301. Under either approach, CRM in the form of guarantees and credit derivatives must not reflect the effect of double default (see paragraph 482).

As such, to the extent that the CRM is recognised by the bank, the adjusted risk weight will not be less than that of a comparable direct exposure to the protection provider.

Consistent with the standardised approach, banks may choose not to recognise credit protection if doing so would result in a higher capital requirement.

Recognition under the foundation approach

302. For banks using the foundation approach for LGD, the approach to guarantees and credit derivatives closely follows the treatment under the standardised approach as specified in paragraphs 189 to 201.

The range of eligible guarantors is the same as under the standardised approach except that companies that are internally rated and associated with a PD equivalent to A- or better may also be recognised under the foundation approach.

To receive recognition, the requirements outlined in paragraphs 189 to 194 must be met.

303. Eligible guarantees from eligible guarantors will be recognised as follows:

• For the covered portion of the exposure, a risk weight is derived by taking:

– the risk-weight function appropriate to the type of guarantor, and

– the PD appropriate to the guarantor’s borrower grade, or some grade between the underlying obligor and the guarantor’s borrower grade if the bank deems a full substitution treatment not to be warranted.

• The bank may replace the LGD of the underlying transaction with the LGD applicable to the guarantee taking into account seniority and any collateralisation of a guaranteed commitment.

304. The uncovered portion of the exposure is assigned the risk weight associated with the underlying obligor.

305. Where partial coverage exists, or where there is a currency mismatch between the underlying obligation and the credit protection, it is necessary to split the exposure into a covered and an uncovered amount.

The treatment in the foundation approach follows that outlined in the standardised approach in paragraphs 198 to 200, and depends upon whether the cover is proportional or tranched.

Recognition under the advanced approach

306. Banks using the advanced approach for estimating LGDs may reflect the risk mitigating effect of guarantees and credit derivatives through either adjusting PD or LGD estimates.

Whether adjustments are done through PD or LGD, they must be done in a consistent manner for a given guarantee or credit derivative type. In doing so, banks must not include the effect of double default in such adjustments.

Thus, the adjusted risk weight must not be less than that of a comparable direct exposure to the protection provider.

307. A bank relying on own-estimates of LGD has the option to adopt the treatment outlined above for banks under the foundation IRB approach (paragraphs 302 to 305), or to make an adjustment to its LGD estimate of the exposure to reflect the presence of the guarantee or credit derivative.

Under this option, there are no limits to the range of eligible guarantors although the set of minimum requirements provided in paragraphs 483 and 484 concerning the type of guarantee must be satisfied.

For credit derivatives, the requirements of paragraphs 488 and 489 must be satisfied.*

* When credit derivatives do not cover the restructuring of the underlying obligation, the partial recognition set out in paragraph 192 applies.

Operational requirements for recognition of double default

307(i). A bank using an IRB approach has the option of using the substitution approach in determining the appropriate capital requirement for an exposure.

However, for exposures hedged by one of the following instruments the double default framework according to
paragraphs 284 (i) to 284 (iii) may be applied subject to the additional operational requirements set out in paragraph 307 (ii).

A bank may decide separately for each eligible exposure to apply either the double default framework or the substitution approach.

(a) Single-name, unfunded credit derivatives (e.g. credit default swaps) or single name guarantees.

(b) First-to-default basket products — the double default treatment will be applied to the asset within the basket with the lowest risk-weighted amount.

(c) nth-to-default basket products — the protection obtained is only eligible for consideration under the double default framework if eligible (n–1)th default protection has also been obtained or where (n–1) of the assets within the basket have already defaulted.

307(ii). The double default framework is only applicable where the following conditions are met.

(a) The risk weight that is associated with the exposure prior to the application of the framework does not already factor in any aspect of the credit protection.

