CA-4 CA-4 Credit Risk — The Standardized Approach — Credit Risk Mitigation
CA-4.1 CA-4.1 Overarching Issues
Introduction
CA-4.1.1
Banks use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralised by first priority claims, in whole or in part with cash or securities, a loan exposure may be guaranteed by a third party, or a bank may buy a credit derivative to offset various forms of credit risk. Additionally banks may agree to net loans owed to them against deposits from the same counterparty. Off-balance sheet items will first be converted into on-balance sheet equivalents prior to the CRM being applied.
Apr 08General remarks
CA-4.1.2
The framework set out in this sub-section of "General remarks" is applicable to all banking book exposures. Certain additional types of collateral are also eligible under the IRB approach (see paragraph CA-5.3.20 and others).
Apr 08CA-4.1.3
The comprehensive approach for the treatment of collateral (see paragraphs CA-4.2.12 to CA-4.2.20 and CA-4.3.1 to CA-4.3.32) will also be applied to calculate the counterparty risk charges for OTC derivatives and repo-style transactions booked in the trading book.
Apr 08CA-4.1.4
No transaction in which CRM techniques are used should receive a higher capital requirement than an otherwise identical transaction where such techniques are not used.
Apr 08CA-4.1.5
The effects of CRM will not be double counted. Therefore, no additional recognition of CRM for regulatory capital purposes will be applicable on claims for which an issue-specific rating is used that already reflects that CRM. As stated in paragraph CA-3.4.8 of the section on the standardised approach, principal-only ratings will also not be allowed within the framework of CRM.
Apr 08CA-4.1.6
While the use of CRM techniques reduces or transfers credit risk, it simultaneously may increase other risks (residual risks). Residual risks include legal, operational, liquidity and market risks. Therefore, it is imperative that banks employ robust procedures and processes to control these risks, including strategy; consideration of the underlying credit; valuation; policies and procedures; systems; control of roll-off risks; and management of concentration risk arising from the bank's use of CRM techniques and its interaction with the bank's overall credit risk profile. Where these risks are not adequately controlled, the CBB may impose additional capital charges or take supervisory actions.
Apr 08CA-4.1.7
Market Discipline requirements must also be observed for banks to obtain capital relief in respect of any CRM techniques.
Apr 08Legal Certainty
CA-4.1.8
In order for banks to obtain capital relief for any use of CRM techniques, the following minimum standards for legal documentation must be met.
Apr 08CA-4.1.9
All documentation used in collateralised transactions and for documenting on- balance sheet netting, guarantees and credit derivatives must be binding on all parties and legally enforceable in all relevant jurisdictions. Banks must have conducted sufficient legal review to verify this and have a well founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability.
Apr 08CA-4.2 CA-4.2 Overview of Credit Risk Mitigation Techniques13
Collateralised Transactions
CA-4.2.1
A collateralised transaction is one in which:
(a) Banks have a credit exposure or potential credit exposure; and(b) That credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty14 or by a third party on behalf of the counterparty.
13 See Appendix CA-5 for an overview of methodologies for the capital treatment of transactions secured by financial collateral under the standardised and IRB approaches.
14 In this section "counterparty" is used to denote a party to whom a bank has an on- or off-balance sheet credit exposure or a potential credit exposure. That exposure may, for example, take the form of a loan of cash or securities (where the counterparty would traditionally be called the borrower), of securities posted as collateral, of a commitment or of exposure under an OTC derivatives contract.
Apr 08CA-4.2.2
Where banks take eligible financial collateral (e.g. cash or securities, more specifically defined in paragraphs CA-4.3.1 and CA-4.3.2), they are allowed to reduce their credit exposure to a counterparty when calculating their capital requirements to take account of the risk mitigating effect of the collateral.
Apr 08Overall Framework and Minimum Conditions
CA-4.2.3
Banks may opt for either the simple approach, which substitutes the risk weighting of the collateral for the risk weighting of the counterparty for the collateralised portion of the exposure (generally subject to a 20% floor), or for the comprehensive approach, which allows fuller offset of collateral against exposures, by effectively reducing the exposure amount by the value ascribed to the collateral. Banks may operate under either, but not both, approaches in the banking book, but only under the comprehensive approach in the trading book. Partial collateralisation is recognised in both approaches. Mismatches in the maturity of the underlying exposure and the collateral will only be allowed under the comprehensive approach.
Apr 08CA-4.2.4
However, before capital relief will be granted in respect of any form of collateral, the standards set out below in paragraphs CA-4.2.5 to CA-4.2.8 must be met under either approach.
Apr 08CA-4.2.5
In addition to the general requirements for legal certainty set out in paragraphs CA-4.1.8 and CA-4.1.9, the legal mechanism by which collateral is pledged or transferred must ensure that the bank has the right to liquidate or take legal possession of it, in a timely manner, in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Furthermore banks must take all steps necessary to fulfil those requirements under the law applicable to the bank's interest in the collateral for obtaining and maintaining an enforceable security interest, e.g. by registering it with a registrar, or for exercising a right to net or set off in relation to title transfer collateral.
