Basel III Enhanced Risk Coverage: Counterparty Credit Risk and Related Issues

Consultation Paper:
Basel III Enhanced Risk Coverage: Counterparty Credit Risk and related issues The Reserve Bank invites submissions on this Consultation Paper by 23 November 2012. Submissions and enquiries about this consultation should be addressed to:
Cavan O’Connor-Close
Adviser, Financial System Policy
Prudential Supervision Department
Reserve Bank of New Zealand
PO Box 2498
Wellington 6140
Email: cavan.oconnor-close@rbnz.govt.nz
Please note that a summary of submissions may be published. If you think any part of your submission should properly be withheld on the grounds of commercial sensitivity or for any other reason, you should indicate this clearly. 29 October 2012 Updated 9 November 2012

Background

1. In December 2010 the Basel Committee on Banking Supervision (BCBS) released the
   new global regulatory standards for bank capital adequacy and liquidity. These standards are commonly referred to as Basel III. 1 The Reserve Bank has already consulted on most aspects of its implementation of Basel III – core capital ratios, definition of capital and the leverage ratio were the subject of a 2011 consultation, while its policies for the operation of the conservation and cyclical buffers formed part of the consultation earlier this year. In both of those consultations the Reserve Bank announced that it would consult separately on its proposed implementation of the Basel III changes to the treatment of counterparty credit risk (CCR).

2. Enhanced risk coverage is one of the core elements of the Basel III minimum capital
   requirements. Counterparty credit risk fall within the area of risk coverage. It applies to long settlement, securities financing (SFT) and OTC derivate transactions not traded on an exchange backed by a central counterparty (CCP). It refers to the risk of incurring a loss due to, for example, the default by a counterparty and is a specific form of (bilateral) credit risk. It differs from other forms credit risk such as mortgage lending in that the amount of the exposure is uncertain and needs to be estimated as it varies with changes in underlying market fundamentals. The bank only incurs a loss if at the time of default the contract takes a positive value. Addressing the reliance on external credit ratings is also
   part of enhanced risk coverage and dealt with at the end of this document.

3. Basel II introduced three methods for estimating a bank’s CCR exposure. The exposure at
   default (EAD) thus calculated is then used in the calculation of the regulatory capital a bank is required to hold. The Reserve Bank’s Capital Adequacy Framework already contains a version of one of those three methods, called the current exposure method (CEM). This is the only method locally incorporated banks are allowed to use when estimating the EAD for CCR. 2 This consultation focuses only on the changes and new requirements that are relevant to the CEM methodology. We do not at this stage propose to incorporate the internal models method or the standardised method into our requirements. Other specific areas that are covered in this consultation are new requirements on : margining and collateralized counterparties; wrong way risk; the treatment of correlations between financial institutions in the internal ratings based approach; and exposures to central counterparties. 1 The Basel III package is available at: http://www.bis.org/publ/bcbs/basel3.htm 2 See BS2A and BS2B available at http://www.rbnz.govt.nz/finstab/banking/regulation/0094291.html

4. In making the following proposals, the Reserve Bank has been guided by its main
   principles for implementing Basel III requirements:

• Adoption of the Basel III standards as a starting point, except where the standards
  are not appropriate for New Zealand circumstances;
• Where Basel III standards are less conservative than our existing standards, retain
  existing standards; and
• Have regard to international consistency and comparability (especially
  consistency with Australia), subject to the other principles above.
  Basel III enhanced risk coverage requirements

5. The new requirements pertaining to enhanced risk coverage consist of the following:

• A charge for mark-to-market CCR called credit valuation adjustment (CVA)
• An asset value correlation (AVC) multiplier for exposures to unregulated and
  large financial institutions
• Strengthening of margining and collateral management requirements and more
  conservative regulatory haircuts for securitization collateral
• A requirement to include stressed market data when calculating the probability of
  default of highly leveraged counterparties
• Identifying and managing instances of wrong way risk
• A 2 percent risk weight for exposures to central counterparties (CCPs)

6. A summary of the detailed changes to BS2A and BS2B of the Reserve Bank’s proposed
   implementation of the new requirements can be found in Annex A to this consultation paper. Credit valuation adjustment

7. The CVA charge captures the risk of incurring a mark-to-market loss on OTC derivatives
   due to the deterioration of a counterparty’s creditworthiness, e.g. a ratings downgrade. Any such losses in a mark-to-market accounting framework impact on the P&L and were a significant source of losses during the global financial crisis. The BIS estimates that two-thirds of CCR losses were due to CVA effects, while only one-third was caused by outright defaults. 3 See http://www.rbnz.govt.nz/finstab/banking/4577705.pdf 4 See www.bis.org/publ/bcbs189.htm

8. This kind of risk has not been adequately addressed by the existing requirements, which
   mainly reflects counterparty default risk. The CVA is an additional capital charge to rectify this issue. It will be added to the existing counterparty credit risk capital charge (for default risk), which in New Zealand has to be calculated as specified in the Reserve Bank’s Capital Adequacy Framework documents (BS2A and BS2B).

