The New Basel Capital Accord - Trading Book Review (PDF)€¦ · slaughter and may Prudent...

The New Basel Capital AccordTrading Book Review

August 2005

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contents

Page No.

Introduction 1

Overview 2

Counterparty Credit Risk and Cross-Product Netting 3

Applicability of the Different Methods 3

Netting and Netting Sets 4

Cross-Product Netting Rules 4

Current Exposure Method (CEM) 6

The Standardised Method (SM) 7

Internal Models Method (IMM) 9

Treatment of Double Default Risk 11

Introduction 11

Eligible Protection Providers 12

Requirements in Respect of Obligors and Obligations 13

Forms of Protection 13

Specific Requirements 15

Calculation of the Capital Requirement 15

Short-Term Maturity Adjustment 16

Introduction 16

Transactions Eligible for the Short-Term Maturity Adjustment 16

Transactions Eligible Subject to National Discretion 17

Other Changes to the Trading Book 18

Boundary Between the Trading Book and Banking Book 18

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Prudent Valuation Guidance 19

Trading Book Treatment of Specific Risk 19

Internal VaR Models and the Trading Book 20

Failed Trades and non-DvP Transactions 22

Delivery versus Payment Transactions 22

Non-Delivery versus Payment Transactions 22

1 slaugh ter and may

introduction

In July 2005 the Basel Committee on Banking Supervision published the outcome of its review of capital requirements for banks in respect of proprietary trading activities (the “Trading Book Review”)1. The intention is to bring the rules set out in the 1995 Market Risk Amendment up to date, and to align the regulatory treatment with the new rules for credit risk set out in the New Basel Capital Accord. It is expected to be implemented at the same time as the New Basel Capital Accord.

The main changes made by the Trading Book Review are :-

> a new treatment for counterparty risk on over-the-counter (OTC) derivatives, repurchase agreements and securities financing transactions;

> the recognition of double-default effects for certain transactions benefiting from credit risk protection under a guarantee or a credit derivative;

> a short-term maturity adjustment for banks applying the internal ratings-based (IRB) approach;

> changes to the treatment of specific risk; and

> the adoption of a specific capital treatment for unsettled and failed transactions.

At the same time the European Commission has consulted on changes to the draft Capital Requirements Directive in order to implement the Trading Book Review at the same time as the New Basel Capital Accord. It is the intention that this will be done without the need for a second directive in order to meet the implementation deadline at the end of 2006. The proposals are accordingly expected to be incorporated into the directive as a single bloc of amendments at the European Parliament plenary session in September 2005.

A guide to the New Basel Capital Accord is available from Slaughter and May.

IMPORTANT NOTE: This Memorandum is intended to provide a guide to certain aspects of the Trading Book Review. It should not be relied upon as a substitute for legal advice which should be sought as required.

Should you require further information or advice, please contact your usual advisor at Slaughter and May or :-

Ruth Fox 020 7090 3001 Charles Harvey-Kelly 020 7090 3053 Sanjev Warna-kula-suriya 020 7090 3100 Jan Putnis 020 7090 3211 John Crosthwait 020 7090 3416 Tolek Petch 020 7090 3006

© Slaughter and May, August 2005

1 The Application of Basel II to Trading Activities and the Treatment of Double Default Effects, July 2005 available at http://www.bis.org/publ/bcbs111.htm.


overview

In June 2004 the Basel Committee on Banking Regulation (the “Basel Committee”) published the International Convergence of Capital Measurement and Capital Standards, known as the New Basel Capital Accord or Basel II (the “New Accord”). The New Accord seeks to improve on the 1988 Capital Accord by aligning regulatory capital requirements more closely to the underlying risks that banks face. In addition, the New Accord is intended to promote a forward-looking approach to capital supervision, encouraging banks to identify the risks they face and to develop their ability to manage and mitigate those risks.

On publication of the New Accord, the Basel Committee made clear its intention to maintain a dialogue with banks to ensure that the new framework keeps pace with, and can be applied to, ongoing developments in the financial services sector. Two areas were identified where work was required. First, how to apply the revised framework to proprietary trading activities. Secondly, finding a prudentially sound treatment under the New Accord for “double default risk”. This refers to the fact that the risk of both a borrower and a provider of credit protection defaulting may be substantially lower than the risk of only one of the parties defaulting.

Given the interest of banks and securities firms in these issues, the Basel Committee worked together with the International Organization of Securities Commissions (IOSCO) and industry representatives. A consultation paper was published in April 2005, leading to the adoption of final rules in July 2005. The Trading Book Review addresses the following topics :-

> counterparty credit risk for OTC derivatives, repo-style and securities financing transactions;

> recognition of cross-product netting arrangements for proprietary trading activities;

> the treatment of double default effects for transactions protected by a guarantee or credit derivative;

> a short-term maturity adjustment;

> improvements to the trading book regime, especially with respect to the treatment of specific risk; and

> a specific capital treatment for failed transactions and transactions that are not settled through a delivery versus payment (DvP) framework.

