6. Credit Risk Mitigation
Section 6 and its sub-sections have been updated by Basel Framework, issued by SAMA circular No (44047144), dated 04/06/1444 H, Corresponding To 27/12/2022 G, Refer to section (9) of minimum capital requirements for Credit Risk Framework.Collateral Management
The new Basel framework identifies two primary types of credit risk mitigation (CRM): guarantees and collateral.
Guarantees are legally binding promises from a third party that the loan obligations of the borrower would be met. The conditions for a guarantee to be eligible are the same as those in current Accord requiring that they are direct, explicit, irrevocable and unconditional. Under the new Basel framework, eligible guarantees would also include additional operational requirements and a treatment for maturity mismatches. The principle of substitution has been retained from current requirements.
The guarantee must be evidenced in writing, non-cancellable on the part of the guarantor, in force until the debt is satisfied in full (to the extent of the amount and tenor of the guarantee) and legally enforceable against the guarantor in a jurisdiction where the guarantor has assets to attach and enforce a judgment. However, in contrast to the foundation approach to corporate, bank, and sovereign exposures, guarantees prescribing conditions under which the guarantor may not be obliged to perform (conditional guarantees) may be recognized under certain conditions. Specifically, the onus is on the bank to demonstrate that the assignment criteria adequately address any potential reduction in the risk mitigation effect.
Under the new Basel framework, eligible guarantees would also include additional operational requirements and a treatment for maturity mismatches. The principle of substitution has been retained from current requirements.
(Refer para 484, International Convergence of Capital Measurement and Capital Standards – June 2006)
Collateral, on the other hand, can be thought of as using financial assets to secure a loan. With collateral, there is the chance that under certain circumstances risk can be eliminated. However, since the financial collateral is subject to valuation changes due to market prices additional criteria has been introduced to account for these changes in value.
No transaction in which CRM techniques are used should receive a higher capital requirement than an otherwise identical transaction where such techniques are not used.
(Refer para 113, International Convergence of Capital Measurement and Capital Standards – June 2006)
The effects of CRM will not be double counted. Therefore, no additional supervisory recognition of CRM for regulatory capital purposes will be granted on claims for which an issue-specific rating is used that already reflects that CRM. As stated in paragraph 100, International Convergence of Capital Measurement and Capital Standards – June 2006 of the section on the standardized approach, principal-only ratings will also not be allowed within the framework of CRM.
(Refer para 114, International Convergence of Capital Measurement and Capital Standards – June 2006)
While the use of CRM techniques reduces or transfers credit risk, it simultaneously may increase other risks (residual risks). Residual risks include legal, operational, liquidity and market risks. Therefore, it is imperative that banks employ robust procedures and processes to control these risks, including strategy; consideration of the underlying credit; valuation; policies and procedures; systems; control of roll-off risks; and management of concentration risk arising from the bank ‘s use of CRM techniques and its interaction with the bank ‘s overall credit risk profile. Where these risks are not adequately controlled, SAMA may impose additional capital charges or take other supervisory actions as outlined in Pillar 2.
(Refer para 115, International Convergence of Capital Measurement and Capital Standards – June 2006)
A collateralized transaction is one in which:
■ Banks have a credit exposure or potential credit exposure; and
■ That credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty.
Here "counterparty” is used to denote a party to whom a bank has an on- or off- balance sheet credit exposure or a potential credit exposure. That exposure may, for example, take the form of a loan of cash or securities (where the counterparty would traditionally be called the borrower), of securities posted as collateral, of a commitment or of exposure under an OTC derivatives contract.
(Refer para 119, International Convergence of Capital Measurement and Capital Standards – June 2006)
6.1 Financial Collateral
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
i) Simple Approach:
In this method the approach of substitution is maintained.
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.
ii) Comprehensive Approach:
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.
(Refer para 112, International Convergence of Capital Measurement and Capital Standards – June 2006)
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.
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.
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.
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.
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.
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.
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.
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:
a. Supervisory Supplied Haircuts
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.
b. Own estimate haircuts
This option allows the banks to develop their own haircuts to be applied to the collateral they have against loans.
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.
Some of the criteria include a 99 percentile one-tailed confidence interval as well as minimum data observations of one year.
c. VAR modeling
• VAR is an estimate of the maximum potential loss expected at a 1 percent confidence interval.
• VAR models aggregate several components of price risk into a single measure of the potential for loss.
• Banks must follow the requirements set in Para 178 to Para 181 of the Basel II document.
1 Exposure amounts may vary where, for example, securities are being lent.
6.2 On Balance Sheet Netting
Where banks have legally enforceable netting arrangements for loans and deposits they may calculate capital requirements on the basis of net credit exposures subject to the conditions in Basel II.
