Minimum Capital Requirements for Market Risk

An nth-to-default credit derivative is a contract where the payoff is based on the nth asset to default in a basket of underlying reference instruments. Once the nth default occurs the transaction terminates and is settled. (1) The capital requirement for specific risk for a first-to-default credit derivative is the lesser of: (a) the sum of the specific risk capital requirements for the individual reference credit instruments in the basket; and (b) the maximum possible credit event payment under the contract. (2) Where a bank has a risk position in one of the reference credit instruments underlying a first-to-default credit derivative and this credit derivative hedges the bank’s risk position, the bank is allowed to reduce, with respect to the hedged amount, both the capital requirement for specific risk for the reference credit instrument and that part of the capital requirement for specific risk for the credit derivative that relates to this particular reference credit instrument. Where a bank has multiple risk positions in reference credit instruments underlying a first-to-default credit derivative, this offset is allowed only for that underlying reference credit instrument having the lowest specific risk capital requirement. (3) The capital requirement for specific risk for an nth-to-default credit derivative with n greater than one is the lesser of: (a) the sum of the specific risk capital requirements for the individual reference credit instruments in the basket but disregarding the (n-1) obligations with the lowest specific risk capital requirements; and (b) the maximum possible credit event payment under the contract. For nth-to- default credit derivatives with n greater than 1, no offset of the capital requirement for specific risk with any underlying reference credit instrument is allowed. (4) If a first or other nth-to-default credit derivative is externally rated, then the protection seller must calculate the specific risk capital requirement using the rating of the derivative and apply the respective securitisation risk weights as specified in [14.14], as applicable. (5) The capital requirement against each net nth-to-default credit derivative position applies irrespective of whether the bank has a long or short position, ie obtains or provides protection. The framework mentions only tranches and nth-to-default products explicitly, but not nth to n+m-th-to-default products (eg the value depends on the default of the 5th, 6th, 7th and 8th default in a pool; only in specific cases such as the same nominal for all underlyings can this product be represented by, for example, a 5% to 8% tranche). The nth to n+m-th-to- default products are covered in the framework, such products are to be decomposed into individual nth-to-default products and the rules for nth-to-default products in [14.21] apply. In the example cited above, the capital requirement for a basket default swap covering defaults five to eight would be calculated as the sum of the capital requirements for a 5th- to-default swap, a 6th-to-default swap, a 7th-to-default swap and an 8th-to-default swap.