Enhancement Risk Under Basel III Framework
6. Enhanced Risk Coverage
In addition to raising the quality and level of the capital base, the Basel III framework recognized the need to ensure that all material risks are captured in the capital framework. Failure to capture major on- and off-balance sheet risks, as well as derivative related exposures, was a key factor that amplified the crisis. This section outlines enhancement to Risk Coverage under the Basel III framework as given below.
A. Counterparty Credit Risk
• Revised metric to better address counterparty credit risk, credit valuation adjustments and wrong-way risks
• Introduction of Asset Value correlation (AVC) for Financial Institutions
• Collateralized counterparties and increased margin period of risk
• Central Counterparties (CCPs)
• Enhanced counterparty credit risk management requirements
B. Addressing Reliance on external credit ratings and minimizing cliff effects
• Standardized Inferred rating treatment for long-term exposure
• Incentive to avoid getting exposures rated
• Incorporation of IOSCO’s Code of Conduct Fundamentals for Credit Rating Agencies
• ‘’Cliff effects’’ arising from guarantees and credit derivatives- ‘’CRM’’
• Unsolicited ratings and recognition of ECAI’s
6.1 Counterparty Credit Risk
As mentioned, Counterparty Credit Risk under Basel II only measured Default Risk which could be calculated by using the following 3 methods, where SAMA adopted the # 3 Current Exposure Method.
1. Internal Model Method
2. Standardized Approach
3. Current Exposure Method (CEM)
In this regard, SAMA had permitted only the Current Exposures Method under Basel II. For Basel III purposes as in Basel II banks are to use the more simple CEM.
Further, Basel III introduced the concept of Current Value Adjustment (CVA) as an additional Counterparty Risk, which again can be determined by using the Internal Model Method (IMM) or the Standardized Method.
It should also be emphasized that Basel III introduced incremental risk or additional risk through the concept of the Credit Value Adjustment which measure the counterparty risk prior to default. Consequently, total risk is an aggregate of these two.
The main revision to Internal Models Method to measure default risk exposure is to using the Effective EPE with stressed parameters.
In this regard, the Default risk capital charge is the greater of:
• Portfolio level capital charge based on effective EPE (not including CVA charge using current market data) and the portfolio level capital charge based on effective EPE under stress calibration.
B. Credit Value Adjustment
Capitalization of the risk of CVA losses
The major element of CVA include the following:
• Applies to IMM and non IMM banks
• Huge mark-to-market losses incurred during financial crisis
• BCBS introduced a ‘’bond equivalent of the counterparty exposure’’ approach which aims to better capture CVA losses
• In addition to default risk, additional capital charge introduced for CCR for OTC derivatives
• Transactions with SFTs and CCPs excluded from CVA capital charge unless these are material, where the materiality threshold for SFT’s will be defined by SAMA and if warranted, bank will be advised accordingly.
• Banks with IMM approval and Specific Interest Rate Risk VaR model approval for bonds will use ‘’Advanced CVA risk capital charge’’
• All other banks will calculate CVA capital charge based on ‘’Standardized CVA risk capital charge’’ methodology
• Under Basel II, Banks in KSA are mandated by SAMA to use ‘’CEM’’ methodology for both Standardized & IRB Approach. However, for Basel III they can utilize IMM as well.
• Under the Standardized Approach, Banks would be required to develop enhanced system’s capability to apply this formula
• Maturity: Mi is the notional weighted average maturity (FAQ- For CVA purposes, the 5-year cap of the effective maturity will not be applied). This applies to all transactions with the counterparty, not only to index CDS- Maturity will be capped at the longest contractual remaining maturity in the netting set.
A. Counterparty credit risk using Internal Models
This section is only applicable for those banks that have been given regulatory approval by SAMA to use the IMM Approach to calculate counterparty credit risk. Alternatively, Banks should use Standardized Approach 6.1.B on page 30. Also, for further clarifications, please refer to SAMA Circular # BCS 24331 dated 4 September 2012 entitled "Basel III Definition of Capital FAQs (p.7).
6.1.A Internal Model Method (IMM)
Default Risk Exposures Calculation
Internal Model (EPE)
25(i). To determine the default risk capital charge for counterparty credit risk as defined in paragraph 105, banks must use the greater of the portfolio-level capital charge (not including the CVA charge in paragraphs 97-104) based on Effective EPE using current market data and the portfolio-level capital charge based on Effective EPE using a stress calibration. The stress calibration should be a single consistent stress calibration for the whole portfolio of counterparties. The greater of Effective EPE using current market data and the stress calibration should not be applied on a counterparty by counterparty basis, but on a total portfolio level.
61. When the Effective EPE model is calibrated using historic market data, the bank must employ current market data to compute current exposures and at least three years of historical data must be used to estimate parameters of the model. Alternatively, market implied data may be used to estimate parameters of the model. In all cases, the data must be updated quarterly or more frequently if market conditions warrant. To calculate the Effective EPE using a stress calibration, the bank must also calibrate Effective EPE using three years of data that include a period of stress to the credit default spreads of a bank’s counterparties or calibrate Effective EPE using market implied data from a suitable period of stress. The following process will be used to assess the adequacy of the stress calibration:
• The bank must demonstrate, at least quarterly, that the stress period coincides with a period of increased CDS or other credit spreads – such as loan or corporate bond spreads – for a representative selection of the bank’s counterparties with traded credit spreads. In situations where the bank does not have adequate credit spread data for a counterparty, the bank should map each counterparty to specific credit spread data based on region, internal rating and business types.
• The exposure model for all counterparties must use data, either historic or implied, that include the data from the stressed credit period, and must use such data in a manner consistent with the method used for the calibration of the Effective EPE model to current data.
• To evaluate the effectiveness of its stress calibration for Effective EPE, the bank must create several benchmark portfolios that are vulnerable to the same main risk factors to which the bank is exposed. The exposure to these benchmark portfolios shall be calculated using (a) current positions at current market prices, stressed volatilities, stressed correlations and other relevant stressed exposure model inputs from the 3-year stress period and (b) current positions at end of stress period market prices, stressed volatilities, stressed correlations and other relevant stressed exposure model inputs from the 3-year stress period. Supervisors may adjust the stress calibration if the exposures of these benchmark portfolios deviate substantially.
Calculation of Credit Value Adjustment (CVA)
The Concept
Credit Value Adjustments (CVA) under Basel III is an incremental credit risk capital charge prior to default. Under Basel II and Basel II.5 counterparty credit risk methodology only calculated capital requirements for default risk. However, Basel III brings in the capital charge with regard to the deterioration of a counterparty risk prior to default. Consequently, the CVA is in addition or as an incremental risk to default risk. SAMA's methodology uses the Current Exposure Method (CEM) for Default Risk which is one of the four methods prescribed under Basel II Annex # 41. Consequently, capital requirements for counterparty risk is the aggregate of CEM and CVA calculations.
Specific Aspects of CVA under IMM Approach
Capitalization of the risk of CVA losses
99. To implement the bond equivalent approach, the following new section VIII will be added to Annex 4 of the Basel II framework.1 The new paragraphs (97 to 105) are to be inserted after paragraph 96 in Annex 4.1
VIII. Treatment of mark-to-market counterparty risk losses (CVA capital charge)
- CVA Risk Capital Charge
97. In addition to the default risk capital requirements for counterparty credit risk determined based on the standardized or internal ratings- based (IRB) approaches for credit risk, a bank must add a capital charge to cover the risk of mark-to-market losses on the expected counterparty risk (such losses being known as credit value adjustments, CVA) to OTC derivatives. The CVA capital charge will be calculated in the manner set forth below depending on the bank’s approved method of calculating capital charges for counterparty credit risk and specific interest rate risk. A bank is not required to include in this capital charge (i) transactions with a central counterparty (CCP); and (ii) securities financing transactions (SFT), unless their supervisor determines that the bank’s CVA loss exposures arising from SFT transactions are material.
A. Banks with IMM approval and Specific Interest Rate Risk VaR model2 approval for bonds: Advanced CVA risk capital charge
98. Banks with IMM approval for counterparty credit risk and approval to use the market risk internal models approach for the specific interest-rate risk of bonds must calculate this additional capital charge by modeling the impact of changes in the counterparties’ credit spreads on the CVAs of all OTC derivative counterparties, together with eligible CVA hedges according to new paragraphs 102 and 103, using the bank’s VaR model for bonds. This VaR model is restricted to changes in the counterparties’ credit spreads and does not model the sensitivity of CVA to changes in other market factors, such as changes in the value of the reference asset, commodity, currency or interest rate of a derivative. Regardless of the accounting valuation method a bank uses for determining CVA, the CVA capital charge calculation must be based on the following formula for the CVA of each counterparty:
Where:
• ti is the time of the i-th revaluation time bucket, starting from t0=0.
• tT is the longest contractual maturity across the netting sets with the counterparty.
• si is the credit spread of the counterparty at tenor ti, used to calculate the CVA of the counterparty. Whenever the CDS spread of the counterparty is available, this must be used. Whenever such a CDS spread is not available, the bank must use a proxy spread that is appropriate based on the rating, industry and region of the counterparty.
• LGDMKT is the loss given default of the counterparty and should be based on the spread of a market instrument of the counterparty (or where a counterparty instrument is not available, based on the proxy spread that is appropriate based on the rating, industry and region of the counterparty). It should be noted that this LGDMKT, which inputs into the calculation of the CVA risk capital charge, is different from the LGD that is determined for the IRB and CCR default risk charge, as this LGDMKT is a market assessment rather than an internal estimate.
• The first factor within the sum represents an approximation of the market implied marginal probability of a default occurring between times ti-1 and ti. Market implied default probability (also known as risk neutral probability) represents the market price of buying protection against a default and is in general different from the real-world likelihood of a default.
• EEi is the expected exposure to the counterparty at revaluation time ti, as defined in paragraph 30 (regulatory expected exposure), where exposures of different netting sets for such counterparty are added, and where the longest maturity of each netting set is given by the longest contractual maturity inside the netting set. For banks using the short cut method (paragraph 41 of Annex 4)1 for margined trades, the paragraph 99 should be applied.
• Di is the default risk-free discount factor at time ti, where D0 = 1.
99. The formula in paragraph 98 must be the basis for all inputs into the bank’s approved VaR model for bonds when calculating the CVA risk capital charge for a counterparty. For example, if this approved VaR model is based on full repricing, then the formula must be used directly. If the bank’s approved VaR model is based on credit spread sensitivities for specific tenors, the bank must base each credit spread sensitivity on the following formula:3
If the bank’s approved VaR model uses credit spread sensitivities to parallel shifts in credit spreads (Regulatory CS01), then the bank must use the following formula:4
If the bank’s approved VaR model uses second-order sensitivities to shifts in credit spreads (spread gamma), the gammas must be calculated based on the formula in paragraph 98.
