The options in the new Basel framework for recognizing financial collateral are, the Simple Approach and the Comprehensive Approach. For the IRB approaches, only the Comprehensive Approach is applicable. For the Standardized Approach both the Simple and the Comprehensive Approaches are available
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| i) | Simple Approach:
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| | In this method the approach of substitution is maintained.
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| | This method requires the collateral to be pledged for at least the life of the exposure and that it is marked to market and revalued at least every six months. The collateralized portion of the loan is subject to the risk weight of the collateral, with a floor on the risk-weighting of 20 percent. For detail refer to Para 182 to Para 185 of the Basel II document.
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| ii) | Comprehensive Approach:
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| | The comprehensive approach for the treatment of collateral (Also refer to paragraphs 130 to 138 and 145 to 181 - International Convergence of Capital Measurement and Capital Standards – June 2006) will also be applied to calculate the counterparty risk charges for OTC Derivatives and repo-style transactions booked in the trading book.
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| | (Refer para 112, International Convergence of Capital Measurement and Capital Standards – June 2006)
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| | Further, the comprehensive approach calculates their adjusted exposure to a counterparty for capital adequacy purposes in order to take account of the effects of that collateral. Using haircuts, banks are required to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either1 occasioned by market movements. This will produce volatility adjusted amounts for both exposure and collateral. Unless either side of the transaction is cash, the volatility adjusted amount for the exposure will be higher than the exposure and for the collateral it will be lower.
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Additionally, where the exposure and collateral are held in different currencies an additional downwards adjustment must be made to the volatility adjusted collateral amount to take account of possible future fluctuations in exchange rates.
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Where the volatility adjusted exposure amount is greater than the volatility adjusted collateral amount including any further adjustment for foreign exchange risk banks shall calculate their risk weighted assets as the difference between the two multiplied by the risk weight of the counterparty.
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In principle, banks have two ways of calculating the haircuts: (i) standard supervisory haircuts using parameters set by Basel-II and (ii) bank’s own internal estimate haircuts, using banks’ own internal estimates of market price volatility. Supervisors will allow banks to use own-estimate haircuts only when they fulfil certain qualitative and quantitative criteria.
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A bank may choose to use standard or own estimate haircuts independently of the choice it has made between the standardized approach and the foundation IRB approach to credit risk. However, if banks seek to use their own-estimate haircuts, they must do so far the full range of instrument types for which they would be eligible to use own estimates, the exception being immaterial portfolios where they may use the standard supervisory haircuts.
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The size of the individual haircuts will depend on the type of instrument, type of transaction and the frequency of marking to market and remargining. For example, repostyple transactions subject to daily marking to market and to daily remargining will receive a haircut based on a 5-business day holding period and secured lending transactions with daily mark to market and no re-margining clauses will receive a haircut based on a 20-business day holding period. These haircut numbers will be scaled up using the square root of time formula depending on the frequency of remargining or marking to market.
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As a further alternative to standard supervisory haircuts and own estimate haircuts, banks may use VaR models for calculating potential price volatility for repo style transactions.
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In specific, approach relies on giving the banks the option to use one of three methods to discount the value of the collateral: Supervisory specified haircuts, own estimate haircuts, and a Value at Risk (VaR) model available only for repo-style transactions at national discretion. The three methods are as follows:
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| | a. | Supervisory Supplied Haircuts
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| | | Banks should follow the requirements described in Para 151 of the Basel II document subject to amendments and conditions prescribed by the Agency on Page 148.
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| | b. | Own estimate haircuts
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| | | This option allows the banks to develop their own haircuts to be applied to the collateral they have against loans.
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| | | This option would be available only to banks that satisfy minimum qualitative and quantitative standard described in the Basel II document from Para 154 to Para 177.
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| | | Some of the criteria include a 99 percentile one-tailed confidence interval as well as minimum data observations of one year.
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| | c. | VAR modeling
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| | | • | VAR is an estimate of the maximum potential loss expected at a 1 percent confidence interval.
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| | | • | VAR models aggregate several components of price risk into a single measure of the potential for loss.
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| | | • | Banks must follow the requirements set in Para 178 to Para 181 of the Basel II document.
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