System institution may exclude: (1) The equity exposure in a hedge pair with the smaller adjusted carrying value; and (2) a proportion of each equity exposure to an investment fund equal to the proportion of the assets of the investment fund that are not equity exposures. If a System institution does not know the actual holdings of the investment fund, the System institution may calculate the proportion of the assets of the fund that are not equity exposures based on the terms of the prospectus, partnership agreement, or similar contract that defines the fund’s permissible investments. If the sum of the investment limits for all exposure classes within the fund exceeds 100 percent, the System institution would assume that the investment fund invests to the maximum extent possible in equity exposures.

To determine which of a System institution’s equity exposures qualify for a 100-percent risk weight based on the 10 percent of capital standard for non-significance, the System institution would aggregate the exposures in the following order:

(1) Equity exposures to unconsolidated rural business investment companies, or those held through consolidated rural business investment companies described in 7 U.S.C. 2009cc et seq.;

(2) Equity exposures that the FCA has authorized pursuant to § 615.5140(e) for a purpose specified in § 615.5132(a) (for System banks) or § 615.5142 (for associations);

(3) Equity exposures to unconsolidated unincorporated business entities and equity exposures held through consolidated unincorporated business entities, as authorized by subpart J of part 611;

(4) Foreclosed collateral in the form of publicly traded equity exposures (including those held indirectly through investment funds); and

(5) Foreclosed collateral in the form of non-publicly traded equity exposures (including those held indirectly through investment funds).

To the extent that any of these aggregated equity exposures exceed 10 percent of a System institution’s total capital, the FCA will determine their risk weighting.

4. Hedged Transactions

Under the proposal, to determine risk-weighted assets under the SRWA, a System institution could identify hedge pairs, which would be defined as two equity exposures that form an effective hedge, as long as each equity exposure is publicly traded or has a return that is primarily based on a publicly traded equity exposure. A System institution would risk weight only the effective and ineffective portions of a hedge pair rather than the entire adjusted carrying value of each exposure that makes up the pair.

Under the proposed rule, two equity exposures form an effective hedge if the exposures either have the same remaining maturity or each has a remaining maturity of at least 3 months; the hedge relationship is formally documented in a prospective manner (that is, before the System institution acquires at least one of the equity exposures); the documentation specifies the measure of effectiveness (E) the System institution would use for the hedge relationship throughout the life of the transaction; and the hedge relationship has an E greater than or equal to 0.8. A System institution would measure E at least quarterly and would use one of three measures of E described in the next section: The dollar-offset method, the variability-reduction method, or the regression method.

It is possible that only part of a System institution’s exposure to a particular equity instrument is part of a hedge pair. For example, assume a System institution has equity exposure A with a $300 adjusted carrying value and chooses to hedge a portion of that exposure with equity exposure B with an adjusted carrying value of $100. Also assume that the combination of equity exposure B and $100 of the adjusted carrying value of equity exposure A form an effective hedge with an E of 0.8. In this situation, the institution would treat $100 of equity exposure A and $100 of equity exposure B as a hedge pair, and the remaining $200 of its equity exposure A as a separate, stand-alone equity position. The effective portion of a hedge pair would be calculated as E multiplied by the greater of the adjusted carrying values of the equity exposures forming the hedge pair. The ineffective portion of a hedge pair would be calculated as (1-E) multiplied by the greater of the adjusted carrying values of the equity exposures forming the hedge pair. In the above example, the effective portion of the hedge pair would be 0.8 × $100 = $80, and the ineffective portion of the hedge pair would be (1 − 0.8) × $100 = $20.

5. Measures of Hedge Effectiveness

As stated above, a System institution could determine effectiveness using any one of three methods—the dollar-offset method, the variability-reduction method, or the regression method. Under the dollar-offset method, a System institution would determine the ratio of the cumulative sum of the changes in value of one equity exposure to the cumulative sum of the changes in value of the other equity exposure, termed the ratio of value change (RVC). If the changes in the values of the two exposures perfectly offset each other, the RVC would be −1. If RVC is positive, implying that the values of the two equity exposures move in the same direction, the hedge is not effective and E equals 0. If RVC is negative and greater than or equal to −1 (that is, between 0 and −1), then E would equal the absolute value of RVC. If RVC is negative and less than −1, then E would equal 2 plus RVC.

The variability-reduction method of measuring effectiveness compares changes in the value of the combined position of the two equity exposures in the hedge pair (labeled X in the equation below) to changes in the value of one exposure as though that one exposure were not hedged (labeled A). This measure of E expresses the time-series variability in X as a proportion of the variability of A. As the variability described by the numerator becomes small relative to the variability described by the denominator, the measure of effectiveness improves, but is bounded from above by a value of one. E would be computed as:

where

The value of t would range from 0 to T, where T is the length of the observation period for the values of A and B, and is comprised of shorter values each labeled t.

The regression method of measuring effectiveness is based on a regression in which the change in value of one exposure in a hedge pair is the dependent variable and the change in value of the other exposure in the hedge pair is the independent variable. E would equal the coefficient of determination of this regression, which is the proportion of the variation in the dependent variable explained by variation in the independent variable. However, if the estimated regression coefficient is positive, then the value of E is 0. Accordingly, E is higher when the relationship between the values of the two exposures is closer.

