The existing riskbased capital requirements focus primarily on credit risk and do not impose explicit capital charges for interest rate, operational, or other risks. These risks, however, are implicitly covered by the existing riskbased capital rules. The riskbased capital charges proposed in this NPR continue the implicit coverage of risks other than credit risk. Moreover, the Agencies are not proposing revisions to the existing leverage ratio requirement (that is, the ratio of Tier 1 capital to total assets).\9\
\9\ 12 CFR 3.6(b) and (c) (OCC); 12 CFR part 208, appendix B and 12 CFR part 225, appendix D (Board); 12 CFR part 325.3 (FDIC); and 12 CFR 567.8 (OTS).

To ensure safety and soundness, the Agencies intend to closely monitor the level of riskbased capital at those banking organizations that choose to opt in to Basel IA. Any significant decline in the aggregate level of riskbased capital for these banking organizations may warrant modifications to the proposed riskbased capital rules.

Question 1: The Agencies welcome comments on all aspects of these proposals, especially suggestions for reducing the burden that may be associated with these proposals. The Agencies believe that a banking organization that chooses to adopt these proposals will generally be able to do so with data it currently uses as part of its credit approval and portfolio management processes. Commenters are particularly requested to address whether any of the proposed changes would require data that are not currently available as part of the organization's existing credit approval and portfolio management systems.

A. OptIn Proposal

In the Basel IA ANPR, the Agencies recognized that certain banking organizations might not want to assume the additional burden that might accompany a more risksensitive approach and might prefer to continue to apply the existing riskbased capital rules. Additionally, many commenters, particularly community bank respondents, favored an approach that would allow wellcapitalized banking organizations to remain under the existing riskbased capital rules. For these commenters, limiting regulatory burden was a higher priority than increasing the risk sensitivity of their riskbased capital charges. One group of midsize banking organizations recommended applying the proposed rules only to banking organizations with assets of $500 million or greater. Some commenters noted the risk of ``cherry picking'' in permitting a choice between the framework discussed in the Basel IA ANPR and the existing riskbased capital rules, or adoption of parts of each.

The Agencies are proposing that a nonBasel II banking organization may, if it chooses, adopt the revisions in this proposed rule. If a banking organization chooses to use these proposed capital rules, however, it would be required to implement them in their entirety. The Agencies are proposing to permit a banking organization to adopt these proposals by notifying its primary Federal supervisor. Before a banking organization decides to opt in to these proposals, the Agencies expect that the organization would review its ability to collect and utilize the information required and evaluate the potential impact on its regulatory capital. A banking organization that chooses to adopt these proposals (that is, opts in) would also be able to request returning to the existing capital rules by first notifying its primary Federal supervisor. In its review of such a request, the primary Federal supervisor would ensure that the riskbased capital requirements appropriately reflect the risk profile of the banking organization and the change is not for purposes of
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capital arbitrage. Further, the Agencies expect that a banking organization would not alternate between the existing and proposed riskbased capital rules. The Agencies would reserve the authority to require a banking organization to calculate its minimum riskbased capital requirements in accordance with this proposal or the existing riskbased capital rules.

Under this proposal, a nonBasel II banking organization could continue to calculate its riskbased capital requirements using the existing riskbased capital rules. In this case, the banking organization would not need to notify its primary Federal supervisor or take any other action. As noted, above, however, the Agencies would retain the authority to require a nonBasel II banking organization to use either the existing or the proposed riskbased capital rules if the banking organization's primary Federal supervisor determines that a particular capital rule is more appropriate for the risk profile of the banking organization.

Question 2: The Agencies seek comment on all aspects of the proposal to allow banks to opt in to and out of the proposed rules. Specifically, the Agencies seek comment on any operational challenges presented by the proposed rules. How far in advance should a banking organization be required to notify its primary Federal supervisor that it intends to implement the proposed rule? If a banking organization wishes to ``opt out'' of the proposed rule, what criteria should guide the review of a request to opt out? When should a banking
organization's election to opt in or opt out be effective? In addition, the Agencies seek comment on the appropriateness of requiring a banking organization to apply the proposed Basel IA capital rules based on a banking organization's asset size, level of complexity, risk profile, or scope of operations.

B. Increase the Number of Risk Weight Categories

The Agencies' existing riskbased capital rules contain five risk weight categories: Zero, 20, 50, 100, and 200 percent. Differentiation of credit quality among individual exposures is generally limited to these few riskweight categories. In the Basel IA ANPR, the Agencies suggested adding four new riskweight categories (35, 75, 150, and 350 percent) and invited comment on whether: (1) Increasing the number of riskweight categories would allow supervisors to more closely align capital requirements with risk; (2) the suggested additional risk weight categories would be appropriate; (3) the riskbased capital framework should include more riskweight categories than the four suggested; and (4) increasing the number of riskweight categories would impose unnecessary burden on banking organizations.