Apr 08CA-4.2.6
In order for collateral to provide protection, the credit quality of the counterparty and the value of the collateral must not have a material positive correlation. For example, securities issued by the counterparty — or by any related group entity — would provide little protection and so would be ineligible.
Apr 08CA-4.2.7
Banks must have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly.
Apr 08CA-4.2.8
Where the collateral is held by a custodian, banks must take reasonable steps to ensure that the custodian segregates the collateral from its own assets.
Apr 08CA-4.2.9
A capital requirement will be applied to a bank on either side of the collateralised transaction: for example, both repos and reverse repos will be subject to capital requirements. Likewise, both sides of a securities lending and borrowing transaction will be subject to explicit capital charges, as will the posting of securities in connection with a derivative exposure or other borrowing.
Apr 08CA-4.2.10
Where a bank, acting as agent, arranges a repo-style transaction (i.e. repurchase/reverse repurchase and securities lending/borrowing transactions) between a customer and a third party and provides a guarantee to the customer that the third party will perform on its obligations, then the risk to the bank is the same as if the bank had entered into the transaction as a principal. In such circumstances, a bank will be required to calculate capital requirements as if it were itself the principal.
Apr 08The Simple Approach
The Comprehensive Approach
CA-4.2.12
In the comprehensive approach, when taking collateral, banks must calculate their adjusted exposure to a counterparty for capital adequacy purposes in order to take account of the effects of that collateral. Using haircuts, banks are required to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either15, occasioned by market movements. This will produce volatility adjusted amounts for both exposure and collateral. Unless either side of the transaction is cash, the volatility adjusted amount for the exposure will be higher than the exposure and for the collateral it will be lower.
15 Exposure amounts may vary where, for example, securities are being lent.
Apr 08CA-4.2.13
Additionally where the exposure and collateral are held in different currencies an additional downwards adjustment must be made to the volatility adjusted collateral amount to take account of possible future fluctuations in exchange rates.
Apr 08CA-4.2.14
Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral amount (including any further adjustment for foreign exchange risk), banks shall calculate their risk-weighted assets as the difference between the two multiplied by the risk weight of the counterparty. The framework for performing these calculations is set out in paragraphs CA-4.3.3 to CA-4.3.6.
Apr 08CA-4.2.15
Banks must use standard haircuts given in paragraph CA-4.3.7 unless allowed to use models under CA-4.3.22.
Apr 08CA-4.2.16
The size of the individual haircuts will depend on the type of instrument, type of transaction and the frequency of marking-to-market and re-margining. For example, repo- style transactions subject to daily marking-to-market and to daily re-margining will receive a haircut based on a 5-business day holding period and secured lending transactions with daily mark-to-market and no re-margining clauses will receive a haircut based on a 20-business day holding period. These haircut numbers will be scaled up using the square root of time formula depending on the frequency of remargining or marking-to-market.
Apr 08CA-4.2.17
For certain types of repo-style transactions (broadly speaking government bond repos as defined in paragraphs CA-4.3.14 and CA-4.3.15), the CBB may allow banks using standard haircuts not to apply these haircuts in calculating the exposure amount after risk mitigation.
Apr 08CA-4.2.18
The effect of master netting agreements covering repo-style transactions can be recognised for the calculation of capital requirements subject to the conditions in paragraph CA-4.3.17.
Apr 08CA-4.2.19
As an alternative to standard haircuts banks may, subject to approval from CBB, use VaR models for calculating potential price volatility for repo-style transactions and other similar SFTs, as set out in paragraphs CA-4.3.22 to CA-4.3.25 below. Alternatively, subject to approval from the CBB's, they may also calculate, for these transactions, an expected positive exposure, as set forth in Appendix CA-2 of this Module.
Apr 08On-balance Sheet Netting
CA-4.2.20
Where banks have legally enforceable netting arrangements for loans and deposits they may calculate capital requirements on the basis of net credit exposures subject to the conditions in paragraph CA-4.4.1.
Apr 08Guarantees and Credit Derivatives
CA-4.2.21
Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and the CBB is satisfied that banks fulfil certain minimum operational conditions relating to risk management processes they may allow banks to take account of such credit protection in calculating capital requirements.
Apr 08CA-4.2.22
A range of guarantors and protection providers are recognised, as shown in paragraph CA-4.5.7. A substitution approach will be applied. Thus only guarantees issued by or protection provided by entities with a lower risk weight than the counterparty will lead to reduced capital charges since the protected portion of the counterparty exposure is assigned the risk weight of the guarantor or protection provider, whereas the uncovered portion retains the risk weight of the underlying counterparty.
