The Basel Committee on Banking Supervision has proposed that banks will only be able to reap 60% of any regulatory capital relief from hedging their loan portfolios with credit derivatives if they do not have protection against a restructuring credit event. According to Derivatives Week, an LMW sister publication, 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-face 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.
Norah Barger, chair of Basel's credit risk mitigation sub-group in Washington, has sent a letter to the International Swaps and Derivatives Association explaining that the committee came up with the figure using industry models in the Basel II framework. She added, "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, however, agrees with the size of the haircut.
Some derivatives practitioners said the 40% figure was too high because the restructuring credit event only occurs for around 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 shows the restructuring event accounts for 12.8% of defaults in CDOs they have rated.
Hugh Evans, credit specialist at Brians and former co-global head of credit derivatives at UBS in London, said 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: