CA-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 08