The Basel Committee recognises that while the proposals are designed to be applied to banks and banking groups, national supervisors may decide to apply them more widely to investment firm groups, or to groups containing banks and investment firms. The European Commission has proposed that the rules apply to such groups.


counterparty credit risk and cross-product netting

The treatment of counterparty credit risk (CCR) arising from OTC derivatives is currently derived from an amendment to the 1988 Basel Accord. This treatment is known as the current exposure method (CEM) and is based on the replacement cost of transactions with positive current value plus an add-on to reflect potential future exposure. The add-on is calculated by applying a weighting factor to the notional principal amount of the underlying book. Transactions that are out of the money will have generated losses accounted for through the profit and loss account. As such transactions have no monetary value, there is no exposure and no counterparty credit capital charge.

The Trading Book Review contains three methods for calculating the exposure at default (EAD) for transactions involving counterparty credit risk in the banking or trading books under the revised framework. These are :-

> the existing CEM;

> a standardised method (SM); and

> an internal models method (IMM) that uses the concept of expected positive exposure (EPE).

The three methods are intended to represent different points along a continuum of sophistication in risk management practices and are intended to provide incentives for banks to improve their management of counterparty credit risk by adopting more sophisticated practices.

Applicability of the Different Methods

The Trading Book Amendment distinguishes between OTC derivative transactions and securities financing transactions (securities borrowing and lending, repurchase and reverse repurchase agreements, buy-sells, securities margin lending and long settlement trades).

Securities financing transactions are treated by the New Accord as collateralised transactions. The New Accord currently contains four alternative methods for assessing the capital requirement in respect of such transactions : (1) the simple approach to collateral, (2) the comprehensive approach to collateral with supervisory “haircuts”, (3) the comprehensive approach to collateral where the bank itself determines the appropriate haircut and (4) an approach using value at risk (VaR) models. These are considered further in the Slaughter and May client publication – The New Basel Capital Accord, 3rd edition.

Given the existence of these approaches, the only additional method available under the Trading Book Amendment for securities financing transactions is the internal models method (IMM). The current exposure method (CEM) and the standardised method (SM) are not available. For OTC derivatives, in contrast, all three methods will be available.


Netting and Netting Sets

The capital requirements for OTC derivatives and securities financing transactions are calculated based on the basis of the net exposure, more specifically across a “netting set”. A netting set is a group of transactions with a single counterparty subject to a legally enforceable bilateral netting arrangement and permitted to be netted under the New Accord.

The New Accord recognises bilateral netting within certain product categories, namely OTC derivatives, repo-style transactions, and on-balance sheet loans/deposits. However, netting across these product categories is not recognised. The legal and operational requirements for netting are specified in the New Accord. Basically, they require that the agreements are legally enforceable in each relevant jurisdiction. For repo-style transactions, for example, the netting agreement must :-

> provide the non-defaulting party with the right to terminate and close out in a timely manner all transactions under the agreement;

> provide for the netting of gains and losses on transactions (including the value of any collateral) terminated and closed out under it so that a single net amount is owed by one party to the other;

> allow for the prompt liquidation or set off of collateral upon an event of default; and

> be legally enforceable in each relevant jurisdiction upon the occurrence of an event of default regardless of the counterparty’s insolvency or bankruptcy. Legal enforceability should be supported by a legal opinion.

Multilateral netting, or cross-affiliate netting, is not recognised for regulatory capital purposes due to doubts as to its enforceability, especially in insolvency2.

Cross-Product Netting Rules

During consultations, industry representatives argued that recognition should be recognised across product categories, i.e. netting among different types of securities financing transactions and netting securities financing transactions against OTC derivatives. Consultations with the financial services industry suggested that legal and operational practices are relatively consistent across different types of transactions and that advances have been made in the legal framework for netting across OTC derivatives and securities financing transactions. The Basel Committee considers that while most banks’ systems do not currently measure and manage credit risk across OTC derivatives and securities financing transactions, the objectives of the revised framework’s “use test” under Pillar 1, and the supervisory review standards set out in Pillar 2, can be met in due course. The result has been the adoption of the cross-product netting rules.

2 In the United Kingdom the House of Lords has held multilateral netting to be ineffective in a winding-up: British Eagle v. Compagnie Nationale Air France [1975] 1 W.L.R. 758.


The Basel Committee does not consider that the requirements are met at the present and further work will be necessary to obtain the requisite legal certainty as to enforceability of cross-product netting in insolvency. The rules only apply to netting across different types of transactions; the netting of particular types of transactions remains subject to the netting rules set out in the New Accord (see above).

The cross-product netting rules will only be available to banks that apply the internal models method (IMM) to counterparty credit risk. Banks using the CEM, the standardised method or one of the simpler methods under the New Accord for securities financing transactions will not be able to recognise cross-product netting.

Cross-product netting is subject to a legally valid bilateral netting agreement that meets the requirements set out below. The bank must also have satisfied any prior approval, or other requirements, that its national supervisor determines for the purposes of recognising a cross-product netting arrangement.