(b) The entity selling credit protection is a bank *, investment firm or insurance company (but only those that are in the business of providing credit protection, including mono-lines, re-insurers, and non-sovereign credit export agencies), ** referred to as a financial firm, that:

• is regulated in a manner broadly equivalent to that in this Framework (where there is appropriate supervisory oversight and transparency/ market discipline), or externally rated as at least investment grade by a credit rating agency deemed suitable for this purpose by supervisors;

• had an internal rating with a PD equivalent to or lower than that associated with an external A– rating at the time the credit protection for an exposure was first provided or for any period of time thereafter; and

• has an internal rating with a PD equivalent to or lower than that associated with an external investment-grade rating.

* This does not include PSEs and MDBs, even though claims on these may be treated as claims on banks according to paragraph 230.

(c) The underlying obligation is:

• a corporate exposure as defined in paragraphs 218 to 228 (excluding specialised lending exposures for which the supervisory slotting criteria approach described in paragraphs 275 to 282 is being used); or

• a claim on a PSE that is not a sovereign exposure as defined in paragraph 229; or

• a loan extended to a small business and classified as a retail exposure as defined in paragraph 231.

(d) The underlying obligor is not:

• a financial firm as defined in (b); or

• a member of the same group as the protection provider.

(e) The credit protection meets the minimum operational requirements for such instruments as outlined in paragraphs 189 to 193.

(f) In keeping with paragraph 190 for guarantees, for any recognition of double default effects for both guarantees and credit derivatives a bank must have the right and expectation to receive payment from the credit protection provider without having to take legal action in order to pursue the counterparty for payment.

To the extent possible, a bank should take steps to satisfy itself that the protection provider is willing to pay promptly if a credit event should occur.

(g) The purchased credit protection absorbs all credit losses incurred on the hedged portion of an exposure that arise due to the credit events outlined in the contract.

(h) If the payout structure provides for physical settlement, then there must be legal certainty with respect to the deliverability of a loan, bond, or contingent liability.

If a bank intends to deliver an obligation other than the underlying exposure, it must ensure that the deliverable obligation is sufficiently liquid so that the bank would have the ability to purchase it for delivery in accordance with the contract.

(i) The terms and conditions of credit protection arrangements must be legally confirmed in writing by both the credit protection provider and the bank.

(j) In the case of protection against dilution risk, the seller of purchased receivables must not be a member of the same group as the protection provider.

(k) There is no excessive correlation between the creditworthiness of a protection provider and the obligor of the underlying exposure due to their performance being dependent on common factors beyond the systematic risk factor.

The bank has a process to detect such excessive correlation.

An example of a situation in which such excessive correlation would arise is when a protection provider guarantees the debt of a supplier of goods or services and the supplier derives a high proportion of its income or revenue from the protection provider.

* This does not include PSEs and MDBs, even though claims on these may be treated as claims on banks according to paragraph 230.

** By non-sovereign it is meant that credit protection in question does not benefit from any explicit sovereign counter-guarantee.

(iii) Exposure at default (EAD)

308. The following sections apply to both on and off-balance sheet positions.

All exposures are measured gross of specific provisions or partial write-offs.

The EAD on drawn amounts should not be less than the sum of

(i) the amount by which a bank’s regulatory capital would be reduced if the exposure were written-off fully, and

(ii) any specific provisions and partial write-offs.

When the difference between the instrument’s EAD and the sum of (i) and (ii) is positive, this amount is termed a discount.

The calculation of risk-weighted assets is independent of any discounts.

Under the limited circumstances described in paragraph 380, discounts may be included in the measurement of total eligible provisions for purposes of the EL-provision calculation set out in Section III.G.

Exposure measurement for on-balance sheet items

309. On-balance sheet netting of loans and deposits will be recognised subject to the same conditions as under the standardised approach (see paragraph 188).

Where currency or maturity mismatched on-balance sheet netting exists, the treatment follows the standardised approach, as set out in paragraphs 200 and 202 to 205.

Exposure measurement for off-balance sheet items (with the exception of FX and interest rate, equity, and commodity-related derivatives)

310. For off-balance sheet items, exposure is calculated as the committed but undrawn amount multiplied by a CCF. There are two approaches for the estimation of CCFs: a foundation approach and an advanced approach.