Apr 08Maturity Mismatch
CA-4.2.24
Where the residual maturity of the CRM is less than that of the underlying credit exposure a maturity mismatch occurs. Where there is a maturity mismatch and the CRM has an original maturity of less than one year, the CRM is not recognised for capital purposes. In other cases where there is a maturity mismatch, partial recognition is given to the CRM for regulatory capital purposes as detailed below in paragraphs CA-4.6.1 to CA-4.6.4. Under the simple approach for collateral maturity mismatches will not be allowed.
Apr 08CA-4.3 CA-4.3 Collateral
Eligible Financial Collateral
CA-4.3.1
The following collateral instruments are eligible for recognition in the simple approach:
(a) Cash (as well as certificates of deposit or comparable instruments issued by the lending bank) on deposit with the bank which is incurring the counterparty exposure;16,17(b) Gold;(c) Debt securities rated by a recognised external credit assessment institution where these are either:(i) At least BB- when issued by sovereigns or PSEs that are treated as sovereigns by the CBB; or(ii) At least BBB- when issued by other entities (including banks and securities firms); or(iii) At least A-3/P-3 for short-term debt instruments.(d) Debt securities not rated by a recognised external credit assessment institution where these are:(i) Issued by a bank; and(ii) Listed on a recognised exchange; and(iii) Classified as senior debt; and(iv) All rated issues of the same seniority by the issuing bank must be rated at least BBB- or A-3/P-3 by a recognised external credit assessment institution; and(v) The bank holding the securities as collateral has no information to suggest that the issue justifies a rating below BBB- or A-3/P-3 (as applicable); and(vi) The CBB is sufficiently confident about the market liquidity of the security.(e) Equities (including convertible bonds) that are included in a main index; and(f) Undertakings for Collective Investments in Transferable Securities (UCITS) and mutual funds where:(i) A price for the units is publicly quoted daily; and(ii) The UCITS/mutual fund is limited to investing in the instruments listed in this paragraph18.
16 Cash funded credit linked notes issued by the bank against exposures in the banking book which fulfil the criteria for credit derivatives will be treated as cash collateralised transactions.
17When cash on deposit, certificates of deposit or comparable instruments issued by the lending bank are held as collateral at a third-party bank in a non-custodial arrangement, if they are openly pledged/assigned to the lending bank and if the pledge /assignment is unconditional and irrevocable, the exposure amount covered by the collateral (after any necessary haircuts for currency risk) will receive the risk weight of the third-party bank.
18 However, the use or potential use by a UCITS/mutual fund of derivative instruments solely to hedge investments listed in this paragraph and paragraph CA-4.3.2 shall not prevent units in that UCITS /mutual fund from being eligible financial collateral.
Amended: April 2011
Apr 08CA-4.3.2
The following collateral instruments are eligible for recognition in the comprehensive approach:
(a) All of the instruments in paragraph CA-4.3.1;(b) Equities (including convertible bonds) which are not included in a main index but which are listed on a recognised exchange;(c) UCITS/mutual funds which include such equities.Apr 08The Comprehensive Approach
Calculation of Capital Requirement
CA-4.3.3
For a collateralised transaction, the exposure amount after risk mitigation is calculated as follows:
E* = Max {0, [E × (1 + He) - C × (1 - Hc - Hfx)]}
where:
E* = The exposure value after risk mitigation
E = Current value of the exposure
He = Haircut appropriate to the exposure
C = The current value of the collateral received
Hc = Haircut appropriate to the collateral
Hfx = Haircut appropriate for currency mismatch between the collateral and exposure
Amended: April 2011
Apr 08CA-4.3.4
The exposure amount after risk mitigation will be multiplied by the risk weight of the counterparty to obtain the risk-weighted asset amount for the collateralised transaction.
Apr 08CA-4.3.5
The treatment for transactions where there is a mismatch between the maturity of the counterparty exposure and the collateral is given in paragraphs CA-4.6.1 to CA-4.6.4.
Apr 08CA-4.3.6
Where the collateral is a basket of assets, the haircut on the basket will be
H = Σi ai Hi , where ai is the weight of the asset (as measured by units of currency) in the i basket and Hi the haircut applicable to that asset.
Apr 08Standard Haircuts
CA-4.3.7
These are the standard haircuts (assuming daily mark-to-market, daily re-margining and a 10-business day holding period), expressed as percentages:
Issue rating for debt securities Residual Maturity Sovereigns19,20 Other issuers21 AAA to AA-/A-1 ≤1 year 0.5 1 >1 year, ≤5 years 2 4 > 5 years 4 8 A+ to BBB-/ A-2/A-3/P-3 and unrated bank securities per para. CA-4.3.1(d) ≤1 year 1 2 >1 year, ≤5 years 3 6 > 5 years 6 12 BB+ to BB- All 15 Main index equities (including convertible bonds) and Gold 15 Other equities (including convertible bonds) listed on a recognised exchange 25 UCITS/Mutual funds Highest haircut applicable to any security in which the fund can invest Cash in the same currency22 0
19 Includes PSEs which are treated as sovereigns by the CBB.
20 Multilateral development banks receiving a 0% risk weight will be treated as sovereigns.
21 Includes PSEs which are not treated as sovereigns by CBB.
22 Eligible cash collateral specified in paragraph CA-4.3.1 (a).
Apr 08CA-4.3.8
The standard haircut for currency risk where exposure and collateral are denominated in different currencies is 8% (also based on a 10-business day holding period and daily mark-to-market).