Banks using the short cut method for collateralized OTC derivatives (paragraph 41 in Appendix 4), must compute the CVA risk capital charge according to paragraph 98, by assuming a constant EE (expected exposure) profile, where EE is set equal to the effective expected positive exposure of the shortcut method for a maturity equal to the maximum of (i) half of the longest maturity occurring in the netting set and (ii) the notional weighted average maturity of all transactions inside the netting set.
Banks with IMM approval for the majority of their businesses, but which use CEM (Current Exposure Method) or SM (Standardized Method) for certain smaller portfolios, and which have approval to use the market risk internal models approach for the specific interest rate risk of bonds, will include these non-IMM netting sets into the CVA risk capital charge, according to paragraph 98, unless the national supervisor decides that paragraph 104 should apply for these portfolios. Non-IMM netting sets are included into the advanced CVA risk capital charge by assuming a constant EE profile, where EE is set equal to the EAD as computed under CEM or SM for a maturity equal to the maximum of (i) half of the longest maturity occurring in the netting set and (ii) the notional weighted average maturity of all transactions inside the netting set. The same approach applies where the IMM model does not produce an expected exposure profile.
For exposures to certain counterparties, the bank's approved market risk VaR model may not reflect the risk of credit spread changes appropriately, because the bank's market risk VaR model does not appropriately reflect the specific risk of debt instruments issued by the counterparty. For such exposures, the bank is not allowed to use the advanced CVA risk charge. Instead, for these exposures the bank must determine the CVA risk charge by application of the standardized method in paragraph 104. Only exposures to counterparties for which the bank has supervisory approval for modeling the specific risk of debt instruments are to be included into the advanced CVA risk charge.
100. The CVA risk capital charge consists of both general and specific credit spread risks, including Stressed VaR but excluding IRC (incremental risk charge). The VaR figure should be determined in accordance with the quantitative standards described in paragraph 718(Lxxvi). It is thus determined as the sum of (i) the non-stressed VaR component and (ii) the stressed VaR component.
i. When calculating the non-stressed VaR, current parameter calibrations for expected exposure must be used.
ii. When calculating the stressed VaR future counterparty EE profiles (according to the stressed exposure parameter calibrations as defined in paragraph 61 of Annex 4)1 must be used. The period of stress for the credit spread parameters should be the most severe one-year stress period contained within the three year stress period used for the exposure parameters.5
101. This additional CVA risk capital charge is the standalone market risk charge, calculated on the set of CVAs (as specified in paragraph 98) for all OTC derivatives counterparties, collateralized and uncollateralized, together with eligible CVA hedges. Within this standalone CVA risk capital charge, no offset against other instruments on the bank’s balance sheet will be permitted (except as otherwise expressly provided herein).
102. Only hedges used for the purpose of mitigating CVA risk, and managed as such, are eligible to be included in the VaR model used to calculate the above CVA capital charge or in the standardized CVA risk capital charge set forth in paragraph 104. For example, if a credit default swap (CDS) referencing an issuer is in the bank’s inventory and that issuer also happens to be an OTC counterparty but the CDS is not managed as a hedge of CVA, then such a CDS is not eligible to offset the CVA within the standalone VaR calculation of the CVA risk capital charge.
103. The only eligible hedges that can be included in the calculation of the CVA risk capital charge under paragraphs 98 or 104 are single-name CDSs, single-name contingent CDSs, other equivalent hedging instruments referencing the counterparty directly, and index CDSs. In case of index CDSs, the following restrictions apply:
• The basis between any individual counterparty spread and the spreads of index CDS hedges must be reflected in the VaR. This requirement also applies to cases where a proxy is used for the spread of a counterparty, since idiosyncratic basis still needs to be reflected in such situations. For all counterparties with no available spread, the bank must use reasonable basis time series out of a representative bucket of similar names for which a spread is available.
• If the basis is not reflected to the satisfaction of the supervisor, then the bank must reflect only 50% of the notional amount of index hedges in the VaR. Other types of counterparty risk hedges must not be reflected within the calculation of the CVA capital charge, and these other hedges must be treated as any other instrument in the bank’s inventory for regulatory capital purposes. Tranched or nthto-default CDSs are not eligible CVA hedges. Eligible hedges that are included in the CVA capital charge must be removed from the bank’s market risk capital charge calculation.
1 Annex 5 of this document.
2 “VaR model” refers to the internal model approach to market risk.
3 This derivation assumes positive marginal default probabilities before and after time bucket ti and is valid for i<T. For the final time bucket i=T, the corresponding formula is:
4 This derivation assumes positive marginal default probabilities.
5 Note that the three-times multiplier inherent in the calculation of a bond VaR and a stressed VaR will apply to these calculations.6.1.B Counterparty Credit Risk (Under the Standardized Approach)
The total capital requirements for counterparty credit risk under the Standardized Approach is also an aggregate of the 1) Default risk under SAMA Basel III calculated using the Current Exposure Method and the Incremental Risk under Basel III called the Credit Value Adjustment.
For further clarifications, please refer to SAMA Circular # BCS 24331 dated 4 September 2012 entitled "Basel III Definition of Capital FAQs (p.7).
Consequently, Bank using the Standardized Approach will calculate the Default Risk using the CEM as prescribed also under Basel II, and the CVA under the Standardized Approach as given below under Basel III.
Standardized CVA risk capital charge
104. When a bank does not have the required approvals to use paragraph 98 to calculate a CVA capital charge for its counterparties, the bank must calculate a portfolio capital charge using the following formula:
Where:
• h is the one-year risk horizon (in units of a year), h = 1.
• wi is the weight applicable to counterparty ‘i’. Counterparty ‘i’ must be mapped to one of the seven weights wi based on its external rating, as shown in the table of this paragraph below. When a counterparty does not have an external rating, the bank must, subject to supervisory approval, map the internal rating of the counterparty to one of the external ratings.
• EADtotali EAD is the exposure at default of counterparty ‘i’ (summed across its netting sets), including the effect of collateral as per the existing IMM, SM or CEM rules as applicable to the calculation of counterparty risk capital charges for such counterparty by the bank. For non-IMM banks the exposure should be discounted by applying the factor (1-exp(-0.05*Mi))/(0.05*Mi). For IMM banks, no such discount should be applied as the discount factor is already included in Mi.
• Bi is the notional of purchased single name CDS hedges (summed if more than one position) referencing counterparty ‘i’, and used to hedge CVA risk. This notional amount should be discounted by applying the factor (1-exp(-0.05*Mihedge))/(0.05* Mihedge).
• Bind is the full notional of one or more index CDS of purchased protection, used to hedge CVA risk. This notional amount should be discounted by applying the factor (1-exp(-0.05*Mind))/(0.05* Mind).
• wind is the weight applicable to index hedges. The bank must map indices to one of the seven weights wi based on the average spread of index ‘ind’.
• Mi is the effective maturity of the transactions with counterparty ‘i’. For IMM banks, Mi is to be calculated as per Annex 4,1 paragraph 38 of the Basel Accord. For non-IMM banks, Mi is the notional weighted average maturity as referred to in the third bullet point of para 320. However, for this purpose, Mi should not be capped at 5 years.
• Mihedge is the maturity of the hedge instrument with notional Bi (the quantities Mihedge Bi are to be summed if these are several positions).
• Mind is the maturity of the index hedge ‘ind’. In case of more than one index hedge position, it is the notional weighted average maturity.
For any counterparty that is also a constituent of an index on which a CDS is used for hedging counterparty credit risk, the notional amount attributable to that single name (as per its reference entity weight) may, with supervisory approval, be subtracted from the index CDS notional amount and treated as a single name hedge (Bi) of the individual counterparty with maturity based on the maturity of the index.
The weights are given in this table, and are based on the external rating of the counterparty:2
Rating Weight Wi AAA 0.7% AA 0.7% A 0.8% BBB 1.0% BB 2.0% B 3.0% CCC 10.0% 1 Annex 5 of this document.
2 The notations follow the methodology used by one institution, Standard & Poor’s. The use of Standard & Poor’s credit ratings is an example only; those of some other approved external credit assessment institutions could be used on an equivalent basis. The ratings used throughout this document, therefore, do not express any preferences or determinations on external assessment institutions by the Committee.6.1.C Further Details on CCR and CVA Aggregation
105. Calculation of the aggregate CCR and CVA risk capital charges for 6.1.A IMM and 6.1.b (Standardized Approach)
As a summary, total counterparty exposure is an aggregate of 1) Default Rate calculated either through IMM, CEM or Standardized Approach and 2) Credit Value Adjustment which again can be calculated as per the IMM or Standardized Approach or CEM.
This paragraph deals with the aggregation of the default risk capital charge and the CVA risk capital charge for potential mark-to-market losses. Note that outstanding EAD referred to in the default risk capital charges below is net of incurred CVA losses according to [new paragraph after Para 9 in Annex 4],1 which affects all items “i” below. In this paragraph, “IMM capital charge” refers to the default risk capital charge for CCR based on the RWAs obtained when multiplying the outstanding EAD of each counterparty under the IMM approach by the applicable credit risk weight (under the Standardized or IRB approach), and summing across counterparties. Equally, Current Exposures Method “(CEM) capital charge” or “SM capital charge” refer to the default risk capital charges where outstanding EADs for all counterparties in the portfolio are determined based on CEM or SM, respectively.
A. Banks with IMM approval and market-risk internal-models approval for the specific interest-rate risk of bonds The total CCR capital charge for such a bank is determined as the sum of the following components:
i. The higher of (a) its IMM capital charge based on current parameter calibrations for EAD and (b) its IMM capital charge based on stressed parameter calibrations for EAD. For IRB banks, the risk weights applied to OTC derivative exposures should be calculated with the full maturity adjustment as a function of PD and M set equal to 1 in the Basel Accord (paragraph 272), provided the bank can demonstrate to SAMA its specific VaR model applied in paragraph 98 contains effects of rating migrations. If the bank cannot demonstrate this to the satisfaction of SAMA, the full maturity adjustment function, given by the formula (1 – 1.5 x b)^-1 × (1 + (M – 2.5) × b)2 should apply.
ii. The advanced CVA risk capital charge determined pursuant to paragraphs 98 to 103.
B. Banks with IMM approval and without Specific Risk VaR approval for bonds The total CCR capital charge for such a bank is determined as the sum of the following components: i. The higher of (a) the IMM capital charge based on current parameter calibrations for EAD and (b) the IMM capital charge based on stressed parameter calibrations for EAD.
ii. The standardized CVA risk capital charge determined by paragraph 104.
C. All other banks The total CCR capital charge for such banks is determined as the sum of the following two components:
i. The sum over all counterparties of the CEM or SM based capital charge (depending on the bank’s CCR approach) with EADs determined by paragraphs 91or 69 respectively.
ii. The standardized CVA risk capital charge determined by paragraph 104.
