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Basel ii Accord Section 191 to 201

Additional operational requirements for credit derivatives
 
191. In order for a credit derivative contract to be recognised, the following conditions
must be satisfied:
 
(a) The credit events specified by the contracting parties must at a minimum cover:
 
• failure to pay the amounts due under terms of the underlying obligation that are
in effect at the time of such failure (with a grace period that is closely in line with
the grace period in the underlying obligation);
 
• bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or
admission in writing of its inability generally to pay its debts as they become due,
and analogous events; and
 
• restructuring of the underlying obligation involving forgiveness or postponement
of principal, interest or fees that results in a credit loss event (i.e. charge-off,
specific provision or other similar debit to the profit and loss account). When
restructuring is not specified as a credit event, refer to paragraph 192.
 
(b) If the credit derivative covers obligations that do not include the underlying
obligation, section (g) below governs whether the asset mismatch is permissible.
 
(c) The credit derivative shall not terminate prior to expiration of any grace period
required for a default on the underlying obligation to occur as a result of a failure
to pay, subject to the provisions of paragraph 203.
 
(d) Credit derivatives allowing for cash settlement are recognised for capital
purposes insofar as a robust valuation process is in place in order to estimate
loss reliably. There must be a clearly specified period for obtaining post-creditevent
valuations of the underlying obligation. If the reference obligation specified
in the credit derivative for purposes of cash settlement is different than the
underlying obligation, section (g) below governs whether the asset mismatch is
permissible.
 
(e) If the protection purchaser’s right/ability to transfer the underlying obligation to
the protection provider is required for settlement, the terms of the underlying
obligation must provide that any required consent to such transfer may not be
unreasonably withheld.
 
(f) The identity of the parties responsible for determining whether a credit event has
occurred must be clearly defined. This determination must not be the sole
responsibility of the protection seller. The protection buyer must have the
right/ability to inform the protection provider of the occurrence of a credit event.
 
(g) A mismatch between the underlying obligation and the reference obligation
under the credit derivative (i.e. the obligation used for purposes of determining
cash settlement value or the deliverable obligation) is permissible if (1) the
reference obligation ranks pari passu with or is junior to the underlying
obligation, and (2) the underlying obligation and reference obligation share the
same obligor (i.e. the same legal entity) and legally enforceable cross-default or
cross-acceleration clauses are in place.
 
(h) A mismatch between the underlying obligation and the obligation used for
purposes of determining whether a credit event has occurred is permissible if
 
(1) the latter obligation ranks pari passu with or is junior to the underlying obligation,
and
 
(2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or crossacceleration clauses are in place.
 
192. When the restructuring of the underlying obligation is not covered by the credit
derivative, but the other requirements in paragraph 191 are met, partial recognition of the
credit derivative will be allowed.
 
If the amount of the credit derivative is less than or equal to the amount of the underlying obligation, 60% of the amount of the hedge can be recognised as covered. If the amount of the credit derivative is larger than that of the underlying obligation, then the amount of eligible hedge is capped at 60% of the amount of the underlying obligation.(55)
 
(55) The 60% recognition factor is provided as an interim treatment, which the Committee intends to refine prior to implementation after considering additional data.
 
193. Only credit default swaps and total return swaps that provide credit protection
equivalent to guarantees will be eligible for recognition. The following exception applies.
Where a bank buys credit protection through a total return swap and records the net
payments received on the swap as net income, but does not record offsetting deterioration in
the value of the asset that is protected (either through reductions in fair value or by an
addition to reserves), the credit protection will not be recognised. The treatment of first-todefault and second-to-default products is covered separately in paragraphs 207 to 210.
 
194. Other types of credit derivatives will not be eligible for recognition at this time. (56)
 
(ii) Range of eligible guarantors (counter-guarantors)/protection providers
 
(56) Cash funded credit linked notes issued by the bank against exposures in the banking book which fulfil the criteria for credit derivatives will be treated as cash collateralised transactions.
 
195. Credit protection given by the following entities will be recognised:
 
• sovereign entities, (57) PSEs, banks (58) and securities firms with a lower risk weight than
the counterparty;
 
• other entities rated A- or better. This would include credit protection provided by
parent, subsidiary and affiliate companies when they have a lower risk weight than
the obligor.
 
(iii) Risk weights
 
(57) This includes the Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community, as well as those MDBs referred to in footnote 24.
 
(58) This includes other MDBs.
 
196. The protected portion is assigned the risk weight of the protection provider. The
uncovered portion of the exposure is assigned the risk weight of the underlying counterparty.
 
197. Materiality thresholds on payments below which no payment is made in the event of
loss are equivalent to retained first loss positions and must be deducted in full from the
capital of the bank purchasing the credit protection.
 
Proportional cover
 
198. Where the amount guaranteed, or against which credit protection is held, is less
than the amount of the exposure, and the secured and unsecured portions are of equal
seniority, i.e. the bank and the guarantor share losses on a pro-rata basis capital relief will be
afforded on a proportional basis: i.e. the protected portion of the exposure will receive the
treatment applicable to eligible guarantees/credit derivatives, with the remainder treated as
unsecured.
 
Tranched cover
 
199. Where the bank transfers a portion of the risk of an exposure in one or more
tranches to a protection seller or sellers and retains some level of risk of the loan and the risk
transferred and the risk retained are of different seniority, banks may obtain credit protection
for either the senior tranches (e.g. second loss portion) or the junior tranche (e.g. first loss
portion). In this case the rules as set out in Section IV (Credit risk ─ securitisation framework) will apply.
 
(iv) Currency mismatches
 
200. Where the credit protection is denominated in a currency different from that in which
the exposure is denominated — i.e. there is a currency mismatch — the amount of the
exposure deemed to be protected will be reduced by the application of a haircut HFX, i.e.
GA = G x (1 – HFX)
where:
 
G = nominal amount of the credit protection
 
HFX = haircut appropriate for currency mismatch between the credit protection
and underlying obligation.
 
The appropriate haircut based on a 10-business day holding period (assuming daily markingto- market) will be applied. If a bank uses the supervisory haircuts it will be 8%. The haircuts must be scaled up using the square root of time formula, depending on the frequency of revaluation of the credit protection as described in paragraph 168.
 
(v) Sovereign guarantees and counter-guarantees
 
201. As specified in paragraph 54, a lower risk weight may be applied at national
discretion to a bank’s exposures to the sovereign (or central bank) where the bank is
incorporated and where the exposure is denominated in domestic currency and funded in
that currency. National authorities may extend this treatment to portions of claims guaranteed by the sovereign (or central bank), where the guarantee is denominated in the domestic currency and the exposure is funded in that currency. A claim may be covered by a guarantee that is indirectly counter-guaranteed by a sovereign. Such a claim may be treated as covered by a sovereign guarantee provided that:
 
(a) the sovereign counter-guarantee covers all credit risk elements of the claim;
 
(b) both the original guarantee and the counter-guarantee meet all operational
requirements for guarantees, except that the counter-guarantee need not be
direct and explicit to the original claim; and
 
(c) the supervisor is satisfied that the cover is robust and that no historical
evidence suggests that the coverage of the counter-guarantee is less than
effectively equivalent to that of a direct sovereign guarantee.
   
 

 

 

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