EAD under the foundation approach

311. The types of instruments and the CCFs applied to them are the same as those in the standardised approach, as outlined in paragraphs 82 to 89 with the exception of commitments, Note Issuance Facilities (NIFs) and Revolving Underwriting Facilities (RUFs).

312. A CCF of 75% will be applied to commitments, NIFs and RUFs regardless of the maturity of the underlying facility. This does not apply to those facilities which are uncommitted, that are unconditionally cancellable, or that effectively provide for automatic cancellation, for example due to deterioration in a borrower’s creditworthiness, at any time by the bank without prior notice.

A CCF of 0% will be applied to these facilities.

313. The amount to which the CCF is applied is the lower of the value of the unused committed credit line, and the value that reflects any possible constraining availability of the facility, such as the existence of a ceiling on the potential lending amount which is related to a borrower’s reported cash flow.

If the facility is constrained in this way, the bank must have sufficient line monitoring and management procedures to support this contention.

314. In order to apply a 0% CCF for unconditionally and immediately cancellable corporate overdrafts and other facilities, banks must demonstrate that they actively monitor the financial condition of the borrower, and that their internal control systems are such that they could cancel the facility upon evidence of a deterioration in the credit quality of the borrower.

315. Where a commitment is obtained on another off-balance sheet exposure, banks under the foundation approach are to apply the lower of the applicable CCFs.

EAD under the advanced approach

316. Banks which meet the minimum requirements for use of their own estimates of EAD (see paragraphs 474 to 478) will be allowed to use their own internal estimates of CCFs across different product types provided the exposure is not subject to a CCF of 100% in the foundation approach (see paragraph 311).

Exposure measurement for transactions that expose banks to counterparty credit risk

317. Measures of exposure for SFTs and OTC derivatives that expose banks to counterparty credit risk under the IRB approach will be calculated as per the rules set forth in Annex 4 of this Framework.

(iv) Effective maturity (M)

318. For banks using the foundation approach for corporate exposures, effective maturity (M) will be 2.5 years except for repo-style transactions where the effective maturity will be 6 months.

National supervisors may choose to require all banks in their jurisdiction (those using the foundation and advanced approaches) to measure M for each facility using the definition provided below.

319. Banks using any element of the advanced IRB approach are required to measure effective maturity for each facility as defined below.

However, national supervisors may exempt facilities to certain smaller domestic corporate borrowers from the explicit maturity adjustment if the reported sales (i.e. turnover) as well as total assets for the consolidated group of which the firm is a part of are less than €500 million.

The consolidated group has to be a domestic company based in the country where the exemption is applied.

If adopted, national supervisors must apply such an exemption to all IRB banks using the advanced approach in that country, rather than on a bank-by-bank basis.

If the exemption is applied, all exposures to qualifying smaller domestic firms will be assumed to have an average maturity of 2.5 years, as under the foundation IRB approach.

320. Except as noted in paragraph 321, M is defined as the greater of one year and the remaining effective maturity in years as defined below. In all cases, M will be no greater than 5 years.

• For an instrument subject to a determined cash flow schedule, effective maturity M is defined as:

where CFt denotes the cash flows (principal, interest payments and fees) contractually payable by the borrower in period t.

• If a bank is not in a position to calculate the effective maturity of the contracted payments as noted above, it is allowed to use a more conservative measure of M such as that it equals the maximum remaining time (in years) that the borrower is permitted to take to fully discharge its contractual obligation (principal, interest, and fees) under the terms of loan agreement.

Normally, this will correspond to the nominal maturity of the instrument.

• For derivatives subject to a master netting agreement, the weighted average maturity of the transactions should be used when applying the explicit maturity adjustment.

Further, the notional amount of each transaction should be used for weighting the maturity.

321. The one-year floor does not apply to certain short-term exposures, comprising fully or nearly-fully collateralised *  capital market-driven transactions (i.e. OTC derivatives transactions and margin lending) and repo-style transactions (i.e. repos/reverse repos and securities lending/borrowing) with an original maturity of less then one year, where the documentation contains daily remargining clauses.