6. Equity Exposures to Investment Funds

We propose three methods of assigning risk weights to equity exposures to investment funds. Regardless of the method a System institution chooses, the risk weight for an exposure to an investment fund would have to be no less than 20 percent.
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System institutions should keep in mind that the only investment funds they are authorized to invest in are diversified investment funds; that is, shares of an investment company registered under section 8 of the Investment Company Act of 1940. The portfolio of the investment company must consist solely of eligible investments authorized by our investment regulations.
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As discussed further below, under the proposed rule, a System institution would determine the risk-weighted asset amount for equity exposures (except equity exposures that the FCA has authorized pursuant to § 615.5140(e) for a purpose other than those specified in § 615.5132(a) (for System banks) or § 615.5142 (for associations)) to investment funds using one of three approaches—the full look-through approach, the simple modified look-through approach, or the alternative modified look-through approach. The risk-weighted asset amount for an equity exposure that the FCA has authorized pursuant to § 615.5140(e) for a purpose other than those specified in § 615.5132(a) (for System banks) or § 615.5142 (for associations) is the exposure’s adjusted carrying value. If a System institution did not use the full look-through approach, and an equity exposure to an investment fund was part of a hedge pair, the System institution would have to use the ineffective portion of the hedge pair as the adjusted carrying value for the equity exposure to the investment fund. The risk-weighted asset amount of the effective portion of the hedge pair would be equal to its adjusted carrying value. A System institution could choose which approach to apply for each equity exposure to an investment fund.

a. Full Look-Through Approach

A System institution could use the full look-through approach only if the institution was able to calculate a risk-weighted asset amount for each of the exposures held by the investment fund. Under the proposal, a System institution using the full look-through approach would be required to calculate the risk-weighted asset amount for its proportional ownership shares of each of the exposures held by the investment fund as if the proportionate ownership share of the adjusted carrying value of each of the exposures were held directly by the institution. The System institution’s risk-weighted asset amount for the fund would be equal to (1) The aggregate risk-weighted asset amount of the exposures held by the fund as if they were held directly by the System institution multiplied by (2) the System institution’s proportional ownership share of the fund.

b. Simple Modified Look-Through Approach

Under the proposed simple modified look-through approach, a System institution would set the risk-weighted asset amount for its equity exposure to an investment fund equal to the adjusted carrying value of the equity exposure multiplied by the highest risk weight that applies to an exposure the fund is permitted to hold under the prospectus, partnership agreement, or similar agreement that defines the fund’s permissible investments. The System institution may exclude derivative contracts held by the fund that are used for hedging, rather than for speculative purposes, as long as they do not constitute a material portion of the fund’s exposures.

c. Alternative Modified Look-Through Approach

Under the proposed alternative modified look-through approach, a System institution may assign the adjusted carrying value of an equity exposure to an investment fund on a pro rata basis to different risk-weight categories based on the investment limits in the fund’s prospectus, partnership agreement, or similar contract that defines the fund’s permissible investments.

The risk-weighted asset amount for the System institution’s equity exposure to the investment fund would be equal to the sum of each portion of the adjusted carrying value assigned to an exposure type multiplied by the applicable risk weight. If the sum of the investment limits for all exposures within the fund exceeds 100 percent, the System institution would assume that the fund invests to the maximum extent permitted under its investment limits in the exposure type with the highest applicable risk weight under the proposed requirements and continues to make investments in the order of the exposure category with the next highest risk weight until the maximum total investment level is reached. If more than one exposure category applies to an exposure, the System institution would use the highest applicable risk weight. A System institution may exclude derivative contracts held by the fund that are used for hedging, rather than for speculative purposes, as long as they do not constitute a material portion of the fund’s exposures.

A. Proposed Disclosure Requirements

Meaningful public disclosure by banking organizations is one of the three pillars of the Basel framework. Public disclosure complements the minimum capital requirements and the supervisory review process by encouraging market discipline. The other Federal banking regulatory agencies adopted disclosure requirements for the banking organizations that they regulate with $50 billion or more in assets.

We propose similar disclosure requirements for System banks on a bank-only basis (not on a consolidated, district-wide basis). We believe these proposed disclosure requirements are appropriate for all System banks—even those that currently have less than $50 billion in assets—because they are jointly and severally liable for the Systemwide debt obligations that they issue.
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A System bank’s exposure to risks and the techniques that it uses to identify, measure, monitor, and control those risks are important factors that market participants consider in their assessment of the bank. A System bank would not, however, have to make any disclosures that do not apply to it.
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We believe this proposal strikes the proper balance between the market benefits of disclosure and the burden of providing the disclosures. We invite comment on the appropriate application of these proposed disclosure requirements to System banks.

We propose to require each System bank to have a board-approved disclosure policy that addresses the bank’s approach for determining the disclosures it will make. The policy would address the associated internal controls, disclosure controls, and procedures. The board of directors and senior management would ensure that disclosures are reviewed appropriately and that effective internal controls, disclosure controls, and procedures are maintained. The System bank’s chief executive officer, chief financial officer, and a designated board member would have to attest that the disclosures meet the requirements of these regulations.

A System bank would decide the relevant material disclosures. Information would be regarded as material if its omission or misstatement could influence the assessment or decision of a user making investment decisions.

We would expect that disclosures of CET1, tier 1, and total capital ratios would be tested by external auditors as part of the financial statement audit in a manner similar to the testing that external auditors perform on banking organizations regulated by the Federal banking regulatory agencies.

B. Location and Frequency of Disclosures

This proposed rule would require that a System bank provide timely public disclosures after each calendar quarter. However, qualitative disclosures that provide a general summary of a System bank’s risk-management objectives and policies, reporting system, and definitions may be disclosed annually after the end of the fourth calendar quarter, provided any significant changes are disclosed in the interim.

The System bank would have to make these disclosures in its quarterly and annual reports to shareholders that are required in part 620 of our regulations.
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We do not require a System bank to make these disclosures in the exact format set out in the proposed regulations, or in the same location in the report, as long as they provide a summary table specifically indicating the location(s) of all disclosures. This flexibility grants System banks discretion in how to disclose the required information and to avoid duplication.

