Regulatory Capital Treatment

Regulatory capital requirements impose a cost on the business of banking. Credit derivatives provide banks with a significant tool for reducing this cost.
Beginning in 1996, bank regulators in a number of jurisdictions -- including the U.S., U.K., France, Germany, Canada, Australia and Hong Kong - took preliminary positions on the effectiveness of credit derivatives (or at least some types of credit derivatives) in reducing regulatory capital under the 1988 Accord (which addresses credit risk) and also, in some cases, under the market risk amendment (which addresses market risk). In June 1999, the Basel Committee on Banking Supervision ("Committee") issued a consultative paper (the "'99 Proposal") proposing a framework that would replace the 1988 Accord.
One of the aims of the '99 Proposal is to establish for internationally active banks a more consistent regulatory capital approach to credit derivatives. After the Committee finalizes the new framework - currently expected to happen in 2001 -it will be the task of national regulators to implement the new framework.
The debate between banks and their regulators on credit derivatives has largely focused on the following issues.

Trading Book versus Banking Book
The capital requirements for credit risk are potentially lower in the trading book than in the banking book. National regulators have differing views on the requirements for trading book treatment. It is not clear whether the Committee will attempt to specify in detail exactly which credit derivative products may receive trading book treatment. It is certain, however, that the Committee will try to avoid regulatory arbitrage between the trading book and the banking book.
Major Banking Book Issues
Good News/Bad News
The good news is twofold:
(i) The '99 Proposal would replace the existing approach to risk weights
with an approach that would use the assessments of "external credit
assessment institutions" - i.e., qualifying rating agencies.
(ii) The Committee believes that, for some sophisticated banks, an
internal ratings-based approach could form the basis for setting capital
charges.
The bad news is that at this stage the Committee does not yet appear ready to accept the use of a full portfolio modeling approach in the process of setting capital charges.
Extent of Risk Reduction
Suppose a bank ("Lender") extends a loan to a corporate customer and hedges the resulting credit risk by buying credit protection referencing that loan from an OECD bank ("Protection Seller"). Under the 1988 Accord's "substitution approach", the Lender may substitute the risk weight of the Protection Seller (20% under the 1988 Accord) for the risk weight of the corporate (100% under the 1988 Accord) when calculating the capital charge for the loan. The Lender will suffer a loss only if the "double default" of the corporate and the Protection Seller occurs.
The Committee has acknowledged that if the probabilities of default of the corporate and the Protection Seller are uncorrelated, a smaller capital charge than that required by the substitution approach would be justified. To mitigate the onerousness of the current substitution approach, the Committee is considering

applying a haircut to the charge resulting from the substitution approach. Some banks have suggested that the Committee should make use of banks' internal assessments of joint default probability in setting capital requirements for hedged exposures.
Maturity Mismatch
The issue here is how to treat forward credit risk if the credit derivative hedge expires before the maturity of the asset being hedged. The Committee is considering the following approach, among others: recognize the hedge for capital purposes even if there is a maturity mismatch, but impose an add-on capital requirement to cover the forward credit risk. The Committee indicated it would consider waiving the add-on if the remaining maturity of the hedge is longer than a minimum period -- say, two or three years.
Asset Mismatch
The issue here is the extent to which regulators should recognize credit risk reduction where the credit derivative hedge protects a bank against exposure to one asset (say, senior debt) while the bank holds a different asset (say, subordinated debt) of the same entity. The Committee is considering imposing three requirements that a credit derivative must meet in order to have a capital reducing effect in these circumstances: (i) the credit derivative and the asset being hedged must be issued or owed by the same entity, (ii) the credit derivative's reference asset must rank pari passu or more junior to the asset being hedged and (iii) cross default clauses must apply between the reference asset and the hedged asset. The rationale for the third requirement is dubious - it would seem that the Committee should focus not on cross default clauses but on whether a failure to perform with respect to the asset being hedged would trigger a payout under the credit derivative.
Major Trading Book Issues
The so-called "market risk" rules apply to banks with significant trading activities, i.e., the most sophisticated internationally active banks. The purpose of these rules is to provide a capital cushion for pricing risks to which these banks are exposed. The market risk rules permit banks to use proprietary models to calculate the capital required for their trading book activities, provided that such banks satisfy quantitative and qualitative standards.
The market risk rules impose capital requirements with respect to three separate risks:
(i) general market risk (which, in the case of credit derivatives is interest
rate risk);
(ii) specific risk; and
(iii) counterparty credit risk on OTC derivatives.
The national regulators that have taken position on the application of the market risk rules to credit derivatives have divergent opinions on the following issues:
Counterparty Credit Risk
Counterparty risk is calculated by summing the mark-to-market value of the derivative transaction and an add-on requirement with respect to potential future exposure. Some national regulators have applied a lower add-on where a credit derivative's reference asset is an investment grade instrument and a higher add-on where the instrument is not investment grade. Some banks have suggested that, instead of retaining the current approach of using add-ons for potential future exposure, the Committee should consider accepting a bank's internally generated measure of potential future exposure with respect to a counterparty's portfolio.

