Basel II

INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS:

A REVISED FRAMEWORK - COMPREHENSIVE VERSION: JUNE 2006

BASEL COMMITTEE ON BANKING SUPERVISION

Part 2: The First Pillar – Minimum Capital Requirements

II. Credit Risk – The Standardised Approach

50. The Committee permits banks a choice between two broad methodologies for calculating their capital requirements for credit risk. One alternative, the Standardised Approach, will be to measure credit risk in a standardised manner, supported by external credit assessments.¹⁴

¹⁴ The notations follow the methodology used by one institution, Standard & Poor’s. the use of Standard & Poor’s credit ratings is an example only; those of some other external credit assessment institutions could equally well be used. The ratings used throughout this document, therefore, do not express any preferences or determinations on external assessment institutions by the Committee.

51. The other alternative, the Internal Ratings-based Approach, which is subject to the explicit approval of the bank’s supervisor, would allow banks to use their internal rating systems for credit risk.

52. The following section sets out revisions to the 1988 Accord for risk weighting banking book exposures. Exposures that are not explicitly addressed in this section will retain the current treatment; however, exposures related to securitisation are dealt with in Section IV. Furthermore, the credit equivalent amount of Securities Financing Transactions (SFT)¹⁵ and OTC derivatives that expose a bank to counterparty credit risk¹⁶ is to be calculated under the rules set forth in Annex 4¹⁷. In determining the risk weights in the standardised approach, banks may use assessments by external credit assessment institutions recognised as eligible for capital purposes by national supervisors in accordance with the criteria defined in paragraphs 90 and 91. Exposures should be risk-weighted net of specific provisions.¹⁸

¹⁵ Securities Financing Transactions (SFT) are transactions such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on the market valuations and the transactions are often subject to margin agreements.

¹⁶ The counterparty credit risk is defined as the risk that the counterparty to a transaction could default before the final settlement of the transaction’s cash flows. An economic loss would occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default. Unlike a firm’s exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending bank faces the risk of loss, the counterparty credit risk creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction. The market value is uncertain and can vary over time with the movement of underlying market factors.

¹⁷ Annex 4 of this Framework is based on the treatment of counterparty credit risk set out in Part 1 of the Committee’s paper The Application of Basel II to Trading Activities and the Treatment of Double Default Effects (July 2005).

¹⁸ A simplified standardised approach is outlined in Annex 11.

A. Individual claims.

1. Claims on sovereigns.

53. Claims on sovereigns and their central banks will be risk weighted as follows:

Credit Assessment	AAA to AA-	A+ to A-	BBB+ to BBB-	BB+ to B-	Below B-	Unrated
Risk Weight	0%	20%	50%	100%	150%	100%

54. At national discretion, a lower risk weight may be applied to banks’ exposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded¹⁹ in that currency.²⁰ Where this discretion is exercised, other national supervisory authorities may also permit their banks to apply the same risk weight to domestic currency exposures to this sovereign (or central bank) funded in that currency.

¹⁹ This is to say that the bank would also have corresponding liabilities denominated in the domestic currency.

²⁰ This lower risk weight may be extended to the risk weighting of collateral and guarantees. See Sections II.D.3 and II.D.5.

55. For the purpose of risk weighting claims on sovereigns, supervisors may recognise the country risk scores assigned by Export Credit Agencies (ECAs). To qualify, an ECA must publish its risk scores and subscribe to the OECD agreed methodology. Banks may choose to use the risk scores published by individual ECAs that are recognised by their supervisor, or the consensus risk scores of ECAs participating in the “Arrangement on Officially Supported Export Credits”.²¹ The OECD agreed methodology establishes eight risk score categories associated with minimum export insurance premiums. These ECA risk scores will correspond to risk weight categories as detailed below.

²¹ The consensus country risk classification is available on the OECD’s website (http://www.oecd.org) in the Export Credit Arrangement web-page of the Trade Directorate.

ECA risk scores	0-1	2	3	4 to 6	7
Risk Weight	0%	20%	50%	100%	150%

56. Claims on the Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community may receive a 0% risk weight.

2. Claims on non-central government public sector entities (PSEs).

57. Claims on domestic PSEs will be risk-weighted at national discretion, according to either option 1 or option 2 for claims on banks.²² When option 2 is selected, it is to be applied without the use of the preferential treatment for short-term claims.

²² This is regardless of the option chosen at national discretion for claims on banks of that country. It therefore does not imply that when one option has been chosen for claims on banks, the same option should also be applied to claims on PSEs.

58. Subject to national discretion, claims on certain domestic PSEs may also be treated as claims on the sovereigns in whose jurisdictions the PSEs are established.²³ Where this discretion is exercised, other national supervisors may allow their banks to risk weight claims on such PSEs in the same manner.

²³ The following examples outline how PSEs might be categorised when focusing on one specific feature, namely revenue raising powers. However, there may be other ways of determining the different treatments applicable to different types of PSEs, for instance by focusing on the extent of guarantees provided by the central government:

- Regional governments and local authorities could qualify for the same treatment as claims on their sovereign or central government if these governments and local authorities have specific revenue raising powers and have specific institutional arrangements the effect of which is to reduce their risks of default.

