Minimum Capital Requirements for Credit Risk

Under the other approaches, when there is a maturity mismatch the credit protection arrangement may only be recognized if the original maturity of the arrangement is greater than or equal to one year, and its residual maturity is greater than or equal to three months. In such cases, credit risk mitigation may be partially recognized as detailed below in paragraph 9.13. 9.13 When there is a maturity mismatch with recognized credit risk mitigants, the following adjustment applies, where: (1) P a = value of the credit protection adjusted for maturity mismatch (2) P = credit protection amount (e.g. collateral amount, guarantee amount)adjusted for any haircuts (3) t = min {T, residual maturity of the credit protection arrangement expressed in years} (4) T = min {five years, residual maturity of the exposure expressed in years} 9.14 The maturity of the underlying exposure and the maturity of the hedge must both be defined conservatively. The effective maturity of the underlying must be gauged as the longest possible remaining time before the counterparty is scheduled to fulfil its obligation, taking into account any applicable grace period. For the hedge, (embedded) options that may reduce the term of the hedge must be taken into account so that the shortest possible effective maturity is used. For example: where, in the case of a credit derivative, the protection seller has a call option, the maturity is the first call date. Likewise, if the protection buyer owns the call option and has a strong incentive to call the transaction at the first call date, for example because of a step-up in cost from this date on, the effective maturity is the remaining time to the first call date. Currency mismatches 9.15 Currency mismatches are allowed under all approaches. Under the simple approach there is no specific treatment for currency mismatches, given that a minimum risk weight of 20% (floor) is generally applied. Under the comprehensive approach and in case of guarantees and credit derivatives, a specific adjustment for currency mismatches is prescribed in paragraph 9.51 and 9.81 to 0, respectively. 39 In this section, “counterparty” is used to denote a party to whom a bank has an on- or off-balance sheet credit exposure. That exposure may, for example, take the form of a loan of cash or securities (where the counterparty would traditionally be called the borrower), of securities posted as collateral, of a commitment or of exposure under an over-the-counter (OTC) derivatives contract. Overview of Credit Risk Mitigation Techniques Collateralized Transactions 9.16 A collateralized transaction is one in which: (1) banks have a credit exposure or a potential credit exposure; and (2) that credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty. 9.17 Where banks take eligible financial collateral, they may reduce their regulatory capital requirements through the application of CRM techniques 40 . 9.18 Banks may opt for either: (1) The simple approach, which replaces the risk weight of the counterparty withthe risk weight of the collateral for the collateralized portion of the exposure(generally subject to a 20% floor); or (2) The comprehensive approach, which allows a more precise offset of collateral against exposures, by effectively reducing the exposure amount bya volatility-adjusted value ascribed to the collateral. 9.19 Detailed operational requirements for both the simple approach and comprehensive approach are given in paragraph 9.32 to 9.64 .Banks may operate under either, but not both, approaches in the banking book.