In last week's issue of DW we looked at the treatment of credit risk in the recently released consultation paper by the European Commission on new capital adequacy rules for European Union financial institutions, and compared it to similar proposals by the Basel Committee on Banking Supervision. In this issue we will analyze how the Commission approaches the crucial article of credit risk mitigation. Next week's article will look at the definition and treatment of other risks, such as operational risk and interest-rate risk in the banking book.
"One of the points of departure of the present capital review has been the premise that the existing regime fails sufficiently to recognise or to encourage prudent risk management techniques."
Like Basel, the Commission is taking an innovative step forward by focusing on general principles that apply across techniques, as opposed to developing criteria for each risk management tool, for example, netting. It feels that the latter approach curbs innovation and opens up regulatory arbitrage opportunities. Instead, the Commission wants to set up principles to treat instruments that have a similar economic effect in a consistent manner. It says there should be an over-arching principle regarding the recognition of credit risk mitigation techniques, which should be supplemented with core principles to assess to what extent the credit risk mitigation should be recognized.
The paper suggests several principles to assist the competent authority in determining what qualifies as a satisfactory credit risk mitigation technique:
* Legal certainty
* Satisfactory management of residual risks and operational
risks created by the credit risk mitigation technique.
It then proposes principles that should be considered to determine the extent to which a credit risk mitigation technique should be recognized:
* Maturity mismatches
* Mismatches due to changes in the market value of the
credit risk protection
* Asset mismatches
* Contingent risk
* Payout/retention structure
* Eligibility.
MATURITY MISMATCHES
"Some relief could be introduced. ... Refusing any relief, as Basel also notes, would be to treat imperfectly hedged transactions in the same way as unhedged transactions, and would not encourage the use of hedging techniques as a risk management tool."
The Committee suggests two options to resolve the controversial issue of maturity mismatches--where the hedge is shorter in maturity than the hedged item.
First, it proposes the establishment of a period up to which full cover will be accepted, possibly subject to an add-on for credit risk. If the hedge's residual maturity exceeds a defined time horizon, the hedge is recognized. If the residual maturity is less than that, no hedge is recognized. For example, if the defined time horizon is three years, and the mismatch occurs after that period--i.e., if a five-year exposure is protected by a four-year hedge, the hedge will be fully recognized.
Second, the Commission suggests that each position with a counterparty could be slotted into a "maturity ladder," based on residual maturity. The capital charge is calculated based on a risk weighting that reflects the net positions in each maturity band.
MISMATCHES DUE TO MARKET SENSITIVITY OF CREDIT PROTECTION
"Current European regulations do not address the issue of mismatches due to changes of value in risk mitigation as a result of market movements."
The Commission wants to implement a mechanism to take account of the risk that credit protection is subject to market movements, i.e. that collateral, though initially sufficient, may decrease in value below the hedge level. The Basel papers have taken an open stance on the subject, discussing add-on and haircut approaches. The Committee proposes four options:
* Haircuts and add-ons
* Haircut plus reduction of risk weight on underlying asset
* Capital Adequacy Directive methodology on market risk
* CAD market risk capital charges where collateral is
used for a specialized purpose and where it meets certain
detailed criteria.
ASSET MISMATCHES
Asset mismatches occur either where the reference asset and the underlying are not issued by the same obligor, or where the reference asset and the underlying are issued by the same obligor but are different instruments, for example, if a bond is taken as the reference asset on an underlying loan obligation. Asset mismatches are acceptable as hedges where the asset is issued by the same obligor, but assets issued by different obligors would not obtain hedge relief.
CONTINGENT RISK
"For the most part, the treatment for a hedged position is identical to that for an unhedged transaction, creating a disincentive for prudent risk management practices."
Contingent risk is the risk that both hedge and underlying exposure default at the same time. At present, a substitution approach has been adopted, whereby the risk weight of, for example, the guarantor/collateral, is substituted for that of the underlying, however, only a limited range of collateral and guarantors is eligible for this treatment. The Commission assumes that the scope of eligibility applies to the collateral/guarantor whose risk weight is less than, or equal to, the weight of the underlying, and is less than, or equal to, 100%. Basel suggests that the collateral/guarantee would have to have a lower, not equal, risk weight than the underlying, and does not explicitly suggest a 100% upper limit. The Committee proposes six options:
Retain the status quo. However, the Commission adds the range of eligible collateral and guarantees should be widened.
Two-tier approach. Institutions using the standardized risk weighting method would use the substitution approach and those using internal ratings would use the actual default correlation between collateral/guarantor and underlying.
Multiplication factor approach. The capital charge on the protection seller could be multiplied by the capital charge on the reference borrower.
Average default correlation approach. Assume an average default correlation between the protection seller and the reference borrower when calculating the risk contingent charge.
Haircut approach. Applying a certain percentage haircut on the guarantor/collateral's capital requirement.
Enhanced multiplicative approach. Basic multiplicative approach plus an additional factor to capture the correlation degree.
PAYOUT/RETENTION STRUCTURE
The Commission emphasizes the importance of determining the degree of cover the credit risk mitigation technique provides, noting that it varies considerably with the payout and retention structure of a transaction, for example a first-loss cover.
ELIGIBILITY
Only certain credit risk mitigation techniques should attract capital relief. They could include, but not be limited to, collateral, guarantees, credit derivatives, netting agreements, securitization and put options.
* Collateral and guarantees. In principle, there should be
equal treatment between collateral and guarantees with
respect to the scope of eligibility.
* Credit derivatives. Asset mismatches, legal risk, as well as
quality of documentation, warrant special attention with
this particular method.
* Bilateral netting. The Commission rejects the Basel
proposal that bilateral netting should be allowed across all
banking book assets and liabilities on the basis that it may
not be legal in all European Union member states. Issues
that will need to be discussed further include close-out
netting, valuation and maturity mismatches. The
Commission also mentions the legal enforceability of
master agreements.
* Securitization. The Commission calls for harmonization of
operational requirements for securitization across Europe,
including rules on revolving structures and conduit schemes.
This week's Learning Curve was written by Elisabeth Bertalanffy, managing editor of Derivatives Week in London, with the help of Simon Gleeson, an attorney in Allen & Overy's financial services group.