In some cases, management may determine that a significant change has occurred, such that the most recent reported amounts do not reflect the System bank’s capital adequacy and risk profile. In those cases, the System bank would need to disclose the general nature of these changes and briefly describe how they are likely to affect public disclosures going forward. A System bank would have to make these interim disclosures as soon as practicable after the determination that a significant change has occurred. This disclosure requirement may be satisfied by providing a notice under § 620.15.

The disclosures required by the proposal would have to be publicly available (for example, included on a public Web site) for each of the last 3 years or such shorter time period beginning when the System bank becomes subject to the disclosure requirements. For example, a System bank that began to make public disclosures in the first quarter of 2015 would have to make all of its required disclosures publicly available until the first quarter of 2018, after which it would have to make its required disclosures for the previous 3 years publicly available.

C. Proprietary and Confidential Information

The FCA believes that proposed disclosure requirements strike the proper balance between the need for meaningful disclosure and the protection of proprietary and confidential information.
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Accordingly, the FCA believes System banks would be able to provide all of these disclosures without revealing proprietary and confidential information. Only in rare circumstances might disclosure of certain items of information required by the proposal compel a System bank to reveal confidential and proprietary information. In these unusual situations, if a System bank believes that disclosure of specific commercial or financial information would compromise its position by making public information that is either proprietary or confidential in nature, the System bank would not be required to disclose those specific items under the rule’s periodic disclosure requirements. Instead, the System bank would have to disclose more general information about the subject matter of the requirement, together with the fact that, and the reason why, the specific items of information have not been disclosed. This provision would apply only to those disclosures included in this proposed rule and would not apply to disclosure requirements imposed by accounting standards or other FCA regulations.

D. Specific Public Disclosure Requirements

The public disclosure requirements are designed to provide important information to market participants on the scope of application, capital structure, risk exposures, risk assessment processes, and the capital adequacy of the System institution. The focus of the proposed disclosure requirements is the substantive content of the tables, not the tables themselves. The table numbers below refer to the table numbers in proposed § 628.63. A System bank would be required to make the disclosures described in Tables 1 through 10.
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Table 1 disclosures, “Scope of Application,” would provide the basic context underlying regulatory capital calculations.

Table 2 disclosures, “Capital Structure,” would provide summary information on the terms and conditions of the main features of regulatory capital instruments, which would allow for an evaluation of the quality of the capital available to absorb losses within a System bank. A System bank also would disclose the total amount of CET1, tier 1, and total capital, with separate disclosures for deductions and adjustments to capital. We believe that many of these disclosure requirements would be captured in revised regulatory reports.

Table 3 disclosures, “Capital Adequacy,” would provide information on a System bank’s approach for categorizing and risk-weighting its exposures, as well as the amount of total risk-weighted assets. The table would also include CET1, and tier 1 and total risk-based capital ratios.

Table 4 disclosures, “Capital Conservation Buffer,” would require a System bank to disclose the capital conservation buffer, the eligible retained income and any limitations on capital distributions and certain discretionary bonus payments, as applicable.

Disclosures in Tables 5, “Credit Risk: General Disclosures,” 6, “General Disclosure for Counterparty Credit Risk-Related Expenses,” and 7, “Credit Risk Mitigation,” would relate to credit risk, counterparty credit risk and credit risk mitigation, respectively, and would provide market participants with insight into different types and concentrations of credit risk to which a System bank is exposed and the techniques it uses to measure, monitor, and mitigate those risks. These disclosures are intended to enable market participants to assess the credit risk exposures of the System bank without revealing proprietary information.

Table 8 disclosures, “Securitization,” would provide information to market participants on the amount of credit risk transferred and retained by a System bank through securitization transactions, the types of products involved in the System bank’s securitizations, the risks inherent in the System bank’s securitized assets, the System bank’s policies regarding credit risk mitigation, and the names of any entities that provide external credit assessments of a securitization. These disclosures would provide a better understanding of how securitization transactions impact the credit risk of a System bank. For purposes of these disclosures (and these capital regulations), a System bank would be considered to have securitized assets if assets that it originated or purchased from third parties are included in a securitization. Securitization transactions in which the originating System bank does not retain any securitization exposure would be shown separately and would only be reported for the year of inception of the transaction.
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Table 9 disclosures, “Equities,” would provide market participants with an understanding of the types of equity securities held by the System bank and how they are valued. The disclosures would also provide information on the capital allocated to different equity products and the amount of unrealized gains and losses. We understand that System banks generally hold few equity securities; nevertheless, we believe disclosure of these securities, when they are held, is warranted.

Table 10 disclosures, “Interest Rate Risk for Non-trading Activities,” would require a System bank to provide certain quantitative and qualitative disclosures regarding the System bank’s management of interest rate risks.

The FCA is proposing a number of conforming changes to current FCA regulations as follows:

