On December 20, the Federal Reserve Board issued SR 13-23, which clarifies the Federal Reserve’s supervisory expectations when assessing a firm’s capital adequacy in certain circumstances when the risk-based capital framework may not fully capture the residual risks of a transaction. The letter states that, while the Federal Reserve generally views a firm’s engagement in risk-reducing transactions as a sound risk management practice, there are certain risk-reducing transactions for which the risk-based capital framework may not fully capture the residual risks that a firm faces on a post-transaction basis. The letter addresses two specific characteristics of risk transfer transactions that give rise to this concern: (i) a firm transfers the risk of a portfolio to a counterparty that is unable to absorb losses equal to the risk-based capital requirement for the risk transferred; or (ii) a firm transfers the risk of a portfolio to an unconsolidated, “sponsored” affiliate entity. The letter stresses that bank supervisors will strongly scrutinize risk transfer transactions that result in substantial reductions in risk-weighted assets, including in supervisors’ assessment of a firm’s overall capital adequacy, capital planning, and risk management through the Comprehensive Capital Analysis and Review. The Federal Reserve may in certain cases determine not to recognize a transaction as a risk mitigant for risk-based capital purposes. Supervisors will evaluate whether a firm can adequately demonstrate that the firm has taken into account any residual risks in connection with the transaction.