Apr 08CA-4.3.9
For transactions in which the bank lends non-eligible instruments (e.g. non-investment grade corporate debt securities), the haircut to be applied on the exposure should be the same as the one for equity traded on a recognised exchange that is not part of a main index.
Apr 08Adjustment for Different Holding Periods and Non Daily Mark-to-market or re-Margining
CA-4.3.10
For some transactions, depending on the nature and frequency of the revaluation and re-margining provisions, different holding periods are appropriate. The framework for collateral haircuts distinguishes between repo-style transactions (i.e. repo/reverse repos and securities lending/borrowing), "other capital-market-driven transactions" (i.e. OTC derivatives transactions and margin lending) and secured lending. In capital-market-driven transactions and repo-style transactions, the documentation contains remargining clauses; in secured lending transactions, it generally does not.
Apr 08CA-4.3.11
The minimum holding period for various products is summarised in the following table.
Transaction type Minimum holding period Condition Repo-style transaction five business days daily re-margining Other capital market transactions ten business days daily re-margining Secured lending twenty business days daily revaluation Apr 08CA-4.3.12
When the frequency of remargining or revaluation is longer than the minimum, the minimum haircut numbers will be scaled up depending on the actual number of business days between remargining or revaluation using the square root of time formula below:
where:
H = Haircut
HM = Haircut under the minimum holding period
TM = Minimum holding period for the type of transaction
NR = Actual number of business days between remargining for capital market transactions or revaluation for secured transactions.
When a bank calculates the volatility on a TN day holding period which is different from the specified minimum holding period TM, the HM will be calculated using the square root of time formula:
TN = Holding period used by the bank for deriving HN
HN = Haircut based on the holding period TN
Amended: April 2011
Apr 08CA-4.3.13
For example, for banks using the standard CBB haircuts, the 10-business day haircuts provided in paragraph CA-4.3.7 will be the basis and this haircut will be scaled up or down depending on the type of transaction and the frequency of re-margining or revaluation using the formula below:
where:
H = Haircut
H10 = 10-business day standard CBB haircut for instrument
NR = Actual number of business days between re-margining for capital
= Market transactions or revaluation for secured transactions.TM = Minimum holding period for the type of transaction
Amended: April 2011
Apr 08Conditions for Zero H
CA-4.3.14
For repo-style transactions where the following conditions are satisfied, and the counterparty is a core market participant, banks are not required to apply the haircuts specified in the comprehensive approach and may instead apply a haircut of zero. This carve-out will not be available for banks using the modelling approaches as described in paragraphs CA-4.3.22 to CA-4.3.25:
(a) Both the exposure and the collateral are cash or a sovereign security or PSE security qualifying for a 0% risk weight in the standardised approach;(b) Both the exposure and the collateral are denominated in the same currency;(c) Either the transaction is overnight or both the exposure and the collateral are marked-to-market daily and are subject to daily re margining;(d) Following a counterparty's failure to re-margin, the time that is required between the last mark-to-market before the failure to re-margin and the liquidation23 of the collateral is considered to be no more than four business days;(e) The transaction is settled across a settlement system proven for that type of transaction;(f) The documentation covering the agreement is standard market documentation for repo-style transactions in the securities concerned;(g) The transaction is governed by documentation specifying that if the counterparty fails to satisfy an obligation to deliver cash or securities or to deliver margin or otherwise defaults, then the transaction is immediately terminable; and(h) Upon any default event, regardless of whether the counterparty is insolvent or bankrupt, the bank has the unfettered, legally enforceable right to immediately seize and liquidate the collateral for its benefit.
23 This does not require the bank to always liquidate the collateral but rather to have the capability to do so within the given time frame.
Amended: April 2011
Apr 08CA-4.3.15
Core market participants include the following entities:
(a) Sovereigns, central banks and PSEs;(b) Banks and securities firms;(c) Other financial companies (including insurance companies) eligible for a 20% risk weight in the standardised approach;(d) Regulated mutual funds that are subject to capital or leverage requirements;(e) Regulated pension funds; and(f) Recognised clearing organisations.Apr 08CA-4.3.16
Where a supervisor has applied a specific carve-out to repo-style transactions in securities issued by its domestic government, then banks incorporated in Bahrain are allowed to adopt the same approach to the same transactions.