For all eligible transactions the documentation must require daily revaluation, and must include provisions that must allow for the prompt liquidation or setoff of the collateral in the event of default or failure to re-margin.

The maturity of such transactions must be calculated as the greater of one-day, and the effective maturity (M, consistent with the definition above).

* The intention is to include both parties of a transaction meeting these conditions where neither of the parties is systematically under-collateralised.

322. In addition to the transactions considered in paragraph 321 above, other short-term exposures with an original maturity of less than one year that are not part of a bank’s ongoing financing of an obligor may be eligible for exemption from the one-year floor.

After a careful review of the particular circumstances in their jurisdictions, national supervisors treatment.

The results of these reviews might, for example, include transactions such as:

• Some capital market-driven transactions and repo-style transactions that might not fall within the scope of paragraph 321;

• Some short-term self-liquidating trade transactions. Import and export letters of credit and similar transactions could be accounted for at their actual remaining maturity;

• Some exposures arising from settling securities purchases and sales. This could also include overdrafts arising from failed securities settlements provided that such overdrafts do not continue more than a short, fixed number of business days;

• Some exposures arising from cash settlements by wire transfer, including overdrafts arising from failed transfers provided that such overdrafts do not continue more than a short, fixed number of business days;

• Some exposures to banks arising from foreign exchange settlements; and

• Some short-term loans and deposits.

323. For transactions falling within the scope of paragraph 321 subject to a master netting agreement, the weighted average maturity of the transactions should be used when applying the explicit maturity adjustment.

A floor equal to the minimum holding period for the transaction type set out in paragraph 167 will apply to the average.

Where more than one transaction type is contained in the master netting agreement a floor equal to the highest
holding period will apply to the average.

Further, the notional amount of each transaction should be used for weighting maturity.

324. Where there is no explicit adjustment, the effective maturity (M) assigned to all exposures is set at 2.5 years unless otherwise specified in paragraph 318.

Treatment of maturity mismatches

325. The treatment of maturity mismatches under IRB is identical to that in the standardised approach ─ see paragraphs 202 to 205.

D. Rules for Retail Exposures

326. Section D presents in detail the method of calculating the UL capital requirements for retail exposures. Section D.1 provides three risk-weight functions, one for residential mortgage exposures, a second for qualifying revolving retail exposures, and a third for other retail exposures.

Section D.2 presents the risk components to serve as inputs to the risk weight functions.

The method of calculating expected losses, and for determining the difference between that measure and provisions is described in Section III.G.

1. Risk-weighted assets for retail exposures

327. There are three separate risk-weight functions for retail exposures, as defined in paragraphs 328 to 330. Risk weights for retail exposures are based on separate assessments of PD and LGD as inputs to the risk-weight functions.

None of the three retail risk-weight functions contains an explicit maturity adjustment.

Throughout this section, PD and LGD are measured as decimals, and EAD is measured as currency (e.g. euros).

(i) Residential mortgage exposures

328. For exposures defined in paragraph 231 that are not in default and are secured or partly secured * by residential mortgages, risk weights will be assigned based on the following formula:

Correlation (R) = 0.15

Capital requirement (K) = LGD × N[(1 – R)^-0.5 × G(PD) + (R / (1 – R))^0.5 × G(0.999)] – PD x LGD

Risk-weighted assets = 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.

* This means that risk weights for residential mortgages also apply to the unsecured portion of such residential mortgages.

(ii) Qualifying revolving retail exposures

329. For qualifying revolving retail exposures as defined in paragraph 234 that are not in default, risk weights are defined based on the following formula:

Correlation (R) = 0.04

Capital requirement (K) = LGD × N[(1 – R)^-0.5 × G(PD) + (R / (1 – R))^0.5 × G(0.999)] – PD x LGD

Risk-weighted assets = 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.

