The Basel Committee on Banking Supervision has proposed that loan houses be limited to only 60% regulatory capital relief when hedging loan portfolios with credit derivatives if they don't have protection against a restructuring credit event. This is especially bad news for Japanese banks because most of their lending is bilateral and they cannot purchase protection against restructuring the loan.
The proposal is an about-turn from the previous framework that said banks would only need protection against a restructuring credit event if they did not have control over any potential restructuring.
A letter Norah Barger, chair of Basel's credit risk mitigation sub-group in Washington, sent to the International Swaps and Derivatives Association, explained that the committee came up with the figure using industry models in the Basel 2 framework. She said, "These models are based upon estimates of the probability of restructuring relative to the probability of default (PR/PD) and loss given restructuring compared to loss given default (LGR/LGD)." Barger told DW the committee would review the number if the industry came up with more exhaustive data.
"ISDA is particularly concerned with the treatment of restructuring risk..." according to a letter Emmanuelle Sebton, head of risk management at ISDA in London, wrote in reply to Barger earlier this month. "The notion of control over restructuring, which ISDA had welcomed, purely and simply disappears," the letter continued. The trade association agrees with the size of the haircut, however.
Some derivatives practitioners said the 40% figure was too high because the restructuring credit event only occurs in approximately 15% of defaults, and recovery rates are typically around 20 cents on the dollar more than after a bankruptcy or failure-to-pay credit event. Fitch Ratings data show the restructuring event accounts for 12.8% of defaults in CDOs they have rated.
Hugh Evans, credit specialist at Brains and former co-global head of credit derivatives at UBS in London, said that the theory of a haircut makes sense from a bank capital point of view because there is a real economic difference between the two contracts. He added, "By giving restructuring an economic value it will simplify the process. It highlights the reality of the basis risk that [dealers] will need to take."
For copies of both letters, please click on the below links:
