Basel Guidance on High-cost Credit Protection

Our Ref.: B1/15C
S4/3C
21 February 2012
The Chief Executive
All Locally Incorporated Authorized Institutions Dear Sir/Madam, Basel Guidance on High-cost Credit Protection As you may be aware, the Basel Committee on Banking Supervision issued a statement on high-cost credit protection on 16 December 2011. The statement highlights concerns among supervisors about potential capital arbitrage within the credit risk mitigation (CRM) framework relating to the calculation of regulatory capital requirements for credit exposures. A copy of the statement is attached for reference. “High-cost credit protection” refers generally to situations where credit protection transactions are structured in such a way as to enable the protection buyer to receive favourable risk-based capital treatment in the short term (e.g. the protection buyer receives an immediate regulatory capital benefit in the form of a lower risk-weight on an exposure on which it is nominally transferring risk) and defer the recognition of losses and costs of protection in earnings over an extended period. In some instances, the terms and conditions of the credit protection combined with the premiums or fees or other direct or indirect costs paid for it, call into question the degree of CRM or credit risk transfer achieved by the transaction. Such arbitrage opportunities exist generally under the CRM framework, however they are more likely to occur in the use of CRM techniques for securitization transactions where the difference in the risk-weight before and after buying protection can be very large. To provide guidance on relevant factors that typically characterise high cost credit protection (which results in ineffective CRM or credit risk transfer), the Basel Committee’s statement sets out (i) a list of factors that banks should consider, and

supervisors will assess, in evaluating the degree of CRM or credit risk transfer of credit protection transactions; and (ii) a number of characteristics exhibited by transactions that would tend to suggest high cost credit protection and therefore merit the specific attention of supervisors. Authorized institutions (AIs) should take note of the guidance provided in the statement in the course of conducting credit protection transactions. Among other things, AIs should analyse and document the economic substance of any credit protection transactions that have unusually high-cost or innovative features to assess the degree of risk transference and the associated impact on their overall capital adequacy. AIs should also bring to the attention of the HKMA any innovative positions which fall under the guidance to ensure they are subject to appropriate prudential treatment. The analysis should also specify how the transaction aligns with the AI’s overall risk management strategy. The HKMA will review the CRM techniques employed by AIs in its on-going supervisory process where necessary, and will incorporate the guidance set out in the Basel Committee’s statement into its relevant supervisory guidance (such as that relating to credit risk transfer and supervisory review process) in due course. Yours faithfully, Karen Kemp Executive Director (Banking Policy) Encl. c.c. The Chairman, The Hong Kong Association of Banks The Chairman, The DTC Association FSTB (Attn: Miss Natalie Li)

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Press release Press enquiries: +41 61 280 8188 press@bis.org www.bis.org Ref no:
16 December 2011
The Basel Committee issues a statement on high cost credit protection Recent transactions have raised concerns among supervisors about potential regulatory capital arbitrage related to some credit protection transactions. Given the supervisory concerns related to such transactions, this statement is intended to alert banks that supervisors will closely scrutinise such transactions in both the specific context of the evaluation of credit risk transfer within the securitisation framework, as well as within the broader context of the Basel Pillar 2 supervisory review process and assessment of capital adequacy. Background The Basel capital framework recognises that credit risk mitigation techniques can significantly reduce credit risk and can serve as an effective risk management tool. In particular, paragraph 140 of the framework establishes that where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and supervisors are satisfied that banks fulfil certain minimum operational conditions relating to risk management processes, banks may take account of such credit protection in calculating capital requirements. Nevertheless, the Committee notes that there exists potential for capital arbitrage within the credit risk mitigation framework, including the use of credit risk mitigation for securitisation exposures, particularly when (i) there is a delay in recognising losses and the costs of protection in earnings while (ii) the bank receives an immediate regulatory capital benefit in the form of a lower risk weight on an exposure on which it is nominally transferring risk. In some instances, the premiums or fees and other direct or indirect costs paid for certain credit protection, combined with other terms and conditions, call into question the degree of credit risk mitigation or credit risk transfer of the transaction. Rather than contributing to a prudent risk management strategy, the primary effect of these high-cost credit protection transactions may be to structure the premiums and fees so to receive

favourable risk-based capital treatment in the short term and defer recognition of losses over an extended period, without meaningful risk mitigation or transfer of risk. For example, consider a bank that purchases credit protection on a first-loss retained securitisation position where the cost of protection is equal to the recorded value of the securitisation tranche on which protection is being purchased or where the terms and conditions of the contract ensure that the premiums paid throughout the life of the contract will equal the amount of the realised losses. Regulatory capital arbitrage may exist where the immediate capital relief recognised for credit protection purchased ultimately will be offset by the premiums paid and recognised in earnings over the life of the contract. While the example above focuses on the use of credit risk mitigation in a securitisation transaction, arbitrage opportunities exist more generally under the credit risk mitigation framework. However, arbitrage opportunities are more likely to occur when credit risk mitigation techniques are used for securitisation transactions, where the difference in the risk weight before and after buying protection can be very large. Supervisory Response and Areas of Heightened Concern In response to these concerns, the Committee is clarifying that supervisors will consider the cost of credit protection that has not yet been recognised in earnings when assessing whether credit protection purchased should be recognised for purposes of regulatory capital, including whether a bank meets the Basel standards for significant credit risk transference within the securitisation framework contained in paragraphs 554(a) and 555(d) of the Basel comprehensive framework. In order for exposures to be de-recognised for risk-based capital purposes under the securitisation framework, significant credit risk associated with the securitised exposures must be transferred to third parties. Material costs of credit protection should be considered in this analysis. 1