In addition, the following paragraph will be inserted after paragraph 9 in Annex 4.1
“Outstanding EAD” for a given OTC derivative counterparty is defined as the greater of zero and the difference between the sum of EADs across all netting sets with the counterparty and the credit valuation adjustment (CVA) for that counterparty which has already been recognized by the bank as an incurred write-down (i.e. a CVA loss). This CVA loss is calculated without taking into account any offsetting debit valuation adjustments which have been deducted from capital under paragraph 75.3 RWAs for a given OTC derivative counterparty may be calculated as the applicable risk weight under the Standardized or IRB approach multiplied by the outstanding EAD of the counterparty. This reduction of EAD by incurred CVA losses does not apply to the determination of the CVA risk capital charge.
1 Annex 5 of this document.
2 Where “M” is the effective maturity and “b” is the maturity adjustment as a function of the PD, as defined in paragraph 272 of the Basel Accord.
3 The incurred CVA loss deduced from exposures to determine outstanding EAD is the CVA loss gross of all debit value adjustments (DVA) which have been separately deducted from capital. To the extent DVA has not been separately deducted from a bank’s capital, the incurred CVA loss used to determine outstanding EAD will be net of such DVA.6.2 Wrong-Way Risk
As a summary, ‘’Wrong-way risk substantially applies only to IMM banks and is typically defined as an exposure to a counterparty that is adversely correlated with the credit quality of that counterparty’’ (Transactions with counterparties such as financial guarantors). However, there are implications for the Standardized and IRB Approaches as described in p.36.
As a summary:
• 2 types of wrong way risk
• General wrong-way risk (GWWR)
• Specific wrong-way risk (SWWR)
• GWWR arises when the PD of the counterparties are positively corrected with general market risk factors
• Arises from purchase of credit protection via CDS from mono-line insurers
• Banks must identify exposures that give rise to general WWR:
■ Stress testing and scenario analysis to be conducted
■ Monitor general wrong way risk by product, by region, by industry etc.
■ Reports to be provided to Senior Management and Board on a regular basis
Implement an explicit Pillar 1 capital charge and revise Annex 41 where specific wrong-way risk (SWWR) has been identified
• Banks exposed to SWWR if future exposure to a counterparty is highly correlated with the counterparty’s PD
• Banks need to have explicit procedure for identifying, monitoring and controlling specific WWR
• Specific WWR charges applies for where there exists a legal connection between the counterparty and the underlying issuer e.g.
■ Single name credit default swaps
■ Equity derivatives referencing single counterparty
■ CDS (Credit Default Swaps): use expected loss assuming underlying in liquidation (LGD for swap = 100%)
■ Equity, bond, securities financing EAD= value of transaction under JtD (jump-to-default)
100. In specific, Paragraph 57 of Annex 41 in Basel II will be revised as follows to explain the following aforementioned summary on wrong way exposures:
57. Banks must identify exposures that give rise to a greater degree of general wrong-way risk. Stress testing and scenario analyses must be designed to identify risk factors that are positively correlated with counterparty credit worthiness. Such testing needs to address the possibility of severe shocks occurring when relationships between risk factors have changed. Banks should monitor general wrong way risk by product, by region, by industry, or by other categories that are germane to the business. Reports should be provided to senior management and the appropriate committee of the Board on a regular basis that communicate wrong way risks and the steps that are being taken to manage that risk.
Implement an explicit Pillar 1 capital charge and revise Annex 41 where specific wrong-way risk has been identified
101. In order to implement the requirement that the EAD calculation reflect a higher EAD value for counterparties where specific wrong way risk has been identified, paragraph 423 of the Basel II text and paragraphs 29 and 58 of Annex 4 will be revised as follows:
423. Each separate legal entity to which the bank is exposed must be separately rated. A bank must have policies acceptable to its supervisor regarding the treatment of individual entities in a connected group including circumstances under which the same rating may or may not be assigned to some or all related entities. Those policies must include a process for the identification of specific wrong way risk for each legal entity to which the bank is exposed. Transactions with counterparties where specific wrong way risk has been identified need to be treated differently when calculating the EAD for such exposures (see paragraph 58, Annex 4).1
29. When using an internal model, exposure amount or EAD is calculated as the product of alpha times Effective EPE, as specified below (except for counterparties that have been identified as having explicit specific wrong way risk – see paragraph 58):
58. A bank is exposed to “specific wrong-way risk” if future exposure to a specific counterparty is highly correlated with the counterparty’s probability of default. For example, a company writing put options on its own stock creates wrong way exposures for the buyer that is specific to the counterparty. A bank must have procedures in place to identify, monitor and control cases of specific wrong way risk, beginning at the inception of a trade and continuing through the life of the trade. To calculate the CCR capital charge, the instruments for which there exists a legal connection between the counterparty and the underlying issuer, and for which specific wrong way risk has been identified, are not considered to be in the same netting set as other transactions with the counterparty. Furthermore, for single-name credit default swaps where there exists a legal connection between the counterparty and the underlying issuer, and where specific wrong way risk has been identified, EAD in respect of such swap counterparty exposure equals the full expected loss in the remaining fair value of the underlying instruments assuming the underlying issuer is in liquidation. The use of the full expected loss in remaining fair value of the underlying instrument allows the bank to recognize, in respect of such swap, the market value that has been lost already and any expected recoveries.
Application to IRB and Standardized Approach
Accordingly LGD for Advanced or Foundation IRB banks must be set to 100% for such swap transactions.2 For banks using the Standardized Approach, the risk weight to use is that of an unsecured transaction. For equity derivatives, bond options, securities financing transactions etc. referencing a single company where there exists a legal connection between the counterparty and the underlying company, and where specific wrong way risk has been identified, EAD equals the value of the transaction under the assumption of a jump-to-default of the underlying security. In as much this makes re-use of possibly existing (market risk) calculations (for IRC) that already contain an LGD assumption, the LGD must be set to 100%.
1 Annex 5 of this document.
2 Note that the recoveries may also be possible on the underlying instrument beneath such swap. The capital requirements for such underlying exposure are to be calculated under the Accord without reduction for the swap which introduces wrong way risk. Generally this means that such underlying exposure will receive the risk weight and capital treatment associated with an unsecured transaction (ie assuming such underlying exposure is an unsecured credit exposure).6.3. Asset Value Correlation (AVC) Multiplier for Large Financial Institutions
As summary, the following elements are relevant.
■ AVC is applicable under credit risk for IRB Approaches only; For banks remaining on Standardized Approach for bank asset class this will not apply
■ Financial institution’s (FIs) credit quality deteriorated in a highly corrected manner during the severe financial crisis
■ To address this Basel III introduced AVC for large financial institutions
■ A multiplier of 1.25 is applied to the correlation parameter of all exposures to large financial institutions meeting the following criteria:
• Regulated financial institutions are whose total assets are greater than or equal to US$100 billion (SR 375 billion)
• Most recent audited financial statements of the parent and consolidated Subsidiaries to be used
Unregulated financial institutions are regardless of size and includes lending, factoring, leasing, securitization etc. (FAQs unregulated financial institution can include a financial institution or leveraged fund that is not subject to prudential solvency regulation)
102. In order to implement the AVC multiplier, paragraph 272 of the Basel framework would be revised as follows: (This relates to the determination of Capital requirements under IRB Approaches.)
272. Throughout this section, PD and LGD are measured as decimals, and EAD is measured as currency (e.g. euros), except where explicitly noted otherwise. For exposures not in default, the formula for calculating risk-weighted assets is:1
Correlation (R) = 0.12 × (1 – EXP(-50 × PD)) / (1 – EXP(-50)) + 0.24 × [1 – (1 – EXP(-50 × PD)) / (1 – EXP(-50))]
Maturity adjustment (b) = (0.11852 – 0.05478 × ln (PD))^2
Capital requirement2 (K) = [LGD × N[(1 – R)^-0.5 × G(PD) + (R / (1 – R))^0.5 × G(0.999)] – PD x LGD] x (1 – 1.5 x b)^-1 × (1 + (M – 2.5) × b)
Risk-weighted assets (RWA) = K x 12.5 x EAD
The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD (described in paragraph 468) and the bank’s best estimate of expected loss (described in paragraph 471). The risk-weighted asset amount for the defaulted exposure is the product of K, 12.5, and the EAD.
A multiplier of 1.25 is applied to the correlation parameter described on page 37 para 102of all exposures to financial institutions meeting the following criteria.
Accordingly, the correlation R as determined by the formats in paragraph 101 will be multiplied by 1.25. This in turn would produce a higher "R" correlation and capital requirements necessary for exposure to large FI.
- Regulated financial institutions whose total assets are greater than or equal to US $100 billion (SR 375 billion). The most recent audited financial statement of the parent company and consolidated subsidiaries must be used in order to determine asset size. For the purpose of this paragraph, a regulated financial institution is defined as a parent and its subsidiaries where any substantial legal entity in the consolidated group is supervised by a regulator that imposes prudential requirements consistent with international norms. These include, but are not limited to, prudentially regulated Insurance Companies, Broker/Dealers, Banks, Thrifts and Futures Commission Merchants;
- Unregulated financial institutions, regardless of size. Unregulated financial institutions are, for the purposes of this paragraph, legal entities whose main business includes: the management of financial assets, lending, factoring, leasing, provision of credit enhancements, securitization, investments, financial custody, central counterparty services, proprietary trading and other financial services activities identified by supervisors.
1 Ln denotes the natural logarithm. N(x) denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with mean zero and variance of one is less than or equal to x). G(z) denotes the inverse cumulative distribution function for a standard normal random variable (ie the value of x such that N(x) = z). The normal cumulative distribution function and the inverse of the normal cumulative distribution function are, for example, available in Excel as the functions NORMSDIST and NORMSINV.
2 If this calculation results in a negative capital charge for any individual sovereign exposure, banks should apply a zero capital charge for that exposure.6.4. Collateralized Counterparties and Margin Period of Risk
Increase the margin period of risk
As a summary the following are relevant.
• Applicable to IMM banks
• Financial crisis showed that the mandated margin period of risks for regulatory capital calculations underestimated the realized risk
• Margin period of risk increased to 20 business days for netting sets where the number of trade exceeds 5000 or that contain illiquid collateral
103. To further explain the aforementioned Summary, and in order to implement the increased margin periods of risk, the following new paragraphs 41(i) and 41 (ii) will be inserted into Annex 41 of the Basel II framework:
41(i). For transactions subject to daily re-margining and mark-to-market valuation, a supervisory floor of five business days for netting sets consisting only of repo-style transactions, and 10 business days for all other netting sets is imposed on the margin period of risk used for the purpose of modeling EAD with margin agreements. In the following cases a higher supervisory floor is imposed:
• For all netting sets where the number of trades exceeds 5,000 at any point during a quarter, a supervisory floor of 20 business days is imposed for the margin period of risk for the following quarter.
• For netting sets containing one or more trades involving either illiquid collateral, or an OTC derivative that cannot be easily replaced, a supervisory floor of 20 business days is imposed for the margin period of risk. For these purposes, “Illiquid collateral” and “OTC derivatives that cannot be easily replaced” must be determined in the context of stressed market conditions and will be characterized by the absence of continuously active markets where a counterparty would, within two or fewer days, obtain multiple price quotations that would not move the market or represent a price reflecting a market discount (in the case of collateral) or premium (in the case of an OTC derivative). Examples of situations where trades are deemed illiquid for this purpose include, but are not limited to, trades that are not marked daily and trades that are subject to specific accounting treatment for valuation purposes (eg OTC derivatives or repostyle transactions referencing securities whose fair value is determined by models with inputs that are not observed in the market).