Commenters generally supported increasing the number of riskweight categories to enhance the overall risksensitivity of the riskbased capital rules. However, many commenters noted that adding too many categories could make the rules too complex. Several commenters argued that the 350 percent risk weight is too high and suggested that any new riskweight categories should be lower than 100 percent to reflect the lower risks associated with certain mortgages and other highquality assets. A few commenters suggested that the Agencies create a new 10 percent risk weight category to account for very lowrisk assets.

The Agencies agree with the commenters that increasing the number of riskweight categories would allow for greater risk sensitivity than the existing riskbased capital rules. Accordingly, the Agencies propose to add 35, 75, and 150 percent riskweight categories. The Agencies believe that adding a 150 percent risk weight category and expanding the use of the existing 200 percent risk weight category would allow for somewhat greater differentiation of credit risk among more risky exposures than is permitted by the existing capital rules. At the same time, for certain types of relatively lowrisk exposures, the existing riskbased capital charge may be higher than warranted. Therefore, the 35 and 75 percent risk weight categories provide an opportunity to increase the risk sensitivity of the regulatory capital charges for these exposures.

The Agencies agree that the credit risks covered by this NPR generally do not warrant a 350 percent category, and are not proposing to add this risk weight. Question 3: The Agencies seek comment on whether these or any other new risk weight categories would be appropriate. More specifically, the Agencies are interested in any comments regarding whether any categories of assets might warrant a risk weight higher than 200 percent and what risk weight might be appropriate for such assets. The Agencies also solicit comment on whether a 10 percent risk weight category would be appropriate and what exposures should be included in this risk weight category.

C. Use of External Credit Ratings to Risk Weight Exposures

The Agencies' existing riskbased capital rules permit the use of external credit ratings issued by a nationally recognized statistical rating organization (NRSRO) \10\ to assign risk weights to recourse obligations, direct credit substitutes (DCS), residual interests (other than a creditenhancing interestonly strip), and asset and mortgage backed securities.\11\ For example, AAA and AArated mortgagebacked securities \12\ are assigned to the 20 percent risk weight category while BBrated mortgagebacked securities are assigned to the 200 percent risk weight category. When the Agencies revised the riskbased capital rules to allow for the use of external credit ratings issued by an NRSRO for the types of exposures listed above, the Agencies acknowledged that such ratings could be used to determine the risk based capital requirements for other types of debt instruments, such as rated corporate debt.
\10\ An NRSRO is an entity recognized by the Division of Market Regulation of the Securities and Exchange Commission (SEC) as a nationally recognized statistical rating organization for various purposes, including the SEC's uniform net capital requirements for brokers and dealers 17 CFR 240.15c31). On September 29, 2006, the President signed the Credit Rating Agency Reform Act of 2006 (Reform Act) (Pub. L. 109291) into law. The Reform Act requires a credit rating agency that wants to represent itself as an NRSRO to register with the SEC. The Agencies may review their riskbased capital rules, guidance and proposals from time to time in order to determine whether any modification of the Agencies' definition of an NRSRO is appropriate.
\11\ Some synthetic structures may also be subject to the external rating approach. For example, certain creditlinked notes issued from a synthetic securitization are risk weighted according to the rating given to the notes. 66 FR 59614, 59622 (November 29, 2001).
\12\ The ratings designations (for example, ``AAA,'' ``BBB,'' ``A1,'' and ``P1''), are illustrative and do not indicate any preference for, or endorsement of, any particular rating agency description system.

In the Basel IA ANPR, the Agencies suggested expanding the use of NRSRO ratings to determine the riskbased capital charge for most categories of NRSROrated exposures, including sovereign and corporate debt securities and rated loans. The Agencies indicated, however, that they were considering retaining the existing riskbased capital treatment for U.S. government and agency exposures, U.S. government sponsored entity exposures, and municipal obligations. Tables 1 and 2 in the Basel IA ANPR matched ratings and possible corresponding risk weights for long and shortterm exposures. The Agencies requested comment on the use of other methodologies to assign risk weights to unrated exposures.

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Many commenters supported the use of external ratings in principle but noted that nonBasel II banking organizations' holdings of securities and loans generally are not rated. Thus, they suggested that the expansion of the use of NRSRO ratings would have little impact on these banking organizations. A few commenters also asserted that using NRSRO ratings might discourage lending to nonrated entities.

Many commenters argued that the risk weights suggested in the Basel IA ANPR were too high. In particular, many commenters said that the 350 percent and 200 percent risk weights for exposures rated BB+ and lower would be unnecessarily punitive. A few commenters also expressed concerns about NRSRO ratings generally. These commenters said that there are too few NRSROs to ensure adequate market discipline, NRSROs are inadequately supervised, and NRSRO ratings often react too slowly to crises.

A number of commenters suggested alternative methods for differentiating risk among commercial exposures and making the capital requirements for these exposures more risk sensitive. Many larger banking organizations suggested allowing an internal risk measurement approach to determine riskbased capital requirements. Some smaller banking organizations sought increased recognition of a variety of risk mitigation techniques, such as personal guarantees and collateral.

