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Strengthening the resilience of the banking sector 1
Proposed changes to Counterparty Credit Risk in Basel Accord
Presentation to PRMIA/ISDA seminarLondon, March 8 2010
Maxine Nelson, FSA
2Strengthening the resilience of the banking sector
Agenda
• Background• Proposed changes summary• CVA loss charge• Central counterparties • Asset value correlation• Wrong way risk• Margin period of risk• Collateral management• Backtesting• Stress testing • Shortcut method• Alpha• Conclusion
3Strengthening the resilience of the banking sector
What is CCR?
• Bilateral risk of loss
• Value of exposure changes over time as market risk factors change
• Applies to – OTC derivatives– Securities financing transactions
The counterparty credit risk is defined as the risk that the counterparty to a transaction could default before the final settlement of the transaction’s cash flows.
4Strengthening the resilience of the banking sector
What is calculated under CCR rules?
• A loan equivalent Exposure at Default (EAD)
• 3 ways of calculating EAD– CCR mark to market method– CCR standardised method– CCR Internal Model Method (IMM)
• Changes generally focus on IMM – IMM uses “Effective Expected Positive Exposure”
(EEPE) “metric” times Alpha
– EEPE assumes diversification, granularity and no wrong-way risk
5Strengthening the resilience of the banking sector
Strengthening capital requirements
• Raise capital buffer
• Reduce procyclicality
• Strengthen risk management
• Incentives to move bilateral OTC derivatives to central counterparties
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Key Issues Identified
• Credit valuation adjustments (CVA) causing large mark-to-market losses
• Higher correlation between financial institution asset correlation
• Central counterparties not sufficiently used• Wrong way risk not adequately captured• Long close-out periods for large netting sets; complex
trades; illiquid collateral• Initial margin increased (in-dept amount)• Securitisations risky • Backtesting• Stress testing• Use of own estimates of alpha
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CVA Charge
• CVA VaR not currently practical
• Bond equivalent approach– Market risk framework
– P&L from CVA as being long a hypothetical bond issued by the counterparty where:
– Notional of the “bond” total EAD of a counterparty (treated as fixed) – Maturity of the “bond” Effective Maturity (M) of the longest
dated netting set of a counterparty– Time horizon one year
Regulatory framework does not capture volatility of CVA losses
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Central Counterparties
• Incentivise the use of CCPs
• Increased capital for non-CCP deals
• Exposure for trades with CCP– Zero exposure to remain for exposures to MtM and posted collateral
– Developing non-zero capital charges for default /guarantee fund exposures – in line with BIPRU
• Update CPSS/IOSCO requirements
Need strong risk management procedures for preferable capital treatment
9Strengthening the resilience of the banking sector
• AVCs for financial firms were 25% or more higher than AVCs for non-financial firms
• 1.25x multiplier for financial firms AVC
• AVCs between financial firms would be 15%-30%
• Non-linear relationship between capital and AVC
• Broad definition of financial firms includes banks, broker dealers, hedge funds, highly levered entities
• Applies to all exposures to financial (e.g. loans) – not just CCR
Asset Value Correlations (AVC)
Financial institutions more correlated
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General wrong way risk
• Calculate EEPE using parameters from more conservative of
– Recent experience
– Period of stress
• Reduces cyclicality
Positive correlation between PD and market risk factors
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General wrong way risk (continued)
Stress testing• To identify general WWR• Monitor WWR by region, industry, etc• Part of senior management MI• Manage the risk
Positive correlation between PD and market risk factors
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Specific WWR charges for:– Single name credit default swaps
– Equity derivatives referencing single counterparty
Specific wrong way risk
Legal connection between underlying and counterparty
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Margin Period of Risk
Margin periods of risk
Current Proposed
Conditions OTC SFT OTC SFT
Netting sets with legally enforceable margin agreements 10 5 10 5
Netting sets with legally enforceable margin agreements containing more than 5,000 trades 10 5 20 20
Netting sets with legally enforceable margin agreements containing an illiquid trade 10 5 20 20
Netting sets with legally enforceable margin agreements containing more than two disputes 10 5 20 10
Netting sets with legally enforceable margin agreements containing more than 5,000 trades or an illiquid trade and more than two disputes 10 5 40 40
Losses due to longer close-outs and “fire sales”
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Collateral Management
• No benefit from collateral agreements with downgrade triggers to be made explicit
• Controls for reuse of collateral
• If can’t model collateral jointly with exposure– Calculate own haircuts under the standard of financial
collateral comprehensive method with own haircut – Use supervisory haircuts estimates
Collateral management practices not robust
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• Performance of collateral management department
– Data integrity– Reuse of collateral – Collateral concentration tracked– Timely and accurate collateral calls– Regular reporting
Collateral Management (cont.)
Collateral management practices not robust
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• Securitisations double haircut of corporate collateral with same rating
• Resecuritisations ineligible as collateral
Collateral Management (cont.)
Securitisation collateral riskier
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More explicit requirements for:• Senior management involvement• Part of risk management• Independent review• Acceptable criteria• When testing must be carried out• Range of tests needed
Back testing
Shortcomings in back-testing approaches
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• Senior management engagement• Multi-factor stress testing• Quarterly joint movement of exposure and PD• Exposure stress testing• Regular reporting
• Severe shocks – impact on capital resources and requirements• Less severe shocks for day-to-day monitoring• Reverse stress tests
Stress testing
Existing risk management not adequate to help prevent unforeseen losses
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Shortcut method
• Allows Effective EPE to be calculated by banks that could not model EPE with margin agreements (but can otherwise model EPE)
• Adjusted to reflect collateral not received at t = 0
Collateral at t = 0 not reflected appropriately
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• Alpha is a broad brush adjustment multiplied by effective EPE to derive EAD
• Insufficient evidence exists to recalibrate Alpha
• Nature of portfolio risk suggests Alpha floors (1.4 standard; 1.2 own estimate) should be maintained
• Concern exists over mis-specifications in Alpha own estimates
• Enhanced requirements to avoid mis-specification in models when banks use their own estimates of Alpha
Alpha
Mis-specification of alpha numerator
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Counterparty Credit Risk Changes
Further questions?
Email [email protected]
and your supervisor
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Wrap-up
• Proposed changes summary• CVA loss charge• Asset value correlation• Central counterparties• Wrong way risk• Margin period of risk• Collateral management• Backtesting• Stress testing• Shortcut method• Alpha