• In § 607.2(b), revision of the definition of “average risk-adjusted asset base”;
• In § 614.4351(a)(3), replacement of the reference to total surplus with a reference to tier 2 capital;
• In § 615.5143(a), removal of references to the net collateral ratio;
• In § 615.5200, removal of references to total capital, surplus, core surplus, total surplus, and unallocated surplus; addition of references to CET1, tier 1 capital, total capital, and tier 1 leverage ratio; and other minor nonsubstantive and technical changes;
• In § 615.5201, removal of definitions that would no longer be used in part 615, subpart H, including “bank,” “commitment,” “credit conversion factor,” “credit derivative,” “credit-enhancing interest-only strip,” “credit-enhancing representations and warranties,” “deferred-tax assets that are dependent on future income or future events,” “direct credit substitute,” “direct lender institution,” “externally rated,” “face amount,” “financial asset,” “financial standby letter of credit,” “Government agency,” “Government-sponsored agency,” “institution,” “nationally recognized statistical rating organization,” “non-OECD bank,” “OECD,” “OECD bank,” “performance-based standby letter of credit,” “qualified residential loan,” “qualifying bilateral netting contract,” “qualifying securities firm,” “recourse,” “residual interest,” “risk participation,” “Rural Business Investment Company,” “securitization,” “servicer cash advance,” “total capital,” “traded position,” and “U.S. depository institution”; revision of the definitions of “permanent capital” and “risk-adjusted asset base”; and addition of definitions of “deferred tax assets” and “System institution”;
• In §§ 615.5206 and 615.5208, removal of references to the Farm Credit System Financial Assistance Corporation in § 615.5206(a); removal of §§ 615.5206(d) and 615.5208(c), which pertain to the Farm Credit System Financial Assistance Corporation; and other minor nonsubstantive and technical changes;
• In § 615.5207, revisions in paragraph (f) (requiring deduction of an investment in the Funding Corporation) and paragraph (j) (elimination of exclusion of AOCI and requirement to exclude any defined benefit pension fund net asset) to make the deductions from the numerator of the permanent capital calculation uniform with the deductions from the denominator;
• Removal of §§ 615.5209 through 615.5212, which pertain to risk-weighting (the risk-weights for the permanent capital ratio would be the same risk weights that would be used for the tier 1 and tier 2 capital ratios in part 628);
• In § 615.5220, minor nonsubstantive and technical changes;
• Revision of § 615.5240 to add a reference to the regulatory capital standards in proposed part 628;
• Revision of § 615.5250 to include references to the regulatory capital standards in proposed part 628;
• In § 615.5255, the addition of part 628 capital standards and minor nonsubstantive and technical changes;
• In § 615.5270, revision to incorporate restrictions and limits on redemptions of equities would be included in tier 1 and tier 2 capital in the proposed rule;
• In § 615.5290, minor nonsubstantive and technical changes;
• Removal of part 615, subpart K, which contains the requirements for the core surplus, total surplus, and net collateral standards;
• In §§ 615.5350, 615.5352, and 615.5355, replacement of references to core surplus, total surplus, and net collateral with references to tier 1 and tier 2 capital;
• In § 615.5357, addition of a reference to the capital restoration plan in proposed § 628.301; and
• Revision of § 620.17 to expand the stockholder notification requirement to include the regulatory capital standards in proposed part 628.

Basel III and the Federal regulatory banking agencies’ rules have numerous phase-in and transition periods for the capital regulations lasting from 2014 (2015 for banking organizations not using the advanced approaches rules) until 2019 or after. Many of these transition provisions pertain to regulatory deductions and adjustments, minority interests, and temporary inclusion of non-qualifying instruments. There is also a transition period for the capital conservation buffer.

The FCA is not proposing any transition or phase-in periods for regulatory adjustments and deductions. The Federal regulatory banking agencies’ transition periods serve several purposes. The agencies, which are members of the BCBS, are generally following the transition and phase-in periods of Basel III and other countries’ banking regulations. Since the primary competitors of many U.S. banking organizations are financial institutions that are regulated by foreign countries that are also following Basel III, there will be a level playing field among such competitors. In addition, the Federal regulatory banking agencies note that the various transition periods will give the banking organizations they regulate sufficient time to build capital to meet the new minimum requirements.

The FCA believes multiple transition periods of varying lengths for multiple adjustments and deductions could be unnecessarily burdensome for System institutions and for the FCA. Instead of a single learning curve and software re-tooling on the calculation of the new framework, institutions and FCA staff would have a new learning curve every 4 quarters for the first 4 or more years after the rule becomes effective.

We have analyzed every System institution’s call report data, and we project that all System institutions would meet all the proposed minimum amounts for the CET1, tier 1 and total capital risk-based ratios if those requirements were in effect today. In reviewing the capital components, we assumed that all institutions would adopt required bylaw provisions for inclusion of stock and allocated equities in tier 1 and tier 2 capital. We also assumed that no institutions that redeem allocated equities on a cycle of less than 10 years would extend their patronage redemption periods in order to include those equities in CET1 capital, but rather they would maintain existing patronage redemption periods and qualify allocated equities as tier 2 capital. For the risk weightings, we used a simple analysis. For System associations, we assumed the proposed risk weightings would not be materially different from existing risk weightings in the current regulations. For System banks, we believe that certain new risk weights or conversion factors could have a material impact but, taken collectively, the impacts should net against each other. For instance, System banks would need to hold additional capital for their unconditionally cancelable unfunded commitments, but they would hold less capital for their end-user derivative portfolios. In the proposed rule, the banks may use credit risk mitigation for the collateral posted to derivative counterparties that are not available to them under current regulations.

All System institutions would meet the 5.0 minimum tier 1 leverage ratio (including the 1.5-percent component of the ratio for URE and equivalents) if the proposed requirement were effective today. Our analysis indicates that the leverage ratio would not be a constraining ratio for System associations because of their strong capital levels. The leverage ratio for associations would be very similar to their tier 1 capital risk-based ratio because most of their assets are risk weighted at 100 percent. If the proposed rule were effective today, the current leverage ratios of System banks would, however, be closer to, but above, the proposed 5.0-percent tier 1 and a 1.5-percent URE and URE equivalents component of the minimum leverage ratio. The System banks’ tier 1 leverage ratios would be significantly lower than their tier 1 risk-based ratios because a large portion of their loans are to their affiliated associations and are risk-weighted at 20 percent.

The FCA has decided to propose a transition period for the capital conservation buffer that would commence on January 1, 2016, with the buffer fully phased in beginning January 1, 2019. Unlike the adjustments and deductions transitions, the calculation of the capital conservation buffer would not change over the transition period, and there would not be an additional burden to revise the calculation each year. Rather, the amount of the capital conservation buffer increases every year until fully phased in. The Federal regulatory banking agencies’ capital conservation buffer rules also will be fully phased in as of January 1, 2019, but their transition period will begin in 2015. We expect our final rule will become effective for the reporting periods beginning in 2016.

