Guarantees and Credit Derivatives

When the restructuring of the underlying obligation is not covered by the credit derivative, but the other requirements in paragraph 9.73 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 recognized 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. Range of eligible guarantors (counter-guarantors)/protection providers and credit derivatives 9.75 Credit protection given by the following entities can be recognized when they have a lower risk weight than the counterparty: (1) Sovereign entities 48 , PSEs, multilateral development banks (MDBs), banks, securities firms and other prudentially regulated financial institutions with alower risk weight than the counterparty 49 ; (2) Other entities that are externally rated except when credit protection is provided to a securitization exposure. This would include credit protection provided by a parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor; (3) 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. 9.76 Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees are eligible for recognition 50 . 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 recognized. 9.77 First-to-default and all other nth-to-default credit derivatives (i.e. by which a bank obtains credit protection for a basket of reference names and where the first- ornth–to-default among the reference names triggers the credit protection and terminates the contract) are not eligible as a credit risk mitigation technique and therefore cannot provide any regulatory capital relief. In transactions in which a bank provided credit protection through such instruments, it shall apply the treatment described in paragraph 7.94 . Risk-weight treatment of transactions in which eligible credit protection is provided 9.78 The general risk-weight treatment for transactions in which eligible credit protection is provided is as follows: (1) 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. (2) Materiality thresholds on payments below which the protection provider is exempt from payment in the event of loss are equivalent to retained first- loss positions. The portion of the exposure that is below a materiality threshold must be assigned a risk weight of 1250% by the bank purchasing the credit protection. 9.79 Where losses are shared pari passu on a pro rata basis between the bank and the guarantor, capital relief is afforded on a proportional basis, i.e. the protected portion of the exposure receives the treatment applicable to eligible guarantees /credit derivatives, with the remainder treated as unsecured.