More generally, banks and supervisors should consider the relevant costs of protection purchased – whether in the context of the Basel securitisation framework or within the credit risk mitigation framework – when assessing a bank’s capital adequacy. Furthermore, banks should analyse and document the economic substance of credit protection transactions that have unusually high-cost or innovative features to assess the degree of risk transference and the associated impact on the bank’s overall capital adequacy. Banks should bring to the attention of their supervisor any innovative positions which fall under this guidance to ensure they are subject to appropriate prudential treatment. The analysis also should specify how the transaction aligns with the bank’s overall risk management strategy. In evaluating the degree of credit risk mitigation or credit risk transfer of a transaction, banks should consider, and supervisors will assess, the following factors, among others, as applicable:

1
For example, in the assessment of significant credit risk transference under paragraphs 554(a) and 555(d), supervisors should consider these unrecognised premia as a retained position. These premia could be quantified for purposes of such an analysis in a number of ways, including through an appropriately conservative present value calculation.

• A comparison of the present value of premiums and other costs not yet
  recognised in capital relative to expected losses of the protected exposures over a variety of stress scenarios;
• The pricing of the transaction relative to market prices, including
  appropriate consideration of non-cash premium payments;
• The timing of payments under the transaction by the protection buyer,
  including potential timing differences between the bank’s provisioning for or write downs of the protected exposures and payments by the protection seller;
• A review of applicable call dates to assess the likely duration of the credit
  protection relative to the potential timing of future credit losses;
• An analysis of whether certain circumstances could lead to the bank’s
  increased reliance on the counterparty at the same time that the counterparty’s ability to meet its obligations is weakened;
• An analysis of whether the bank can prudently afford the premiums given
  its earnings, capital, and overall financial condition; and,
• A review of any internal memos or records outlining the rationale for the
  transaction and the bank’s analysis of the anticipated costs and benefits of the transaction. Supervisors also should focus more attention on credit protection transactions that exhibit the characteristics noted below.
• Protection premiums are high relative to the amount of the exposures
  being protected - for example, when the cost of protection over the life of the protection contract approaches equals, or exceeds, the amount of the exposures for which protection is being purchased. Rebate mechanisms (ie where the protection seller agrees to refund parts of the premium to the protection buyer according to the performance/deterioration of the protected exposure) are an indication of excessive premium and, consequently, regulatory arbitrage.
• Transactions where the exposure being protected has not been fair
  valued and losses on the exposure have not been recognised in earnings. This situation can increase the potential for a transaction to involve regulatory capital arbitrage in the form of deferral of loss recognition.
• Transactions where the potential for reduction in risk weights or
  regulatory capital as a result of the transaction is greatest. This is most likely in transactions where the exposures for which protection is purchased would otherwise be assigned a high risk weight, for example, exceeding 150%. Nevertheless, the potential for arbitrage still exists for relatively lower risk-weighted reference exposures, and supervisors may also need to focus on individual transactions level that raise concerns due to unique deal features.
• Protection premiums are not proportional to the exposures being
  protected. This can occur, for example, when (1) premiums are guaranteed over time without respect to write-downs or default of the reference exposure (that is, the premium payments are not a proportion of the amount of still performing positions of the protected portfolio), or (2)

upfront premiums or premiums payable at termination have not been recognised in retained earnings.

• Structural features of the transaction that can increase the total cost of
  credit risk mitigation. These features can include: high transaction costs for the protection buyer; obligations of the protection buyer to the counterparty to post additional collateral; additional payments at maturity required of the protection buyer; and, early termination of the transaction at the option of the protection buyer. Other features that should lead to increased scrutiny include pre-agreed mechanisms, for example ‘at￾market unwinds’, where the protection seller and protection buyer agree that the transaction can be terminated in the future at an agreed upon ‘market’ value where calculation of the ‘market’ value is pre-specified. Conclusion The guidance provided above is intended to ensure that the costs, as well as the benefits, of purchased credit protection are appropriately recognised in regulatory and other capital adequacy assessments. These considerations are intended to provide supervisors with the tools necessary to effectively assess the degree of risk transference of certain credit protection transactions, while also providing the flexibility to deal with the variety of transaction structures that have been observed in the market, as well as those that might appear in the future. The Basel Committee will continue to monitor developments with respect to high-cost credit protection transactions and will consider taking a more comprehensive Pillar 1 approach to these transactions. About the Basel Committee The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. It seeks to promote and strengthen supervisory and risk management practices globally. The Committee comprises representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. Observers on the Basel Committee are: the European Banking Authority, the European Central Bank, the European Commission, the Financial Stability Institute and the International Monetary Fund.