Minimum Capital Requirements for Credit Risk

Third, we would calculate the counterparty credit risk associated with the derivative contract. As set out in paragraph 24.7 of Minimum Capital Requirements for Credit Risk (3) : (1) If we do not know the replacement cost related to the futures contract, we would approximate it by the maximum notional amount, ie USD 100. (2) If we do not know the aggregate add-on for potential future exposure, we would approximate this by 15% of the maximum notional amount (ie 15% of USD 100=USD 15). (3) The CCR exposure is calculated by multiplying (i) the sum of the replacement cost and aggregate add-on for potential future exposure; by (ii) 1.4, which is the prescribed value of alpha. 29.5 The counterparty credit risk exposure in this example, assuming the replacement cost and aggregate add-on amounts are unknown, is therefore USD 161 (= 1.4 *(100+15)). Assuming the futures contract is cleared through a qualifying CCP, a risk weight of 2% applies, so that RWA CCR = USD 161 * 2% = USD 3.2. There is no CVA charge assessed since the futures contract is cleared through a CCP. 29.6 The RWA of the fund is hence obtained by adding RWA on-BS , RWA underlying and RWA CCR , ie USD 503.2 (=250 + 250 + 3.2). 29.7 The RWA (USD 503.2) will be divided by the total assets of the fund (USD 100) resulting in an average risk-weight of 503.2%. The bank’s total RWA associated with its equity investment is calculated as the product of the average risk weight of the fund, the fund’s maximum leverage and the size of the bank’s equity investment. That is the bank’s total associated RWA are 503.2% * 1.1 * USD 18.18 = USD 100.6. 30. Equity Investments in Funds: Illustrative Examples of the Leverage Adjustment 30.1 Consider a fund with assets of USD 100 that invests in corporate debt. Assume that the fund is highly levered with equity of USD 5 and debt of USD 95. Such a fund would have financial leverage of 100/5=20. Consider the two cases below. 30.2 In Case 1 the fund specializes in low-rated corporate debt, it has the following balance sheet: Assets Cash USD 10 A+ to A- bonds USD 20 BBB+ to BBBbonds USD 30 BB+ to BB- bonds USD 40 Liabilities Debt Debt USD 95 Equity Shares, retained earnings and other reserves USD 5 30.3 The average risk weight of the fund is (USD10*0% + USD20*50% + USD30*75% + USD40*100%)/USD100 = 72.5%. The financial leverage of 20 would result in an effective risk weight of 1,450% for banks’ investments in this highly levered fund, however, this is capped at a conservative risk weight of 1,250%. 30.4 In Case 2 the fund specializes in high-rated corporate debt, it has the following balance sheet: Assets Cash USD 5 AAA to AA- bonds USD 75 A+ to A- bonds USD 20 Liabilities Debt USD 95 Equity Shares, retained earnings and other reserves USD 5 30.5 The average risk weight of the fund is (USD5*0% + USD75*20% + USD20*50%)/USD100 = 25%. The financial leverage of 20 results in an effective risk weight of 500%. 30.6 The above examples illustrate that the rate at which the 1,250% cap is reached depends on the underlying riskiness of the portfolio (as judged by the average risk weight) as captured by SA risk weights or the IRB approach. For example, for a “risky” portfolio (72.5% average risk weight), the 1,250% limit is reached fairly quickly with a leverage of 17.2x, while for a “low risk” portfolio (25% average risk weight) this limit is reached at a leverage of 50x.