In the event that some System institutions do not meet the tier 1 and tier 2 capital standards when the rules become effective, we are proposing to permit them to comply by submitting a capital restoration plan. The plan, which the institution would be required to submit within 20 days of the quarterend during which the new capital standards become effective, would describe how the institution proposes to achieve and maintain compliance with the new requirements, demonstrating progress towards meeting that goal. If the FCA did not approve the plan, the institution would have to revise and re-submit the plan. There is a list of factors in the proposed rule that the FCA would consider in evaluating a plan. They include: (1) Circumstances leading to the institution’s decrease in capital and whether they were caused by the institution or by circumstances beyond the institution’s control; (2) the institution’s financial ratios (e.g., capital, adverse assets, ALL) compared to those of its peers or industry norms; and (3) the institution’s previous compliance practices; and (4) the views of the institution’s directors and managers regarding the plan. If the capital restoration plan is adopted by the institution and approved by the FCA within 180 days of the quarterend in which the tier 1 and tier 2 capital requirements become effective, the institution will be deemed to be in compliance with the requirements.
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Pursuant to section 605(b) of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.), the FCA hereby certifies that the proposed rule would not have a significant economic impact on a substantial number of small entities. Each of the banks in the Farm Credit System, considered together with its affiliated associations, has assets and annual income in excess of the amounts that would qualify them as small entities. Therefore, Farm Credit System institutions are not “small entities” as defined in the Regulatory Flexibility Act.

The FCA is issuing a proposed rule (proposal or proposed rule) to update the capital rules for the System by adopting certain changes comparable to those suggested by the Basel Committee on Banking Supervision (BCBS) to the international regulatory capital framework, the Federal banking regulatory agencies’ regulations, and requirements of the Dodd-Frank Act. Among other things, the proposed rule would:

• Establish minimum risk-based CET1, tier 1, and total capital ratio requirements;
• Establish a minimum tier 1 leverage ratio requirement;
• Establish a capital conservation buffer below which an institution’s discretionary cash distributions and bonuses would be limited or prohibited without FCA approval;
• Increase capital requirements for past-due loans, high volatility commercial real estate exposures, and certain short-term loan commitments;
• Expand the recognition of collateral and guarantors in determining risk-weighted assets;
• Remove references to credit ratings;
• Establish due diligence requirements for securitization exposures; and
• Increase required regulatory capital disclosures of System banks.

This addendum summarizes this proposed rule. The FCA intends for this addendum to act as a guide for System institutions to navigate the proposed rule and identify the provisions that may be most relevant to them, but it is not comprehensive. The FCA expects and encourages all System institutions to review the proposed rule in its entirety.

We remind System institutions that the presence of a particular risk weighting does not itself provide authority for a System institution to have an exposure to that asset or item.

A. Capital Components

1. Common Equity Tier 1 Capital (CET1)

(a) Common cooperative equities (purchased member stock, purchased participation certificates, and allocated equities) with the following key criteria (among others):

• Borrower stock (regardless of redemption or revolvement period) up to the statutory minimum of $1000 or 2 percent of the loan amount, whichever is less;
• Equities are perpetual;
• Equities subject to discretionary revolvement or redemption are not retired for at least 10 years after issuance;
• Equities can be retired only with FCA prior approval (unless it is the statutory minimum borrower stock requirement or unless the distribution meets “safe harbor” standards) and the System institution has a capitalization bylaw providing that it must obtain FCA approval prior to redeeming or revolving any equities it includes in CET1 before the end of the 10-year period;
• Equities represent a claim subordinated to all preferred stock, all subordinated debt, and all liabilities of the institution in a receivership, liquidation, or similar proceeding; and

(b) Unallocated retained earnings (URE).

The FCA is proposing to require System institutions to exclude AOCI from CET1.

2. Additional Tier 1 Capital (AT1)

Equities other than common cooperative equities (i.e., equities issued primarily to third-party investors) that meet most of the CET1 criteria, except that AT1 capital equities represent a claim that ranks senior to all common cooperative equities in a receivership, liquidation, or similar proceeding.

3. Tier 2 Capital

(a) Equities, which may be common cooperative equities or equities held by third parties, not includable in Tier 1 with the following key criteria:

• Equities are perpetual or have an original maturity of at least 5 years;
• Equities subject to discretionary revolvement or redemption are not retired for at least 5 years after issuance; and
• Equities may not be redeemed or revolved prior to maturity or the end of the stated revolvement period without FCA prior approval (unless the distribution meets “safe harbor” standards);

(b) Subordinated debt that is not callable for at least 5 years and not subject to acceleration except in the event of a receivership, liquidation, or similar proceeding; and

(c) Allowance for losses (ALL) up to 1.25 percent of total risk-weighted assets.

4. Regulatory Adjustments and Deductions

(a) Deductions from CET1 capital.

• Goodwill, intangible assets, gains-on-sale in connection with a securitization exposure, and defined benefit pension fund net assets, all of which are net of associated deferred tax liabilities; and
• The System institution’s allocated equity investments in another System institution.

(b) Deductions from regulatory capital using the corresponding deduction approach.

• A System institution’s purchased equity investments in other System institutions must be deducted using the corresponding deduction approach.

This means that a System institution would make deductions from the component of capital for which the underlying instrument qualified if it were issued by the System institution itself.