9. The CVA charge is calculated as the difference between the risk free value of the portfolio
   and its risk adjusted mark-to-market value. The BCBS’s “…framework for more resilient banks and banking systems” requires the charge to be calculated as follows:
   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 and wind are the weights applicable to counterparty i and index hedges respectively. Each counterparty has to be mapped to one of the seven weights as shown in the table below. The index weights (wind) must be mapped to one of those seven weights wi based on the average spread of index ‘ind’. EADi total is summed across all netting sets and includes the effects of collateral. It is discounted by the factor (1-exp(-0.05Mi))/(0.05Mi) Bi and is the notional of purchased single name CDS hedges referencing counterparty i and used to hedge CVA risk. This amount is discounted by (1-exp(-0.05Mi hedge))/(0.05Mi hedge) Bind is the notional of index CDS protection against CVA risk. The notinal amount is discounted by the following factor: (1-exp(-0.05Mind))/(0.05Mind) Mi is the effective maturity of transactions with counterparty i. It is the notional average maturity (note: it is not capped at five years.). Mi hedge is the maturity of the hedge instrument with notional Bi (the quantities Mi hedge and Bi are to be summed if these are several positions). Mind is the maturity of the index hedge ‘ind’. Where there is more than one index hedge position, the notional weighted average maturity should be used. 5 See http://www.rbnz.govt.nz/finstab/banking/regulation/0094291.html

10. The seven weights to which counterparties have to be mapped are:

11. If a counterparty does not have an external rating, the bank may, subject to Reserve Bank
    approval, map the internal rating of the counterparty to one of the external ratings. The bank must use a consistent and sufficiently conservative process for this mapping. Non￾IRB approved banks must use the weight applicable to a level 4 rating.

12. The CVA calculation allows for single name and index CDS hedges to be taken into
    account by subtracting them as per the formula above. Only hedges explicitly used for the mitigation of CVA risk and which are managed as such may be included. The CDS hedges must be single-name CDSs, single-name contingent CDSs or index CDSs. Other equivalent hedging instruments must name the counterparty directly in order to be eligible.

13. The impact of the CVA will differ across banks depending on the amount of OTC
    derivative trading a bank conducts and the risk drivers contained in the above formula. The lower rated one’s counterparties are, the higher the CVA charge (ceteris paribus). Likewise, longer maturities tend to produce higher CVA charges due to M being a term in the formula and because of the impact of the maturity on the EAD. In other words, there may be scope for banks to reduce the CVA effects by choosing more highly rated counterparties and appropriate maturities. External rating grade Weight wi in % 1 0.7% 2 0.8% 3 1.0% 4 (or unrated) 2.0% 5 3.0% 6 10.0%

14. In its 2010 quantitative impact study (QIS), the BIS calculated that the overall impact
    from the CCR changes on group 1 banks6 would be an increase of around 7.6 percent of overall risk weighted assets. The increase for group 2 banks, to which our banks belong, is only 0.3 percent.

15. The Reserve Bank considers it right to better account for mark-to-market counterparty
    credit risk and agrees with the new Basel III requirements. In addition, the Reserve Bank is conscious of the benefits of adopting the new international standard where it makes sense to do so. We therefore propose that a CVA charge be calculated and added to the standard CCR default risk charge as outlined in the preceding paragraphs. Asset Value Correlation multiplier

16. The asset value correlation multiplier adjusts the Basel IRB capital equation and applies to
    exposures to all unregulated and/or large financial institutions. The latter is defined as firms that have more than US$ 100bn in assets. The AVC multiplies the correlation coefficient (R) in the capital equation by 1.25. 7 This is done to take better account of the systemic risk and greater contagion potential stemming from these financial institutions. Exposures to large or unregulated financial institutions were a greater source of losses than to non-financial or smaller institutions and put a greater strain on the financial system. It is estimated that the correlation between financial institutions is 25 percent higher than for non-financial institutions.