Apr 08Treatment of Repo-style Transactions Covered under Master Netting Agreements
CA-4.3.17
The effects of bilateral netting agreements covering repo-style transactions will be recognised on a counterparty-by-counterparty basis if the agreements are legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of whether the counterparty is insolvent or bankrupt. In addition, netting agreements must:
(a) Provide the non-defaulting party the right to terminate and close-out in a timely manner all transactions under the agreement upon an event of default, including in the event of insolvency or bankruptcy of the counterparty;(b) 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;(c) Allow for the prompt liquidation or setoff of collateral upon the event of default; and(d) Be, together with the rights arising from the provisions required in (a) to (c) above, legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of the counterparty's insolvency or bankruptcy.Amended: April 2011
Apr 08CA-4.3.18
Netting across positions in the banking and trading book will only be recognised when the netted transactions fulfill the following conditions:
(a) All transactions are marked to market daily24; and(b) The collateral instruments used in the transactions are recognised as eligible financial collateral in the banking book.
24The holding period for the haircuts will depend as in other repo-style transactions on the frequency of margining.
Apr 08CA-4.3.19
The formula in paragraph CA-4.3.3 will be adapted to calculate the capital requirements for transactions with netting agreements.
Apr 08CA-4.3.20
For banks using the standard haircuts, the framework below will apply to take into account the impact of master netting agreements.
E* = Max {0, [(Σ(E) - Σ(C)) + Σ (ES × HS) +Σ (EFX × HFX)]}25
Where:
E* = The exposure value after risk mitigation
E = Current value of the exposure
C = The value of the collateral received
ES = Absolute value of the net position in a given security
HS = Haircut appropriate to ES
EFX = Absolute value of the net position in a currency different from the settlement currency
HFX = Haircut appropriate for currency mismatch
25The starting point for this formula is the formula in paragraph CA-4.3.3 which can also be presented as the following: E* = max {0, [(E - C) + (E x He) + (C x Hc) + (C x Hfx)]}
Amended: April 2011
Apr 08CA-4.3.21
The intention here is to obtain a net exposure amount after netting of the exposures and collateral and have an add-on amount reflecting possible price changes for the securities involved in the transactions and for foreign exchange risk if any. The net long or short position of each security included in the netting agreement will be multiplied by the appropriate haircut. All other rules regarding the calculation of haircuts stated in paragraphs CA-4.3.3 to CA-4.3.16 equivalently apply for banks using bilateral netting agreements for repo-style transactions.
Apr 08Use of Models
CA-4.3.22
As an alternative to the use of standard haircuts, CBB may allow banks to use a VaR models approach to reflect the price volatility of the exposure and collateral for repo-style transactions, taking into account correlation effects between security positions. This approach would apply to repo-style transactions covered by bilateral netting agreements on a counterparty-by-counterparty basis. At the discretion of CBB, firms are also eligible to use the VaR model approach for margin lending transactions, if the transactions are covered under a bilateral master netting agreement that meets the requirements of paragraphs CA-4.3.17 and CA-4.3.18. The VaR models approach is available to banks that have received CBB's recognition for an internal market risk model under the chapter CA-14. Banks which have not received CBB's recognition for use of models under the chapter CA-14 can separately apply for CBB's recognition to use their internal VaR models for calculation of potential price volatility for repo-style transactions. Internal models will only be accepted when a bank can prove the quality of its model to CBB through the backtesting of its output using one year of historical data. Banks must meet the model validation requirement of paragraph 43 of Appendix CA-2 to use VaR for repo-style and other SFTs. In addition, other transactions similar to repo-style transactions (like prime brokerage) and that meet the requirements for repo-style transactions, are also eligible to use the VaR models approach provided the model used meets the operational requirements set forth in Section I.F of Appendix CA-2.
Apr 08CA-4.3.23
The quantitative and qualitative criteria for recognition of internal market risk models for repo-style transactions and other similar transactions are in principle the same as under Chapter CA-14. With regard to the holding period, the minimum will be 5- business days for repo-style transactions, rather than the 10-business days under the Market Risk Amendment. For other transactions eligible for the VaR models approach, the 10- business day holding period will be retained. The minimum holding period should be adjusted upwards for market instruments where such a holding period would be inappropriate given the liquidity of the instrument concerned.
Apr 08CA-4.3.24
The calculation of the exposure E* for banks using their internal model will be the following:
E* = Max {0, [(ΣE - ΣC) + VaR output from internal model]}
In calculating capital requirements banks will use the previous business day's VaR number.
Amended: April 2011
Apr 08CA-4.3.25
Subject to CBB's approval, instead of using the VaR approach, banks may also calculate an expected positive exposure for repo-style and other similar SFTs, in accordance with the Internal Model Method set out in Appendix CA-2 of this Module.
Apr 08The Simple Approach
Minimum Conditions
CA-4.3.26
For collateral to be recognised in the simple approach, the collateral must be pledged for at least the life of the exposure and it must be marked to market and revalued with a minimum frequency of six months. Those portions of claims collateralised by the market value of recognised collateral receive the risk weight applicable to the collateral instrument. The risk weight on the collateralised portion will be subject to a floor of 20% except under the conditions specified in paragraphs CA-4.3.27 to CA-4.3.29. The remainder of the claim should be assigned to the risk weight appropriate to the counterparty. A capital requirement will be applied to banks on either side of the collateralised transaction: for example, both repos and reverse repos will be subject to capital requirements.
