The Bundesaufsichtsamt für das Kreditwesen, the German Federal Banking Supervisory Authority, recently issued what it believes is the final circular on the capital adequacy treatment of credit derivatives (DW, 6/21).
The most significant difference to initial papers published in July and September last year is the compilation of two formerly separate areas: the capital adequacy and the large exposure rules. The rest of the paper seems to be open to thorough scrutiny by linguistic experts who are familiar with the semantics of regulators in Germany. Also, some of the more practical industry comments have been implemented in order to make the regime more market-oriented. Some suggestions, such as on the treatment of basket and spread products, have intentionally not been implemented as the BAKred is taking the view that capital adequacy has to be regulated on each risk asset individually.
The bottom line of capital adequacy in relation to credit derivatives is that the protection seller will assume for risk weighting purposes 100% of the transferred credit risk and therefore have to provide for a capital charge of 8% of liable equity on the notional amount of the credit risk. The protection buyer is relieved and reduces the risk weight on the underlying to 20%, reducing the capital to be set aside to 1.6%. The risk weighting follows the treatment of guarantees, and the regulator recognizes the use of standardized market documentation; currently the International Swaps and Derivatives Association master agreement and the recently released credit derivatives definitions and confirmations.
On the capital charges for credit derivatives, the BAKred makes a distinction between the banking book and the trading book in respect to which general provisions apply to the allocation of individual instruments. Reference assets such as credits are not (or rather, not yet) financial instruments under section 1 sub-section 11 of the German Banking Act (Gesetz über das Kreditwesen). Provided there is adequate standardization, they can be allocated to the trading book as tradable claims (section 1 sub-section 12 KWG) and be netted against other claims in the trading book. According to the initial draft, a risk-reducing weighting was admissible only if: the effectiveness of the risk transfer is clear from the contract documentation; the reference asset (i.e. to which reference is made for payment obligations of the protection seller) and the underlying (i.e. the loan for which protection is sought) are comparable pursuant to the criteria set out in the draft; and there is a maturity match between the reference asset and the underlying.
In the banking book, the maximum effect of a credit default swap, or a total return swap, respectively, matches that of a guarantee, i.e. the protection buyer gets the capital charge on the secured risk asset reduced to the risk-weight of its counterparty (i.e. the protection seller). For the protection seller, the derivative transaction must be considered an off-balance sheet transaction under the relevant section of the capital adequacy regime. The proceeds received under a credit-linked note (CLN) are treated as cash collateral for the protection buyer. The protection seller has to provide for the higher risk weighting of either the protection buyer or the reference debtor. In the trading book, the buyer of a CLN has to cover the general and specific price risk as laid down in table 2.
For the protection buyer, the general price risk of total return swaps is calculated as the short position in the reference asset and the long position in the financing component, which is for payment of the consideration under the total return swap and could be either a synthetic floating-rate note or a fixed-rate bond. The special price risk is taken into account by a short position in the reference asset. The aforesaid is subject to a set-off in the trading book, according to the capital adequacy principles, if the protection buyer holds a long position in the secured instrument as well. The protection seller has to back a long position in the reference asset and a short position as financing component in relation to the general price risk, and a long position in the reference asset in relation to the specific price risk.
For the protection buyer the general price risk under a credit default swap is reflected by the financing component, which has to be considered a long position if periodic premium payments were agreed. Regarding the specific price risk, the protection buyer has to count a synthetic short position in the amount of the settlement payment upon the occurrence of a credit event in relation to the reference debtor with the same maturity as the swap, but no additional inclusion beyond the secured position. As regards the general price risk, the protection seller has to consider the financing component a short position if periodic premium payments were agreed. The specific market risk is counted as a synthetic long position in the amount of the settlement payment upon the occurrence of a credit event in relation to the reference debtor with the same maturity as the swap.
Regarding the counterparty risk allocated to the trading book, BAKred applies to total return swaps the add-on applicable to the reference asset, and for credit default swaps the equity add-ons (except for securities with a high quality of an investment).
This week's Learning Curve was written by Hans-Günther Nordhues and Marc Benzler at Clifford Chancein Frankfurt.