Banks must have a written bilateral netting agreement with the counterparty that creates a single legal obligation covering all included bilateral master agreements and transactions with the result that the bank would have either a claim to receive, or obligation to pay, only the net sum of the positive and negative (1) close-out values of any included individual master agreements and (2) mark-to-market values of any included individual transactions (the “cross-product net amount”), in the event a counterparty fails to perform due to any of the following : default, bankruptcy, liquidation or similar circumstances.

The bank must have written and reasoned legal opinions that conclude with a high degree of certainty that, in the event of a legal challenge, the relevant courts or administrative authorities would find the firm’s exposure under the cross-product netting arrangement to be the cross-product net amount under the laws of all relevant jurisdictions. In reaching this conclusion, the legal opinions must address the validity and enforceability of the entire cross-product netting arrangement under its terms and the impact of the cross-product netting arrangement on the material provisions of any included bilateral master agreement. The laws of “all relevant jurisdictions” are :-

> the law of the jurisdiction in which the counterparty is incorporated and, if the foreign branch of a counterparty is involved, the law of the jurisdiction in which the branch is located;

> the law that governs the individual transactions; and

> the law that governs any contract or agreement necessary to effect the netting.

Legal opinions must be generally recognised as such by the legal community in the firm’s home country and address all relevant issues in a reasoned manner.


The bank must have internal procedures to verify that, prior to including a transaction in a netting set, the transaction is covered by legal opinions that meet the above criteria. The bank must also undertake to update the legal opinions to ensure continuing of enforceability of the cross-product netting arrangement. The cross-product netting arrangement must not include a walkaway clause. This is a clause which permits a non-defaulting counterparty to make only limited payments, or no payment at all, to the defaulting party, even if it is a net creditor.

The rules provide that in the interests of comity, particularly for banks that operate in multiple jurisdictions, supervisors recognising cross-product netting will communicate the recognition of such arrangements to the appropriate home/host supervisor and to other supervisors.

Current Exposure Method (CEM)

The 1995 Market Risk Amendment permits the calculation of capital based on the positive value of those contracts that are in the money, together with an “add-on” to reflect the volatility of the exposure. The capital charge is calculated as follows :-

Counterparty Capital Charge = [(RC + add-on) – volatility adjusted collateral] x Risk Weight x 8%

Where :-

RC = current replacement cost;

Add-on = the estimated amount of potential future exposure calculated under the 1988 Accord (as amended);

volatility adjusted collateral = the value of collateral as specified in the New Accord; and

Risk Weight = the risk weight of the counterparty.

Under the CEM, exposure amount or EAD is equal to [(RC + add-on) – volatility adjusted collateral]. As mentioned above, it is only available for OTC derivative transactions.

The add-ons specified by the 1988 Capital Accord, as amended, continue to apply.

Interest Rates

FX and Gold

Equities Precious Metals Except Gold

Other Commodities

One year or less 0.0% 1.0% 6.0% 7.0% 10.0%

Over one year to five years

0.5% 5.0% 8.0% 7.0% 12.0%

Over five years 1.5% 7.5% 10.0% 8.0% 15.0%


The Standardised Method (SM)

The standardised method is intended to provide a more risk-sensitive way of calculating the counterparty risk charge on OTC derivatives transactions than the CEM, while being relatively simple to calculate. The standardised method makes a number of simplifying assumptions. For example, counterparty credit risk exposures are expressed in risk positions that reference short-term changes in valuation parameters (e.g. modified duration for debt instruments, delta values for options). It also assumes that the positions are open under a short-term forecasting horizon and are unchanged throughout that horizon. There is no recognition of diversification effects.

Under the standardised method, the exposure amount represents the product of :-

> the larger of the net current market value or the “supervisory EPE” multiplied by

> a scaling factor, termed beta (β).

EPE is the expected positive exposure and is the time-weighted average of individual expected exposures estimated for a given forecasting horizon of one year. The supervisory EPE has two characteristics: (1) for netting sets that are deeply in the money, the EPE is determined by the current market value of the netting set and (2) for netting sets that are at the money, the current market value is not relevant, and counterparty credit risk is driven only by the potential change in the market value of the transactions. Neither of these features are applicable in the CEM.

The second factor, beta, implicitly conditions the exposure amount or exposure at default (EAD) on a “bad” state of the economy. It is also intended to address stochastic dependency of the market values of exposures across counterparties, and to cover estimation and modelling error. The beta factor is also intended to provide an incentive for banks to choose the internal models method over the standardised method, particularly if a bank’s derivative transactions are diversified and not narrowly focused on certain risk areas. Beta is set at 1.4 providing a 40% upward scaling factor.

Under the standardised method, the supervisory EPE is determined using a mapping technique that is employed in market risk modelling. OTC derivative transactions are mapped to risk positions that represent certain drivers of potential change in value. For example, a foreign exchange swap is mapped to a foreign exchange risk position and one interest rate risk position in each of the currencies involved.

Risk positions in the same category (e.g. currencies, remaining maturities and market factors) that arise from transactions within the same netting set form a “hedging set”. Within each hedging set, offsets are fully recognised - only the net amount of all risk positions within a hedging set is relevant for the exposure amount or EAD.