The Agencies acknowledge that expanding the use of external ratings may have little effect on the riskbased capital requirements for existing loan portfolios at most banking organizations. To the extent that assets in a banking organization's investment portfolio are rated, however, the Agencies believe that using external ratings will improve risk sensitivity of the capital charges for these assets. Furthermore, implementing broader use of external ratings would also provide a basis for expanding recognition of eligible guarantees and recognized collateral. Accordingly, the Agencies are proposing to expand the use of external ratings for purposes of determining the riskbased capital charge for certain externally rated exposures as described below in the sections on direct exposures, recognized collateral, and eligible guarantees.

An external rating would be defined as a credit rating that is assigned by an NRSRO, provided that the credit rating (1) fully reflects the entire amount of credit risk with regard to all payments owed to the holder and the credit risk associated with timely repayment of principal and interest; (2) is published in an accessible public form, for example, on the NRSRO's Web site and in financial media; (3) is monitored by the NRSRO; and (4) is, or will be, included in the issuing NRSRO's publicly available transition matrix.\13\ If an exposure has two or more external ratings, the banking organization must use the lowest assigned external rating to risk weight the exposure. If an exposure has components that are assigned different external ratings, a banking organization would be required to assign the lowest rating to the entire exposure. If a component is not externally rated, the entire exposure would be treated as unrated. \13\ A transition matrix tracks the performance and stability (or ratings migration) of an NRSRO's issued external ratings. i. Direct Exposures

The Agencies are proposing to use external ratings to risk weight (1) sovereign \14\ debt and debt securities, and (2) debt securities issued by and rated loans to nonsovereign entities including securities firms, insurance companies, bank holding companies, savings and loan holding companies, multilateral lending and regional development institutions, partnerships, limited liability companies, business trusts, special purpose entities, associations and other similar organizations. External ratings for direct exposures to sovereigns would be based on the external rating of the exposure or, if the exposure is unrated, on the sovereign's issuer rating. Direct exposures to nonsovereigns would be risk weighted based on the external rating of the exposure. For example, a banking organization would assign any AAArated debt security issued by a corporation, insurance company, or securities firm to the 20 percent risk weight category. The Agencies are, however, not proposing to permit the use of issuer ratings for nonsovereigns.
\14\ A sovereign is defined as a central government, including its agencies, departments, ministries, and the central bank. A soverign does not include state, provincial, or local governments, or commercial enterprises owned by a central government.

The risk weights for direct exposures are detailed in Table 1 (longterm exposures) and Table 2 (shortterm exposures) below. The Agencies are also proposing to replace the existing riskweight tables for externally rated recourse obligations, DCS, residual interests (other than a creditenhancing interestonly strip), and asset and mortgagebacked securities \15\ with the risk weights in Tables 1 and 2.\16\ This proposed treatment would apply to all externally rated exposures unless the banking organization uses a market risk rule.\17\ For a banking organization that uses a market risk rule, this treatment applies only to externally rated exposures held in the banking book. \15\ 12 CFR part 3, appendix A, section 4, Tables B and C (OCC); 12 CFR parts 208 and 225, appendix A, section III.B.3.c.i. (Board); 12 CFR part 325, appendix A, section II.B.5.(d) (FDIC); and 12 CFR 567.6(b) (OTS) (the Recourse Rule).
\16\ With the exception of the clarification of the definition of an external rating and the proposed riskbased capital charge for securitizations with early amortization features described in section F of this NPR, the Agencies are not proposing to make other changes to the existing riskbased capital rules for recourse obligations, DCS, and residual interests. See 12 CFR part 3, appendix A, section 4 (OCC); 12 CFR parts 208 and 225, appendix A, section III.B.3 (Board); 12 CFR part 325, appendix A, section II.B.5 (FDIC); and 12 CFR 567.6(b) (OTS) (Recourse Rule).
\17\ See 12 CFR part 3, appendix B (OCC); 12 CFR parts 208 and 225, appendix E (Board); and 12 CFR part 325 appendix C (FDIC). The Agencies issued an NPR that proposes revisions to the Market Risk rules. OTS does not currently have a market risk rule, but has proposed to add a new rule on this topic in the Market Risk NPR. See 71 FR 55958 (September 25, 2006).

