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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