The hedging sets are designed to capture general market risk. However, with respect to interest rates, there is a differentiation based on specific risk (i.e. the risk of issuer default). There is also a differentiation with regard to the type of reference rate used – those based on sovereign issued


instruments as opposed to those based on non-sovereign issued instruments. With respect to equities, price changes across issuers are too different to permit netting at a national equity index level. Therefore, netting will be recognised only at the level of individual issuers. Interest rate derivatives, foreign exchange derivatives and the payment leg of equity and commodity derivatives are subject to interest rate risk. The sensitivity to interest rate changes differs with the remaining maturity of the payments due. For floating rate notes and floating rate legs of interest swaps, the time to the next adjustment of the interest rate to the reference rate takes the place of the remaining maturity.

Risk positions that reflect long positions arising from transactions with linear risk profiles carry a positive sign, while short positions carry a negative sign. Positions with non-linear risk profiles are represented by their delta-equivalent notional values. As a result, institutions using the standardised method must be capable of calculating such delta-equivalent notional values (this is the product of the first partial derivative of an option valuation formula multiplied by the notional principal of the contract). For this purpose, the standardised method relies on instrument models that are recognised under the rules for market risk, i.e. on instrument models recognised by supervisors under the standardised approach for market risk, or on models that form part of recognised internal models for market risk. The use of delta-equivalent notional values for options means that sold options enter the calculation of risk positions. This is different from the CEM, which includes only purchased options.

The standardised method captures simple directional risk, but not basis risk. To compensate for this omission, limitations on the recognition of offsets for positions of opposite sign are employed. This is done by limiting allowable hedging sets.

Under the standardised method the EAD or exposure amount is to be calculated as follows :-

exposure amount or EAD = β. max(CMV - CMC;ΣΣRPTij

- ΣRPClj

xCCFj )

j i

where :-

CMV = current market value of the portfolio of transactions within the netting set with a counterparty gross of collateral, i.e. CMV = ΣCMV

i i

, where CMVi is the current market value of transaction i.

CMC = current market value of the collateral assigned to the netting set, i.e., CMC = ΣCMCl

l,

where CMCl is the current market value of collateral l.

i = index designating transaction.

l = index designating collateral.

j = index designating supervisory hedging sets. These hedging sets correspond to risk factors for which risk positions of opposite sign can be offset to yield a net risk position on which the exposure measure is then based.


RPTij = Risk position from transaction i with respect to hedging set j.

RPClj = Risk position from collateral l with respect to hedging set j.

CCFj = Supervisory credit conversion factor with respect to the hedging set j.

β = Supervisory scaling parameter.

Collateral received from a counterparty has a positive sign; collateral posted to a counterparty has a negative sign.

Internal Models Method (IMM)

This is the most sophisticated method available and can be used for calculating counterparty risk charges for securities financing transactions and OTC derivatives. The internal models method is based upon the expected positive exposure (EPE), like the standardised approach. However, under the IMM banks will be able to apply their own internal models to calculate EPE rather than relying on supervisory estimates. However, to address concerns that the EPE might not, on its own, capture all the risks it is multiplied by a scaling factor, alpha (α).

EAD = α x Effective EPE

The alpha multiplier provides a means of conditioning internal estimates of EPE on a “bad” state of the economy consistent with the determination of credit risk under the New Accord (as with beta under the standardised method). In addition, it acts to adjust internal EPE estimates for both correlations of exposures across counterparties exposed to common risk factors and a possible lack of granularity across a firm’s counterparty exposures. Alpha is set at 1.2 representing a 20% scaling factor, which is half that for the standardised method.

Effective EPE is calculated using the time profile of estimated effective exposure (EE) for a netting set. “Effective EE” is defined recursively as :-

Effective EEtk = max(Effective EE

tk-1, EE

tk),

where exposure is measured at future dates t1, t2, t3, … and Effective EEt0

equals current exposure.

“Effective EPE” is the average Effective EE during the first year of future exposure. If all contracts in the netting set mature before one year, EPE is the average of expected exposure until all contracts in the netting set mature. It is computed as a weighted average of Effective EE :-

Σk = 1

min(1year, maturity)

Effective EPE = Effective EEtk

x Δtk

In the figure below, the time profile of Effective EE is the dashed line. Effective EPE is the average of Effective EE and is represented by the solid straight line.


0 0.25 0.5 0.75 1

Time (years)

Figure 2CCR Effective EE Profile & Effective EPE

Expo

sure

Effective EPEEffective EE

EE

EPE

Effective EPE will always lie somewhere between EPE and peak EE. For upward sloping EE profiles, Effective EPE will equal EPE. For downward sloping profiles, Effective EPE will equal peak EE. In general, the earlier that EE peaks, the closer Effective EPE will be to peak EE; the later EE peaks, the closer Effective EPE will be to EPE. Supervisors recognise that banks could, in the future, take account of roll over in their EPE models.

Under the IMM, a measure that is more conservative than Effective EPE for every counterparty (i.e. a measure based on peak exposure) can be used in place of Effective EPE with prior approval of the national supervisor (e.g. for repo-style transactions, a counterparty VaR model as described in the New Accord).

