6. Credit Risk Mitigation

No: BCS 290

Date(g): 12/6/2006 | Date(h): 16/5/1427

Effective from Jan 01 2008 - Dec 31 2007
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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)