5. FCA Prior Approval of Cash Patronage Refunds, Cash Dividend Payments, and Allocated Equity Redemptions; “Safe Harbor” Treatment for Certain Such Payments

FCA prior approval would be required for redemption of equities included in tier 1 and tier 2, comparable to Basel III and the banking agencies’ rule. Prior approval is also required for cash dividends and cash patronage in excess of a specified level, comparable to U.S. banking law and regulations. An exception to the FCA prior approval requirement is that System institutions could retire member stock up to an amount equal to the Farm Credit Act’s minimum member-borrower stock requirement of $1,000 or 2 percent of the member’s loan, whichever is less. In addition, this amount of borrower stock would not have to be outstanding for a minimum period of 10 years in order for the institution to include it in CET1. However, redemptions of such amounts of stock would be included in the calculation for the “safe harbor” in proposed § 628.22(f)(5).

Under the proposed “safe harbor,” FCA prior approval is deemed to be granted (i.e., a request for approval does not have to be made to the FCA) for cash distributions to pay dividends, patronage, or revolvements and redemptions of common cooperative equities provided that:

(a) For revolvements or redemptions of common cooperative equities included in CET1 capital, such equities were issued or allocated at least 10 years ago;

(b) For revolvements or redemptions of common cooperative equities included in Tier 2 capital, such equities were issued or allocated at least 5 years ago;

(c) After such cash distributions, the dollar amount of the System institution’s CET1 capital equals or exceeds the dollar amount of CET1 capital on the same date of the previous calendar year; and

(d) After such cash distributions, the System institution continues to comply with all minimum regulatory capital requirements and supervisory or enforcement actions.

6. Capital Conservation Buffer

The capital conservation buffer of 2.5 percent provides a cushion above regulatory capital minimums. The buffer’s purpose is to restrict an institution’s discretionary distributions of earnings before that institution reaches the minimum capital requirements.

If a System institution’s CET1, tier 1 and total capital ratios exceed minimum requirements, the capital conservation buffer is proposed to be the lowest of the following:

• The System institution’s CET1 capital ratio minus the System institution’s minimum CET1 capital ratio of 4.5 percent;
• The System institution’s tier 1 capital ratio minus the System institution’s minimum tier 1 capital ratio of 6 percent; and
• The System institution’s total capital ratio minus the System institution’s minimum total capital ratio of 8 percent.

If the CET1 ratio, tier 1 ratio, or total capital ratio does not exceed minimum requirements, then the capital conservation buffer would be zero.

B. Risk Weightings

1. Zero-Percent (0%) Risk-Weighted Exposures

• An exposure to the U.S. Government, its central bank, or a U.S. Government agency—§ 628.32(a)(1)(i)(A);
• The portion of an exposure that is directly and unconditionally guaranteed by the U.S. Government, its central bank, or a U.S. Government agency—§ 628.32(a)(1)(i)(B);
• An exposure to a sovereign entity that meets certain criteria (as discussed below)—§ 628.32(a) and Table 1;
• Exposures to certain supranational entities and multilateral development banks—§ 628.32(b);
• Cash—§ 628.32(l);
• Certain gold bullion—§ 628.32(l);
• Certain exposures that arise from the settlement of cash transactions with a central counterparty—§ 628.32(l);
• An exposure to an OTC derivative contract that meets certain criteria—§ 628.37(b)(3)(i);
• The collateralized portion of an exposure with respect to which the financial collateral meets certain criteria—§ 628.37(b)(3)(iii); and
• An equity exposure to any entity whose credit exposures receive a 0-percent risk weight—§ 628.52(b)(1).

2. Twenty-Percent (20%) Risk-Weighted Exposures

• The portion of an exposure that is conditionally guaranteed by the U.S. Government, its central bank, or a U.S. Government agency—§ 628.32(a)(1)(ii);
• An exposure to a sovereign entity that meets certain criteria (as discussed below)—§ 628.32(a) and Table 1;
• An exposure to a GSE, other than an equity exposure or preferred stock—§ 628.32(c)(1);
• Most exposures to U.S.- or state-organized depository institutions or credit unions, including those that are OFIs—§ 628.32(d)(1);
• An exposure to a foreign bank that meets certain criteria (as discussed below)—§ 628.32(d)(2) and Table 2;
• A general obligation exposure to a U.S. or state PSE—§ 628.32(e)(1)(i);
• An exposure to a non-U.S. PSE that meets certain criteria (as discussed below)—§ 628.32(e)(2), (e)(3), and (e)(4)(i) and Table 3;
• Cash items in the process of collection—§ 628.32(l)(2);
• A loan that a System bank makes to an association (a direct loan)—§ 628.32(m); and
• An equity exposure to a PSE or the Federal Agricultural Mortgage Corporation (Farmer Mac)—§ 628.52(b)(2).

3. Fifty-Percent (50%) Risk-Weighted Exposures

• An exposure to a sovereign entity that meets certain criteria (as discussed below)—§ 628.32(a) and Table 1;
• An exposure to a foreign bank that meets certain criteria (as discussed below)—§ 628.32(d)(2) and Table 2;
• A revenue obligation exposure to a U.S. or state PSE—§ 628.32(e)(1)(ii);
• An exposure to a non-U.S. PSE that meets certain criteria (as discussed below)—§ 628.32(e)(2), (e)(3), (e)(4)(ii) and Tables 3 and 4; and
• First lien residential mortgage exposures that meet certain criteria—§ 628.32(g).