Like corporate loan exposures with maturity (M) greater than one year, counterparty exposure on netting sets with maturity greater than one year is susceptible to changes in economic value that stem from a deterioration in the counterparty’s creditworthiness short of default. Supervisors will therefore require a maturity adjustment, similar to that in the New Accord for the advanced IRB approach. However, the formula used to compute M for netting sets with maturity greater than one year is different from that employed in the New Accord to reflect how counterparty credit exposures change over time.

If the netting set is subject to a margin agreement, and the internal model captures the effects of margining when estimating EE, the model’s EE measure may be used directly to calculate EAD. Supervisors recognise that, for certain margined netting sets, estimating Effective EE at the end of the margin period of risk may provide a conservative proxy to estimate Effective EPE over a one-year forecasting horizon. In the supervisory approval of the internal model, such a result would have to be demonstrated by the bank only out to the margin period of risk to be accepted. If the internal model does not fully capture the effects of margining, a method is proposed that will provide some benefit, in the form of a smaller EAD for margined counterparties. Although this method will be permitted, supervisors expect banks that make extensive use of margining to develop the modelling capacity to measure the impact of margining on EE.

Banks with more advanced systems may, subject to meeting operational requirements, seek permission to use their own estimates of the alpha scaling factor subject to a floor of 1.2, where alpha equals the ratio of economic capital from a full simulation of counterparty exposure across counterparties (numerator) and economic capital based on EPE (denominator).


treatment of double default risk

The reduction in risk provided by credit protection (an eligible guarantee or a credit derivative) is recognised in the New Accord through a substitution approach. This means that, in the standardised approach, a bank may substitute the risk weight of the protection provider for that of the obligor. Under the IRB approaches the probability of default (PD) or loss given default (LGD) of the obligor may be revised, subject in both instances to the derived risk weight being no lower than that of a comparable direct exposure to the protection provider. Under these conditions the maximum capital benefit that might be obtained through a hedge is equivalent to the reduction in the capital requirement through replacing the exposure to the original obligor with one to the protection provider. The New Accord does not, therefore, fully reflect the additional benefit obtained from the presence of credit protection, as the underlying obligor and the protection provider must both default for a loss to be incurred (double default). This led to prolonged discussion between the Basel Committee and the industry of the circumstances in which recognition should be given to this double default effect.

Introduction

The proposals on double default risk apply in both the trading book and the banking book. However, they will only apply to banks that use the foundation or advanced IRB approach. The reason for excluding banks on the standardised approach is stated to be the difficulty in assessing an appropriate treatment for unrated corporate exposures (which are assigned a cross-the-board 100% counterparty risk weight under the New Accord). The double default treatment is not compulsory, so that banks that consider the costs involved in applying it to be excessive may instead apply the substitution approach.

Under no circumstances are double default effects allowed to be recognised where an aspect of the protection has already been incorporated through an adjusted PD or LGD to reflect the substitution approach or the internal/external rating (as might be the case for some structured finance transactions).

Although double default will be recognised in certain cases, there will be no recognition of double recovery (i.e. recovery both under the guarantee/credit derivative and from the underlying obligor). The Basel Committee gives three reasons :-

> there is considerable doubt as to whether double recovery may ever be achieved in practice, bearing in mind the contractual, legal and practical obstacles;

> it is difficult to prescribe conditions in respect of obligors, protection providers and forms of protection that could give sufficient certainty of the prospect of double recovery in the event of double default; and

> there is little evidence that, in the event of double default, banks currently delineate recoveries between the underlying obligor and protection provider.

The Trading Book Review specifies requirements in respect of the identity of protection providers, obligors and the forms of protection eligible for double default treatment. The intention has been


to develop operational requirements that minimise the possibility of an excessive correlation arising between the creditworthiness of a protection provider and the underlying obligor due to their performance being dependent on common economic factors.

Eligible Protection Providers

The Basel Committee considers that protection providers must be of sufficient credit quality. Only providers of credit protection with an internal rating of A– or better will therefore be recognised. However, in order to avoid cliff effects, transactions in which the protection provider had an internal rating equivalent to at least A– at the time the credit protection was first provided, or for any period of time thereafter, and still has a credit rating with a PD equivalent to or lower than that associated with an external investment grade rating will remain eligible for the double default framework.

The Basel Committee has decided to restrict recognition to transactions in which the protection provider is a financial firm with appropriate expertise in the area. The rationale is that the very existence of a credit risk transfer transaction usually creates additional, idiosyncratic correlation between the protection provider and obligor, as the protection provider has a credit exposure to the obligor. If providing credit protection is not part of the normal business of the protection provider, the existence of the transaction may also be evidence of an economic or legal link between the protection provider and the obligor.

The only protection providers that are eligible are :-

> banks;

> investment firms; and

> insurance companies. The insurer must be in the business of providing credit protection, including mono-lines, reinsurers and non-sovereign credit export agencies.