The Agencies intend to retain the existing riskbased capital treatment for direct exposures to publicsector entities,\18\ the U.S. government and its agencies, U.S. governmentsponsored agencies, and depository institutions (U.S. and foreign) and for unrated loans made to nonsovereign entities. Exposures issued by these entities are not subject to Table 1 or 2.
\18\ Publicsector entities include states, local authorities and governmental subdivisions below the central government level in an Organization for Economic Cooperation and Development (OECD) country. In the United States, this definition encompasses a state, county, city, town, or other municipal corporation, a public authority, and generally any publiclyowned entity that is an instrument of a state or municipal corporation. This definition does not include commercial companies owned by the public sector. The OECDbased group of countries comprises all full members of the OECD, as well as countries that have concluded special lending arrangements with the International Monetary Fund (IMF) associated with the Fund's General Arrangements to Borrow.
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Table 1.Proposed Risk Weights Based on External Ratings for LongTerm Exposures Securitization Sovereign risk Nonsovereign exposure \1\ Longterm rating category Example weight (in risk weight risk weight percent) (in percent) (in percent) Highest investment grade rating........ AAA.................... 0 20 20 Secondhighest investment grade rating. AA..................... 20 20 20 Thirdhighest investment grade rating.. A...................... 20 35 35 Lowestinvestment grade ratingplus... BBB+................... 35 50 50 Lowestinvestment grade rating......... BBB.................... 50 75 75 Lowestinvestment grade ratingminus.. BBB................... 75 100 100 One category below investment grade.... BB+, BB................ 75 150 200 One category below investment grade BB.................... 100 200 200 minus.
Two or more categories below investment B, CCC................. 150 200 \1\ grade.
Unrated \2\............................ n/a.................... 200 200 \1\ \1\ A securitization exposure includes asset and mortgagebacked securities, recourse obligations, DCS, and residuals (other than a creditenhancing interestonly strip). For longterm securitization exposures that are externally rated more than one category below investment grade, shortterm exposures that are rated below investment grade, or any unrated securitization exposures, the existing riskbased capital treatment as described in the Agencies' Recourse Rule would be used.
\2\ Unrated sovereign exposures and unrated debt securities issued by nonsovereigns would receive the risk weight indicated in Tables 1 and 2. Other unrated exposures, for example, unrated loans to nonsovereigns, would continue to be risk weighted under the existing riskbased capital rules. Table 2.Proposed Risk Weights Based on External Ratings for ShortTerm Exposures Securitization Sovereign risk Nonsovereign exposure \1\ Shortterm rating category Example weight (in risk weight risk weight percent) (in percent) (in percent) Highest investment grade rating........ A1, P1............... 0 20 20 Secondhighest investment grade rating. A2, P2............... 20 35 3 Lowest investment grade................ A3, P3............... 50 75 75 Unrated \2\............................ n/a.................... 100 100 (\1\) \1\ A securitization exposure includes asset and mortgagebacked securities, recourse obligations, DCS, and residuals (other than a creditenhancing interestonly strip). For longterm securitization exposures that are externally rated more than one category below investment grade, shortterm exposures that are rated below investment grade, or any unrated securitization exposures, the existing riskbased capital treatment as described in the Agencies' Recourse Rule would be used.
\2\ Unrated sovereign exposures and unrated debt securities issued by nonsovereigns would receive the risk weight indicated in Tables 1 and 2. Other unrated exposures, for example, unrated loans to nonsovereigns, would continue to be risk weighted under the existing riskbased capital rules.

The proposed risk weights in Tables 1 and 2 are generally consistent with the historical default rates reported in the default studies published by NRSROs. The Agencies believe that the additional application of external ratings to the exposures specified above would improve the risk sensitivity of the capital treatment for those exposures. Furthermore, the Agencies believe that the revised risk weight tables for externally rated recourse obligations, DCS, residual interests (other than creditenhancing interest onlystrips), and asset and mortgagebacked securities would also better reflect risk than the Agencies' existing riskbased capital rules.

Under the proposal, the Agencies would retain their authority to reassign an exposure to a different risk weight on a casebycase basis to address the risk of a particular exposure.

ii. Recognized Financial Collateral

The Agencies' existing riskbased capital rules recognize limited types of collateral: (1) Cash on deposit; (2) securities issued or guaranteed by central governments of the OECD countries; (3) securities issued or guaranteed by the U.S. government or its agencies; (4) securities issued or guaranteed by U.S. governmentsponsored agencies; and (5) securities issued by certain multilateral lending institutions or regional development banks.\19\ In the past, the banking industry has commented that the Agencies should recognize a wider array of collateral types for purposes of reducing riskbased capital requirements.
\19\ The Agencies' rules for collateral transactions, however, differ somewhat as described in the Agencies' joint report to Congress. ``Joint Report: Differences in Accounting and Capital Standards among the Federal Banking Agences,'' 70 FR 15379 (March 25, 2005).

In the Basel IA ANPR, the Agencies noted that they were considering expanding the list of recognized collateral to include shortor long term debt securities (for example, corporate and asset and mortgage backed securities) that are externally rated at least investment grade by an NRSRO, or issued or guaranteed by a sovereign central government that is externally rated at least investment grade by an NRSRO. Consistent with the proposed treatment for direct exposures, the Basel IA ANPR suggested assigning exposures or portions of exposures collateralized by financial collateral to riskweight categories based on the external rating of that collateral. To use this expanded list of collateral, the Basel IA ANPR considered requiring a banking organization to have collateral management systems to track collateral and readily determine its realizable value. The Agencies sought comment on whether this approach for expanding the scope of recognized collateral would improve risk sensitivity without being overly burdensome.

