of Credit Derivatives
Derivatives: Market Info and awareness
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BIS II proposals
on credit derivatives
The BIS has issued the 3rd (and possibly the final) consultative paper on 29th April 2003 which made elaborate provisions on risk mitigations in general including credit derivatives. Most of these changes have been retained in the final draft.
The essential approach of the Basle II on credit derivatives is substitution approach - that is, the risk weight of the protection seller substitutes the risk weight of the underlying asset.
The new guidelines put in extensive eligibility conditions for the protection seller, have dropped restructuring to be a credit event in certain circumstances, have allowed asset mismatches in certain circumstances, etc.
By way of a general qualification, a credit derivative must be a direct claim on the protection seller and must be unconditional and irrevocable. The following are the further specific requirements in case of credit derivatives:
Asset mismatches, that is, the referece obligation in the credit derivative being diferent from hedged asset, the hedged asset and the reference obligation must be with the same obligor, and the reference obligation must be either ranking at par or junior to the hedged obligation.
Eligible protection sellers
The list of eligible protection providers is greatly expanded to include:
The capital charge is computed as usual by assigning the risk weight of the protection seller to the obligor.
Materiality thresholds are equivalent to the first loss, and are a deduction from capital straightaway.
The w factor contained in the initial drafts is not found in the April 2003 draft.
In case of tranched cover, that is, first loss, second loss or subsequent loss tranched out to different parties, the rules relating to securitisation framework will be applicable. As for securitisation framework, refer to our site http://vinodkothari.com.
This is the original write up before the CP3 issued in April 2003
BIS II refers to the revised standard on regulatory capital proposed by the Bank for International Settlements (BIS) in January 2001.
BIS-II lays down new criteria for credit derivatives to provide capital relief to the protection buyer and capital charge to the protection seller.
Para 117 to 145 of BIS -II provide for impact of guarantees and credit derivatives on bank capital.
As a general rule, no credit-protected exposure can lead to a higher capital requirement than identical asset which is unprotected. In other words, protection cannot be worse than the lack of it.
Basic qualifying conditions
The w factor
The w factor in case of credit derivatives is assumed to be 15%.
Computation of risk weightage
r* = w x r + (1 - w) x g
where r* is the adjusted risk weightage to be computed;
So, assuming the risk weightage of the protection seller is 20% and that of the obligor is 100%, the risk weightage of the protected transaction is:
= 15% x 100% + 85% x 20% = 32%
In case the protection is available for a part of the amount of an exposure, the part protected is subject to the above formula and the balance is treated as unprotected.
In case of tranched protection
If a bank transfers junior risk and retains senior risk, the extent of junior risk transferred is taken as protected and the senior risk is taken as unprotected, risk-weighted at the weightage applicable to the obligor.
For the protection proviver, assumption of junior or first-loss risk leads to a reduction from capital.
If the transferring bank retains junior risk and transfers senior risk, the junior risk is deducted from the capital of the protection seller. For the protection buyer, the risk weightage will be based on the weighted average of the risks of the protection buyer and the obligor, based on a w factor of 15%.
These definitions are not exactly the same as the ISDA definitions - for comparision, see our page here.
As per BIS, only credit default swaps and total rate of return swaps qualify for protection.