Basel III Enhanced Risk Coverage Consultation Annex A

Ref #5009042 Annex A This annex lists the detailed changes that need to be made to the Reserve Bank’s BS2A and BS2B in order to implement the the new requirements as per the accompanying consultation document. Please note that the numbering in the following draft text does not correspond with either BS2A or BS2B, however it is clearly indicated where in BS2A and BS2B a paragraph is amended or a new one introduced. BS2A Subpart 4E BS2B 4.82 (i-x) or new annex 4 Treatment of mark-to-market counterparty credit risk losses for bilateral transactions Credit Valuation Adjustment capital charge

1. This section applies to OTC derivative transactions. It does not apply to transactions with a qualifying central counterparty (QCCP) or to security financing transactions (SFTs) unless the Reserve Bank determines that the loss exposures from SFTs are such that it does apply.
2. Subpart 4 D sets out how the capital charge for the default risk of a counterparty is calculated The CVA capital charge captures the risk of a mark-to-market loss due to the deterioration of a counterparty’s creditworthiness. The CVA capital charge must be calculated in the following way: K = 2.33√ℎ*�(∑ 0.5𝑤𝑖(𝑀𝑖𝐸𝐴𝐷𝑖 𝑡𝑜𝑡𝑎𝑙 − 𝑀𝑖 ℎ𝑒𝑑𝑔𝑒𝐵𝑖 𝑖 ) − ∑ 𝑤𝑖𝑛𝑑𝑀𝑖𝑛𝑑𝐵𝑖𝑛𝑑)2 𝑖𝑛𝑑 +∑ 0.75𝑤𝑖 2(𝑀𝑖𝐸𝐴𝐷𝑖 𝑡𝑜𝑡𝑎𝑙 𝑖 − 𝑀𝑖 ℎ𝑒𝑑𝑔𝑒𝐵𝑖)2 Where h is the one year risk horizon (in units of year), h=1 wi is the weight applicable to counterparty i. Counterparty ‘i’ has to be mapped to one of the seven weights as shown in the table below. The weights reflect a counterparty’s external credit rating (see Table 1 in section 3 of this note). If a counterparty does not have an external rating, the bank must use the level 4 rating or, subject to the Reserve Bank’s approval, may map the internal rating of the counterparty to another external rating. EADi total is the exposure at default of counterparty ‘i’ summed across all netting sets and includes the effects of collateral. It is calculated as per section 4D and discounted by the factor (1-exp(-0.05Mi))/0.05Mi)

2 Ref #5009042 Bi and is the notional of purchased single name CDS hedges referencing counterparty i (summed if more than one position) and used to hedge CVA risk. This notional amount should be discounted by the factor (1-exp(-0.05Mi hedge))/0.05Mi hedge) Bind is the full notional of one or more index CDS of purchased protection used to hedge CVA risk. This notional amount should be discounted by the factor (1-exp(- 0.05Mind))/0.05Mind) Wind is the weight for index hedges. The bank must map indices to one of the seven weights wi based on the average spread of index ‘ind’. Mi is the effective maturity of the transactions with counterparty ‘i’. It is the notional weighted average maturity. However, for the purpose of calculating the CVA, it is not capped at 5 years. Mhedge is the maturity of the hedge instrument with notional Bi (the quantities Mi hedge * Bi are to be summed if these are several positions). Mind is the maturity of the index hedge ‘ind’. In case of more than one index hedge position, it is the notional weighted average maturity. 3. A bank must use the following weights in accordance with a counterparty’s or an index hedge’s rating: Table 1: Long term credit rating grade Capital risk weighting 1 0.7 2 0.8 3 1.0 4 (or unrated) 2.0 5 3.0 6 10.0 4. A bank may include eligible CVA hedges in the calculation of the CVA charge. In order to qualify as an eligible hedge: a. It must be transacted with an external counterparty, used for the purpose of mitigating CVA risk, and be managed as such; and b. It must be a single-name CDS (including a sovereign CDS), a single-name contingent CDS, an equivalent hedging instrument referencing the counterparty directly, or an index CDS.