Many commenters supported expanding the list of recognized collateral, but several also noted that using NRSRO ratings would have little effect on most community banks. Some commenters suggested reducing the risk weights applied to exposures secured by
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any collateral that is legally perfected and has objective methods of valuation or can be readily markedtomarket. Many commenters also stated that any collateral valuation and monitoring requirements likely would be too costly to benefit smaller community banks.

To increase the risk sensitivity of the existing riskbased capital rules, the Agencies are proposing to revise the list of recognized collateral to include a broader array of externally rated, liquid, and readily marketable financial instruments. The revised list would incorporate long and shortterm debt securities and securitization exposures that are:

a. Issued or guaranteed by a sovereign where such securities are externally rated at least investment grade by an NRSRO; or an exposure issued or guaranteed by a sovereign with an issuer rating that is at least investment grade; or

b. Issued by nonsovereigns where such securities are externally rated at least investment grade by an NRSRO.
Consistent with the Agencies' existing riskbased capital rules, the Agencies propose to continue to recognize collateral that is either issued or guaranteed by certain sovereigns. For nonsovereign exposures, however, the Agencies propose that the collateral itself must be externally rated investment grade or better to qualify as recognized collateral. The Agencies believe that this more conservative approach for recognizing nonsovereign collateral is appropriate and expect that any guarantee provided by a nonsovereign would be reflected in the external rating of the collateral.

A banking organization would assign exposures collateralized by financial collateral externally rated at least investment grade to the appropriate risk weight in Table 1 or 2 above. If an exposure is partially collateralized, a banking organization could assign the portions of exposures collateralized by the market value of the externally rated collateral to the appropriate risk weight category in Tables 1 and 2 of this NPR. For example, the portion of an exposure collateralized by the market value of a AAArated corporate debt security would be assigned to the 20 percent risk weight category. The Agencies are proposing a minimum risk weight of 20 percent for collateralized exposures except as noted below.

The Agencies have decided to retain their respective riskbased capital rules that govern the following collateral: Cash, securities issued or guaranteed by the U.S. government or its agencies, and securities issued or guaranteed by U.S. governmentsponsored agencies. The Agencies are also retaining the existing riskbased capital rules for exposures collateralized by securities issued or guaranteed by other OECD central governments that meet certain criteria.\20\ \20\ 12 CFR part 3, appendix A, section 3(a)(1)(viii) (OCC); and 12 CFR parts 208 and 225, appendix A, section III.C.1 (Board). iii. Eligible Guarantors

Under the Agencies' existing riskbased capital rules, the recognition of third party guarantees is limited to guarantees provided by central governments of OECD countries, U.S. government and governmentsponsored entities, publicsector entities in OECD countries, multilateral lending institutions and regional development banks, depository institutions and qualifying securities firms in OECD countries, depository institutions in nonOECD countries (shortterm claims), and central governments of nonOECD countries (local currency exposures only).

In the Basel IA ANPR, the Agencies suggested expanding the scope of eligible guarantors to include any entity whose longterm senior debt has been assigned an external credit rating of at least investment grade by an NRSRO. The applicable risk weight for guaranteed exposures would be based on the risk weights corresponding to the rating of the longterm debt of the guarantor.

Most commenters supported, in principle, expanding the list of eligible guarantors. However, many commenters noted that very few community and midsize banking organizations have exposures that are guaranteed by externally rated entities. Thus, many commenters suggested that this provision would have little impact unless the proposed revisions recognized more types of guarantees.

The Agencies believe that the range of eligible thirdparty guarantors under the existing riskbased capital rules is restrictive and ignores market practice. As a result, the Agencies are proposing to expand the list of eligible guarantors by recognizing entities that have longterm senior debt (without credit enhancement) rated at least investment grade by an NRSRO or, in the case of a sovereign, an issuer rating that is at least investment grade. Under this NPR, a recognized thirdparty guarantee would have to:
(1) Be written and unconditional, and, for a sovereign guarantee, be backed by the full faith and credit of the sovereign;
(2) Cover all or a pro rata portion of contractual payments of the obligor on the reference exposure; \21\
\21\ If an exposure is partially guaranteed, the pro rata portion not covered by the guarantee would be assigned to the risk weight category appropriate to the obligor, after consideration of collateral and external ratings.
(3) Give the beneficiary a direct claim against the protection provider;
(4) Be noncancelable by the protection provider for reasons other than the breach of the contract by the beneficiary;
(5) Be legally enforceable against the protection provider in a jurisdiction where the protection provider has sufficient assets against which a judgment may be attached and enforced; and
(6) Require the protection provider to make payment to the beneficiary on the occurrence of a default (as defined in the guarantee) of the obligor on the reference exposure without first requiring the beneficiary to demand payment from the obligor.

