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 they may allow banks to take account of such credit protection in calculating capital requirements.
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A range of guarantors and protection providers are recognized. As under the 1988 Accord, a substitution approach will be applied. Thus, only guarantees issued by or protection provided by entities with a lower risk weight than the counterparty will lead to reduced capital charges since the protected portion of the counterparty exposure is assigned the risk weight of the guarantor or protection provider, whereas the uncovered portion retains the risk weight of the underlying counterparty.
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Banks are permitted to recognize guarantees but not collateral obtained on an equity position wherein the capital requirement is determined through use of the market-based approach.
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(Refer para 349, International Convergence of Capital Measurement and Capital Standards – June 2006).
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In addition to the legal certainty requirements in in International Convergence of Capital Measurement and Capital Standards – June 2006 , paragraphs 117 and 118, in order for a guarantee to be recognized, the following conditions must be satisfied:
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| (a) | On the qualifying default/non-payment of the counterparty, the bank may in a timely manner pursue the guarantor for any monies outstanding under the documentation governing the transaction. The guarantor may make one lump sum payment of all monies under such documentation to the bank, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The bank must have the right to receive any such payments from the guarantor without first having to take legal actions in order to pursue the counterparty for payment.
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| (b) | The guarantee is an explicitly documented obligation assumed by the guarantor.
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| (c) | Except as noted in the following sentence, the guarantee covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments etc. where a guarantee covers payment of principal only, interests and other uncovered payments should be treated as an unsecured amount in accordance with BIS guidelines – in International Convergence of Capital Measurement and Capital Standards – June 2006, paragraph 198.
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| | (Refer para 190, International Convergence of Capital Measurement and Capital Standards – June 2006)
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For Credit derivatives and guarantees, materiality thresholds on payments below which no payment is made in the event of loss are equivalent to retained first loss positions and must be deducted in full from the capital of the bank purchasing the credit protection. (Refer para 197, International Convergence of Capital Measurement and Capital Standards – June 2006)
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Where the bank transfers a portion of the risk of an exposure in one or more tranches to a protection seller or sellers and retains some level of risk of the loan and the risk transferred and the risk retained are of different seniority, banks may obtain credit protection for either the senior tranches (e.g. second loss portion) or the junior tranche (e.g. first loss portion). In this case the rules as set out in Section IV (Credit risk ─ securitization framework) will apply.
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(Refer para 199, International Convergence of Capital Measurement and Capital Standards – June 2006)
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Currency mismatches
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Where the credit protection is denominated in a currency different from that in which the exposure is denominated — i.e. there is a currency mismatch — the amount of the exposure deemed to be protected will be reduced by the application of a haircut HFX, i.e.
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GA = G x (1 – HFX)
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where: G = nominal amount of the credit protection
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HFX = haircut appropriate for currency mismatch between the credit protection and underlying obligation.
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The appropriate haircut based on a 10-business day holding period (assuming daily marking-to- market) will be applied. If a bank uses the supervisory haircuts, it will be 8%. The haircuts must be scaled up using the square root of time formula, depending on the frequency of revaluation of the credit protection as described in paragraph 168, International Convergence of Capital Measurement and Capital Standards – June 2006
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(Refer para 200, International Convergence of Capital Measurement and Capital Standards – June 2006).
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