The protection provider must :-

> be regulated in a manner broadly equivalent to that set out in the New Accord (where there is appropriate supervisory oversight and transparency/market discipline), or externally rated as at least investment grade by a credit rating agency deemed suitable for this purpose by supervisors;

> have an internal rating with a PD equivalent to or lower than that associated with an external A– rating at the time the credit protection for an exposure was first provided or for any period of time thereafter; and

> have an internal rating with a PD equivalent to or lower than that associated with an external investment-grade rating.


Requirements in Respect of Obligors and Obligations

To be eligible for the double default framework, the underlying obligation must be :-

> a corporate exposure as defined in the New Accord;

> a claim on a public sector entity that is not a sovereign exposure; or

> a loan extended to a small business and classified as a retail exposure under the New Accord.

Exposures to the following types of obligors are excluded from the double default framework :-

> financial firms; and

> members of the same group as the protection provider.

In these cases, the Basel Committee considers that the risk of the presence of excessive correlation is too great.

Banks must have a process in place to detect excessive correlations between the creditworthiness of the protection provider and the obligor of the underlying exposure. If there is such an excessive correlation, the respective exposure is not eligible for double default treatment. An example given is when a protection provider guarantees the debt of a supplier of goods or services and the supplier derives a high proportion of its income or revenue from the protection provider.

Forms of Protection

Only guarantees and credit derivatives meeting the minimum requirements in the New Accord as well as additional requirements set out in the Trading Book Review are eligible. This includes protection provided through the use of single-name, unfunded credit derivatives and single-name guarantees as well as nth-to-default basket products subject to the conditions outlined in the New Accord.

No recognition for double default will be available for :-

> multiple-name credit derivatives (other than nth-to-default basket products eligible as above) or multiple-name guarantees or index-based products. The Basel Committee considers that the level of risk inherent in these products is too high;

> synthetic securitisations and other tranched products that fall within the scope of the securitisation framework, and covered bonds to the extent such instruments are externally rated; and

> funded credit derivatives. Exposures hedged by credit-linked notes, to the extent of their cash funding, are treated as collateralised transactions.


Specific Requirements

The Trading Book Review specifies the following legal and operational requirements :-

> The bank must have the right and expectation to receive payment from the credit protection provider without having to take legal action in order to pursue the counterparty for payment. To the extent possible, a bank should take steps to satisfy itself that the protection provider is willing to pay promptly if a credit event should occur.

> Purchased credit protection must absorb all credit losses incurred on the hedged portion of an exposure that arises due to the credit events outlined in the contract.

> If the payout structure provides for physical settlement, there must be legal certainty with respect to the deliverability of the loan, bond or contingent liability. If a bank intends to deliver an obligation, other than the underlying exposure, it must ensure that the deliverable obligation is sufficiently liquid so that the bank would have the ability to purchase it for delivery in accordance with the contract.

> The terms and conditions of credit protection arrangements must be legally confirmed in writing by both the credit protection provider and the bank.

> In the case of protection against dilution risk, the seller of purchased receivables must not be a member of the same group as the protection provider.

Calculation of the Capital Requirement

For any transaction where a bank wishes to apply the double default framework, it will have to calculate the PD, LGD and EAD for an unhedged exposure to the underlying obligor (although the LGD and EAD parameters will be set by supervisors for banks using the foundation IRB approach). In addition, it will have to determine a PD for the guarantor and a separate EAD

g defined as the

amount of the underlying exposure that is hedged, as well as the LGD associated with the hedged portion of the facility (LGD

g). For consistency with the substitution approach, the bank should

use the LGD of a comparable direct exposure to the guarantor for the LGD of the hedged portion of the facility.

The Basel Committee has developed a simplified formula for the calculation of capital requirements for exposures subject to the double default treatment (K

DD). Capital requirements

are calculated by multiplying a capital requirement (K0) similar to that for unhedged exposures by

an adjustment factor :-

KDD

= K0 x (0.15+160 x PD

g)

The base requirement K0 is calculated using the normal formula for corporate exposures with

some changes to the input parameters. If the underlying obligation is a loan to a small business


qualifying as a retail exposure, the capital requirement K0 in the above formula must be calculated

according to the risk-weight function for corporate exposures. The bank must also take into account the effect of maturity.


short-term maturity adjustment

The capital requirements under the New Accord are calculated on the basis that the minimum maturity of an exposure is one year. Since publication, banks have argued that this overstates the level of risk on short-term transactions where the bank would be able to respond rapidly to a deterioration in the credit quality of the obligor. While accepting this in principle, the Basel Committee is concerned that a bank’s ability to respond to a change in creditworthiness, through refusing to “roll over” the transaction, may be illusory in practice given relationship considerations.

Introduction

The Basel Committee considers that the overriding consideration is the economic substance and associated riskiness of transactions and the reinvestment strategy of the creditor. The Basel Committee has therefore sought to identify with IOSCO transactions where the effective maturity matches the contractual maturity, and develop capital requirements that capture the risk of such short-term transactions where the option not to roll over exists in reality and will be exercised. Underpinning this has been an attempt to identify cases (i) that might be termed “non-relationship”, i.e. there is no pressure on the creditor bank to roll over the transaction at maturity with the same counterparty, and (ii) those where relationship concerns are judged to be possibly material.

