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  • (ii) Loss Given Default (LGD)

    • — Treatment of Unsecured Claims and Non-recognised Collateral

      • CA-5.3.18

        Under the foundation approach, senior claims on corporates, sovereigns and banks not secured by recognised collateral will be assigned a 45% LGD.

        Apr 08

      • CA-5.3.19

        All subordinated claims on corporates, sovereigns and banks must be assigned a 75% LGD. A subordinated loan is a facility that is expressly subordinated to another facility. This also includes economic subordination, such as cases where the facility is unsecured and the bulk of the borrower's assets are used to secure other exposures. CBB will review subordinated claims on a case by case basis. In case the subordinated claim (i) is on a banking, securities or other financial entity and (ii) exceeds (when combined with other investments in regulatory capital instruments of the investee) 20% of the concerned investee's eligible regulatory capital, such holding must be treated as described in Prudential Consolidation and Deduction Requirements Module.

        Apr 08

    • — Collateral under the Foundation Approach

      • CA-5.3.20

        In addition to the eligible financial collateral recognised in the standardised approach, under the foundation IRB approach some other forms of collateral, known as eligible IRB collateral, are also recognised. These include receivables, specified commercial and residential real estate (CRE/RRE), and other collateral, where they meet the minimum requirements set out in paragraphs CA-5.8.119 to CA-5.8.134.40 For eligible financial collateral, the requirements are identical to the operational standards as set out in chapter CA-4.

        40 The LGD applied to the collateralised portion of such exposures, subject to the limitations set out in paragraphs CA-4.2.1 to CA-4.3.25 of the standardised approach, will be set at 35%. The LGD applied to the remaining portion of this exposure will be set at 45%.

        Apr 08

    • — Methodology for Recognition of Eligible Financial Collateral under the Foundation Approach

      • CA-5.3.21

        The methodology for the recognition of eligible financial collateral closely follows that outlined in the comprehensive approach to collateral in the standardised approach in paragraphs CA-4.3.3 to CA-4.3.25. The simple approach to collateral presented in the standardised approach will not be available to banks applying the IRB approach.

        Apr 08

      • CA-5.3.22

        Following the comprehensive approach, the effective loss given default (LGD*) applicable to a collateralised transaction can be expressed as follows, where:

        (a) LGD is that of the senior unsecured exposure before recognition of collateral (45%);
        (b) E is the current value of the exposure (i.e. cash lent or securities lent or posted);
        (c) E* is the exposure value after risk mitigation as determined in paragraphs CA-4.3.3 to CA-4.3.6 of the standardised approach. This concept is only used to calculate LGD*. Banks must continue to calculate EAD without taking into account the presence of any collateral, unless otherwise specified.

        LGD* = LGD × (E* / E)

        Apr 08

      • CA-5.3.23

        Banks that qualify for the foundation IRB approach may calculate E* using any of the ways specified under the comprehensive approach for collateralised transactions under the standardised approach.

        Apr 08

      • CA-5.3.24

        Where repo-style transactions are subject to a master netting agreement, a bank may choose not to recognise the netting effects in calculating capital. Banks that want to recognise the effect of master netting agreements on such transactions for capital purposes must satisfy the criteria provided in paragraph CA-4.3.17 and CA-4.3.18 of the standardised approach. The bank must calculate E* in accordance with paragraphs CA-4.3.20 and 4.3.21 or CA-4.3.22 to 4.3.25 and equate this to EAD. The impact of collateral on these transactions may not be reflected through an adjustment to LGD.

        Apr 08

    • — Carve Out from the Comprehensive Approach

      • CA-5.3.25

        As in the standardised approach, for transactions where the conditions in paragraph CA-4.3.14 are met, and in addition, the counterparty is a core market participant as specified in paragraph CA-4.3.15, banks can apply a zero H.

