Credit derivatives practitioners panned the Basel Capital Adequacy Accord in formal responses submitted to the Bank for International Settlements last week. In particular, bankers and the International Swaps and Derivatives Association criticized the accord because it would require credit derivatives trading books to be better capitalized, doesn't allow for the joint probability of default and imposes a ceiling on the amount of regulatory relief banks can claim against credit derivatives positions, known as the w-factor.
"No one could believe the w-factor," commented Hermann Watzinger, managing director and co-head of securitization and portfolio credit derivatives at Merrill Lynch in London. "It was a killer," he added.
An official at the BIS said it expects 200 responses by the end of this week. He added the bank is "not bolting the stable door" and will continue to consult with banks before publishing a final paper.
The accord proposes establishing a 20% charge for specific risk capital on credit derivatives transactions in the trading book. At the moment if a bank buys and sells an identical credit derivative instrument it receives 100% relief on the capital charge and is only liable for a counterparty risk charge. Under the Basel proposals banks would only get 80% capital relief. Andrea Fabbri, deputy head of credit derivatives at IntesaBci in Milan, said this could lead to distortions in pricing.
A further point of contention is that regulators are not allowing banks to use the probability of both the reference entity and the protection seller defaulting when calculating how much capital to assign to a position. Instead regulators insist the calculation must be based on whichever has the lower probability of default. IntesaBci's Fabbri accepts there is not a reliable model at the moment to calculate joint probability of default but wants an option in the accord to add this at a later stage.
Bankers have been continuously militating against the w-factor, which imposes a 15% floor on regulatory capital relief, whereas a bank guarantee does not have this floor. Fabbri warns the w-factor could lead to fragmentation of the market, as some banks rename the credit derivatives as guarantees, and a rise in the cost of credit protection (DW, 5/30).