Apr 08Exceptions to the Risk Weight Floor
CA-4.3.27
Transactions which fulfil the criteria outlined in paragraph CA-4.3.14 and are with a core market participant, as defined in paragraph CA-4.3.15, receive a risk weight of 0%. If the counterparty to the transactions is not a core market participant the transaction should receive a risk weight of 10%.
Apr 08CA-4.3.28
OTC derivative transactions subject to daily mark-to-market, collateralised by cash and where there is no currency mismatch receive a 0% risk weight. Such transactions collateralised by sovereign or PSE securities qualifying for a 0% risk weight in the standardised approach will receive a 10% risk weight.
Apr 08CA-4.3.29
The 20% floor for the risk weight on a collateralised transaction will not be applied and a 0% risk weight can be applied where the exposure and the collateral are denominated in the same currency, and either:
(a) The collateral is cash on deposit as defined in paragraph CA-4.3.1(a); or(b) The collateral is in the form of sovereign/PSE securities eligible for a 0% risk weight, and its market value has been discounted by 20%.Amended: April 2011
Apr 08Collateralised OTC Derivatives Transactions
CA-4.3.30
Under the Current Exposure Method, the calculation of the counterparty credit risk charge for an individual contract will be as follows:
Counterparty charge = [(RC + add-on) - CA] × r × 8%
Where:
RC = The replacement cost,
Add-on = The amount for potential future exposure calculated in CBB's 2004 Rule Book.
CA = The volatility adjusted collateral amount under the comprehensive approach prescribed in paragraphs CA-4.3.3 to CA-4.3.16, or zero if no eligible collateral is applied to the transaction, and
r = The risk weight of the counterparty.
Amended: April 2011
Apr 08CA-4.3.31
When effective bilateral netting contracts are in place, RC will be the net replacement cost and the add-on will be ANet as calculated according to paragraph 96 (i) to 96 (vi) of Appendix 2. The haircut for currency risk (Hfx) should be applied when there is a mismatch between the collateral currency and the settlement currency. Even in the case where there are more than two currencies involved in the exposure, collateral and settlement currency, a single haircut assuming a 10-business day holding period scaled up as necessary depending on the frequency of mark-to-market will be applied.
Apr 08CA-4.3.32
As an alternative to the Current Exposure Method for the calculation of the counterparty credit risk charge, banks may also use the Standardised Method and, subject to CBB's approval, the Internal Model Method as set out in Appendix CA-2 of this Module.
Apr 08CA-4.4 CA-4.4 On-balance Sheet Netting
CA-4.4.1
Where a bank:
(a) Has a well-founded legal basis for concluding that the netting or offsetting agreement is enforceable in each relevant jurisdiction regardless of whether the counterparty is insolvent or bankrupt;(b) Is able at any time to determine those assets and liabilities with the same counterparty that are subject to the netting agreement;(c) Monitors and controls its roll-off risks; and(d) Monitors and controls the relevant exposures on a net basis,it may use the net exposure of loans and deposits as the basis for its capital adequacy calculation in accordance with the formula in paragraph CA-4.3.3. Assets (loans) are treated as exposure and liabilities (deposits) as collateral. The haircuts will be zero except when a currency mismatch exists. A 10-business day holding period will apply when daily mark-to- market is conducted and all the requirements contained in paragraphs CA-4.3.7, CA-4.3.13, and CA-4.6.1 to CA-4.6.4 will apply.
Amended: April 2011
Apr 08CA-4.5 CA-4.5 Guarantees and Credit Derivatives
Operational Requirements
Operational Requirements Common to Guarantees and Credit Derivatives
CA-4.5.1
A guarantee (counter-guarantee) or credit derivative must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible. Other than non-payment by a protection purchaser of money due in respect of the credit protection contract it must be irrevocable; there must be no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure26. It must also be unconditional; there should be no clause in the protection contract outside the direct control of the bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due.
26 Note that the irrevocability condition does not require that the credit protection and the exposure be maturity matched; rather that the maturity agreed ex ante may not be reduced ex post by the protection provider. Paragraph CA-4.6.2 sets forth the treatment of call options in determining remaining maturity for credit protection.