• In addition, a bank must consider whether trades or securities it holds as collateral are concentrated in a particular counterparty and if that counterparty exited the market precipitously whether the bank would be able to replace its trades.
41 (ii). If a bank has experienced more than two margin call disputes on a particular netting set over the previous two quarters that have lasted longer than the applicable margin period of risk (before consideration of this provision), then the least double the supervisory floor for that netting set for the subsequent two quarters.
41 (iii). For re-margining with a periodicity of N-days, irrespective of the shortcut method or full IMM model, the margin period of risk should be at least equal to the supervisory floor, F, plus the N days minus one day. That is,
Margin Period of Risk = F + N - 1.
Paragraph 167 of Basel II (Adjustment for different holding periods and non daily mark-to-market or re-margining) will be replaced with the following:
167. The minimum holding period for various products is summarized in the following table.
Transaction Type Minimum holding period Condition Repo-style transaction 5 business days Daily re-margining Other capital market transactions Ten business days Daily re-margining Secured lending Twenty business days Daily revaluation
Where a bank has such a transaction or netting set which meets the criteria outlined in paragraphs 41(i) or 41 (ii) of Annex 4, the minimum holding period should be the margin period of risk that would apply under those paragraphs.
Paragraph 179 of Basel II (Use of models) will be replaced with the following:
179. The quantitative and qualitative criteria for recognition of internal market risk models for repo-style transactions and other similar transactions are in principle the same as in paragraphs 718 (LXXIV) to 718 (LXXVI). With regard to the holding period, the minimum will be 5- business days for repo-style transactions, rather than the 10-business days in paragraph 718 (LXXVI) (c). For other transactions eligible for the VaR models approach, the 10-business day holding period will be retained. The minimum holding period should be adjusted upwards for market instruments where such a holding period would be inappropriate given the liquidity of the instrument concerned. At a minimum, where a bank has a repo-style or similar transaction or netting set which meets the criteria outlined in paragraphs 41(i) or 41 (ii) of Annex 4, the minimum holding period should be the margin period of risk that would apply under those paragraphs, in combination with paragraph 41(iii).
6.4.1 Revise the Shortcut Method for Estimating Effective EPE
The following is a summary of the components.
• Applicable to IMM banks
• Amended ‘’short-cut‘’ method to take more realistic simplifying assumptions to estimate Effective EPE when a bank is unable to model margin requirements along with exposures
104. In order to elaborate on the aforementioned, Paragraph 41 of Annex 41 in Basel II will be revised as follows:
41. Shortcut method: a bank that can model EPE without margin agreements but cannot achieve the higher level of modeling sophistication to model EPE with margin agreements can use the following method for margined counterparties subject to re-margining and daily mark-to-market as described in paragraph 41 (i)2. The method is a simple approximation to Effective EPE and sets Effective EPE for a margined counterparty equal to the lesser of:
a) Effective EPE without any held or posted margining collateral, plus any collateral that has been posted to the counterparty independent of the daily valuation and margining process or current exposure (ie initial margin or independent amount); or
b) An add-on that reflects the potential increase in exposure over the margin period of risk plus the larger of
i. the current exposure net of and including all collateral currently held or posted, excluding any collateral called or in dispute; or
ii. the largest net exposure including all collateral held or posted under the margin agreement that would not trigger a collateral call. This amount should reflect all applicable thresholds, minimum transfer amounts, independent amounts and initial margins under the margin agreement.
The add-on is calculated as E[max(ΔMtM, 0)], where E[…] is the expectation (ie the average over scenarios) and ΔMtM is the possible change of the mark-to-market value of the transactions during the margin period of risk. Changes in the value of collateral need to be reflected using the supervisory haircut method or the internal estimates method, but no collateral payments are assumed during the margin period of risk. The margin period of risk is subject to the supervisory floor specified in paragraphs 41(i) to 41(iii). Backtesting should test whether realized (current) exposures are consistent with the shortcut method prediction over all margin periods within one year. If some of the trades in the netting set have a maturity of less than one year, and the netting set has higher risk factor sensitivities without these trades, this fact should be taken into account. If backtesting indicates that effective EPE is underestimated, the bank should take actions to make the method more conservative, eg by scaling up risk factor moves.
1 Annex 5 of this document.
2 Where a bank generally uses this shortcut method to measure Effective EPE, this shortcut method may be used by a bank that is a clearing member in a CCP for its transactions with the CCP and with clients, including those client transactions that result in back-to-back trades with a CCP.6.4.2 Preclude Downgrade Triggers from Being Reflected in EAD
As a summary:
• Applicable to IMM banks
• Downgrade triggers in margin agreements resulted in liquidity strains for market participants during the crisis
• Prevent the reflection in EAD of any clause in a collateral agreement that requires receipt of collateral when a counterparty’s credit quality deteriorates (downgrade triggers)
105. In order to explicitly disallow downgrade triggers in EAD, a new paragraph 41(iv) will be inserted into Annex 41 to read as follows:
41(iv). Banks using the internal models method must not capture the effect of a reduction of EAD due to any clause in a collateral agreement that requires receipt of collateral when counterparty credit quality deteriorates.
6.4.3 Add Requirements to Improve Operational Performance of the Collateral Department
• Only applicable to IMM Banks.
To implement the requirements designed to improve the collateral department operations, two new paragraphs, 51(i) and 51(ii), will be incorporated into Annex 4 and paragraph 777(x), Part 3: The Second Pillar – Supervisory Review Process, will be revised as follows:
51(i). Banks applying the internal model method must have a collateral management unit that is responsible for calculating and making margin calls, managing margin call disputes and reporting levels of independent amounts, initial margins and variation margins accurately on a daily basis. This unit must control the integrity of the data used to make margin calls, and ensure that it is consistent and reconciled regularly with all relevant sources of data within the bank. This unit must also track the extent of reuse of collateral (both cash and non-cash) and the rights that the bank gives away to its respective counterparties for the collateral that it posts. These internal reports must indicate the categories of collateral assets that are reused, and the terms of such reuse including instrument, credit quality and maturity. The unit must also track concentration to individual collateral asset classes accepted by the banks. Senior management must allocate sufficient resources to this unit for its systems to have an appropriate level of operational performance, as measured by the timeliness and accuracy of outgoing calls and response time to incoming calls. Senior management must ensure that this unit is adequately staffed to process calls and disputes in a timely manner even under severe market crisis, and to enable the bank to limit its number of large disputes caused by trade volumes.
51(ii). The bank’s collateral management unit must produce and maintain appropriate collateral management information that is reported on a regular basis to senior management. Such internal reporting should include information on the type of collateral (both cash and non-cash) received and posted, as well as the size, aging and cause for margin call disputes. This internal reporting should also reflect trends in these figures.
777(x). The bank must conduct an independent review of the CCR management system regularly through its own internal auditing process. This review must include both the activities of the business credit and trading units and of the independent CCR control unit. A review of the overall CCR management process must take place at regular intervals (ideally not less than once a year) and must specifically address, at a minimum:
• the adequacy of the documentation of the CCR management system and process;
• the organization of the collateral management unit;
• the organization of the CCR control unit;
• the integration of CCR measures into daily risk management;
• the approval process for risk pricing models and valuation systems used by front and back-office personnel;
• the validation of any significant change in the CCR measurement process;
• the scope of counterparty credit risks captured by the risk measurement model;
• the integrity of the management information system;
• the accuracy and completeness of CCR data;
• the accurate reflection of legal terms in collateral and netting agreements into exposure measurements;
• the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;
• the accuracy and appropriateness of volatility and correlation assumptions;
• the accuracy of valuation and risk transformation calculations; and
• the verification of the model’s accuracy through frequent backtesting.
Refer to Pillar 2 section of this document with regard to BCBS Basel III requirements to improve the operational performance of the collateral definition.
6.4.4 Requirements on the Controls Around the Reuse of Collateral by IMM Banks
As a summary, please note the following:
• Applicable to IMM banks
• Relates to variation margin, initial or independent margin and calls resulting from potential downgrade.
• Cash management policies for IMM banks to account liquidity risks of potential incoming margin calls
To further elaborate on the aforementioned,
107. To implement the requirements on controls regarding the reuse of collateral, a new paragraph 51(iii) will be included in Annex 41 as follows:
51(iii). A bank employing the internal models method must ensure that its cash management policies account simultaneously for the liquidity risks of potential incoming margin calls in the context of exchanges of variation margin or other margin types, such as initial or independent margin, under adverse market shocks, potential incoming calls for the return of excess collateral posted by counterparties, and calls resulting from a potential downgrade of its own public rating. The bank must ensure that the nature and horizon of collateral reuse is consistent with its liquidity needs and does not jeopardize its ability to post or return collateral in a timely manner.
6.4.5 Require Banks to Use Supervisory Haircuts when Transforming Non-Cash OTC Collateral into Cash-Equivalent
• Applicable to IMM banks
• Implementation of supervisory haircuts for non-cash OTC collateral
• Recognition in EAD calculation the effect of collateral other than cash
• Must use either haircuts that meets the standards of the financial collateral comprehensive method or standard supervisory haircuts
108. To implement the supervisory haircuts for non-cash OTC collateral, a new paragraph 61(i) would be incorporated in Annex 41 as follows:
61(i). For a bank to recognize in its EAD calculations for OTC derivatives the effect of collateral other than cash of the same currency as the exposure itself, if it is not able to model collateral jointly with the exposure then it must use either haircuts that meet the standards of the financial collateral comprehensive method with own haircut estimates or the standard supervisory haircuts.
6.4.6 Requirement for Banks to Model Non-Cash Collateral Jointly with Underlying Securities for OTC Derivatives and SFTs
The following summary is appropriate.
• Applicable to IMM banks
• Regulation ensures robustness of non-cash collateral
• Ensure the effect of collateral on changes in the market for SFTs for EAD calculation
In order to further explain this component:
109. To ensure the robustness of non-cash collateral, a new paragraph 61(ii) will be inserted in Annex 41 as follows:
61(ii). If the internal model includes the effect of collateral on changes in the market value of the netting set, the bank must model collateral other than cash of the same currency as the exposure itself jointly with the exposure in its EAD calculations for securities-financing transactions.
6.4.7 Revise Credit Risk Mitigation Section to Add a Qualitative Collateral Management Requirement
The following summary is appropriate.