3 Ref #5009042 5. Hedges that do not meet these conditions may not be included in the CVA calculation. Moreover, a tranched or nth-to-default CDS, or an instrument for which the associated payment depends on cross-default are not eligible hedges. 6. Hedges that are included in the CVA capital charge calculation must not be included in the market risk capital calculation. Other hedges and ineligible hedges must be treated as any other instrument for regulatory capital purposes. 7. For a counterparty that is also a constituent of an index on which a CDS is used for hedging counterparty credit risk, the notional amount attributable to that single name (as per its reference weight) may, with the Reserve Bank’s approval, be subtracted from the index CDS notional amount and treated as a single name eligible hedge (Bi) of the individual counterparty with maturity based on the maturity of the index. 8. The total counterparty credit risk capital charge is calculated as the sum of the default risk charge as calculated by the CEA methodology outlined in subpart 4D, and the CVA charge as determined by paragraphs 1 to 8 of subpart 4E. Exposures to central counterparties 9. This section sets out how exposures to central counterparties arising from OTC derivatives transactions, exchange traded derivatives transactions and SFTs are to be treated. Exposures to qualifying central counterparties (QCCPs) 10. A qualifying central counterparty (QCCP) is a counterparty that meets the CPSS/IOSCO Principles for Financial Market Infrastructures. Whether a CCP meets the principles is determined by the Reserve Bank. Where the CCP is from a jurisdiction in which the regulator applies the CPSS/IOSCO principles and determines that the CCP complies with those principles, the Reserve Bank will in general consider that the CCP is a QCCP. However, the Reserve Bank reserves the right to decide otherwise and may require a bank to hold additional capital against its exposures to a QCCP if there are material shortcomings in the regulation of that QCCP. CCPs located in a jurisdictions where the regulator does not apply the CPSS/IOSCO principles will be treated as a non-qualifying unless determined otherwise by the Reserve Bank. Requirements for exposures cleared through a QCCP Requirements for clearing member banks

4 Ref #5009042 11. If a bank is a clearing member of a QCCP and acts for its own purposes, it must hold capital for its trade exposures to the QCCP and for its exposure to the QCCPs default fund. A risk weight of 2 percent must be applied to the bank’s trade exposure to the QCCP. The exposure amount is to be calculated by using the CEA method as per sections 48-55 in subpart 4D. 12. In addition to the capital charge for the bank’s trade exposure, clearing member banks also have to hold capital for their exposure to the QCCP’s default fund. The total risk￾weighted-assets for exposures to QCCPs, i.e. for trade exposures and for default fund exposures, must be calculated as follows: Min {2%x(TE)+1250%xDF; 20%x(TE)} Where, TE = the bank’s trade exposure to the QCCP as calculated in accordance with paragraph 11 of this subpart DF = the bank’s pre-funded contribution to the QCCP’s default fund 13. Where a default fund is shared between products or types of products with settlement risk only, e.g. equities and bonds, and products or types of products that give rise to counterparty credit risk, i.e. OTC derivatives, exchange traded derivatives of SFTs, all of the default fund contributions will receive the risk weight determined according to the formula in paragraph 12 above, without apportioning to different classes or types of business or products. However, where the default fund contributions from clearing members are segregated by product types and only accessible for specific products types, the capital requirements for those default fund exposures determined according the formula in paragraph 12 above must be calculated or each specific product giving rise to counterparty credit risk. Requirements for banks that are clients of clearing member banks 14. Where a bank is a client of a clearing member, and enters into a transaction with the clearing member acting as a financial intermediary (ie the clearing member completes an offsetting transaction with a QCCP), or where a client enters into a transaction with the QCCP with a clearing member guaranteeing its performance, the client’s exposures to the clearing member may receive the treatment as set out in paragraphs 11 if the following conditions are met. a. The offsetting transactions are identified by the QCCP as client transactions, and the collateral to support them is held in such a way that prevents any losses to the client bank due to the default or insolvency of the clearing member; the default or insolvency of the clearing member’s other clients; or the joint default or insolvency of the clearing member and any of its clients. In addition, the bank

5 Ref #5009042 acting as a client must be in a position to provide, upon request, an independent, written and reasoned legal opinion to the Reserve Bank that proves that in the event of a legal challenge this condition is met under relevant law, including the law of the jurisdictions of i. The client, the clearing member bank and the QCCP ii. Any foreign branches of the client, clearing member or QCCP involved in the trade; and iii. The law that governs the individual transactions and collateral; and iv. The law that governs any contract or agreement necessary to meet this condition. b. The relevant laws, regulation, rules, contractual, or administrative arrangements provide that the offsetting transactions with the defaulted or insolvent clearing member are highly likely to continue to be indirectly transacted through the QCCP, or by the QCCP, should the clearing member default or become insolvent. In such circumstances, the client positions and collateral with the QCCP will be transferred at market value unless the client requests to close out the position at market value.

15. Where a client is not protected from losses in the case that the clearing member and another client of the clearing member jointly default or become jointly insolvent, but all other conditions in the preceding paragraph are met, a risk weight of 4 percent will apply to the client’s exposure to the clearing member. If any of the other requirements of the preceding paragraph are not met, the bank must capitalise its exposure, including any potential CVA exposure, as a bilateral trade. Requirements for clearing members’ exposures to clients
16. A clearing member banks must treat its exposure, including its CVA risk exposure, to a client as a bilateral trade, irrespective of whether the clearing member guarantees the clients trade or acts as an intermediary between the client and the QCCP. However, to recognise the shorter close out period for cleared transactions, the clearing member bank may multiply the exposure as calculated by the CEA by a scalar of no less than 0.71. Treatment of posted collateral
17. Any assets or collateral posted by a bank either as a clearing member or as a client must be risk weighted in accordance with the Reserve Bank’s capital adequacy framework, regardless of the fact that the assets have been posted as collateral. Where assets or collateral of a clearing member or client are posted with a CCP or a clearing member and are not held in a bankruptcy remote manner, the bank posting such assets or collateral must also recognise credit risk based upon the assets or collateral being exposed to risk of loss based on the creditworthiness of the entity9 holding such assets or collateral.