Apr 08Additional Operational Requirements for Guarantees
CA-4.5.2
In addition to the legal certainty requirements in paragraphs CA-4.1.8 and CA-4.1.9 above, in order for a guarantee to be recognised, the following conditions must be satisfied:
(a) On the qualifying default/non-payment of the counterparty, the bank may in a timely manner pursue the guarantor for any monies outstanding under the documentation governing the transaction. The guarantor may make one lump sum payment of all monies under such documentation to the bank, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The bank must have the right to receive any such payments from the guarantor without first having to take legal actions in order to pursue the counterparty for payment;(b) The guarantee is an explicitly documented obligation assumed by the guarantor; and(c) Except as noted in the following sentence, the guarantee covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments etc. Where a guarantee covers payment of principal only, interests and other uncovered payments should be treated as an unsecured amount in accordance with paragraph CA-4.5.10.Amended: April 2011
Apr 08Additional Operational Requirements for Credit Derivatives
CA-4.5.3
In order for a credit derivative contract to be recognised, the following conditions must be satisfied:
(a) The credit events specified by the contracting parties must at a minimum cover:• failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation);• bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and• restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account). When restructuring is not specified as a credit event, refer to paragraph CA-4.5.4.(b) If the credit derivative covers obligations that do not include the underlying obligation, section (g) below governs whether the asset mismatch is permissible;(c) The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay, subject to the provisions of paragraph CA-4.6.2;(d) Credit derivatives allowing for cash settlement are recognised for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There must be a clearly specified period for obtaining post-credit- event valuations of the underlying obligation. If the reference obligation specified in the credit derivative for purposes of cash settlement is different than the underlying obligation, section (g) below governs whether the asset mismatch is permissible;(e) If the protection purchaser's right/ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation must provide that any required consent to such transfer may not be unreasonably withheld;(f) The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event;(g) A mismatch between the underlying obligation and the reference obligation under the credit derivative (i.e. the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if (1) the reference obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place; and(h) A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if (1) the latter obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross- acceleration clauses are in place.Amended: April 2011
Apr 08CA-4.5.4
When the restructuring of the underlying obligation is not covered by the credit derivative, but the other requirements in paragraph CA-4.5.3 are met, partial recognition of the credit derivative will be allowed. If the amount of the credit derivative is less than or equal to the amount of the underlying obligation, 60% of the amount of the hedge can be recognised as covered. If the amount of the credit derivative is larger than that of the underlying obligation, then the amount of eligible hedge is capped at 60% of the amount of the underlying obligation27.
27 The 60% recognition factor is provided as an interim treatment, which the CBB may refine in the future.
Apr 08CA-4.5.5
Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees will be eligible for recognition. The following exception applies. Where a bank buys credit protection through a total return swap and records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by an addition to reserves), the credit protection will not be recognised. The treatment of first-to-default and second-to-default products is covered separately in paragraphs CA-4.7.2 to CA-4.7.5.
Apr 08CA-4.5.6
Other types of credit derivatives will not be eligible for recognition at this time28.
28Cash funded credit linked notes issued by the bank against exposures in the banking book which fulfill the criteria for credit derivatives will be treated as cash collateralised transactions.
Apr 08Range of Eligible Guarantors (counter-guarantors)/Protection Providers
CA-4.5.7
Credit protection given by the following entities will be recognised:
(a) Sovereign entities29, PSEs, banks30 and securities firms with a lower risk weight than the counterparty;(b) Other entities rated A- or better. This would include credit protection provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor.
29 This includes the Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community, as well as those MDBs referred to in footnote 24.
30 This includes other MDBs.
Amended: April 2011
Apr 08Risk Weights
CA-4.5.8
The protected portion is assigned the risk weight of the protection provider. The uncovered portion of the exposure is assigned the risk weight of the underlying counterparty.
Apr 08CA-4.5.9
Materiality thresholds on payments below which no payment is made in the event of loss are equivalent to retained first loss positions and must be deducted in full from the capital of the bank purchasing the credit protection.
Apr 08Proportional Cover
CA-4.5.10
Where the amount guaranteed, or against which credit protection is held, is less than the amount of the exposure, and the secured and unsecured portions are of equal seniority, i.e. the bank and the guarantor share losses on a pro-rata basis capital relief will be afforded on a proportional basis: i.e. the protected portion of the exposure will receive the treatment applicable to eligible guarantees/credit derivatives, with the remainder treated as unsecured.
Apr 08Tranched Cover
CA-4.5.11
Where the bank transfers a portion of the risk of an exposure in one or more tranches to a protection seller or sellers and retains some level of risk of the loan and the risk transferred and the risk retained are of different seniority, banks may obtain credit protection for either the senior tranches (e.g. second loss portion) or the junior tranche (e.g. first loss portion). In this case the rules as set out in CA-6 (Credit risk — securitisation framework) will apply.
Apr 08Currency Mismatches
CA-4.5.12
Where the credit protection is denominated in a currency different from that in which the exposure is denominated — i.e. there is a currency mismatch — the amount of the exposure deemed to be protected will be reduced by the application of a haircut HFX, i.e.
GA = G × (1 - HFX)
Where:
G = Nominal amount of the credit protection
HFX = Haircut appropriate for currency mismatch between the credit protection and underlying obligation.
The appropriate haircut based on a 10-business day holding period (assuming daily marking-to-market) will be applied. If a bank uses the standard haircuts it will be 8%. The haircuts must be scaled up using the square root of time formula, depending on the frequency of revaluation of the credit protection as described in paragraph CA-4.3.12.
