CA-4.2.1

A collateralised transaction is one in which:

¹⁷ 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.

CA-4.2.2

Where conventional bank licensees 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.

CA-4.2.3

Conventional bank licensees 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. Conventional bank licensees 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.

CA-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.

CA-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 conventional bank licensee 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 conventional bank licensees must take all steps necessary to fulfil those requirements under the law applicable to the conventional bank licensee'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.

CA-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.

CA-4.2.7

Conventional bank licensees 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.

CA-4.2.8

Where the collateral is held by a custodian, conventional bank licensees must take reasonable steps to ensure that the custodian segregates the collateral from its own assets.

CA-4.2.9

A capital requirement will be applied to a conventional bank licensee 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.

CA-4.2.10

Where a conventional bank licensee, 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 conventional bank licensee is the same as if the conventional bank licensee had entered into the transaction as a principal. In such circumstances, a conventional bank licensee will be required to calculate capital requirements as if it were itself the principal.

CA-4.2.11

In the simple approach the risk weighting of the collateral instrument collateralising or partially collateralising the exposure is substituted for the risk weighting of the counterparty. Details of this framework are provided in Paragraphs CA-4.3.26 to CA-4.3.29.

CA-4.2.12

In the comprehensive approach, when taking collateral, conventional bank licensees 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 and add-ons, conventional bank licensees 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 either¹⁸, 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 due to the add-on and for the collateral it will be lower due to the haircut.

¹⁸ Exposure amounts may vary where, for example, securities are being lent.

CA-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.

CA-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), conventional bank licensees must 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.

CA-4.2.15

Conventional bank licensees must use standard haircuts given in Paragraph CA-4.3.7 unless allowed to use models under Paragraph CA-4.3.22.

CA-4.2.16

The size of the individual haircuts and add-ons will depend on the type of instrument, type of transaction and the frequency of marking-to-market and remargining. 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 re-margining or marking-to-market.

CA-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 conventional bank licensees using standard haircuts not to apply these haircuts in calculating the exposure amount after risk mitigation.

CA-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.

CA-4.2.19

As an alternative to standard haircuts conventional bank licensees 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. 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.

CA-4.2.20

Where conventional bank licensees 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.

CA-4.2.21

Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and the CBB is satisfied that conventional bank licensees fulfil certain minimum operational conditions relating to risk management processes the CBB may allow conventional bank licensees to take account of such credit protection in calculating capital requirements.

CA-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.

CA-4.2.23

Detailed operational requirements are given in Paragraphs CA-4.5.1 to CA-4.5.5.

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.

CA-4.2.25

Treatments for pools of credit risk mitigants and first- and second-to-default credit derivatives are given in Paragraphs CA-4.7.1 to CA-4.7.5.