The Trading Book Review identifies a number of transactions which satisfy the “non-relationship” condition. Banks will therefore be able to take account of the shorter maturity in respect of these transactions. In other cases, it will be up to national supervisors to determine, depending on local market characteristics, which transactions will be recognised as benefiting from the short-term maturity adjustment. Criteria that national supervisors might consider are whether the bank has :-

> knowledge in a timely manner of any deterioration in the credit quality of the obligor;

> legal certainty and the practical ability of the bank to terminate the transaction in the event of credit deterioration; and

> the bank’s commercial willingness to terminate the transaction.

Transactions Eligible for the Short-Term Maturity Adjustment

The Basel Committee has identified certain short-term exposures, which include capital market-driven transactions and repo-style transactions where the documentation contains daily re-margining clauses as being eligible. The documentation of such transactions must require daily revaluation and include provisions that allow for the prompt liquidation or set off of collateral in the event of default or a failure to re-margin. The maturity of such transactions must be calculated as the greater of one day and the effective maturity.

For transactions falling within the above treatment subject to a master netting agreement, the weighted average maturity of the transactions should be used when applying the maturity


adjustment. A floor equal to the minimum holding period for the transaction type will apply to the average.

Transactions Eligible Subject to National Discretion

In addition to the transactions considered to be eligible above, other short-term exposures with an original maturity of less than one year may be eligible for exemption from the one year floor. National supervisors are required to assess the types of short-term exposures that will be covered. The New Accord envisions the following transactions as being potentially eligible :-

> capital market-driven transactions and repo-style transactions that do not meet the above requirements;

> short-term self-liquidating trade transactions, import and export letters of credit and similar transactions;

> exposures arising from settling securities purchases and sales. This could include overdrafts arising from failed securities settlements provided that such overdrafts do not continue for more than a short, fixed number of business days;

> exposures arising from cash settlements by wire transfer, including overdrafts arising from failed transfers provided that such overdrafts do not continue for more than a short, fixed number of business days;

> exposures to banks arising from foreign exchange settlements; and

> some short-term loans and deposits.


other changes to the trading book

The Trading Book Review makes a number of consequential changes to the New Accord, both to Pillar 1 (minimum capital requirements) and Pillar 2 (supervisory review). The focus here is on the Pillar 1 changes.

Boundary Between the Trading Book and Banking Book

The New Accord defines the trading book for regulatory capital purposes as consisting of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book. It also makes clear that positions held with trading intent must be held intentionally for short-term resale and/or with the intent of benefiting from actual or expected short-term price movements, or to lock in arbitrage profits.

Banks are required to have clearly defined policies and procedures for determining which exposures to include in, and to exclude from, the trading book when calculating their regulatory capital requirements. Compliance with these policies and procedures needs to be fully documented and is subject to periodic internal audit.

The Trading Book Review amplifies these requirements and states that the policies and procedures adopted should address the following considerations :-

> the activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes;

> the extent to which an exposure can be marked-to-market daily by reference to an active, liquid two-way market;

> for exposures that are marked-to-model, the extent to which the bank can: (1) identify the material risks of the exposure, (2) hedge the material risks of the exposure and the extent to which hedging instruments would have an active, liquid two-way market and (3) derive reliable estimates for the key assumptions and parameters used in the model;

> the extent to which the bank can, and is required to, generate valuations for the exposure that can be validated externally in a consistent manner;

> the extent to which legal restrictions, or other operational requirements, would impede the bank’s ability to effect an immediate liquidation of the exposure;

> the extent to which the bank is required to, and can, actively risk manage the exposure within its trading operations; and

> the extent to which the bank may transfer risk or exposures between the banking and the trading books and the criteria for such transfers.

The Basel Committee considers that open equity stakes in hedge funds, merchant banking investments and real estate holdings are not eligible for inclusion in the trading book.


Prudent Valuation Guidance

The New Accord gives guidance on the prudent valuation of positions. However, it is less precise with respect to the valuation of illiquid or less liquid positions. In order to address liquidity risks, the Basel Committee has decided to strengthen the requirement that firms make appropriate valuation adjustments for less liquid positions. Given that the underlying ten-day assumption of the 1995 Market Risk Amendment may not be consistent with the firm’s ability to sell or hedge out positions under normal market conditions, firms will be required to make downward valuation adjustments/reserves for less liquid positions. Where possible, these adjustments/reserves should be made through fair value. Banks are required to consider all relevant factors when determining the appropriateness of valuation adjustments/reserves for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes, market concentrations, the ageing of positions, the extent to which valuation relies on marking-to-model and the impact of other model risks.

Trading Book Treatment of Specific Risk

Under the Market Risk Amendment, the standard capital charges for specific risk associated with interest rates are tied to the risk weights applicable to banking book exposures in the 1988 Capital Accord. The New Accord modifies the Market Risk Amendment capital charges for specific (issuer) risk arising from government paper, in order to reflect the introduction of external ratings under the standardised approach for banking book claims. However, under this new set of capital charges the maximum charge remains at 8%, which does not reflect the fact that, in the banking book, the risk-weight for claims on sovereigns rated below B– has been increased to 150%.