To be considered an eligible guarantor, a sovereign or its senior longterm debt (without credit enhancement) must be externally rated at least investment grade. Nonsovereigns must have longterm senior debt (without credit enhancement) that is externally rated at least investment grade. Under this proposal, a banking organization could assign the portions of exposures guaranteed by eligible guarantors to the proposed risk weight category corresponding to the external rating of the eligible guarantors' longterm senior debt in accordance with Table 1 above.

The Agencies would retain the existing riskweight treatment of exposures guaranteed by the U.S. government and its agencies, U.S. governmentsponsored agencies, publicsector entities, depository institutions in OECD countries, and depository institutions in nonOECD countries (shortterm exposures only).

Question 4: The Agencies solicit comment on all aspects of the proposed use of external ratings including the appropriateness of the risk weights, expanded collateral, and additional eligible guarantors. The Agencies also seek comment on whether to exclude certain externally rated exposures from the ratings treatment as proposed or to use external ratings as a measure for all externally rated exposures, collateral, and guarantees. Alternatively, should the Agencies retain the existing riskbased capital treatment for certain types of exposures, for example, qualifying securities firms? The Agencies are also interested in comments on all aspects of the scope of the terms sovereign, non
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sovereign, and securitization exposures. Specifically, the Agencies seek comment on the scope of these terms, whether they should be expanded to cover other entities, or whether any entities included in these definitions should be excluded.

iv. GovernmentSponsored Agencies

One area of particular interest to the Agencies is the risk weighting of exposures to U.S. governmentsponsored agencies, also commonly referred to as governmentsponsored entities (GSEs). The Agencies' existing riskbased capital regulations assign a 20 percent risk weight to exposures issued or guaranteed by GSEs. The Basel IA NPR proposes to retain this riskbased capital treatment. The Agencies are aware that there are various types of ratings that might increase the risk sensitivity of risk weights assigned to GSE exposures. For example, NRSROs rate the creditworthiness of shortterm senior debt, senior unsecured debt, subordinated debt and preferred stock of some GSEs. These ratings on individual exposures, however, are often based in part on the NRSROs' assessment of the extent to which the U.S. government might come to the financial aid of a GSE if necessary. In this context, and as indicated in the preamble to the Basel II NPR, the Agencies do not believe that risk weight determinations should be based on the possibility of U.S. government financial assistance, except for the financial assistance the U.S. government has legally committed to provide. The Agencies believe the existing approach has thus far met this objective. However, the Agencies also note that as part of the October 19, 2000 agreement with their regulator,\22\ both Fannie Mae and Freddie Mac agreed to obtain and disclose annually ratings that would ``assess the risk to the government, or the independent financial strength, of each of the companies.'' \23\
\22\ ``Freddie Mac and Fannie Mae Enhancements to Capital Strength, Disclosure and Market Discipline'', October 19, 2000 (agreement between the GSEs and the Office of Federal Housing Enterprise Oversight).

\23\ Ibid, p. 2.

In accordance with the agreement, Fannie Mae and Freddie Mac currently obtain and disclose separate ratings from two NRSROs ``Standard & Poor's (S&P) and Moody's Investors Service (Moody's). The S&P ``risk to the government rating'' uses the same scale as its standard corporate credit ratings. Currently, Fannie Mae and Freddie Mac both have a risk to the government issuer rating of AA from S&P, which is unchanged from the initial AA issuer rating that S&P initially provided in 2001. Moody's ``bank financial strength rating'' (BFSR) uses a scale of AE. In 2002, Moody's provided a BFSR of A to both GSEs. On March 28, 2005, Moody's downgraded Fannie Mae's BFSR to B+. Based on Moody's mapping of BFSRs to Moody's basic credit assessment ratings, A− is the equivalent of an Aa1 and B+ maps to an Aa2.

Both the risk to government rating and the BFSR (collectively, financial strength ratings) are issuer ratings that evaluate the financial strength of each GSE without respect to any implied financial assistance from the U.S. government. These financial strength ratings are published and monitored by the issuing NRSRO but they are not included in the NRSROs' transition matrices. These ratings are an indicator of each GSE's overall financial condition and safety and soundness and, thus, do not apply to any specific financial obligation or the probability of timely payment thereof.\24\ If the Agencies were to use these S&P and Moody's financial strength ratings to risk weight exposures to Fannie Mae and Freddie Mac in a manner similar to the use of external ratings for rated exposures as proposed in the Basel IA NPR, the current ratings would map to a 20 percent risk weight. \24\ Moody's and S&P's financial strength ratings would not meet the definition of an ``external rating'' as proposed in this NPR. Furthermore, the difficulty of defining an event of default and the lack of default data suggest that it would not be feasible to incorporate this type of rating into a transition matrix.