Specific Risk
The issue here is the extent to which, for specific risk purposes, long positions can be offset against short positions where such positions give rise to a maturity or asset mismatch.
The approach that the Committee will take with respect to the issues highlighted above is not yet clear. It is safe to say, however, that the more regulatory capital rules evolve to recognize the credit risk reductions effected by credit derivatives, the more powerful credit derivatives become for reducing the cost of regulatory capital.

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A Review of Valuation Models

Credit models can be broadly separated into comparative pricing models (also known as arbitrage-free models) and econometric models (also known as equilibrium models). In the context of comparative pricing, one tries to derive the price of a new financial instrument from existing instruments in the market. The derivation typically assumes that the credit referenced can be freely traded with little friction (bid/ask spread), high liquidity (daily hedges), and the availability of short positions. Econometric models try to predict default rates based on historical information on default rates for different economic environments and current economic information. Most models proposed in the literature use comparative pricing methodologies (sometime called arbitrage-free pricing). However, long-term buy and hold investors use econometric models.
Econometric models require significant data and sophisticated techniques to analyze the data. The models are typically used to produce buy/sell options and their output may not match observed market prices. However, they provide a useful tool for making decisions on the relative value of various bonds. The key to choosing between these two types of models is whether one is more concerned about estimating intrinsic value (equilibrium models) or value relative to current market prices (arbitrage-free models).
Another important question when implementing a model of credit risk is the technique to be used in the determination of actual prices. The common approaches are closed form (formulaic) solutions, tree frameworks, and Monte Carlo simulations. Closed form solutions are convenient to use and provide quick intuition on important variables, but usually are too simple or too inflexible to be practical in valuing complex securities. Tree frameworks provide more flexibility and are computationally feasible if the problem can be solved with a recombining binomial or trinomial tree. Finally, Monte Carlo simulation provides the most flexibility and is useful for solving non-Markov models (i.e. those that are path-dependent and require a non-recombining tree). However, Monte Carlo analysis is slow and computationally intensive.

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The Role of Special Purpose Vehicles

Special purpose vehicles (SPVs) facilitate asset repackaging by embedding credit derivatives in SPVs, allocating cash flows, or by tranching credit risk. Many investors are unable or unwilling to enter into interest rate swaps, default swaps, currency swaps or other derivatives directly. For some, credit availability is an issue; for others it is the additional resources required to document and manage separate derivative positions. SPVs accommodate investors' needs for various coupons, credit ratings, maturities, and volume, all in the form of a security. SPVs are generally structured to avoid entity-level tax.
The Global Credit Derivatives group at Merrill Lynch utilizes several SPVs, including:
• STructured EnhancEd Return TrustS (public and private STEERS®)
• Asset Backed Trusts (ABTs)
• Secured, Individually Repackaged & Exchangeable Securities (SIRES, Limited.)
• Loan Co.'s
• CBOs and CLOs
Each of the SPVs above are a series of bankruptcy remote trusts or companies that are established to purchase assets, use swaps and options, and thereby create a customized coupon, as shown below in Figure 8. The certificates or notes can be individually rated by one or more of the major ratings agencies (Moody's, Standard & Poor's, Fitch, and Duff and Phelps). The rating of an SPV will typically reflect the rating on the underlying security along with some consideration given to the rating of the derivative counterparty.

Applications
Investors utilize SPVs to increase market access. SPVs allow investors to buy a security with a customized coupon, currency, call features and tenor without entering into swaps, options or other over the counter derivatives directly. Use of SPVs also allows investors to benefit from efficiencies of scale. Because an SPV can hold multiple assets, bonds can be aggregated and purchased in a single, large transaction. The SPV coupon can be one aggregate round coupon, eliminating the need to process frequent and varying cash flows.
■ Examples• A corporate bond investor is looking for high yielding instruments with strong corporate names. America Online issues a subordinated zero-coupon
convertible bond at a high yield. Default swaps offer an opportunity for investors to purchase credit exposure directly, without worrying about the zero-coupon accretion or the embedded equity option. However, due to restrictions in their charter, the investor is unable to use derivative instruments as investment opportunities. Therefore, the investor purchases a STEERS with an embedded AOL default swap. The investor achieves a high yielding synthetic AOL bond that meets all charter restrictions despite the lack of any plain vanilla AOL bonds in the market.
• A money market fund cannot buy a five-year credit card asset backed security according to the Rule 2a-7 guidelines that govern money market fund investments. The fund could, however, purchase an ABT trust certificate that evidenced beneficial ownership in (a) those same securities and (b) a derivative contract with Merrill Lynch that converts the tenor of the security from five years to one year using a put option (which adheres to the guidelines for the fund). The investor has increased the fund's access to new investments and will often achieve a yield pickup over similarly rated investments. Merrill makes a secondary market in ABTs.
■ Documentation
Grantor trust transactions (e.g., STEERS® and ABTs) and special purpose companies (e.g., SIRES and Loan Co.'s) have similar documentation. The transactions are described in an offering memorandum and supplement. There are also documents that establish the vehicle: a trust agreement for trusts and incorporation documents for special purpose companies

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