6.3 Guarantees and Credit Derivatives
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.
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.
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.
(Refer para 349, International Convergence of Capital Measurement and Capital Standards – June 2006).
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:
(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.
(b) The guarantee is an explicitly documented obligation assumed by the guarantor.
(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.
(Refer para 190, International Convergence of Capital Measurement and Capital Standards – June 2006)
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)
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.
(Refer para 199, International Convergence of Capital Measurement and Capital Standards – June 2006)
Currency mismatches
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.
GA = G x (1 – HFX)
where: G = nominal amount of the credit protection
HFX = haircut appropriate for currency mismatch between the credit protection and underlying obligation.
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
(Refer para 200, International Convergence of Capital Measurement and Capital Standards – June 2006).
6.3.1 Additional Capital Requirements for Credit Derivatives
In order for a credit derivative contract to be recognized, the following conditions must be satisfied:
(a) The credit events specified by the contracting parties must at a minimum cover:
• failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation);
• bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and
• restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account). When restructuring is not specified as a credit event, refer to paragraph 192, International Convergence of Capital Measurement and Capital Standards – June 2006
(b) If the credit derivative covers obligations that do not include the underlying obligation, section (g) below governs whether the asset mismatch is permissible.
(c) The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay, subject to the provisions of paragraph 203, International Convergence of Capital Measurement and Capital Standards – June 2006
(d) Credit derivatives allowing for cash settlement are recognized for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There must be a clearly specified period for obtaining post-credit event valuations of the underlying obligation. If the reference obligation specified in the credit derivative for purposes of cash settlement is different than the underlying obligation, section (g) below governs whether the asset mismatch is permissible.
(e) If the protection purchaser‘s right/ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation must provide that any required consent to such transfer may not be unreasonably withheld.
(f) The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event.
(g) A mismatch between the underlying obligation and the reference obligation under the credit derivative (i.e. the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if (1) the reference obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.
(h) A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if (1) the latter obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross acceleration clauses are in place.
When the restructuring of the underlying obligation is not covered by the credit derivative, but the other requirements in paragraph 191 are met, partial recognition of the credit derivative will be allowed. If the amount of the credit derivative is less than or equal to the amount of the underlying obligation, 60% of the amount of the hedge can be recognized as covered. If the amount of the credit derivative is larger than that of the underlying obligation, then the amount of eligible hedge is capped at 60% of the amount of the underlying obligation.
Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees will be eligible for recognition. The following exception applies.
Where a bank buys credit protection through a total return swap and records the net payments received on the swap as net income but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by an addition to reserves), the credit protection will not be recognized. The treatment of first-to-default and second-to-default products is covered separately in paragraphs 207 to 210, International Convergence of Capital Measurement and Capital Standards – June 2006
Other types of credit derivatives will not be eligible for recognition at this time.
(Refer para 191-194, International Convergence of Capital Measurement and Capital Standards – June 2006)
6.4 Legal and Operational Certainty
All documentation used in collateralized transactions and for documenting, guarantees and credit derivatives must be binding on all parties and legally enforceable in all relevant jurisdictions. Banks must have conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion and undertake such further review as necessary to ensure continuing enforceability.(Refer para 118, International Convergence of Capital Measurement and Capital Standards – June 2006)
In addition to the general requirements for legal certainty set out in paragraphs 117 and 118 of International Convergence of Capital Measurement and Capital Standards – June 2006, the legal mechanism by which collateral is pledged or transferred must ensure that the bank has the right to liquidate or take legal possession of it, in a timely manner, in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Furthermore, banks must take all steps necessary to fulfil these requirements under the law applicable to the bank’s interest in the collateral for obtaining and maintaining an enforceable security interest, e.g. by registering it with a registrar, or for exercising a right to net or set off in relation to title transfer collateral. (Refer para 123, International Convergence of Capital Measurement and Capital Standards – June 2006)
In order for collateral to provide protection, the credit quality of the counterparty and the value of the collateral must not have a material positive correlation. For example, securities issued by the counterparty ─ or by any related group entity ─ would provide little protection and so would be ineligible. (Refer para 124, International Convergence of Capital Measurement and Capital Standards – June 2006)
Banks must have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly. .(Refer para 125, International Convergence of Capital Measurement and Capital Standards – June 2006
Where the collateral is held by a custodian, banks must take reasonable steps to ensure that the custodian segregates the collateral from its own assets.
(Refer para 126, International Convergence of Capital Measurement and Capital Standards – June 2006)
6.4.1 Repo Style Transaction
Where a bank, acting as an agent, arranges a repo-style transaction (i.e. repurchase/reverse repurchase and securities lending/borrowing transactions) between a customer and a third party and provides a guarantee to the customer that the third party will perform on its obligations, then the risk to the bank is the same as if the bank had entered into the transaction as a principal. In such circumstances, a bank will be required to calculate capital requirements as if it were itself the principal.
