The Basel Committee’s final standard on “The standardized approach for measuring counterparty credit risk exposures” includes a comprehensive, non-modeled approach for measuring counterparty credit risk associated with over-the-counter (OTC) derivatives, exchange-traded derivatives, and long settlement transactions. The new standardized approach for measuring counterparty credit risk (SA-CCR) replaces both the Current Exposure Method (CEM) and the Standardized Method (SM) in the capital adequacy framework. In addition, the Internal Model Method (IMM) shortcut method will be eliminated from the framework once SA-CCR takes effect, which is scheduled for January 1, 2017.
The CEM had been criticized for several limitations, in particular that it did not differentiate between margined and un-margined transactions, that the supervisory add-on factor did not sufficiently capture the level of volatilities as observed over recent stress periods, and the recognition of netting benefits was too simplistic and not reflective of economically meaningful relationships between derivatives positions.1
Although being more risk-sensitive than the CEM, the SM was also criticized for several weaknesses. Like the CEM, it did not differentiate between margined and un-margined transactions and nor did it sufficiently capture the level of volatilities observed during the stress periods of the last five years. In addition, the definition of “hedging set” led to operational complexity resulting in an inability to implement the SM, or implementing it in inconsistent ways. Further, the relationship between current exposure and potential future exposure (PFE) was misrepresented in the SM because only current exposure or PFE was capitalized. Finally, the SM did not provide banks with a true non-internal model alternative for calculating EAD because the SM used internal methods for computing delta-equivalents for non-linear transactions.1
In our view, the Committee’s objective in undertaking this work was to develop a risk sensitive methodology that can appropriately differentiate between margined and un-margined trades, and provide more meaningful recognition of netting benefits than either of the existing non-modeled approaches.
In measuring aggregate pre-settlement credit-risk exposures to a single counterparty, institutions may use either a transactions approach or a portfolio approach.1 Under a transactions approach, the loan-equivalent amounts for each derivative contract with a counterparty are added together. Some institutions may take a purely transactional approach to aggregation and do not incorporate the netting of long and short derivatives contracts, even when legally enforceable bilateral netting agreements are available. In such cases, simple sum estimates of positive exposures may seriously overestimate true credit exposure.
Master close-out netting agreements are bilateral contracts intended to reduce pre-settlement credit risk in the event that the counterparty becomes insolvent before settlement. Upon default, the non-defaulting party nets gains and losses with the defaulting counterparty to a single payment for all covered transactions.1
The SA-CCR requirement limits the need for discretion by national authorities, minimizes the use of banks’ internal estimates that were based on undefined “hedging sets” (i.e. each bank developed their own idiosyncratic hedging set), and avoids undue complexity by drawing upon prudential approaches already available in the capital framework. It has been calibrated to reflect the level of volatilities observed over the recent stress period, while also giving regard to incentives for centralized clearing of derivative transactions.1
The SA-CCR retains the same general structure as that used in the CEM, consisting of two key regulatory components: replacement cost and potential future exposure. An alpha factor is applied to the sum of these components in arriving at the exposure at default (EAD). The EAD is multiplied by the risk weight of a given counterparty in accordance with either the Standardized or Internal Ratings-Based approaches for credit risk to calculate the corresponding capital requirement.1
The draft was enhanced by utilizing the responses received to develop this final rule. This in our view should be a positive development for most firms as the amount of capital required will be more in line with the economic implications of their portfolio (i.e. decrease) versus the prior version which did not give any credit to the margin (i.e. capital) that the firm was required to provide to the various exchanges and clearinghouses. The enhanced rules also:1
- increased specificity regarding the application of the approach to complex instruments;
- the introduction of a supervisory measure of duration for interest rate and credit derivative exposures;
- removal of the one-year trade maturity floor for un-margined trades and the addition of a formula to scale down the maturity factor for any such trades with remaining maturities of less than one year;
- the inclusion of a supervisory option pricing formula to estimate the supervisory delta for options;
- a cap on the measured exposure for margined transactions to mitigate distortions arising from high threshold values in some margining agreements; and
- adjustments to the calibration of the approach with respect to foreign exchange, credit and some commodity derivatives.
