Credit Derivatives Players Unite Against Basel Detail
Major credit derivatives market makers, including Merrill Lynch, Lehman Brothers and J.P. Morgan Chase, have unanimously agreed that a regulation in the proposed Basel Capital Adequacy Accord would treat credit derivatives unfavorably compared to bank guarantees and should not be adopted. Over 40 derivatives professionals and three trade organizations met in London last week to thrash out a response to the proposals.
The proposal is "absolutely unjustified and should be abolished," according to Emmanuelle Sebton, head of risk management at the International Swaps and Derivatives Association in London. Hermann Watzinger, managing director of debt markets and credit derivatives at Merrill Lynch in London, agreed. If credit derivatives work then banks should not need to put excess capital behind them and if they do not the product is useless and that would be reflected in the pricing, he argued.
The sticking point, according to bankers, is the so-called W-factor: a proposed increase in the amount of regulatory capital banks would have to assign to credit derivatives positions. Under the current Basel Accord credit derivatives purchased from anOrganisation for Economic Co-Operation and Development bank reduces the amount of regulatory capital the bank has to put behind the trade to 20%. The proposal stipulates that credit derivatives can only reduce the amount of regulatory capital required on 85% of its exposure: the remaining 15% will have a 100% risk weighting. Conversely, a bank guarantee will reduce the amount of regulatory capital to 20% for all the portfolio.
Richard Boulton, credit risk manager at the Financial Services Authority in London and a member of the credit risk mitigation group for the Basel Committee, said it is not going to change the regulation because market makers do not like it, they will have to prove it wrong. Bank guarantees have been around for a long time and have proved they work, but credit derivatives are a new product, he said, adding that documentation associated with the product is in a state of flux.