The standard capital charges for specific risk on qualifying issuers remain unchanged. However, in order to reflect the new banking book treatment for claims on banks and investment firms, set out in the New Accord, the definition of “qualifying issuers” is expanded to include institutions that are deemed equivalent to investment grade quality and subject to supervisory and regulatory arrangements comparable to those set out in the New Accord.

In order to increase consistency with the New Accord, the “other” category set out in the Market Risk Amendment is updated to remove the 8% capital charge ceiling for banking book claims on corporates. Similarly, for the sake of consistency, securitisation exposures that are subject to a deduction treatment under the securitisation framework (e.g. equity tranches that absorb first loss), as well as securitisation exposures that are unrated liquidity lines or letters of credit will be subject to the same capital treatment as set out in the securitisation framework.


The new capital charges for specific risk are as follows :-

Categories External credit assessment

Specific risk capital charge

Government AAA to AA-

A+ to BBB-

BB+ to B-

Below B-

Unrated

0%

0.25% (residual term to final maturity 6 months or less)

1.00% (residual term to final maturity greater than 6 and up to and including 24 months)

1.60% (residual term to final maturity exceeding 24 months)

8.00%

12.00%

8.00%

Qualifying 0.25% (residual term to final maturity 6 months or less)

1.00% (residual term to final maturity greater than 6 and up to and including 24 months)

1.60% (residual term to final maturity exceeding 24 months)

Other Similar to credit risk charges under the standardised approach of the Revised Framework, e.g.:

BB+ to BB-

Below BB-

Unrated

8.00%

12.00%

8.00%

Internal VaR Models and the Trading Book

The Trading Book Review reinforces the requirements in respect of the internal model approval process to reflect improvements in the standards of model validation since 1995. It also clarifies the requirements to model specific risk. This includes a stronger requirement for banks to model default and event risks in order to achieve specific risk model recognition. At the same time the specific risk 4x multiplier is replaced with a 3x multiplier for both general market and specific risk.

The Basel Committee considers that the standard ten-day, 99th percentile VaR requirements adopted in 1995 do not adequately capture a firm’s exposures to the default of one or more issuers, particularly those for which it has concentrations across its various trading portfolios (bonds, credit derivatives, equities and other structured credit products). This is because exposures to sudden defaults are embedded in firms’ trading portfolios and, therefore, are difficult to hedge. As a result, banks will need to capture risks that are incremental to the risk captured


in their VaR-based calculation (i.e. default risks that are not captured in the historical spread data of the VaR model). While no specific approach is prescribed all approaches will be subject to soundness standards comparable to the IRB-based approach for credit risk.

Where banks are unable to meet the requirement to model default risk using their internal model they may instead calculate a charge based on the IRB methodology applied to positions in the banking book. While the Basel Committee acknowledges that the IRB approach will include some double-counting of spread risks, it considers that this approach is more risk sensitive than the current 4x multiplier.


failed trades and non-dvp transactions

Neither the 1988 Capital Accord nor the New Accord contains any specific capital requirements for failed trades. This has led to the development of divergent approaches in different jurisdictions. The Basel Committee has therefore decided to specify a uniform treatment for the various types of failed transactions, and, where possible, to encourage orderly markets. The rules distinguish between delivery versus payment (DvP) transactions and non-DvP transactions. They are intended to apply to the settlement of commodities transactions as well as to the settlement of foreign exchange and securities transactions. The rules will also apply to transactions cleared through recognised clearing houses that are subject to daily mark-to-market and the payment of daily variation margin. However, it is expected that such transactions would not incur a capital charge unless they involve a mismatched trade.

Delivery versus Payment Transactions

For DvP transactions, if the payment has not taken place five business days after the settlement date, firms must calculate a capital charge by multiplying the positive current exposure of the transaction by the appropriate factor according to the table below.

Number of working days after the agreed settlement date

Corresponding risk multiplier

From 5 to 15 8%

From 16 to 30 50%

From 31 to 45 75%

46 or more 100%

A reasonable transition period may be allowed for firms to upgrade their information systems to track the number of days after the agreed settlement date and to calculate the corresponding capital charge.

Non-Delivery versus Payment Transactions

For non-DvP transactions (i.e. free deliveries), after the first contractual payment/delivery leg, the bank that has made the payment must treat its exposure as a loan if the second leg has not been received by the end of the business day. This means that a bank under the IRB approach will apply the appropriate IRB formula set out in the New Accord, for the exposure to the counterparty, in the same way as it does for banking book exposures. Banks under the standardised approach will use the standardised risk-weights set forth in the New Accord. However, when exposures are not material, banks may choose to apply a uniform 100% risk-weight to these exposures, in order to avoid the burden of a full credit assessment. If, five business days after the second contractual payment/delivery date the second leg has not yet effectively taken place, the bank that has made the first payment leg will deduct from capital the full amount of the value transferred plus replacement cost, if any. This treatment will apply until the second payment/delivery leg is made.

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