(iii) Other retail exposures

330. For all other retail exposures that are not in default, risk weights are assigned based on the following function, which allows correlation to vary with PD:

Correlation (R) = 0.03 × (1 – EXP(-35 × PD)) / (1 – EXP(-35)) + 0.16 × [1 – (1 – EXP(-35 × PD))/(1 – EXP(-35))]

Capital requirement (K) = LGD × N[(1 – R)^-0.5 × G(PD) + (R / (1 – R))^0.5 × G(0.999)] – PD x LGD

Risk-weighted assets = K x 12.5 x EAD

The capital requirement (K) for a defaulted exposure is equal to the greater of zero and thedifference 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.

Illustrative risk weights are shown in Annex 5.

2. Risk components

(i) Probability of default (PD) and loss given default (LGD)

331. For each identified pool of retail exposures, banks are expected to provide an estimate of the PD and LGD associated with the pool, subject to the minimum requirements as set out in Section III.H. Additionally, the PD for retail exposures is the greater of the one year PD associated with the internal borrower grade to which the pool of retail exposures is assigned or 0.03%.

(ii) Recognition of guarantees and credit derivatives

332. Banks may reflect the risk-reducing effects of guarantees and credit derivatives, either in support of an individual obligation or a pool of exposures, through an adjustment of either the PD or LGD estimate, subject to the minimum requirements in paragraphs 480 to 489.

Whether adjustments are done through PD or LGD, they must be done in a consistent manner for a given guarantee or credit derivative type.

333. Consistent with the requirements outlined above for corporate, sovereign, and bank exposures, banks must not include the effect of double default in such adjustments.

The adjusted risk weight must not be less than that of a comparable direct exposure to the protection provider. Consistent with the standardised approach, banks may choose not to recognise credit protection if doing so would result in a higher capital requirement.

(iii) Exposure at default (EAD)

334. Both on and off-balance sheet retail exposures are measured gross of specific provisions or partial write-offs.

The EAD on drawn amounts should not be less than the sum of

(i) the amount by which a bank’s regulatory capital would be reduced if the exposure were written-off fully, and

(ii) any specific provisions and partial write-offs.

When the difference between the instrument’s EAD and the sum of (i) and (ii) is positive, this amount is termed a
discount.

The calculation of risk-weighted assets is independent of any discounts.

Under the limited circumstances described in paragraph 380, discounts may be included in the measurement of total eligible provisions for purposes of the EL-provision calculation set out in Section III.G.

335. On-balance sheet netting of loans and deposits of a bank to or from a retail customer will be permitted subject to the same conditions outlined in paragraph 188 of the standardised approach. For retail off-balance sheet items, banks must use their own estimates of CCFs provided the minimum requirements in paragraphs 474 to 477 and 479
are satisfied.

336. For retail exposures with uncertain future drawdown such as credit cards, banks must take into account their history and/or expectation of additional drawings prior to default in their overall calibration of loss estimates. In particular, where a bank does not reflect conversion factors for undrawn lines in its EAD estimates, it must reflect in its LGD estimates the likelihood of additional drawings prior to default.

Conversely, if the bank does not incorporate the possibility of additional drawings in its LGD estimates, it must do so in its EAD estimates.

337. When only the drawn balances of retail facilities have been securitised, banks must ensure that they continue to hold required capital against their share (i.e. seller’s interest) of undrawn balances related to the securitised exposures using the IRB approach to credit risk.

This means that for such facilities, banks must reflect the impact of CCFs in their EAD estimates rather than in the LGD estimates. For determining the EAD associated with the seller’s interest in the undrawn lines, the undrawn balances of securitised exposures would be allocated between the seller’s and investors’ interests on a pro rata basis, based on the proportions of the seller’s and investors’ shares of the securitised drawn balances.

The investors’ share of undrawn balances related to the securitised exposures is subject to the treatment in paragraph 643.

338. To the extent that foreign exchange and interest rate commitments exist within a bank’s retail portfolio for IRB purposes, banks are not permitted to provide their internal assessments of credit equivalent amounts.

Instead, the rules for the standardised approach continue to apply.

E. Rules for Equity Exposures

339. Section E presents the method of calculating the UL capital requirements for equity exposures. Section E.1 discusses

(a) the market-based approach (which is further subdivided into a simple risk weight method and an internal models method), and

(b) the PD/LGD approach.