• Applicable to IMM and non IMM banks
• Sufficient resources are devoted to the orderly operation of margin agreements for OTC and SFTs
• Appropriate collateral management policies to be in place
110. To ensure that sufficient resources are devoted to the orderly operation of margin agreements for OTC derivative and SFT counterparties, and that appropriate collateral management policies are in place, a new paragraph 115(i) will be inserted into the main text and will read as follows:
115(i). Banks must ensure that sufficient resources are devoted to the orderly operation of margin agreements with OTC derivative and securities-financing counterparties, as measured by the timeliness and accuracy of its outgoing calls and response time to incoming calls. Banks must have collateral management policies in place to control, monitor and report:
• the risk to which margin agreements exposes them (such as the volatility and liquidity of the securities exchanged as collateral),
• the concentration risk to particular types of collateral,
• the reuse of collateral (both cash and non-cash) including the potential liquidity shortfalls resulting from the reuse of collateral received from counterparties, and
• the surrender of rights on collateral posted to counterparties.
6.4.8 Revise Text to Establish Standard Supervisory Haircuts for Securitization Collateral
The following summary is appropriate.
• Applicable to IMM and non IMM banks
• Re-securitization no more an eligible collateral
• Under Basel II framework, the standardized haircuts currently treat corporate debt and securitizations collateral in the same manner
• Collateral haircuts for securitization exposures are doubled due to stressed volatilities
111. To implement the supervisory haircuts for securitization collateral, a new paragraph 145(i) will be inserted into the Basel text and paragraph 151 will be revised as follows:
145(i). Re-securitizations (as defined in the securitization framework), irrespective of any credit ratings, are not eligible financial collateral. This prohibition applies whether the bank is using the supervisory haircuts method, the own estimates of haircuts method, the repo VaR method or the internal model method.
151. These are the standardized supervisory haircuts (assuming daily mark-to-market, daily re-margining and a 10-business day holding period), expressed as percentages:
Issue rating for debt
securitiesResidual
MaturitySovereigns Other
IssuersSecuritization
ExposuresAAA to AA-/A-1 <1 year 0.5 1 2 >1 year <5 years 2 4 8 > 5 years 4 8 16 A+ to BBB-/ <1 year 1 2 4 A-2/A-3/P-3 and >1 year <5 years 3 6 12 unrated bank securities > 5 years 6 12 24 BB+ to BB- All 15 Not eligible Not eligible main index equities 15 other equities 25 UCITS/mutual funds Highest haircut applicable to any security in
Fund
Cash in the same currency 0 (The footnotes associated with the table are not included. However, securitization exposures would be defined as those exposures that meet the definition set forth in the securitization framework.) 6.5 Treatment of Highly Leveraged Counterparties (HLC)
The following summary is appropriate.
• Applicable to IMM and non IMM banks (IRB Approach)
• New rule stipulates that PD for a highly leveraged counterparty (hedge funds) should be based on a period of stressed volatilities
• While, the definition of highly-leveraged counterparties is aimed at hedge funds or any other equivalently highly-leveraged counterparties that are financial entities, SAMA will in due course provide a clear definition of HLC's for IRB purposes.
112. The Committee believes it is appropriate to add a qualitative requirement indicating that the PD estimates for highly leveraged counterparties should reflect the performance of their assets based on a stressed period and, thus, is introducing a new paragraph after 415 of the framework to read as follows:
415(i). PD estimates for borrowers that are highly leveraged or for borrowers whose assets are predominantly traded assets must reflect the performance of the underlying assets based on periods of stressed volatilities.
6.6 Central Counterparties to be Implemented
The following represents a summary of the additional capital requirements to central counterparties.
• International regulators intention to move to CCPs to clear OTC trades
• No local CCP’s is in KSA- banks will be at disadvantage
For further clarifications also refer to SAMA Circular # BCS 25092 dated 21/11/1433 (Hijri) entitled "BCBS Finalized Document Entitled "Capital Requirements for Bank Exposures to Central Counterparties".
Definition of CCP
‘’is a clearing house that interposes itself between counterparties to contracts traded on or more financial markets, becoming the buyer to every seller and the seller to every buyer and thereby ensuring the future performance of open contracts’’
• In 2009, the G20’s ambition of moving standardized over-the-counter (OTC) derivatives from a bilaterally cleared to a centrally cleared model by the end of 2012 reducing systemic risks in global banking
• Capitalizing exposures to CCPs builds on the new CPSS-IOSCO Principles for Financial Market Infrastructures (PFMIs)
Key features of Interim rules published by BCBS July, 2012
As part of the reform process BCBS released interim rules for the risk weighting of exposures to CCP’s (Document entitled: Capital requirements for bank exposures to central counterparties July, 2012)
The decision to publish the rules on an interim basis suggests that Basel Committee will monitor and make further changes if necessary
Exposures to Qualifying CCPs
Trade exposures:
Where a bank acts as a clearing member of a CCP, a risk weight of 2% must be applied to the bank’s trade exposure to the CCP in respect of OTC derivatives, exchange-traded derivative transactions and SFT’s.
Where a clearing member offers clearing services to clients 2% risk weight also applies when the clearing member is obligated to reimburse the clients for any losses suffered due to changes in the value of transactions in the event CCP defaults.
(‘’A qualifying CCP is a CCP that meets the new ‘’Principles for Financial Market Infrastructures’’ published by Payment and Settlement Systems and International Organization of Securities Commission’’)
Clearing member exposures to clients
‘’A clearing member is a member of or a direct participant in a CCP that is entitled to enter into transactions with the CCP’’
• Clearing member will always calculate its exposure (including potential CVA risk exposure) to clients as bilateral trades
• To recognize shorter close-out period for cleared transactions clearing members can capitalize the exposure to their clients applying a margin of period of risk of at least 5 days in case if they adopt the IMM or multiply the EAD by a scalar of no less than 0.71 if they adopt either the CEM or the Standardized Method
Client exposure
‘’A client is a party to a transaction with a CCP through either a clearing member acting as a financial intermediary or a clearing member guaranteeing the performance of the client to the CCP’’
• Where a bank is a client of a clearing member and enters into a transaction with the clearing member acting as financial intermediary the client’s exposures to the clearing member may receive the same treatment as defined for clearing member exposures to CCPs subject to meeting two conditions as defined in Para 114 (a) and (b) of Basel Document for central counterparties
Basel III imposed a capital charge on a bank’s exposures to a CCPs default funds
‘’CCP default funds consist of contributions made by clearing members which are designed to protect the relevant CCP from losses caused by the default of a clearing member’’
• Whenever a bank is required to capitalize for exposures arising from default fund contributions to a ‘’Qualifying CCP’’
• Clearing member banks may apply one of the following approaches:
Method 1: Risk sensitive approach
Risk sensitive formula considers size and quality of a qualifying CCP’s financial resources
Method 2: Simplified method
Clearing member banks: Default fund exposures will be subject to a 1250% risk weight subject to an overall cap of 20% of the total trade exposures to the relevant CCP
Exposures to Non-Qualifying CCPs
• Banks must apply the Standardized Approach for credit risk in the main framework according to the category of the counterparty to their trade exposures
• Banks must also apply a risk weight of 1250% to their default fund contributions to a non-qualifying CCP
7. Internal Models
This section deals with the IMM Approach to calculating default risks. – see section 6.1.A.
Enhanced counterparty credit risk management requirements
Stress testing
• Applicable to IMM banks
• New requirement enhancing counterparty credit risk management
• Explicit requirements defined for stress testing, revised model validation standards and new supervisory guidance for sound backtesting practices of CCR
• Engagement of senior management
114. Paragraph 36 of Annex 41 will be revised as follows to increase the robustness of banks’ own estimates of alpha.
36. To this end, banks must ensure that the numerator and denominator of alpha are computed in a consistent fashion with respect to the modeling methodology, parameter specifications and portfolio composition. The approach used must be based on the bank’s internal economic capital approach, be well documented and be subject to independent validation. In addition, banks must review their estimates on at least a quarterly basis, and more frequently when the composition of the portfolio varies over time. Banks must assess the model risk and supervisors should be alert to the significant variation in estimates of alpha that arises from the possibility for mis-specification in the models used for the numerator, especially where convexity is present.
115. The qualitative requirements set forth in Annex 41 for stress testing that banks must perform when using the internal model method have been expanded and made more explicit. More specifically, the existing paragraph 56, Annex 41, of the Basel II text will be replaced with the following:
56. Banks must have a comprehensive stress testing program for counterparty credit risk. The stress testing program must include the following elements:
• Banks must ensure complete trade capture and exposure aggregation across all forms of counterparty credit risk (not just OTC derivatives) at the counterparty-specific level in a sufficient time frame to conduct regular stress testing.
• For all counterparties, banks should produce, at least monthly, exposure stress testing of principal market risk factors (e.g. interest rates, FX, equities, credit spreads, and commodity prices) in order to proactively identify, and when necessary, reduce outsized concentrations to specific directional sensitivities.
• Banks should apply multifactor stress testing scenarios and assess material non-directional risks (i.e. yield curve exposure, basis risks, etc.) at least quarterly. Multiple-factor stress tests should, at a minimum, aim to address scenarios in which a) severe economic or market events have occurred; b) broad market liquidity has decreased significantly; and c) the market impact of liquidating positions of a large financial intermediary. These stress tests may be part of bank-wide stress testing.
• Stressed market movements have an impact not only on counterparty exposures, but also on the credit quality of counterparties. At least quarterly, banks should conduct stress testing applying stressed conditions to the joint movement of exposures and counterparty creditworthiness.
• Exposure stress testing (including single factor, multifactor and material non-directional risks) and joint stressing of exposure and creditworthiness should be performed at the counterparty-specific, counterparty group (e.g. industry and region), and aggregate bank wide CCR levels.
• Stress tests results should be integrated into regular reporting to senior management. The analysis should capture the largest counterparty-level impacts across the portfolio, material concentrations within segments of the portfolio (within the same industry or region), and relevant portfolio and counterparty specific trends.
• The severity of factor shocks should be consistent with the purpose of the stress test. When evaluating solvency under stress, factor shocks should be severe enough to capture historical extreme market environments and/or extreme but plausible stressed market conditions. The impact of such shocks on capital resources should be evaluated, as well as the impact on capital requirements and earnings. For the purpose of day-to-day portfolio monitoring, hedging, and management of concentrations, banks should also consider scenarios of lesser severity and higher probability.
• Banks should consider reverse stress tests to identify extreme, but plausible, scenarios that could result in significant adverse outcomes.
• Senior management must take a lead role in the integration of stress testing into the risk management framework and risk culture of the bank and ensure that the results are meaningful and proactively used to manage counterparty credit risk. At a minimum, the results of stress testing for significant exposures should be compared to guidelines that express the bank’s risk appetite and elevated for discussion and action when excessive or concentrated risks are present.
Model validation and backtesting
116. On model validation, the following paragraph (currently in paragraph 42) will be moved after paragraph 40 of Annex 41:
40bis. An EPE model must also include transaction-specific information in order to capture the effects of margining. It must take into account both the current amount of margin and margin that would be passed between counterparties in the future. Such a model must account for the nature of margin agreements (unilateral or bilateral), the frequency of margin calls, the margin period of risk, the thresholds of unmargined exposure the bank is willing to accept, and the minimum transfer amount. Such a model must either model the mark-to-market change in the value of collateral posted or apply this Framework’s rules for collateral.