17. The AVC is a straight forward multiplier of 1.25 which is applied to the correlation
    coefficient in the Basel equation.
    8 The impact on a bank’s capital needs depends on the 6 Group 1 banks have are classified as banks that have more than US$ 3 bn in tier 1 assets, are well diversified and internationally active. All other banks are group 2 banks. 7 See Annex A 8 See Annex A. Q1: Do you think the CVA charge will adequately address the mark-to￾market risk of OTC derivative contracts? Q2: Would it be useful to have a simplified method for banks that have very little OTC derivative trading, e.g. a doubling of the existing CCR charge? Q3: What is the impact of the new CVA charge on your institution, including in terms of risk-weighted assets? Will it change your behaviour (perhaps by choosing different counterparties or maturities) or have unintended consequences? (Please give detailed cost information.)

amount of business it does with unregulated or large financial institutions but the Reserve Bank expects that impact to be manageable.
18. The Reserve Bank does not consider that there are any valid reasons for not adopting the
new internal standard and proposes that an AVC multiplier be applied to all exposures to large (i.e. more than US$ 100 bn assets) and unregulated financial institutions.
19. It should be noted that Basel III also makes a few minor amendments to bank’s internal
CCR management review processes. The Reserve Bank intends to deal with them as part of a wider review of its ICAAP guidance (BS12), scheduled for early next year. Margining and collateral management
20. New qualitative collateral management requirements oblige banks to ensure that sufficient
resources are devoted to the orderly operation of margin agreements with OTC derivative and securities-financing counterparties. This is intended to ensure the timely and accurate handling of outgoing calls and responses to incoming calls. At a minimum, banks must have policies in place and act upon them to control, monitor and report:

• the risk to which margin agreements expose them (e.g. the volatility and liquidity
  of the securities exchanged as collateral;
• the concentration risk to particular types of collateral;
• the re-use of collateral (both cash and non-cash) including the potential liquidity
  shortfalls resulting from the re-use of collateral received from counterparties; and
• the surrender of rights on collateral posting to counterparties.
  We do not expect a specific requirement along these lines to be of concern to banks in New Zealand. Q4: Do you agree that the AVC will lead to a more accurate reflection of risk in terms of capital for relevant exposures? Q5: : Are there any reasons as to why the Reserve Bank should not implement this (AVC) component of Basel III? Q6: What will be the impact of the AVC on your organisation? (Please give detailed cost information, including the impact on RWA, and where relevant distinguish between the short term and long term impact.)

Revised standard supervisory haircuts for securitisation collateral
21. Basel III explicitly disallows the use of re-securitisations, irrespective of any credit
ratings, as financial collateral. This prohibition applies regardless of whether a bank uses the supervisory haircuts method, the own estimates of haircuts method, the repo VAR method or the internal model method.
22. Basel III also introduces standardised supervisory haircuts for securitisation exposures as
follows (see new column to be added to Table 4.4 of BS2B):
Standard supervisory haircuts (only new column included) 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 › 5 years 24 4 (long term) All N/A
23. The Reserve Bank plans to adopt both of these aforementioned new requirements. We
consider them sensible and do not envisage them to be a serious issue for New Zealand registered banks. Q7: Do you have any concerns about the introduction of a qualitative collateral management requirement as outlined in paragraph 20? Q8: Do you have any comments, particularly as regards the costs and benefits, about the Reserve Bank’s proposal to adopt the Basel III requirements in relation to securitisation collateral as outlined in paragraphs 20 and 21 above?

Collateralised counterparties and holding periods
24. The Reserve Bank also intends to follow Basel III in implementing longer holding periods
under certain circumstances for non-daily re-margining or revaluation. 9 The longer holding periods apply to and are as follows:

• For all netting sets where the number of trades exceeds 5,000 at any point during
  a quarter, a floor of at least 20 business days must be applied to the next quarter
• For netting sets containing one or more trades involving either illiquid collateral
  or an OTC derivative that cannot be easily replaced, a minimum floor of 20 business days is imposed. Whether collateral is illiquid or the difficulty of replacing an OTC derivative has to be assessed in the context of stressed market conditions.
• In addition, a bank must consider whether trades or securities it holds as collateral
  are concentrated in a particular counterparty and in the event of that counterparty exiting the market whether those trades could be replaced.
• If a bank has experienced more than two margin call disputes on a particular
  netting set over the previous two quarters that have lasted longer than the applicable holding period (before consideration of this provision), then the bank must reflect this history appropriately by using a holding period that is at least double the supervisory floor for that netting set for the subsequent two quarters. Treatment of highly leveraged counterparties

25. The Reserve Bank agrees with the BCBS’s view that the estimation of the PD of highly
    leveraged counterparties should include asset performance data from a stressed period. The Reserve Bank considers that this should already be done as part of prudent risk management and to the extent that it is not yet done, it would lead to a more accurate risk estimation and regulatory capital outcome. As such, we propose to include a qualitative requirement in our capital adequacy framework requiring PD estimates for borrowers that are highly leveraged or whose assets are mainly traded assets to reflect also periods of stressed volatilities. 9 See BS2B Table 4.5 and paragraph 4.40 Q10: Do you have any comments as regards this requirement? Q9: Do you have any comments on this proposal?