4. One Hundred-Percent (100%) Risk-Weighted Exposures

• An exposure to a sovereign entity that meets certain criteria (as discussed below)—§ 628.32(a) and Table 1;
• Preferred stock issued by a GSE—§ 628.32(c)(2);
• An exposure to a foreign bank that meets certain criteria (as discussed below)—§ 628.32(d)(2) and Table 2;
• An exposure to a non-U.S. PSE that meets certain criteria (as discussed below)—§ 628.32(e)(2), (e)(3), (e)(5) and Tables 3 and 4;
• All corporate exposures—§ 628.32(f). This category would include the following:

○ Borrower loans such as agricultural loans and consumer loans, regardless of the corporate form, of the borrower, unless those loans qualify for different risk weights under other risk-weighting provisions;

○ System bank exposures to OFIs that do not satisfy the criteria for a 20-percent risk weight; and

○ Premises, fixed assets, and other real estate owned;

• All residential mortgage exposures that do not satisfy the criteria for a 50-percent risk weight—§ 628.32(g);
• DTAs arising from temporary differences that could be realized through net operating loss carrybacks—§ 628.32(l)(3);
• All MSAs—§ 628.32(l)(4);
• All assets that are not specifically assigned a different risk weight and that are not deducted from tier 1 or tier 2 capital pursuant to § 628.22—§ 628.32(l)(5);
• Certain equity exposures authorized under § 615.5140(e)—§ 628.52(b)(3)(i);
• The effective portion of a hedge pair—§ 628.52(b)(3)(ii); and
• Non-significant equity exposures—§ 628.52(b)(3)(iii).

5. One Hundred Fifty-Percent (150%) Risk-Weighted Exposures

• An exposure to a sovereign entity that meet certain criteria (as discussed below)—§ 628.32(a) and Table 1;
• A sovereign exposure, if an event of sovereign default has occurred during the previous 5 years—§ 628.32(a)(6) and Table 1;
• An exposure to a foreign bank, if an event of sovereign default has occurred during the previous 5 years in the foreign bank’s home country—§ 628.32(d)(2)(iv) and Table 2;
• An exposure to a non-U.S. PSE that meets certain criteria (as discussed below)—§ 628.32(e)(2), (e)(3), (e)(5) and Tables 3 and 4;
• An exposure to a PSE, if an event of sovereign default has occurred during the previous 5 years in the PSE’s home country—§ 628.32(e)(6) and Tables 3 and 4;
• HVCRE exposures—§ 628.32(j); and
• The portion of a past due exposure that is not guaranteed or that is not secured by financial collateral (except for a sovereign exposure or a residential mortgage exposure, both risk-weighted as discussed above)—§ 628.32(k).

6. Six Hundred-Percent (600%) Risk-Weighted Exposures

• An equity exposure to an investment firm, provided that the investment firm meets specified conditions—§ 628.52(b).

7. One Thousand Two Hundred Fifty-Percent (1,250%) Risk-Weighted Exposures

• Certain high-risk securitization exposures, such as CEIO strips—§§ 628.41-628.45.

8. Past Due Exposures (90 Days or More Past Due or in Nonaccrual Status)

• One hundred (100) percent—residential mortgage exposures—§ 628.32(g);
• A System institution may assign a risk weight to the guaranteed portion of a past due exposure based on the risk weight that applies under § 628.36 if the guarantee or credit derivative meets the requirements of that section—§ 628.32(k)(2);
• A System institution may assign a risk weight to the portion of a past due exposure that is collateralized by financial collateral based on the risk weight that applies under § 628.37 if the financial collateral meets the requirements of that section—§ 628.32(k)(3); and
• One hundred fifty (150) percent—all other past due exposures—§ 628.32(k).

9. Conversion Factors for Off-Balance Sheet Items—§ 628.33

• Zero percent (0%)—the unused portion of a commitment that is unconditionally cancellable by the System institution;
• Twenty percent (20%)—

○ Commitment with an original maturity of 14 months or less that is not unconditionally cancellable by the System institution; and

○ Self-liquidating, trade-related contingent items that arise from the movement of goods, with an original maturity of 14 months or less;

• Fifty percent (50%)—

○ Commitments with an original maturity of more than 14 months that are not unconditionally cancellable by the System institution; and

○ Transaction-related contingent items, including performance bonds, bid bonds, warranties, and performance standby letters of credit;

• One hundred percent (100%)—

○ Guarantees;

○ Repurchase agreements (the off-balance sheet component of which equals the sum of the current fair values of all positions the System institution has sold subject to repurchase);

○ Credit-enhancing representations and warranties that are not securitization exposures;

○ Off-balance sheet securities lending transactions (the off-balance sheet component of which equals the sum of the current fair values of all positions the System institution has lent under the transaction);

○ Off-balance sheet securities borrowing transactions (the off-balance sheet component of which equals the sum of the current fair values of all non-cash positions the System institution has posted as collateral under the transaction);

○ Financial standby letters of credit; and

○ Forward agreements.

10. Over-the-Counter (OTC) Derivative Contracts—§ 628.34

The System institution would determine the risk-based capital requirement for a derivative contract by determining the exposure amount and then assigning a risk weight based on the counterparty or collateral. The exposure amount is the sum of current exposure plus potential future credit exposure (PFE). The current credit exposure is the greater of 0 or the mark-to-fair value of the derivative contract. The PFE is generally the notional amount of the derivative contract multiplied by a credit conversion factor for the type of derivative contract. Table 1 to proposed § 628.34 shows the credit conversion factors for derivative contracts.

11. Treatment of Cleared Transactions—§ 628.35

The proposal introduces a specific capital treatment for exposures to central counterparties (CCPs), including certain transactions conducted through clearing members by System institutions that are not themselves clearing members of a CCP. Proposed § 628.35 describes the capital treatment of cleared transactions and of default fund exposures to CCPs, including more favorable capital treatment for cleared transactions through CCPs that meet certain criteria.

12. Treatment of Guarantees—§ 628.36

The proposal would allow a System institution to substitute the risk weight of an eligible guarantor for the risk weight otherwise applicable to the guaranteed exposure. This treatment would apply only to eligible guarantees and eligible credit derivatives, and it would provide certain adjustments for maturity mismatches, currency mismatches, and situations where restructuring is not treated as a credit event. To be an eligible guarantee, the guarantee would be required to be from an eligible guarantor (as defined in the proposal) and would have to satisfy the definitional requirements of eligible guarantee.