117. The current Basel II requirements for backtesting will be replaced with the following:
42. It is important that supervisory authorities are able to assure themselves that banks using models have counterparty credit risk management systems that are conceptually sound and implemented with integrity. Accordingly the supervisory authority will specify a number of qualitative criteria that banks would have to meet before they are permitted to use a models-based approach. The extent to which banks meet the qualitative criteria may influence the level at which supervisory authorities will set the multiplication factor referred to in paragraph 32 (Alpha) above. Only those banks in full compliance with the qualitative criteria will be eligible for application of the minimum multiplication factor. The qualitative criteria include:
• The bank must conduct a regular programme of backtesting, ie an ex-post comparison of the risk measures2 generated by the model against realized risk measures, as well as comparing hypothetical changes based on static positions with realized measures.
• The bank must carry out an initial validation and an on-going periodic review of its IMM model and the risk measures generated by it. The validation and review must be independent of the model developers.
• The board of directors and senior management should be actively involved in the risk control process and must regard credit and counterparty credit risk control as an essential aspect of the business to which significant resources need to be devoted. In this regard, the daily reports prepared by the independent risk control unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions of positions taken by individual traders and reductions in the bank’s overall risk exposure.
• The bank’s internal risk measurement exposure model must be closely integrated into the day-to-day risk management process of the bank. Its output should accordingly be an integral part of the process of planning, monitoring and controlling the bank’s counterparty credit risk profile.
• The risk measurement system should be used in conjunction with internal trading and exposure limits. In this regard, exposure limits should be related to the bank’s risk measurement model in a manner that is consistent over time and that is well understood by traders, the credit function and senior management.
• Banks should have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system. The bank’s risk measurement system must be well documented, for example, through a risk management manual that describes the basic principles of the risk management system and that provides an explanation of the empirical techniques used to measure counterparty credit risk.
• An independent review of the risk measurement system should be carried out regularly in the bank’s own internal auditing process. This review should include both the activities of the business trading units and of the independent risk control unit. A review of the overall risk management process should take place at regular intervals (ideally no less than once a year) and should specifically address, at a minimum:
• The adequacy of the documentation of the risk management system and process;
• The organization of the risk control unit;
• The integration of counterparty credit risk measures into daily risk management;
• The approval process for counterparty credit risk models used in the calculation of counterparty credit risk used by front office and back office personnel;
• The validation of any significant change in the risk measurement process;
• The scope of counterparty credit risks captured by the risk measurement model;
• The integrity of the management information system;
• The accuracy and completeness of position data;
• The verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;
• The accuracy and appropriateness of volatility and correlation assumptions;
• The accuracy of valuation and risk transformation calculations; and
• The verification of the model’s accuracy as described below in paragraphs 43-46.
• The on-going validation of counterparty credit risk models, including backtesting, must be reviewed periodically by a level of management with sufficient authority to decide the course of action that will be taken to address weaknesses in the models.
43. Banks must document the process for initial and on-going validation of their IMM model to a level of detail that would enable a third party to recreate the analysis. Banks must also document the calculation of the risk measures generated by the models to a level of detail that would allow a third party to re-create the risk measures. This documentation must set out the frequency with which backtesting analysis and any other on-going validation will be conducted, how the validation is conducted with respect to data flows and portfolios and the analyses that are used.
44. Banks must define criteria with which to assess their EPE models and the models that input into the calculation of EPE and have a written policy in place that describes the process by which unacceptable performance will be determined and remedied.
45. Banks must define how representative counterparty portfolios are constructed for the purposes of validating an EPE model and its risk measures.
46. When validating EPE models and its risk measures that produce forecast distributions, validation must assess more than a single statistic of the model distribution.
46(i) As part of the initial and on-going validation of an IMM model and its risk measures, the following requirements must be met:
• A bank must carry out backtesting using historical data on movements in market risk factors prior to supervisory approval. Backtesting must consider a number of distinct prediction time horizons out to at least one year, over a range of various start (initialisation) dates and covering a wide range of market conditions.
• Banks must back-test the performance of their EPE model and the model’s relevant risk measures as well as the market risk factor predictions that support EPE. For collateralized trades, the prediction time horizons considered must include those reflecting typical margin periods of risk applied in collateralized/margined trading, and must include long time horizons of at least 1 year.
• The pricing models used to calculate counterparty credit risk exposure for a given scenario of future shocks to market risk factors must be tested as part of the initial and on-going model validation process. These pricing models may be different from those used to calculate Market Risk over a short horizon. Pricing models for options must account for the nonlinearity of option value with respect to market risk factors.
• An EPE model must capture transaction specific information in order to aggregate exposures at the level of the netting set. Banks must verify that transactions are assigned to the appropriate netting set within the model.
• Static, historical backtesting on representative counterparty portfolios must be a part of the validation process. At regular intervals as directed by its supervisor, a bank must conduct such backtesting on a number of representative counterparty portfolios. The representative portfolios must be chosen based on their sensitivity to the material risk factors and correlations to which the bank is exposed. In addition, IMM banks need to conduct backtesting that is designed to test the key assumptions of the EPE model and the relevant risk measures, eg the modeled relationship between tenors of the same risk factor, and the modeled relationships between risk factors.
• Significant differences between realized exposures and the forecast distribution could indicate a problem with the model or the underlying data that the supervisor would require the bank to correct. Under such circumstances, supervisors may require additional capital to be held while the problem is being solved.
• The performance of EPE models and its risk measures must be subject to good backtesting practice. The backtesting programme must be capable of identifying poor performance in an EPE model’s risk measures.
• Banks must validate their EPE models and all relevant risk measures out to time horizons commensurate with the maturity of trades for which exposure is calculated using an internal modeling method.
• The pricing models used to calculate counterparty exposure must be regularly tested against appropriate independent benchmarks as part of the on-going model validation process.
• The on-going validation of a bank’s EPE model and the relevant risk measures include an assessment of recent performance.
• The frequency with which the parameters of an EPE model are updated needs to be assessed as part of the validation process.
• Under the IMM, a measure that is more conservative than the metric used to calculate regulatory EAD for every counterparty, may be used in place of alpha times Effective EPE with the prior approval of the supervisor. The degree of relative conservatism will be assessed upon initial supervisory approval and at the regular supervisory reviews of the EPE models. The bank must validate the conservatism regularly.
• The on-going assessment of model performance needs to cover all counterparties for which the models are used.
• The validation of IMM models must assess whether or not the bank level and netting set exposure calculations of EPE are appropriate.
49(i). The bank must have an independent risk control unit that is responsible for the design and implementation of the bank’s counterparty credit risk management system. The unit should produce and analyze daily reports on the output of the bank’s risk measurement model, including an evaluation of the relationship between measures of counterparty credit exposure and trading limits. The unit must be independent from the business trading units and should report directly to senior management of the bank.
1 Annex 5 of this document.
2 “Risk measures” refers not only to Effective EPE, the risk measure used to derive regulatory capital, but also to the other risk measures used in the calculation of Effective EPE such as the exposure distribution at a series of future dates, the positive exposure distribution at a series of future dates, the market risk factors used to derive those exposures and the values of the constituent trades of a portfolio.8. Other Major Enhancement to Basel III Regarding Enhanced Risk Coverage
8.1 Addressing Reliance on External Credit Ratings and Minimizing Cliff Effects
The following is a summary of this component.
• A major consequence under Basel II was to rely excessively on external ratings for regulatory capital requirements
• This resulted in the neglect of bank’s own independent internal assessment of risks to a certain degree
• Rating agencies have an incentive to produce ‘’good ratings’’
• Given the Basel II rules banks have an incentive to seek ratings just above the ‘’cliff’’
• For e.g. the Standardized Approach prescribes a higher risk weight to corporate exposures that are rated below BB- (150%) than for unrated exposures (100%)- This provides incentives to banks not to get ratings for companies that are likely to be rated below BB-
• Applicable under Standardized Approach
Further elaboration on the above are given below.
8.1.1 Standardised Inferred Rating Treatment for Long-Term Exposures
• Relates to determining of an inferred rating under Standardized Approach Para 99 of Basel II framework
‘’Issuer vs issues assessment para 99 ‘’if either the issuer or a single issue has a low quality assessment (mapping into a risk weight equal or higher than that which applies to unrated claims), an unassessed claim on the same counterparty will be assigned the same risk weight as is applicable to the low quality assessment.
For e.g. if a Corporate issuer has subordinated debt rated single -B and a bank holds an unrated senior exposure to that issuer, the unrated senior exposure must be assigned to the risk weight category corresponding to the single –B rating (eg the 150% risk weight), even if there are other rated senior exposures of the issuer (eg AA)
In specific,
118. Para. 99 of the Basel II text would be modified as follows:
99. Where a bank invests in a particular issue that has an issue-specific assessment, the risk weight of the claim will be based on this assessment. Where the bank’s claim is not an investment in a specific assessed issue, the following general principles apply.
• In circumstances where the borrower has a specific assessment for an issued debt – but the bank’s claim is not an investment in this particular debt – a high quality credit assessment (one which maps into a risk weight lower than that which applies to an unrated claim) on that specific debt may only be applied to the bank’s unassessed claim if this claim ranks pari passu or senior to the claim with an assessment in all respects. If not, the credit assessment cannot be used and the unassessed claim will receive the risk weight for unrated claims.
• In circumstances where the borrower has an issuer assessment, this assessment typically applies to senior unsecured claims on that issuer. Consequently, only senior claims on that issuer will benefit from a high quality issuer assessment. Other unassessed claims of a highly assessed issuer will be treated as unrated. If either the issuer or a single issue has a low quality assessment (mapping into a risk weight equal to or higher than that which applies to unrated claims), an unassessed claim on the same counterparty that ranks pari passu or is subordinated to either the senior unsecured issuer assessment or the exposure assessment will be assigned the same risk weight as is applicable to the low quality assessment.
8.2. Incentive to Avoid Getting Exposures Rated
As a summary:
• Revised Para 733 of the Basel II framework (Supervisory Review Process Pillar 2)
• Banks should internally assess if the risk weights applied under the Standardized Approach are appropriate for their inherent risk.
• If it turns out that that the inherent risk is higher, then the bank should consider the higher degree of risk
119. Para. 733 of the Basel II text will read as follows:
733. Credit risk: Banks should have methodologies that enable them to assess the credit risk involved in exposures to individual borrowers or counterparties as well as at the portfolio level. Banks should assess exposures, regardless of whether they are rated or unrated, and determine whether the risk weights applied to such exposures, under the Standardized Approach, are appropriate for their inherent risk. In those instances where a bank determines that the inherent risk of such an exposure, particularly if it is unrated, is significantly higher than that implied by the risk weight to which it is assigned, the bank should consider the higher degree of credit risk in the evaluation of its overall capital adequacy. For more sophisticated banks, the credit review assessment of capital adequacy, at a minimum, should cover four areas: risk rating systems, portfolio analysis/aggregation, securitization/complex credit derivatives, and large exposures and risk concentrations.