The exposures under the SA-CCR consist of two components: replacement cost (RC) and potential future exposure (PFE). Mathematically:
SA under default at Exposure = EAD = alpha*(RC+PFE)
Where alpha equals 1.4, which is carried over from the alpha value set by the Basel Committee for the IMM. The PFE portion consists of a multiplier that allows for the partial recognition of excess collateral and an aggregate add-on, which is derived from add-ons developed for each asset class (similar to the five asset classes used for the CEM (i.e. interest rate, foreign exchange, credit, equity and commodity).
The methodology for calculating the add-ons for each asset class hinges on the key concept of a “hedging set”. A “hedging set” under the SA-CCR is a set of transactions within a single netting set and for which partial or full offsetting is recognized for the purpose of calculating the PFE add-on. Add-on’s will vary based on the number of hedging sets that are available within an asset class. These variations are necessary to account for basis risk and differences in correlations within asset classes.
The BCBS paper (The standardized approach for measuring counterparty credit risk exposures) presents the four methodologies for calculating the add-ons and are listed below:
- Interest rate derivatives – A hedging set consists of all derivatives that reference interest rates of the same currency such as USD, EUR, JPY, etc. Hedging sets are further divided into maturity categories. Long and short positions in the same hedging set are permitted to fully offset each other within maturity categories; across maturity categories, partial offset is recognized.
- Foreign exchange derivatives – A hedging set consists of derivatives that reference the same foreign exchange currency pair such as USD/JPY, EUR/JPY, or USD/EUR. Long and short positions in the same currency pair are permitted to perfectly offset, but no offset may be recognized across currency pairs.
- Credit derivatives and equity derivatives – A single hedging set is employed for each asset class. Full offset is recognized for derivatives referencing the same entity (name or index), while partial offset is recognized between derivatives referencing different entities.
- Commodity derivatives – Four hedging sets are employed for different classes of commodities (one each for energy, metals, agricultural, and other commodities). Within the same hedging set, full offset is recognized between derivatives referencing the same commodity and partial offset is recognized between derivatives referencing different commodities. No offset is recognized between different hedging sets.
The Bank for International Settlements realized that this is a big change and has allowed for a longer transitional phase for compliance and will be enforcing starting on January 1, 2017. All current Accenture clients using the standardized approach will be affected and are required to institute the changes outlined in this paper and an accompanying standards document.
The intent of the proposal is to allow Regulators to obtain a more consistent and granular view of counterparty credit risk. It acknowledges its limitation in dealing with commodity risk hedging. Nevertheless, it will become required and clients will need to incorporate the regulatory changes into their current procedures at some point.
This BCBS consultative document is highly technical and specialized; its applicability is only for those individuals working with the market risk and CCR modeling group and executive management. Consequently, there will be a premium on Basel CCR skills and experience that can plan, design, and execute practical approaches to achieving compliance.
A bank’s ability to govern, control and route trade populations that require IMM vs. non-IMM treatment will likely be a key area of focus and investment in our view. In our observation, banks have a strong understanding of the value and importance of ensuring that all eligible exposures receive the most beneficial capital treatment, while regulators have been sharp at pointing out failures in population control of exposures receiving certain capital treatments – so the stakes are high. Additionally, the introduction of the Standardized Approach will likely result in new and/or recalibrated models leading to an opportunity for Regulators to evaluate model management and governance practices as well.
Accenture has been supporting some of the largest global banks in comprehending the practical implications of changes to Basel rules across multiple organizational groups including: CCR, Quant, Model Risk, Compliance, Data, Technology, and Change Management. Specifically, Accenture has helped banks in their efforts to achieve Basel IMM approval through strategy and implementation of enhancements to their CCR capabilities with a clear focus on optimizing the capital treatment for their exposures. This has included developing robust governance routines around data/population control for IMM and non-IMM trades, designing exposure monitoring analytics, and validating changes to the model design and compliance teams.
1“The standardized approach for measuring counterparty credit risk exposures,” Basel Committee on Banking Supervision, March 2014 (rev. April 2014).
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