(Refer para 128, International Convergence of Capital Measurement and Capital Standards – June 2006)
6.5 Maturity Mismatch
For the purposes of calculating risk-weighted assets, a maturity mismatch occurs when the residual maturity of a hedge is less than that of the underlying exposure.
Definition of maturity
The maturity of the underlying exposure and the maturity of the hedge should both be defined conservatively. The effective maturity of the underlying should be gauged as the longest possible remaining time before the counterparty is scheduled to fulfil its obligation, taking into account any applicable grace period. For the hedge, embedded options which may reduce the term of the hedge should be taken into account so that the shortest possible effective maturity is used.
Where a call is at the discretion of the protection seller, the maturity will always be at the first call date. If the call is at the discretion of the protection buying bank but the terms of the arrangement at origination of the hedge contain a positive incentive for the bank to call the transaction before contractual maturity, the remaining time to the first call date will be deemed to be the effective maturity. For example, where there is a step-up in cost in conjunction with a call feature or where the effective cost of cover increases over time even if credit quality remains the same or increases, the effective maturity will be the remaining time to the first call.
Risk weights for maturity mismatches
As outlined in paragraph 143 of the International Convergence of Capital Measurement and Capital Standards – June 2006, hedges with maturity mismatches are only recognized when their original maturities are greater than or equal to one year. As a result, the maturity of hedges for exposures with original maturities of less than one year must be matched to be recognized. In all cases, hedges with maturity mismatches will no longer be recognized when they have a residual maturity of three months or less.
When there is a maturity mismatch with recognized credit risk mitigants (collateral, on-balance sheet netting, guarantees and credit derivatives) the following adjustment will be applied.
Pa = P x (t – 0.25) / (T – 0.25)
where:
Pa = value of the credit protection adjusted for maturity mismatch
P = credit protection (e.g. collateral amount, guarantee amount) adjusted for any haircuts
t = min (T, residual maturity of the credit protection arrangement) expressed in years
T = min (5, residual maturity of the exposure) expressed in years
(Refer para 202-205, International Convergence of Capital Measurement and Capital Standards – June 2006)
6.6 Other Items Related to CRM Techniques
Treatment of pools of CRM techniques
In the case where a bank has multiple CRM techniques covering a single exposure (e.g. a bank has both collateral and guarantee partially covering an exposure), the bank will be required to subdivide the exposure into portions covered by each type of CRM technique (e.g. portion covered by collateral, portion covered by guarantee) and the risk-weighted assets of each portion must be calculated separately. When credit protection provided by a single protection provider has differing maturities, they must be subdivided into separate protection as well.
First-to-default credit derivatives
There are cases where a bank obtains credit protection for a basket of reference names and where the first default among the reference names triggers the credit protection and the credit event also terminates the contract. In this case, the bank may recognize regulatory capital relief for the asset within the basket with the lowest risk-weighted amount, but only if the notional amount is less than or equal to the notional amount of the credit derivative.
With regard to the bank providing credit protection through such an instrument, if the product has an external credit assessment from an eligible credit assessment institution, the risk weight in paragraph 567, International Convergence of Capital Measurement and Capital Standards – June 2006 applied to securitization tranches will be applied. If the product
Second-to-default credit derivatives
is not rated by an eligible external credit assessment institution, the risk weights of the assets included in the basket will be aggregated up to a maximum of 1250% and multiplied by the nominal amount of the protection provided by the credit derivative to obtain the risk-weighted asset amount.
In the case where the second default among the assets within the basket triggers the credit protection, the bank obtaining credit protection through such a product will only be able to recognize any capital relief if first-default-protection has also be obtained or when one of the assets within the basket has already defaulted.
For banks providing credit protection through such a product, the capital treatment is the same as in paragraph 208, International Convergence of Capital Measurement and Capital Standards – June 2006 with one exception. The exception is that, in aggregating the risk weights, the asset with the lowest risk weighted amount can be excluded from the calculation.
(Refer para 206-210, International Convergence of Capital Measurement and Capital Standards – June 2006)
Credit Risk Mitigants
A. HAIRCUTS TO COLLATERALS
. Debt Securities • As per issuer, maturity, and rating from 0.5% up to 15%. (Para 151)
• However, KSA Government bonds and bonds of Public Sector Entities (PSEs) eligible for sovereign treatment in local currency to be at 0% haircut.
B. ADDITIONAL COLLATERALS
2nd mortgage-SIDF (Junior Lien) Residual value to be eligible CRM as per existing Basel II.