        Apr 08

    • — Methodology for Recognition of Eligible IRB Collateral

      • CA-5.3.26

        The methodology for determining the effective LGD under the foundation approach for cases where banks have taken eligible IRB collateral to secure a corporate exposure is as follows:

        (a) Exposures where the minimum eligibility requirements are met, but the ratio of the current value of the collateral received (C) to the current value of the exposure (E) is below a threshold level of C* (i.e. the required minimum collateralisation level for the exposure) would receive the appropriate LGD for unsecured exposures or those secured by collateral which is not eligible financial collateral or eligible IRB collateral;
        (b) Exposures where the ratio of C to E exceeds a second, higher threshold level of C** (i.e. the required level of over-collateralisation for full LGD recognition) would be assigned an LGD according to the following table.

        The following table displays the applicable LGD and required over-collateralisation levels for the secured parts of senior exposures:

        Minimum LGD for Secured Portion of Senior Exposures

          Minimum LGD Required minimum collateralisation level of the exposure (C*) Required level of over-collateralisation for full LGD recognition (C**)
        Eligible Financial collateral 0% 0% n.a.
        Receivables 35% 0% 125%
        CRE/RRE 35% 30% 140%
        Other collateral41 40% 30% 140%
        (a) Senior exposures are to be divided into fully collateralised and un-collateralised portions;
        (b) The part of the exposure considered to be fully collateralised, C/C**, receives the LGD associated with the type of collateral;
        (c) The remaining part of the exposure is regarded as unsecured and receives an LGD of 45%.

        41 Other collateral excludes physical assets acquired by the bank as a result of a loan default.

        Amended: April 2011
        Apr 08

    • — Methodology for the Treatment of Pools of Collateral

      • CA-5.3.27

        The methodology for determining the effective LGD of a transaction under the foundation approach where banks have taken both financial collateral and other eligible IRB collateral is aligned to the treatment in the standardised approach and based on the following guidance:

        (a) In the case where a bank has obtained multiple forms of CRM, it will be required to subdivide the adjusted value of the exposure (after the haircut for eligible financial collateral) into portions each covered by only one CRM type. That is, the bank must divide the exposure into the portion covered by eligible financial collateral, the portion covered by receivables, the portion covered by CRE/RRE collateral, a portion covered by other collateral, and an unsecured portion, where relevant;
        (b) Where the ratio of the sum of the value of CRE/RRE and other collateral to the reduced exposure (after recognising the effect of eligible financial collateral and receivables collateral) is below the associated threshold level (i.e. the minimum degree of collateralisation of the exposure), the exposure would receive the appropriate unsecured LGD value of 45%; and
        (c) The risk-weighted assets for each fully secured portion of exposure must be calculated separately.
        Amended: April 2011
        Apr 08

    • — Treatment of Certain Repo-style Transactions

      • CA-5.3.28

        Banks that want to recognise the effects of master netting agreements on repo-style transactions for capital purposes must apply the methodology outlined in paragraph CA-5.3.24 for determining E* for use as the EAD.

        Apr 08

    • — Treatment of Guarantees and Credit Derivatives

      • CA-5.3.29

        CRM in the form of guarantees and credit derivatives must not reflect the effect of double default (see paragraph CA-5.8.93). As such, to the extent that the CRM is recognised by the bank, the adjusted risk weight will not be less than that of a comparable direct exposure to the protection provider. Consistent with the standardised approach, banks may choose not to recognise credit protection if doing so would result in a higher capital requirement.

        Apr 08

      • CA-5.3.30

        The approach to guarantees and credit derivatives closely follows the treatment under the standardised approach as specified in paragraphs CA-4.5.1 to CA-4.5.13. The range of eligible guarantors is the same as under the standardised approach except that companies that are internally rated and associated with a PD equivalent to A- or better may also be recognised. To receive recognition, the requirements outlined in paragraphs CA-4.5.1 to CA-4.5.6 must be met.

        Apr 08

      • CA-5.3.31

        Eligible guarantees from eligible guarantors will be recognised as follows:

        (a) For the covered portion of the exposure, a risk weight is derived by taking:
        •   the risk-weight function appropriate to the type of guarantor, and
        •   the PD appropriate to the guarantor's borrower grade, or some grade between the underlying obligor and the guarantor's borrower grade if the bank deems a full substitution treatment not to be warranted.
        (b) The bank may replace the LGD of the underlying transaction with the LGD applicable to the guarantee taking into account seniority and any collateralisation of a guaranteed commitment.
        Apr 08

      • CA-5.3.32

        The uncovered portion of the exposure is assigned the risk weight associated with the underlying obligor.