The risk components are provided in Section E.2.

The method of calculating expected losses, and for determining the difference between that measure and provisions is described in Section III.G.

1. Risk-weighted assets for equity exposures

340. Risk-weighted assets for equity exposures in the trading book are subject to the market risk capital rules.

341. There are two approaches to calculate risk-weighted assets for equity exposures not held in the trading book: a market-based approach and a PD/LGD approach.

Supervisors will decide which approach or approaches will be used by banks, and in what circumstances.

Certain equity holdings are excluded as defined in paragraphs 356 to 358 and are subject to the capital charges required under the standardised approach.

342. Where supervisors permit both methodologies, banks’ choices must be made consistently, and in particular not determined by regulatory arbitrage considerations.

(i) Market-based approach

343. Under the market-based approach, institutions are permitted to calculate the minimum capital requirements for their banking book equity holdings using one or both of two separate and distinct methods: a simple risk weight method or an internal models method.

The method used should be consistent with the amount and complexity of the institution’s equity holdings and commensurate with the overall size and sophistication of the institution.

Supervisors may require the use of either method based on the individual circumstances of an institution.

Simple risk weight method

344. Under the simple risk weight method, a 300% risk weight is to be applied to equity holdings that are publicly traded and a 400% risk weight is to be applied to all other equity holdings.

A publicly traded holding is defined as any equity security traded on a recognised security exchange.

345. Short cash positions and derivative instruments held in the banking book are permitted to offset long positions in the same individual stocks provided that these instruments have been explicitly designated as hedges of specific equity holdings and that they have remaining maturities of at least one year.

Other short positions are to be treated as if they are long positions with the relevant risk weight applied to the absolute value of each position.

In the context of maturity mismatched positions, the methodology is that for corporate exposures.

Internal models method

346. IRB banks may use, or may be required by their supervisor to use, internal risk measurement models to calculate the risk-based capital requirement.

Under this alternative, banks must hold capital equal to the potential loss on the institution’s equity holdings as
derived using internal value-at-risk models subject to the 99th percentile, one-tailed confidence interval of the difference between quarterly returns and an appropriate risk-free rate computed over a long-term sample period.

The capital charge would be incorporated into an institution’s risk-based capital ratio through the calculation of risk-weighted equivalent assets.

347. The risk weight used to convert holdings into risk-weighted equivalent assets would be calculated by multiplying the derived capital charge by 12.5 (i.e. the inverse of the minimum 8% risk-based capital requirement).

Capital charges calculated under the internal models method may be no less than the capital charges that would be calculated under the simple risk weight method using a 200% risk weight for publicly traded equity holdings and a
300% risk weight for all other equity holdings.

These minimum capital charges would be calculated separately using the methodology of the simple risk weight approach.

Further, these minimum risk weights are to apply at the individual exposure level rather than at the portfolio level.

348. A bank may be permitted by its supervisor to employ different market-based approaches to different portfolios based on appropriate considerations and where the bank itself uses different approaches internally.

349. Banks are permitted to recognise guarantees but not collateral obtained on an equity position wherein the capital requirement is determined through use of the market based approach.

(ii) PD/LGD approach

350. The minimum requirements and methodology for the PD/LGD approach for equity exposures (including equity of companies that are included in the retail asset class) are the same as those for the IRB foundation approach for corporate exposures subject to the following specifications: *

• The bank’s estimate of the PD of a corporate entity in which it holds an equity position must satisfy the same requirements as the bank’s estimate of the PD of a corporate entity where the bank holds debt.**

If a bank does not hold debt of the company in whose equity it has invested, and does not have sufficient information on the position of that company to be able to use the applicable definition of default in practice but meets the other standards, a 1.5 scaling factor will be applied to the risk weights derived from the corporate risk-weight function, given the PD set by the bank.

If, however, the bank’s equity holdings are material and it is permitted to use a PD/LGD approach for regulatory purposes but the bank has not yet met the relevant standards, the simple risk-weight method under the market-based approach will apply.

• An LGD of 90% would be assumed in deriving the risk weight for equity exposures.