13. Treatment of Collateralized Transactions—§ 628.37

The proposal allows System institutions to recognize the risk-mitigating benefits of financial collateral (as defined) in risk-weighted assets. In all cases, the System institution would be required to have a perfected, first priority interest in the financial collateral.

Where the collateral satisfies specified criteria, a System institution could use the simple approach—that is, it could apply a risk weight to the portion of an exposure that is secured by the fair value of financial collateral by using the risk weight of the collateral. There is a general risk weight floor of 20 percent.

For repo-style transactions, eligible margin loans, collateralized derivative contracts, and single-product netting sets of such transactions, a System institution could instead use the collateral haircut approach—that is, it could reduce the amount of exposure to be risk weighted (rather than substituting the risk weight of the collateral).

A System institution would be required to use the same approach for similar exposures or transactions.

14. Unsettled Transactions—§ 628.38

The proposal provides for a separate risk-based capital requirement for transactions involving securities, foreign exchange instruments, and commodities that have a risk of delayed settlement or delivery. The proposed capital requirement would not, however, apply to certain types of transactions, including cleared transactions that are marked-to-market daily and subject to daily receipt and payment of variation margin. The proposal contains separate treatments for delivery-versus-payment (DvP) and payment-versus-payment (PvP) transactions with a normal settlement period, and non-DvP/non-PvP transactions with a normal settlement period.

15. Securitization Exposures—§§ 628.41-628.45

The proposed rule introduces due diligence and other requirements for System institutions that own, originate, or purchase securitization exposures and introduces a new definition of securitization exposure. Under the proposed rule, a System institution that originates the underlying exposures included in a securitization could have a securitization exposure and, if so, would be subject to the requirements.

Note that mortgage-backed pass-through securities (for example, those guaranteed by FHLMC or FNMA) do not meet the proposed definition of a securitization exposure because they do not involve a tranching of credit risk. Rather, only those MBS that involve tranching of credit risk would be securitization exposures.

16. Equity Exposures—§§ 628.51-628.52

A System institution would apply a simple risk-weight approach (SRWA) to determine the risk weight for equity exposures that are not exposures to an investment fund.

17. Equity Exposures to Investment Funds—§ 628.53

The proposals described in this section would apply to equity exposures to investment funds such as mutual funds, but not to hedge funds or other leveraged investment funds. For exposures to investment funds (other than certain equity exposures authorized under § 615.5140(e), for which the risk-weighted asset amount is equal to their adjusted carrying value for the fund), a System institution must use one of three risk-weighting approaches: The full-look through approach; the simple modified look-through approach; or the alternative modified look-through approach.

18. Foreign Exposures—§ 628.32(a), (d), and (e), and Tables 1, 2, 3, and 4

Under the proposal a System institution would risk weight an exposure to a foreign government, foreign public sector entity (PSE), and a foreign bank based on the Country Risk Classification (CRC) that is applicable to the foreign government, or the home country of the foreign PSE or foreign bank. If a foreign country does not have a CRC, the risk weighting for its government, PSEs, and banks would depend on whether or not the country is a member of the Organization for Economic Cooperation and Development (OECD). A sovereign exposure would be assigned a 150-percent risk weight immediately upon determining that an event of sovereign default has occurred, or if an event of sovereign default has occurred during the previous 5 years.

The risk weights for foreign sovereigns, foreign banks, and foreign PSEs are shown in the tables below:

20. Disclosure Requirements—§§ 628.61-628.63 (Including Tables 1-10)

The proposed rule would require each System bank, generally on a quarterly basis, to make public disclosures related to its capital requirements. Disclosures would be required as follows:

Table 1—Scope of Application—would provide the basic context underlying regulatory capital calculations.

Table 2—Capital Structure—would provide summary information on the terms and conditions of the main features of regulatory capital instruments. Would also require disclosure of the total amount of CET1, tier 1, and total capital, with separate disclosures for deductions and adjustments to capital.

Table 3—Capital Adequacy—would provide information on a System bank’s approach for categorizing and risk-weighting its exposures, as well as the amount of total risk-weighted assets.

Table 4—Capital Conservation Buffer—would require a System bank to disclosure the capital conservation buffer, the eligible retained income and any limitations on capital distributions and certain discretionary bonus payments, as applicable.

Table 5—Credit Risk: General Disclosures—would require a System bank to disclose information pertaining to its general credit risk.

Table 6—General Disclosure for Counterparty Credit Risk-Related Exposures—would require a System bank to disclose information pertaining to its counterparty credit risk.

Table 7—Credit Risk Mitigation—would require a System bank to disclose information pertaining to credit risk mitigation.

Table 8—Securitization—would provide information to market participants on the amount of credit risk transferred and retained by a System bank through securitization transactions, the types of products involved in the System bank’s securitizations, the risks inherent in the System bank’s securitized assets, the System bank’s policies regarding credit risk mitigation, and the names of any entities that provide external credit assessments of a securitization.
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Securitization transactions in which the originating System bank does not retain any securitization exposure would be shown separately and would only be reported for the year of inception of the transaction.
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Table 9—Equities—would provide market participants with an understanding of the types of equity securities held by the System bank and how they are valued. Would also provide information on the capital allocated to different equity products and the amount of unrealized gains and losses.

Table 10—Interest Rate Risk for Non-Trading Activities—would require a System bank to provide certain quantitative and qualitative disclosures regarding the System bank’s management of interest rate risks.

12 CFR Part 607

12 CFR Part 614

12 CFR Part 615

12 CFR Part 620

12 CFR Part 628

For the reasons stated in the preamble, parts 607, 614, 615, 620, and 628 of chapter VI, title 12 of the Code of Federal Regulations are proposed to be amended as follows:

[FR Doc. 2014-19179 Filed 9-3-14; 8:45 am]

BILLING CODE 6705-01-P