Question 5: The Agencies are considering whether to use financial strength ratings to determine risk weights for exposures to GSEs, where this type of rating is available, and are seeking comment on how a financial strength rating might be applied. For example, should the financial strength rating be mapped to the nonsovereign risk weights in Tables 1 and 2? Should these ratings apply to all GSE exposures including short and longterm debt, mortgagebacked securities, collateral, and guarantees? How should exposures to a GSE that lacks a financial strength rating be risk weighted? Are there any requirements in addition to publication and ongoing monitoring that should be incorporated into the definition of an acceptable financial strength rating?

Question 6: The Agencies also seek comment on whether to exclude certain other externally rated exposures from the ratings treatment as proposed or to use external ratings as a measure for additional externally rated exposures, collateral, and guarantees. Should the proposed ratings treatment be applicable for direct exposures to public sector entities or depository institutions? Likewise, should the proposed ratings treatment be applicable to exposures guaranteed by public sector entities or depository institutions, and to exposures collateralized by debt securities issued by those entities? D. Mortgage Loans Secured by a Lien on a OnetoFour Family Residential Property

i. First Lien Risk Weights

The Agencies' existing riskbased capital rules assign firstlien, onetofour family residential mortgages to either the 50 percent or 100 percent risk weight category. Most mortgage loans secured by a first lien on a onetofour family residential property (first lien mortgages) meet the criteria to receive a 50 percent risk weight.\25\ The broad assignment of most first lien mortgages to the 50 percent risk weight category has been criticized for not being sufficiently risk sensitive.
\25\ 12 CFR part 3 appendix A section 3(c)(iii) (OCC); 12 CFR parts 208 and 225 appendix A section III.C.3 (Board); 12 CFR part 325, appendix A, section II.C.3 (FDIC); and 12 CFR 567.1 (definition of ``qualifying mortgage loan'') and 12 CFR 567.6(a)(1)(iii)(B) (50 percent risk weight) (OTS).

In the Basel IA ANPR, the Agencies stated they were considering options to make the riskbased capital requirement for residential mortgages more risk sensitive while not unnecessarily increasing regulatory burden. One option was to base the capital requirement on loantovalue ratios (LTV), determined after consideration of private mortgage insurance (PMI). This option was illustrated by an LTV risk weight table that suggested risk weights of 20, 35, 50, and 100 percent.

Another option discussed in the Basel IA ANPR was to assign risk weights based on LTV in combination with an evaluation of borrower creditworthiness. Under this scenario, different ranges of LTV could be paired with specified credit assessments, such as credit scores. A first lien mortgage with a lower LTV made to a borrower with higher creditworthiness would receive a lower risk weight than a loan with higher LTV made to a borrower with lower creditworthiness.

The Agencies received many comments about how to risk weight first lien mortgages. Many commenters cautioned against rules that would be burdensome and costly to implement. Commenters generally supported the use of LTV and stated that use of LTV in assigning risk weights would not be overly burdensome because LTV
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information is collected when lenders originate mortgage loans.

Some commenters supported the use of a matrix based on LTV and a measure of creditworthiness, to further improve the risk sensitivity of the risk weights assigned to residential mortgage loans. They stated that this approach would address both collateral and borrower risk and would mirror current practices among mortgage lenders. Other commenters expressed concern about the potential burden of this approach, particularly for smaller banking organizations. Some commenters noted that certain credit assessment measures such as creditscoring models vary by region or credit reporting agency, and may harm lower income borrowers, borrowers without credit histories, and borrowers who have experienced unusual financial difficulties. Many of these commenters suggested that the use of credit scores as a measure of borrower creditworthiness be optional to alleviate the burden for some smaller banking organizations.

To increase the risk sensitivity of the existing riskbased capital rules while minimizing the overall burden to banking organizations, the Agencies are proposing to risk weight first lien mortgages based on LTV. LTV is a meaningful indicator of potential loss and the likelihood of borrower default. Consequently, under this proposal a banking organization would assign a risk weight for a first lien mortgage, including mortgages held for sale and mortgages held in portfolio as outlined in Table 3.
Table 3.Proposed LTV and Risk Weights for 14 Family First Liens Risk weight LoantoValue ratios (in percent) (in percent) 60 or less................................................. 20 Greater than 60 and less than or equal to 80............... 35 Greater than 80 and less than or equal to 85............... 50 Greater than 85 and less than or equal to 90............... 75 Greater than 90 and less than or equal to 95............... 100 Greater than 95............................................ 150

The Agencies believe the implementation of this proposed approach would not impose a significant burden on banking organizations because LTV information is readily available and is commonly used in the underwriting process.

The Agencies believe that the use of LTV would enhance the risk sensitivity of regulatory capital but it remains a fairly simple measurement of risk. Use of LTV in risk weighting first lien mortgages does not substitute for, or otherwise release a banking organization from, its obligation to have prudent loan underwriting and risk management practices that are consistent with the size, type, and risk of a mortgage product. Through the supervisory process, the Agencies would continue to ensure that banking organizations engage in prudent underwriting and risk management practices consistent with existing rules, supervisory guidance, and safety and soundness. The Agencies would continue to reserve the authority to require banking organizations to hold additional capital where appropriate.