• For these purposes, the risk weight is subject to a five-year maturity adjustment whether or not the bank is using the explicit approach to maturity elsewhere in its IRB portfolio.

* There is no advanced approach for equity exposures, given the 90% LGD assumption.

** In practice, if there is both an equity exposure and an IRB credit exposure to the same counterparty, a default on the credit exposure would thus trigger a simultaneous default for regulatory purposes on the equity exposure.

351. Under the PD/LGD approach, minimum risk weights as set out in paragraphs 352 and 353 apply.

When the sum of UL and EL associated with the equity exposure results in less capital than would be required from application of one of the minimum risk weights, the minimum risk weights must be used.

In other words, the minimum risk weights must be applied, if the risk weights calculated according to paragraph 350 plus the EL associated with the equity exposure multiplied by 12.5 are smaller than the applicable minimum risk weights.

352. A minimum risk weight of 100% applies for the following types of equities for as long as the portfolio is managed in the manner outlined below:

• Public equities where the investment is part of a long-term customer relationship, any capital gains are not expected to be realised in the short term and there is no anticipation of (above trend) capital gains in the long term.

It is expected that in almost all cases, the institution will have lending and/or general banking relationships with the portfolio company so that the estimated probability of default is readily available.

Given their long-term nature, specification of an appropriate holding period for such investments merits careful consideration.

In general, it is expected that the bank will hold the equity over the long term (at least five years).

• Private equities where the returns on the investment are based on regular and periodic cash flows not derived from capital gains and there is no expectation of future (above trend) capital gain or of realising any existing gain.

353. For all other equity positions, including net short positions (as defined in paragraph 345), capital charges calculated under the PD/LGD approach may be no less than the capital charges that would be calculated under a simple risk weight method using a 200% risk weight for publicly traded equity holdings and a 300% risk weight for all other equity holdings.

354. The maximum risk weight for the PD/LGD approach for equity exposures is 1250%.

This maximum risk weight can be applied, if risk weights calculated according to paragraph 350 plus the EL associated with the equity exposure multiplied by 12.5 exceed the 1250% risk weight.

Alternatively, banks may deduct the entire equity exposure amount, assuming it represents the EL amount, 50% from Tier 1 capital and 50% from Tier 2 capital.

In practice, if there is both an equity exposure and an IRB credit exposure to the same counterparty, a default
on the credit exposure would thus trigger a simultaneous default for regulatory purposes on the equity exposure.
 

355. Hedging for PD/LGD equity exposures is, as for corporate exposures, subject to an LGD of 90% on the exposure to the provider of the hedge.

For these purposes equity positions will be treated as having a five-year maturity.

(iii) Exclusions to the market-based and PD/LGD approaches

356. Equity holdings in entities whose debt obligations qualify for a zero risk weight under the standardised approach to credit risk can be excluded from the IRB approaches to equity (including those publicly sponsored entities where a zero risk weight can be applied), at the discretion of the national supervisor.

If a national supervisor makes such an exclusion this will be available to all banks.

357. To promote specified sectors of the economy, supervisors may exclude from the IRB capital charges equity holdings made under legislated programmes that provide significant subsidies for the investment to the bank and involve some form of government oversight and restrictions on the equity investments.

Example of restrictions are limitations on the size and types of businesses in which the bank is investing, allowable amounts of ownership interests, geographical location and other pertinent factors that limit the potential risk of the investment to the bank.

Equity holdings made under legislated programmes can only be excluded from the IRB approaches up to an aggregate of 10% of Tier 1 plus Tier 2 capital.

358. Supervisors may also exclude the equity exposures of a bank from the IRB treatment based on materiality.

The equity exposures of a bank are considered material if their aggregate value, excluding all legislative programmes discussed in paragraph 357, exceeds, on average over the prior year, 10% of bank's Tier 1 plus Tier 2 capital.

This materiality threshold is lowered to 5% of a bank's Tier 1 plus Tier 2 capital if the equity portfolio consists of less than 10 individual holdings.

National supervisors may use lower materiality thresholds.

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