The standardised approach allows for the incorporation of several types of credit risk mitigation in determining the regulatory capital for a claim. For a form of risk mitigation to qualify it should be legally enforceable. This means there should be a strong legal basis for actually obtaining the value of the risk mitigation, when necessary. The precise definition of legally enforceable is given in paragraph 117 and 118 of the BIS II paper.
As with the claims, the risk mitigation types are first categorised. Each category has its own rules for calculating the risk mitigation value. The following categories are identified:
Collateral<
Different types of collateral may be incorporated in the capital calculations for the claim to which it is linked. This poses the problem of calculating the effect of the collateral. The standardised approach proposes two different methods for determining the impact of collateral. One of which is again split in two calculation methods:
In the simple approach the claim is split into the following parts.
The type 1 and type 2 act as examples. A claim can be collateralized by many types of eligible collateral. For each part of the claim collateralized by different collateral the regulatory capital is separately calculated. For the collateralized part of the claim the regulatory capital is calculated by multiplying the value of the collateral by the risk weight assigned to that collateral item. The regulatory capital of the unsecured part of the claim is calculated by assigning the claim to one of the claim-categories and determining its grade.
In the comprehensive approach the value of both the claim and the collateral is adjusted. The claim is adjusted to represent possible claim growth. A claim could grow in exposure if for instance securities are lent. The collateral is adjusted to represent the collateral value loss due to market fluctuations. A separate adjustment is made to incorporate the risk of exchange rate changes when the collateral and the claim are in different currencies. After both values have been adjusted the latter is subtracted from the former leaving the exposure after collateral. The regulatory capital is calculated by multiplying the exposure after collateral by the risk weight of the claim. The haircuts for the claim and the collateral can either be calculated by the bank (in the Own Estimates of Haircuts approach) or the regulatory haircuts can be used (in the Standard Supervisory Haircuts approach).
On balance sheet netting
On balance sheet netting means that a debit exposure (a claim) is directly offset by a credit exposure. This is done with limited use of haircuts or further calculation. Regulatory capital will have to be calculated over the remaining (net) debit exposure if any. Basel states the following:
“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 147. 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 151, 169, and 202 to 205 will apply.”
The formula referred to is the comprehensive approach for calculating regulatory capital. In essence the formula is used with claim and collateral haircuts of zero percent.
Guarantees and credit derivatives<
-Guarantees<
Guarantees given by the following institutions are eligible as risk mitigation:
A guarantee with a rating worse then the counterparty should be ignored (comments on the subject are appreciated, what is your opinion)
Furthermore there are several contractual and operational requirements which have to be met. Basically the contract has to be legally enforceable in any circumstance. There may be no exit clause freeing (reducing) the guarantor from his obligations.
If there is a materiality threshold before which the guarantor is not obliged to pay, this amount should be subtracted directly from the regulatory capital (it is unknown which capital should be used tier one, tier two or both).
If the guarantee does not cover all expected income (principle, interest, fees, etc.) but for instance only the principle, the uncovered income should be considered an unsecured claim. It is not clear how this should be accomplished; comments on the subject are welcome. A possibility would be to discount the expected interest payments and fees using the funding rate. The discounted value can then be added to the claim. If the guarantee is set in a different currency than the claim a currency haircut should be made on the guarantee amount.
The regulatory capital is calculated by using the guarantors risk weight for the guaranteed portion of the claim, and the counterparties risk weight for the unsecured portion of the claim.
In other words:
Ga = G * (1 – Hfx)
Ga = The guarantee amount after the currency mismatch haircut.
G = Value of the guarantee (contractually set)
Hfx = The appropriate currency mismatch haircut (Any insights in how to determine the appropriate haircut are welcome, please post comments on the subject)
RWA = (C + UI – Ga) * RWC + Ga * RWG
RWA = Risk Weighted Asset
C = Exposure of the claim
UI = Value of Unsecured Income (interest payments, fees, etc.)
RWC = Risk Weight of the Counterparty
RWG = Risk Weight of the Guarantor
RC = RWA * 8%
RC = Regulatory Capital<
- Credit Derivatives<
This section is still under construction. Comments, suggestions and articles are welcome.
Maturity Mismatch
This section is still under construction. Comments, suggestions and articles are welcome.
Other items relating to credit risk mitigation<
This section is still under construction. Comments, suggestions and articles are welcome.