In general, Table 3 would apply to first lien mortgages. The Agencies would maintain their respective riskbased capital criteria for a first lien mortgage (for example, prudent underwriting) to receive a risk weight less than 100 percent.\26\ Table 3 would not apply to loans to builders secured by certain presold properties, which are subject to a statutory 50 percent risk weight.\27\ Other loans to builders for the construction of residential property would continue to be subject to a 100 percent risk weight. The Agencies would maintain their respective capital treatment for a onetofour family residential mortgage loan to a borrower for the construction of the borrower's own home.\28\ Question 7: The Agencies seek comment on all aspects of using LTV to determine the risk weights for first lien mortgages.
\26\ 12 CFR part 3 appendix A, section 3(3)(iii) (OCC); 12 CFR Parts 208 and 225, appendix A, section III.C.3 (Board); 12 CFR part 325, appendix A, section II.C.3 (FDIC); and 12 CFR 567.1 (definition of ``qualifying mortgage loan'') and 12 CFR 567.6(a)(1)(iii)(B) (50 percent risk weight) (OTS).
\27\ This statutory risk weight applies to loans to builders secured by onetofour family residential properties with
substantial project equity for the construction of onetofour family residences that have been presold under firm contracts to purchasers who have obtained firm commitments for permanent qualifying mortgage loans and have made substantial earnest money deposits. See Resolution Trust Corporation Refinancing,
Restructuring, and Improvement Act of 1991, Pub. L. 102233, Sec. 618(a), 105 Stat. 1761, 178991 (codified at 12 U.S.C. 1831n note (1991)).
\28\ 12 CFR part 3 appendix A, section 3(3)(iv) (OCC); 12 CFR parts 208 and 225, appendix A, section III.C.3. (Board); 12 CFR part 325, appendix A, section II.C.3 (FDIC); and 12 CFR 567.1 (definition of ``qualifying mortgage loan'') (OTS).

The Agencies' existing riskbased capital rules place certain privatelyissued mortgagebacked securities that do not carry the guarantee of a government or a governmentsponsored entity (for example, unrated senior positions) in the 50 percent risk weight category, provided the underlying mortgages would qualify for a 50 percent risk weight. The Agencies intend to continue to risk weight these privatelyissued mortgagebacked securities using the risk weights assigned to underlying mortgages under the Agencies' existing capital rules. Question 8: The Agencies seek comment on this treatment and other methods for riskweighting these privatelyissued mortgage backed securities, including the appropriateness of assigning risk weights to these securities based on the risk weights of the underlying mortgages as determined under Table 3.

While the Agencies are not proposing to use LTV and borrower creditworthiness to risk weight mortgages, the Agencies continue to evaluate approaches that would consider borrower creditworthiness in risk weighting first lien mortgages. One such approach could use LTV and a measure of borrower creditworthiness to assign risk weights in a manner similar to that shown in Table 3A below. Table 3A would assign a lower risk weight to mortgages with a lower LTV that are underwritten to borrowers with a stronger credit history and a higher risk weight to mortgages with a higher LTV that are underwritten to borrowers with a weaker credit history.
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Table 3A.Illustrative RiskWeight Ranges for LTV and Credit History for 14 Family [First liens] First lien mortgages Illustrative risk weight ranges Credit history Credit history Credit history LoantoValue ratios (in percent) group 1 (in group 2 (in group 3 (in percent) percent) percent) 60 or less...................................................... 2035 2035 2035 Greater than 60 and less than or equal to 80.................... 2035 2035 3575 Greater than 80 and less than or equal to 90.................... 2050 3575 75150 Greater than 90 and less than or equal to 95.................... 2050 50100 100200 Greater than 95................................................. 3575 50100 150200

Table 3A presents three broad categories of relative credit performance (credit history groups). The Agencies would determine the credit history groups using default odds.

FOR FURTHER INFORMATION CONTACT

OCC: Nancy Hunt, Risk Expert, (202) 8744923; or Kristin Bogue, Risk Expert, (202) 8745411, Capital Policy Division; Ron Shimabukuro, Special Counsel, or Carl Kaminski, Attorney, Legislative and Regulatory Activities Division, (202) 8745090; Office of the Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219.

Board: Thomas R. Boemio, Senior Project Manager, Policy, (202) 452 2982; Barbara Bouchard, Deputy Associate Director, (202) 4523072; William Tiernay, Supervisory Financial Analyst (202) 8727579; or Juan C. Climent, Supervisory Financial Analyst, (202) 8727526, Division of Banking Supervision and Regulation; or Mark E. Van Der Weide, Senior Counsel, (202) 4522263, Legal Division. For the hearing impaired only, Telecommunication Device for the Deaf (TDD), (202) 2634869.