8.3. Incorporation of IOSCO’s Code of Conduct Fundamentals for Credit Rating Agencies
As a summary:
• SAMA to refer to IOSCO Code of Conduct Fundamentals for Credit Rating Agencies when determining ECAI eligibility
120. Paragraph 91 and 565(b) of the Basel II text will read as follows (paragraph 90 does not need additional changes):
1. The recognition process
90. SAMA is responsible for determining on a continuous basis whether an external credit assessment institution (ECAI) meets the criteria listed in the paragraph below. SAMA will accordingly refer to the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies when determining ECAI eligibility. The assessments of ECAIs may be recognized on a limited basis, e.g. by type of claims or by jurisdiction. The supervisory process for recognizing ECAIs should be made public to avoid unnecessary barriers to entry.
2. Eligibility criteria
91. An ECAI must satisfy each of the following six criteria.
• objectivity: no change suggested
• Independence: no change suggested
• International access/Transparency: The individual assessments, the key elements underlining the assessments and whether the issuer participated in the assessment process should be publicly available on a non-selective basis, unless they are private assessments. In addition, the general procedures, methodologies and assumptions for arriving at assessments used by the ECAI should be publicly available.
• Disclosure: An ECAI should disclose the following information: its code of conduct; the general nature of its compensation arrangements with assessed entities; its assessment methodologies, including the definition of default, the time horizon, and the meaning of each rating; the actual default rates experienced in each assessment category; and the transitions of the assessments, e.g. the likelihood of AA ratings becoming A over time.
• Resources: no change suggested
• Credibility: no change suggested
3. Operational requirements for use of external credit assessments
565. The following operational criteria concerning the use of external credit assessments apply in the standardized and IRB approaches of the securitization framework:
(a) no change
(b) The external credit assessments must be from an eligible ECAI as recognized by SAMA in accordance with paragraphs 90 to 108 with the following exception. In contrast with bullet three of paragraph 91, an eligible credit assessment, procedures, methodologies, assumptions, and the key elements underlining the assessments must be publicly available, on a non-selective basis and free of charge.1 In other words, a rating must be published in an accessible form and included in the ECAI’s transition matrix. Also, loss and cash flow analysis as well as sensitivity of ratings to changes in the underlying ratings assumptions should be publicly available. Consequently, ratings that are made available only to the parties to a transaction do not satisfy this requirement.
(c) to (f) no change
1. Where the eligible credit assessment is not provided free of charge the ECAI should provide an adequate justification, within their own publicly available Code of Conduct, in accordance with the 'comply or explain' nature of the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies.
8.4. “Cliff Effects” Arising from Guarantees and Credit Derivatives - Credit Risk Mitigation (CRM)
As a summary:
• Current CRM rules requires under Standardized Approach requires ‘’eligible guarantors’’ to be externally rated ‘’A-’’ or better or ‘’internally rated’’ and associated with a PD equivalent to A- or better
• In order to mitigate the ‘’cliff effects’’ that arises when the credit worthiness of a guarantor falls below the A-level of credit quality BCBS revised Para 195 (Standardized Approach) and Para 302 (FIRB Approach)
• BCBS proposed the elimination of the A-minimum requirement for guarantors in the Standardized Approach and the FIRB
Standardized Approach - Range of eligible guarantors (counter- guarantors)/protection providers
195. Credit protection given by the following entities will be recognized:
• sovereign entities, PSEs, banks, and securities firms with a lower risk weight than the counterparty.
• other entities that are externally rated except when credit protection is provided to a securitization exposure. This would include credit protection provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor.
• when credit protection is provided to a securitization exposure, other entities that currently are externally rated BBB- or better and that were externally rated A- or better at the time the credit protection was provided. This would include credit protection provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor.
Recognition under the Foundation IRB approach
302. For banks using the foundation approach for LGD, the approach to guarantees and credit derivatives closely follows the treatment under the standardized approach as specified in paragraphs 189 to 201. The range of eligible guarantors is the same as under the standardized approach except that companies that are internally rated may also be recognized under the foundation approach. To receive recognition, the requirements outlined in paragraphs 189 to 194 must be met.
8.5. Unsolicited Ratings and Recognition of ECAIs
As a summary:
• To address the risk that the credit assessments of unsolicited ratings may be inferior in quality to the general quality of solicited ratings and the potential risk that ECAIs used unsolicited ratings to put pressure on the entities to obtain solicited ratings
• Banks must use chosen ECAIs and their ratings consistently and will not be allowed to ‘’cherry pick’’ the assessments and to arbitrarily change the use of ECAIs
• As a general rule, banks should use solicited ratings from eligible ECAIs
121. Accordingly, paragraph 94 and 108 of the Basel II text will be modified as follows:
94. Banks must use the chosen ECAIs and their ratings consistently for each type of claim, for both risk weighting and risk management purposes. Banks will not be allowed to “cherry-pick” the assessments provided by different ECAIs and to arbitrarily change the use of ECAIs.
108. As a general rule, banks should use solicited ratings from eligible ECAIs. SAMA may, however, allow banks to use unsolicited ratings in the same way as solicited ratings if it is satisfied that the credit assessments of unsolicited ratings are not inferior in quality to the general quality of solicited ratings. SAMA will advise should it permit banks to use consolidated rating. However, there may be the potential for ECAIs to use unsolicited ratings to put pressure on entities to obtain solicited ratings. Such behavior, when identified, will cause SAMA to consider whether to continue recognizing such ECAIs as eligible for capital adequacy purposes.
9. Capital Buffer
Basel III Framework proposes two type of Capital buffers.
1. Capital conservation buffer
2. Countercyclical buffer
This section outlines the operation of the capital conservation buffer, which is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements.
9.1 Capital Conservation Buffer
A. Best practice
• Outside of periods of stress, banks should hold buffers of capital above the regulatory minimum.
• When buffers have been drawn down, one way banks should look to rebuild them is through reducing discretionary distributions of earnings. This could include reducing dividend payments, share-backs and staff bonus payments. Banks may also choose to raise new capital from the private sector as an alternative to conserving internally generated capital.
The balance between these options should be discussed with supervisors as part of the capital planning process.
• It is clear that greater efforts should be made to rebuild buffers the more they have been depleted. Therefore, in the absence of raising capital in the private sector, the share of earnings retained by banks for the purpose of rebuilding their capital buffers should increase the nearer their actual capital levels are to the minimum capital requirement.
• It is not acceptable for banks which have depleted their capital buffers to use future predictions of recovery as justification for maintaining generous distributions to shareholders, other capital providers and employees. These stakeholders, rather than depositors, must bear the risk that recovery will not be forthcoming.
• It is also not acceptable for banks which have depleted their capital buffers to try and use the distribution of capital as a way to signal their financial strength. Not only is this irresponsible from the perspective of an individual bank, putting shareholders interests above depositors, it may also encourage other banks to follow suit. As a consequence, banks in aggregate can end up increasing distributions at the exact point in time when they should be conserving earnings.
• The framework reduces the discretion of banks which have depleted their capital buffers to further reduce them through generous distributions of earnings. In doing so, the framework will strengthen their ability to withstand adverse environments. Implementation of the framework through internationally agreed capital conservation rules will help increase sector resilience both going into a downturn, and provide the mechanism for rebuilding capital during the early stages of economic recovery. Retaining a greater proportion of earnings during a downturn will help ensure that capital remains available to support the ongoing business operations of banks through the period of stress. In this way the framework should help reduce procyclicality.
B. The framework
A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement.1 Capital distribution constraints will be imposed on a bank when capital levels fall within this range. Banks will be able to conduct business as normal when their capital levels fall into the conservation range as they experience losses. The constraints imposed only relate to distributions, not the operation of the bank.
The distribution constraints imposed on banks when their capital levels fall into the range increase as the banks’ capital levels approach the minimum requirements. By design, the constraints imposed on banks with capital levels at the top of the range would be minimal. This reflects an expectation that banks’ capital levels will from time to time fall into this range. The Basel Committee does not wish to impose constraints for entering the range that would be so restrictive as to result in the range being viewed as establishing a new minimum capital requirement.
The table below shows the minimum capital conservation ratios a bank must meet at various levels of the Common Equity Tier 1 (CET1) capital ratios. For example, a bank with a CET1 capital ratio in the range of 5.125% to 5.75% is required to conserve 80% of its earnings in the subsequent financial year (ie payout no more than 20% in terms of dividends, share buybacks and discretionary bonus payments). If the bank wants to make payments in excess of the constraints imposed by this regime, it would have the option of raising capital in the private sector equal to the amount above the constraint which it wishes to distribute. This would be discussed with the bank’s supervisor as part of the capital planning process. The Common Equity Tier 1 ratio includes amounts used to meet the 4.5% minimum Common Equity Tier 1 requirement, but excludes any additional Common Equity Tier 1 needed to meet the 6% Tier 1 and 8% Total Capital requirements. For example, a bank with 8% CET1 and no Additional Tier 1 or Tier 2 capital would meet all minimum capital requirements, but would have a zero conservation buffer and therefore by subject to the 100% constraint on capital distributions.
Individual bank minimum capital conservation standards Common Equity Tier 1 Ratio Minimum Capital Conservation Ratios (express as a percentage of earnings) 4.5% - 5.125% 100% >5.125% - 5.75% 80% >5.75% - 6.375 60% >6.375% - 7.0% 40% >7.0% 0% Set out below are a number of other key aspects of the requirements:
(a) Elements subject to the restriction on distributions: Items considered to be distributions include dividends and share buybacks, discretionary payments on other Tier 1 capital instruments and discretionary bonus payments to staff. Payments that do not result in a depletion of Common Equity Tier 1, which may for example include certain scrip dividends, are not considered distributions.
(b) Definition of earnings: Earnings are defined as distributable profits calculated prior to the deduction of elements subject to the restriction on distributions. Earnings are calculated after the tax which would have been reported had none of the distributable items been paid. As such, any tax impact of making such distributions are reversed out. Where a bank does not have positive earnings and has a Common Equity Tier 1 ratio less than 7%, it would be restricted from making positive net distributions.
(c) Solo or consolidated application: The framework should be applied at the consolidated level, ie restrictions would be imposed on distributions out of the consolidated group. SAMA would have the option of applying the regime at the solo level to conserve resources in specific parts of the group.
(d) Additional supervisory discretion: Although the buffer must be capable of being drawn down, banks should not choose in normal times to operate in the buffer range simply to compete with other banks and win market share. To ensure that this does not happen, supervisors have the additional discretion to impose time limits on banks operating within the buffer range on a case-by- case basis. In any case, supervisors should ensure that the capital plans of banks seek to rebuild buffers over an appropriate timeframe.
C. Transitional arrangements
The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. SAMA has the discretion to impose shorter transition periods and will do so where appropriate.
Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% Common Equity Tier 1 target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.
The division of the buffer into quartiles that determine the minimum capital conservation ratios will begin on 1 January 2016. These quartiles will expand as the capital conservation buffer is phased in and will take into account any countercyclical buffer in effect during this period.
