OTC DERIVATIVES
Derivative exposures currently are calculated by marking the transaction to market, applying an "add-on" to reflect the outstanding duration of the derivative and the riskiness of the underlying asset, applying the credit risk weighting of the counterparty and then reducing this total by 50%. The original justification for the 50% reduction was that the OTC derivative business was usually conducted between highly creditworthy institutions.
The proposals are that the 50% "discount" will be abolished. This has been done on the basis that higher rated institutions will have the benefit of the lower risk weightings under the new proposals. This may disadvantage financial institutions or sovereigns not do not benefit from a better risk weighting for their debt obligations under the new regime. However, the proposed relaxation of the rules on acceptable collateral will create opportunities for such counterparties to mitigate such exposures in other ways.
COLLATERAL AND GUARANTEES
The current regime gives only limited recognition to the risk-reducing effects of collateral and guarantees. Exposures secured by cash and OECD government (or OECD public sector entity or multilateral development bank) securities attract a zero (or low) risk weight. Exposures guaranteed by an OECD government or public sector entity, an OECD bank or securities firm or (for short-term exposures) a non-OECD bank, benefit from the risk weighting applicable to the guarantor.
It is proposed that eligible collateral be extended to all financial assets--not just marketable securities--that attract a lower risk weighting than the secured exposure. The collateral must be supported by a robust legal opinion and have a readily determinable value which can be recognized by the bank. This would include all trading book securities but might also include AAA/AA corporates or even cash flows from derivative contracts.
The scope of on-balance sheet netting may be expanded to all assets and liabilities in the banking book.
HEDGING
The Committee accepts that the existing rules are highly restrictive in terms of when it will be accepted that hedging reduces the amount of credit risk on the banking book.
Where a hedging instrument does not match the maturity of the underlying asset (a maturity mismatch), the Basel Committee proposes to recognise such mismatches subject to an additional capital requirement in the form of an "add-on" to deal with the un-hedged risk involved in the position. It may also consider a minimum remaining maturity for the hedge of one year.
The Committee invites comments on how to address "basis risk" where the exposure on the hedging instrument is subject to potential changes in market price that could create a shortfall in the value of the hedge. It also proposes to disallow credit protection based on distinct and separate assets (asset mismatches).
OPERATIONAL RISK
The Committee intends to impose a higher weight of capital charge for banks with significantly higher exposure to interest rate risk in their banking books than the industry norm. The Committee believes that operational risk should be brought into the capital framework.
TRADING BOOK
The consultative paper is completely silent as to proposed changes to the trading book rules. However, it states that the regulatory treatment of reverse repo transactions in the trading book has become an area of special concern.
CONSOLIDATION
The existing accord applies to banks on a consolidated basis only. The new proposals include holding companies that are parents of banking groups and international active banks at every tier within the banking group, on a fully consolidated basis.
In order to implement the new proposals when they are agreed, substantial amendments will need to be made to the European Union directives and to U.K. banking supervisory policy. The enactment of amending directives at EU level will take time. However the EU Commission has announced its good intentions to keep up.
Editors note: This is the second part to last week's Learning Curve by Simon Gleesonat Allen & Overyin London.
The first part addressed credit exposures.