        Apr 08

      • CA-5.3.33

        Where partial coverage exists, or where there is a currency mismatch between the underlying obligation and the credit protection, it is necessary to split the exposure into a covered and an uncovered amount. The treatment in this approach follows that outlined in the standardised approach in paragraphs CA-4.5.10 to CA-4.5.12, and depends upon whether the cover is proportional or tranched.

        Apr 08

      • CA-5.3.34

        A bank using an IRB approach has the option of using the substitution approach in determining the appropriate capital requirement for an exposure. However, for exposures hedged by one of the following instruments the double default framework according to paragraphs CA-5.3.12 to CA-5.3.16 may be applied subject to the additional operational requirements set out in paragraph CA-5.3.39. A bank may decide separately for each eligible exposure to apply either the double default framework or the substitution approach:

        (a) Single-name, unfunded credit derivatives (e.g. credit default swaps) or single-name guarantees;
        (b) First-to-default basket products — the double default treatment will be applied to the asset within the basket with the lowest risk-weighted amount; and
        (c) nth-to-default basket products — the protection obtained is only eligible for consideration under the double default framework if eligible (n-1)th default protection has also been obtained or where (n-1) of the assets within the basket have already defaulted.
        Amended: April 2011
        Apr 08

    • — Operational Requirements for Recognition of Double Default

      • CA-5.3.35

        The double default framework is only applicable where the following conditions are met:

        (a) The risk weight that is associated with the exposure prior to the application of the framework does not already factor in any aspect of the credit protection;
        (b) The entity selling credit protection is a bank42, investment firm or insurance company (but only those that are in the business of providing credit protection, including mono-lines, re-insurers, and non-sovereign credit export agencies43), referred to as a financial firm, that:
        •   It is regulated in a manner broadly equivalent to that in this Module (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 CBB;
        •   Had 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
        •   Has an internal rating with a PD equivalent to or lower than that associated with an external investment-grade rating.
        (c) The underlying obligation is:
        •   A corporate exposure as defined in paragraphs CA-5.2.5 to CA-5.2.15 (excluding specialised lending exposures for which the supervisory slotting criteria approach described in paragraphs CA-5.3.6 to CA-5.3.11 is being used); or
        •   A claim on a PSE that is not a sovereign exposure as defined in paragraph CA-5.2.16; or
        •   A loan extended to a small business and classified as a retail exposure as defined in paragraph CA-5.2.18.
        (d) The underlying obligor is not:
        •   A financial firm as defined in (b); or
        •   A member of the same group as the protection provider.
        (e) The credit protection meets the minimum operational requirements for such instruments as outlined in paragraphs CA-4.5.1 to CA-4.5.5;
        (f) In keeping with paragraph CA-4.5.2 for guarantees, for any recognition of double default effects for both guarantees and credit derivatives a 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 must take steps to satisfy itself that the protection provider is willing to pay promptly if a credit event should occur;
        (g) The purchased credit protection absorbs all credit losses incurred on the hedged portion of an exposure that arise due to the credit events outlined in the contract;
        (h) If the payout structure provides for physical settlement, then there must be legal certainty with respect to the deliverability of a 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;
        (i) The terms and conditions of credit protection arrangements must be legally confirmed in writing by both the credit protection provider and the bank;
        (j) 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; and
        (k) There is no excessive correlation between the creditworthiness of a protection provider and the obligor of the underlying exposure due to their performance being dependent on common factors beyond the systematic risk factor. The bank has a process to detect such excessive correlation. An example of a situation in which such excessive correlation would arise 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.

        42 This does not include PSEs and MDBs, even though claims on these may be treated as claims on banks according to paragraph CA-5.2.17.

        43By non-sovereign it is meant that credit protection in question does not benefit from any explicit sovereign counter-guarantee.

        Amended: April 2011
        Apr 08