6 Ref #5009042 a. Collateral posted by a clearing member (including cash, securities, other pledged assets, and excess initial or variation margin, also called overcollateralisation), that is held by a custodian or the QCCP, and is bankruptcy remote from the QCCP, is not subject to a capital requirement for counterparty credit risk exposure and a risk weight of zero may be applied. b. Collateral posted by a client, that is held by a custodian or the QCCP, and is bankruptcy remote from the QCCP, the clearing member and other clients, is not subject to a capital requirement for counterparty credit risk. If the collateral is held at the CCP on a client’s behalf and is not held on a bankruptcy remote basis, a 2% risk-weight must be applied to the collateral if the conditions established in paragraph 14 are met; or 4% if the conditions in paragraph 15 are met. Requirements for exposures to non-qualifying CCPs 18. Trade exposures to non-qualifying CCPs must be treated as bilateral trade exposures. The capital requirement must be calculated in accordance with subpart 4D and paragraphs - of subpart 4E. 19. If a bank is a clearing member of a non-qualifying CCP and is exposed to the CCPs default fund, the bank must apply a risk weight of 1250 percent to that exposure: RWA = 1250%x DF Where RWA = risk weighted assets from the default fund exposure DF = the bank’s pre-funded and unfunded contributions to the CCP’s default fund. Where there are unfunded, i.e. unlimit5ed binding contributions, the Reserve Bank will determine the amount of unfunded contributions that is to be included. And BS2B section 4.12 and 4.13 New sentence Exposures to central counterparties must be calculated in accordance with section 4.82 (or new annex 4) Qualitative collateral management requirement

7 Ref #5009042 BS2A Part 5, 56 (7) BS2B 4.300A 20. Banks must ensure that sufficient resources are devoted to the orderly operation of margin agreements with OTC derivative and securities-financing counterparties, as measured by the timeliness and accuracy of its outgoing calls and response time to incoming calls. Banks must have collateral management policies in place to control, monitor and report: (a) the risk to which margin agreements exposes them (such as the volatility and liquidity of the securities exchanged as collateral); (b) the concentration risk to particular types of collateral; (c) the reuse of collateral (both cash and non-cash) including the potential liquidity shortfalls resulting from the reuse of collateral received from counterparties; and (d) the surrender of rights on collateral posted to counterparties BS2A Part 5, 60 (f) BS2B 4.38 Table 4.4 Re-securitisations, irrespective of credit ratings, are not eligible financial collateral. Part 5, 65 Table 5.1 (only shows new column) External rating grade for debt securities Residual maturity Securitisation exposures 1 (long-and-short-Term) ≤ 1 year 2 › 1 year, ≤ 5 years 8 › 5 years 16 2-3 (long-and-short-term) and unrated bank securities ≤ 1 year 4 › 1 year, ≤ 5 years 12

8 Ref #5009042 › 5 years 24 4 (long term) All N/A Specific wrong way risk BS2B 4.241 (extend last sentence to include) ...and include a process for the identification of specific wrong-way risk. PD estimates of hedge funds, etc must include stressed market data BS2B 4.235A The PD estimates of hedge funds, highly leveraged financial institutions or borrowers whose assets are mainly traded assets, must reflect the performance of the underlying assets based on periods of stressed market volatilities. AVCM BS2B 4.136 A Correlation (R) = 0.12*( 1−𝑒−50∗𝑃𝐷 1−𝑒−50 )+0.24*[1-( 1−𝑒−50∗𝑃𝐷 1−𝑒−50 )] AVCM = 1.25 The asset value correlation multiplier (AVCM) of 1.25 is applied to the correlation parameter R for exposures to financial institutions meeting one of the following criteria: a) The exposure is to a regulated financial institution whose total assets are greater than or equal to US $ 100 billion. The most recent audited financial statement of the parent company and consolidated subsidiaries must be used to determine the asset size. For the purpose of this paragraph, a regulated financial institution is defined as a parent and its subsidiaries where any substantial legal entity in the consolidated group is supervised by a regulator that imposes prudential requirements consistent with international norms. These include, but are not limited to, prudentially regulated insurance companies, broker/dealers, banks, thrifts and futures commission merchants. b) The exposure is to an unregulated financial institution, regardless of its size. For the purpose of this paragraph, an unregulated financial institutions are defined as a legal entities whose main business includes: the management of financial assets, lending, factoring, leasing, the provision of credit enhancements, securitisation, investments,

9 Ref #5009042 financial custody, central counterparty services, proprietary trading and other financial services activities as determined by the Reserve Bank. Correlation (R) = 1.25*{0.12*( 1−𝑒−50∗𝑃𝐷 1−𝑒−50 )+0.24*[1-( 1−𝑒−50∗𝑃𝐷 1−𝑒−50 )]}