Amended: April 2011
Apr 08Sovereign Guarantees and Counter-guarantees
CA-4.5.13
Portions of claims guaranteed by the entities detailed in paragraph CA-3.2.1 above, where the guarantee is denominated in the domestic currency (and US$ in case of a guarantee provided by the Government of Bahrain and CBB) may get a 0% risk-weighting. A claim may be covered by a guarantee that is indirectly counter-guaranteed by such entities. Such a claim may be treated as covered by a sovereign guarantee provided that:
(a) The sovereign counter-guarantee covers all credit risk elements of the claim;(b) Both the original guarantee and the counter-guarantee meet all operational requirements for guarantees, except that the counter-guarantee need not be direct and explicit to the original claim; and(c) CBB is satisfied that the cover is robust and that no historical evidence suggests that the coverage of the counter-guarantee is less than effectively equivalent to that of a direct sovereign guarantee.Amended: April 2011
Apr 08CA-4.6 CA-4.6 Maturity Mismatches
CA-4.6.1
For the purposes of calculating risk-weighted assets, a maturity mismatch occurs when the residual maturity of a hedge is less than that of the underlying exposure.
Apr 08Definition of Maturity
CA-4.6.2
The maturity of the underlying exposure and the maturity of the hedge should both be defined conservatively. The effective maturity of the underlying should be gauged as the longest possible remaining time before the counterparty is scheduled to fulfill its obligation, taking into account any applicable grace period. For the hedge, embedded options which may reduce the term of the hedge should be taken into account so that the shortest possible effective maturity is used. Where a call is at the discretion of the protection seller, the maturity will always be at the first call date. If the call is at the discretion of the protection buying bank but the terms of the arrangement at origination of the hedge contain a positive incentive for the bank to call the transaction before contractual maturity, the remaining time to the first call date will be deemed to be the effective maturity. For example, where there is a step-up in cost in conjunction with a call feature or where the effective cost of cover increases over time even if credit quality remains the same or increases, the effective maturity will be the remaining time to the first call.
Apr 08Risk Weights for Maturity Mismatches
CA-4.6.3
As outlined in paragraph CA-4.2.24, hedges with maturity mismatches are only recognised when their original maturities are greater than or equal to one year. As a result, the maturity of hedges for exposures with original maturities of less than one year must be matched to be recognised. In all cases, hedges with maturity mismatches will no longer be recognised when they have a residual maturity of three months or less.
Apr 08CA-4.6.4
When there is a maturity mismatch with recognised credit risk mitigants (collateral, on-balance sheet netting, guarantees and credit derivatives) the following adjustment will be applied.
Pa = P × (t - 0.25) / (T - 0.25)
Where:
Pa = Value of the credit protection adjusted for maturity mismatch.
P = Credit protection (e.g. collateral amount, guarantee amount) adjusted for any haircuts.
t = Min (T, residual maturity of the credit protection arrangement) expressed in years.
T = Min (5, residual maturity of the exposure) expressed in years.
Amended: April 2011
Apr 08CA-4.7 CA-4.7 Other Items Related to the Treatment of CRM Techniques
Treatment of Pools of CRM Techniques
CA-4.7.1
In the case where a bank has multiple CRM techniques covering a single exposure (e.g. a bank has both collateral and guarantee partially covering an exposure), the bank will be required to subdivide the exposure into portions covered by each type of CRM technique (e.g. portion covered by collateral, portion covered by guarantee) and the risk-weighted assets of each portion must be calculated separately. When credit protection provided by a single protection provider has differing maturities, they must be subdivided into separate protection as well.
Apr 08First-to-default Credit Derivatives
CA-4.7.2
There are cases where a bank obtains credit protection for a basket of reference names and where the first default among the reference names triggers the credit protection and the credit event also terminates the contract. In this case, the bank may recognise regulatory capital relief for the asset within the basket with the lowest risk-weighted amount, but only if the notional amount is less than or equal to the notional amount of the credit derivative.
Apr 08CA-4.7.3
With regard to the bank providing credit protection through such an instrument, if the product has an external credit assessment from an eligible credit assessment institution, the risk weight in paragraph CA-6.4.8 applied to securitisation tranches will be applied. If the product is not rated by an eligible external credit assessment institution, the risk weights of the assets included in the basket will be aggregated up to a maximum of 1250% and multiplied by the nominal amount of the protection provided by the credit derivative to obtain the risk-weighted asset amount.
Apr 08Second-to-default Credit Derivatives
CA-4.7.4
In the case where the second default among the assets within the basket triggers the credit protection, the bank obtaining credit protection through such a product will only be able to recognise any capital relief if first-default-protection has also be obtained or when one of the assets within the basket has already defaulted.
Apr 08CA-4.7.5
For banks providing credit protection through such a product, the capital treatment is the same as in paragraph CA-4.7.3 above with one exception. The exception is that, in aggregating the risk weights, the asset with the lowest risk weighted amount can be excluded from the calculation.
Apr 08