1 Common Equity Tier 1 must first be used to meet the minimum capital requirements (including the 6% Tier 1and 8% Total capital requirements if necessary), before the remainder can contribute to the capital conservation buffer.
9.2. Countercyclical Buffer
A. Introduction
Losses incurred in the banking sector can be extremely large when a downturn is preceded by a period of excess credit growth. These losses can destabilize the banking sector and spark a vicious circle, whereby problems in the financial system can contribute to a downturn in the real economy that then feeds back on to the banking sector. These interactions highlight the particular importance of the banking sector building up additional capital defences in periods where the risks of system-wide stress are growing markedly.
The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses. This focus on excess aggregate credit growth means that jurisdictions are likely to only need to deploy the buffer on an infrequent basis. The buffer for internationally-active banks will be a weighted average of the buffers deployed across all the jurisdictions to which it has credit exposures. This means that they will likely find themselves subject to a small buffer on a more frequent basis, since credit cycles are not always highly correlated across jurisdictions.
The countercyclical buffer regime consists of the following elements:
(a) SAMA will monitor credit growth and other indicators that may signal a build up of system-wide risk and make assessments of whether credit growth is excessive and is leading to the build up of system-wide risk. Based on this assessment they will put in place a countercyclical buffer requirement when circumstances warrant. This requirement will be released when system-wide risk crystallizes or dissipates.
(b) Internationally active banks will look at the geographic location of their private sector credit exposures and calculate their bank specific countercyclical capital buffer requirement as a weighted average of the requirements that are being applied in jurisdictions to which they have credit exposures.
(c) The countercyclical buffer requirement to which a bank is subject will extend the size of the capital conservation buffer. Banks will be subject to restrictions on distributions if they do not meet the requirement.
B. National countercyclical buffer requirements
Each Basel Committee member jurisdiction will identify an authority with the responsibility to make decisions on the size of the countercyclical capital buffer. Consequently, if SAMA judges a period of excess credit growth leading to the build up of system-wide risk, it will consider, together with any other macroprudential tools at its disposal by putting in place a countercyclical buffer requirement. This will vary between zero and 2.5% of risk weighted assets, depending on its judgment as to the extent of the build up of systemwide risk.1
The document entitled Guidance for national authorities operating the countercyclical capital buffer, sets out the principles that national authorities have agreed to follow in making buffer decisions. This document provides information that should help banks to understand and anticipate the buffer decisions made by national authorities in the jurisdictions to which they have credit exposures.
To give banks time to adjust to a buffer level, a jurisdiction will pre-announce its decision to raise the level of the countercyclical buffer by up to 12 months.2 Decisions by a jurisdiction to decrease the level of the countercyclical buffer will take effect immediately. The pre-announced buffer decisions and the actual buffers in place for all Committee member jurisdictions will be published on the BIS website.
C. Bank specific countercyclical buffer
Banks will be subject to a countercyclical buffer that varies between zero and 2.5% to total risk weighted assets.3 The buffer that will apply to each bank will reflect the geographic composition of its portfolio of credit exposures. Banks must meet this buffer with Common Equity Tier 1 or other fully loss absorbing capital4 or be subject to the restrictions on distributions set out in the next Section.
Internationally active banks will look at the geographic location of their private sector credit exposures (including non-bank financial sector exposures) and calculate their countercyclical capital buffer requirement as a weighted average of the buffers that are being applied in jurisdictions to which they have an exposure. Credit exposures in this case include all private sector credit exposures that attract a credit risk capital charge or the risk weighted equivalent trading book capital charges for specific risk, IRC and securitization.
The weighting applied to the buffer in place in each jurisdiction will be the bank’s total credit risk charge that relates to private sector credit exposures in that jurisdiction5, divided by the bank’s total credit risk charge that relates to private sector credit exposures across all jurisdictions.
For the VaR for specific risk, the incremental risk charge and the comprehensive risk measurement charge, banks should work with their supervisors to develop an approach that would translate these charges into individual instrument risk weights that would then be allocated to the geographic location of the specific counterparties that make up the charge. However, it may not always be possible to break down the charges in this way due to the charges being calculated on a portfolio by portfolio basis. In such cases, the charge for the relevant portfolio should be allocated to the geographic regions of the constituents of the portfolio by calculating the proportion of the portfolio’s total exposure at default (EAD) that is due to the EAD resulting from counterparties in each geographic region.
D. Extension of the capital conservation buffer
The countercyclical buffer requirement to which a bank is subject is implemented through an extension of the capital conservation buffer described in section III.
The table below shows the minimum capital conservation ratios a bank must meet at various levels of the Common Equity Tier 1 capital ratio.6 When the countercyclical capital buffer is zero in all of the regions to which a bank has private sector credit exposures, the capital levels and restrictions set out in the table are the same as those set out in section III.
Individual bank minimum capital conservation standards Common Equity Tier 1 (including other fully loss absorbing capital) Minimum Capital Conservation Ratios (express as a percentage of earnings) Within first quartile of buffer 100% Within second quartile of buffer 80% Within third quartile of buffer 60% Within fourth quartile of buffer 40% Above top of buffer 40% 148. For illustrative purposes, the following table sets out the conservation ratios a bank must meet at various levels of Common Equity Tier 1 capital if the bank is subject to a 2.5% countercyclical buffer requirement.
Individual bank minimum capital conservation standards, when a bank is subject to a 2.5% countercyclical requirement Common Equity Tier 1 (including other fully loss absorbing capital) Minimum Capital Conservation Ratios (express as a percentage of earnings) 4.5% - 5.75% 100% >5.75% - 7.0% 80% >7.0% - 8.25 60% >8.25% - 9.5% 40% >9.5% 0% E. Frequency of calculation and disclosure
Banks must ensure that their countercyclical buffer requirements are calculated and publically disclosed with at least the same frequency as their minimum capital requirements. The buffer should be based on the latest relevant jurisdictional countercyclical buffers that are available at the date that they calculate their minimum capital requirement. In addition, when disclosing their buffer requirement, banks must also disclose the geographic breakdown of their private sector credit exposures used in the calculation of the buffer requirement.
F. Transitional arrangements
The countercyclical buffer regime will be phased-in in parallel with the capital conservation buffer between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. This means that the maximum countercyclical buffer requirement will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final maximum of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth during this transition period will consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. In addition, jurisdictions may choose to implement larger countercyclical buffer requirements. In such cases the reciprocity provisions of the regime will not apply to the additional amounts or earlier time-frames.
Ratio Calculation – Standardized Approach Basel III
Quarterly Capital Adequacy Ratios Standardized Approach
NOTE: This section is only for information purposes as the end result of implementing Basel III. Banks will have to complete the Basel III Prudential Returns package sent separately in order to obtain the actual ratios. Further, the minimum BCBS Basel III CAR requirements are given in attachment # 1. 1. Basel III Actual Ratios Ratios % 1.1 Actual Common Equity Tier 1 (as a percentage of risk weighted assets), to be calculated as row 2912 divided by row 6012 (expressed as a percentage) refer to page 16 % 1.2 Actual Tier 1 (as a percentage of risk weighted assets), to be calculated as row 4512 divided by row 6012 (expressed as a percentage) refer to page 16 % 1.3 Actual Total capital (as a percentage of risk weighted assets), to be calculated as row 597 divided by row 607 (expressed as a percentage) refer to page 17 % 2. Basel III Minimum Capital Ratio Requirements7 and excess/(deficit) of Actual Ratio for the following ratios %: Ratios 2.1 Minimum Common Equity Tier 1 Capital Ratio7 % Excess/(Deficit) of Actual 1.1 over above 2.1 % 2.2 Capital Conservation Buffer7 % 2.3 Minimum Common Equity Tier 1 ratio plus Capital Conservation buffer (2.1+2.2)7 % Excess/(Deficit) of actual (1.1) over above 2.3 % 2.4 Minimum Tier 1 Capital Ratio7 % Excess of Actual/(Deficit) of 1.2 over 2.4 % 2.5 Minimum Total Capital Ratio 8% Excess of Actual/(Deficit) of 1.3 over 2.5 (8%) % 2.6 Minimum Total Capital ratio plus Conservation buffer (2.5+2.2)7 % Excess of Actual/(Deficit) of 1.3 over 2.6 % 2.7 Minimum Total Capital ratio plus all buffers concerning conservation7, countercyclical and DSIBs % Excess/(Deficit) of actual Total Capital Ratio (1.3) over Minimum Total Capital Ratio + Conservation Buffer (2.6) plus countercyclical buffer (3.2) plus DSIBs (3.3) % 3. Basel III Buffers including capital buffer concerning Conservation, Countercyclical and Domestic SIB (DSIBs) Buffers % 3.1 Capital Conservation ratio7,11 Nil% 3.2 Countercyclical ratio10 Nil% 3.3 Domestic SIBSs ratio8,9 Nil% 1 SAMA can implement a range of additional macroprudential tools, including a buffer in excess of 2.5% for banks in Saudi Arabia, if this is deemed appropriate in Saudi Arabia. However, the international reciprocity provisions set out in this regime treat the maximum countercyclical buffer as 2.5%.
2 Banks outside of Saudi Arabia with credit exposures to counterparties in Saudi Arabia will also be subject to the increased buffer level after the pre-announcement period in respect of these exposures. However, in cases where the pre-announcement period of a jurisdiction is shorter than 12 months, the home authority of such banks should seek to match the preannouncement period where practical, or as soon as possible (subject to a maximum preannouncement period of 12 months), before the new buffer level comes into effect.
3 As with the capital conservation buffer, the framework will be applied at the consolidated level. In addition, SAMA may apply the regime at the solo level to conserve resources in specific parts of the group.
4 The Committee is still reviewing the question of permitting other fully loss absorbing capital beyond Common Equity Tier 1 and what form it would take. Until the Committee has issued further guidance, the countercyclical buffer is to be met with Common Equity Tier 1 only.
5 When considering the jurisdiction to which a private sector credit exposure relates, banks should use, where possible, an ultimate risk basis; i.e. it should use the country where the guarantor of the exposure resides, not where the exposure has been booked.
6 Consistent with the conservation buffer, the Common Equity Tier 1 ratio in this context includes amounts used to meet the 4.5% minimum Common Equity Tier 1 requirement, but excludes any additional Common Equity Tier 1 needed to meet the 6% Tier 1 and 8% Total Capital requirements.
7 Refer to minimum required ratios contingent on the phase-in requirements (Annex 1)
8 SAMA to provide Nil for now.
9 D-SIB not relevant to Saudi banks at the present.
10 For DSIBs and countercyclical buffer, SAMA has nil for each.
11 Capital Conservation buffers are nil until 2016.
12 All reference to Rows are to the attached Prudential Returns (P15-P17).
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SAMA Regulatory Rulebook has no legal effect and it does not aim to amend or revoke any legal provisions. The Rulebook still Contains some documents under review, including translated versions. Therefore, SAMA Regulatory content circulated through SAMA official channels remains in force.
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