Managing wrong way risk
26. Basel III obliges banks to actively identify and manage instances of wrong way risk. A
bank is exposed to general wrong way risk if the level of exposure is positively correlated with the default probability of the counterparty due to general market factors. Specific wrong way risk is when a bank’s exposure to a counterparty is positively correlated with that party’s probability of default. The Reserve Bank expects that banks have processes in place for identifying and managing general wrong way risk.
27. In line with Basel III, the Reserve Bank will require that each separate legal entity to
which a bank is exposed must be separately rated. A bank must have policies and processes in place regarding the treatment of individual entities in a connected group, including circumstances under which the same rating may or may not be assigned to some or all related entities. Those policies and processes must include ways of identifying and managing instances of specific wrong way risk. Exposures to central counterparties
28. In accordance with Basel III, the Reserve Bank plans to introduce a 2 percent risk weight
for trade exposures to qualifying central counterparties (CCPs).This means that banks would have to calculate their exposure based on the CEM method10 as per our existing BS2A and BS2B and then apply a risk weight of 2 percent. This risk weight is new since exposures to CCPs have not had one thus far. Attaching a risk weight reflects the fact that those exposures are also not entirely risk free. A qualifying CCP is one that complies with the standards as defined by the Committee on Payments and Settlements Systems (CPSS) and the International Organization of Securities Commissions (IOSCO). Exposures to non-qualifying CCPs have to be calculated in the same way as a bilateral exposure to a financial institution, i.e. the 2 percent risk weight does not apply.
29. It should be noted that arrangements for qualifying CCPs and access criteria are still being
developed. Banks that become clearing member banks of a CCP will also have to hold capital against their CCP default fund exposure risk. The capital charge for banks that are 10 See subpart 4C of BS2A and section 4.71 of BS2B Q11: Do you have any comments on the new requirements to identify and manage instances of wrong way risk?

clearing members of a qualifying CCP will be lower than for exposures to the default fund of a non-qualifying CCP. Default fund exposures to a qualifying CCP have a risk weight of 1250 percent, subject to an overall cap on the risk weighted assets from all exposures to the QCCP equal to 20% times the trade exposure to the qualifying CCP. The total QCCP exposure should then be calculated according to the following formula:
RWA = MIN{(2%*TEi+1250%*DFi ); (20%*TEi)}
Where,
TE is the bank’s trade exposure the QCCP
DF is the bank’s default fund exposure.
30. If New Zealand registered banks do not become clearing member banks of a qualifying
CCP, they will have to go through an clearing member who will act as an intermediary to access the qualifying CCP. In order for such exposures to classify as exposures to a qualifying CCP, they will have to be bankruptcy remote from the intermediary and the qualifying CCP has to identify the transaction as a clearing member’s transaction on behalf of a client. The Reserve Bank will require the New Zealand registered bank to provide an independent legal opinion confirming that the transaction and any collateral posted would not be affected in the event of the clearing member’s insolvency. In addition, banks may be required to make use of more than one intermediary in order to reduce their exposure to a single clearing member (concentration risk). 11 Note that this method already includes the 2 percent risk weight for trade exposures. Q12: Do you agree that the new requirements for exposures to qualifying CCP better reflect the actual risk and encourage more trades to be conducted via QCCPs? Do you plan to make greater use of CCPs? Q13 : How do you envisage your bank accessing qualifying central counterparties? Q14: What are the likely costs in terms of, for example, additional capital or providing legal certainty for exposures to qualifying CCPs through an intermediary?

Addressing reliance on external credit ratings and minimising cliff effects
31. Basel III measures to enhance the risk coverage of bank capital adequacy standards
include five specific measures to address reliance on external credit ratings and minimise cliff effects. These measures relate to:

• Standardised inferred rating treatment for long-term exposures.
• Incentive to avoid getting exposures rated.
• Incorporation of the ISCSCO code of conduct fundamentals for credit rating
  agencies.
• Cliff effects arising from guarantees and credit derivatives – credit risk mitigation.
• Unsolicited ratings and recognition of external credit assessment institutions.

32. The Reserve Bank has assessed each of these measures and decided not to implement any
    of them as part of the initial implementation of Basel III in New Zealand. In coming to this decision the Reserve Bank took account of the following:

• Our established principle of retaining our existing requirements where the Basel
  III standards are less conservative.
• Materiality issues (i.e. what difference implementation of the measures would
  make to the quantity and quality of regulatory capital held by New Zealand banks).
• The benefits of considering some of the measures in the context of subsequent
  reviews (e.g. the incentive to avoid getting exposures rated is best considered in the context of a review of our guidelines on a bank’s internal capital adequacy assessment process). Timing

33. The consultation will close on 23 November 2012. The Reserve Bank will publish a
    summary of the consultation feedback and its ultimate decision for implementing this part Q15: Do you have any comments on this?

of Basel III later this year. Subject to the outcome of this consultation, the new requirements will take effect on 01 January 2013.