- Administrative bodies responsible to central governments, regional governments or to local authorities and other non-commercial undertakings owned by the governments or local authorities may not warrant the same treatment as claims on their sovereign if the entities do not have revenue raising powers or other arrangements as described above. If strict lending rules apply to these entities and a declaration of bankruptcy is not possible because of their special public status, it may be appropriate to treat these claims in the same manner as claims on banks.

- Commercial undertakings owned by central governments, regional governments or by local authorities may be treated as normal commercial enterprises. However, if these entities function as a corporate in competitive markets even though the state, a regional authority or a local authority is the major shareholder of these entities, supervisors should decide to consider them as corporates and therefore attach to them the applicable risk weights.

3. Claims on multilateral development banks (MDBs).

59. The risk weights applied to claims on MDBs will generally be based on external credit assessments as set out under option 2 for claims on banks but without the possibility of using the preferential treatment for short-term claims. A 0% risk weight will be applied to claims on highly rated MDBs that fulfil to the Committee’s satisfaction the criteria provided below.²⁴ The Committee will continue to evaluate eligibility on a case-by-case basis. The eligibility criteria for MDBs risk weighted at 0% are:

²⁴ MDBs currently eligible for a 0% risk weight are: the World Bank Group comprised of the International Bank for Reconstruction and Development (IBRD) and the International Finance Corporation (IFC), the Asian Development Bank (ADB), the African Development Bank (AfDB), the European Bank for Reconstruction and Development (EBRD), the Inter-American Development Bank (IADB), the European Investment Bank (EIB), the European Investment Fund (EIF), the Nordic Investment Bank (NIB), the Caribbean Development Bank (CDB), the Islamic Development Bank (IDB), and the Council of Europe Development Bank (CEDB).

• very high quality long-term issuer ratings, i.e. a majority of an MDB’s external assessments must be AAA;

• shareholder structure is comprised of a significant proportion of sovereigns with long-term issuer credit assessments of AA- or better, or the majority of the MDB’s fund-raising are in the form of paid-in equity/capital and there is little or no leverage;

• strong shareholder support demonstrated by the amount of paid-in capital contributed by the shareholders; the amount of further capital the MDBs have the right to call, if required, to repay their liabilities; and continued capital contributions and new pledges from sovereign shareholders;

• adequate level of capital and liquidity (a case-by-case approach is necessary in order to assess whether each MDB’s capital and liquidity are adequate); and,

• strict statutory lending requirements and conservative financial policies, which would include among other conditions a structured approval process, internal creditworthiness and risk concentration limits (per country, sector, and individual exposure and credit category), large exposures approval by the board or a committee of the board, fixed repayment schedules, effective monitoring of use of proceeds, status review process, and rigorous assessment of risk and provisioning to loan loss reserve.

4. Claims on banks.

60. There are two options for claims on banks. National supervisors will apply one option to all banks in their jurisdiction. No claim on an unrated bank may receive a risk weight lower than that applied to claims on its sovereign of incorporation.

61. Under the first option, all banks incorporated in a given country will be assigned a risk weight one category less favourable than that assigned to claims on the sovereign of that country. However, for claims on banks in countries with sovereigns rated BB+ to B- and on banks in unrated countries the risk weight will be capped at 100%.

62. The second option bases the risk weighting on the external credit assessment of the bank itself with claims on unrated banks being risk-weighted at 50%. Under this option, a preferential risk weight that is one category more favourable may be applied to claims with an original maturity²⁵ of three months or less, subject to a floor of 20%. This treatment will be available to both rated and unrated banks, but not to banks risk weighted at 150%.

²⁵ Supervisors should ensure that claims with (contractual) original maturity under 3 months which are expected to be rolled over (i.e. where the effective maturity is longer than 3 months) do not qualify for this preferential treatment for capital adequacy purposes.

63. The two options are summarised in the tables below.

Option 1

Credit assessment of Sovereign	AAA to AA-	A+ to A-	BBB+ to BBB-	BB+ to B-	Below B-	Unrated
Risk weight under Option 1	20%	50%	100%	100%	150%	100%

Option 2

Credit assessment of Banks	AAA to AA-	A+ to A-	BBB+ to BBB-	BB+ to B-	Below B-	Unrated
Risk weight under Option 2	20%	50%	50%	100%	150%	50%
Risk weight for short-term claims26under Option 2	20%	20%	20%	50%	150%	20%

²⁶ Short-term claims in Option 2 are defined as having an original maturity of three months or less. These tables do not reflect the potential preferential risk weights for domestic currency claims that banks may be allowed to apply based on paragraph 64.

64. When the national supervisor has chosen to apply the preferential treatment for claims on the sovereign as described in paragraph 54, it can also assign, under both options 1 and 2, a risk weight that is one category less favourable than that assigned to claims on the sovereign, subject to a floor of 20%, to claims on banks of an original maturity of 3 months or less denominated and funded in the domestic currency.

5. Claims on securities firms.

65. Claims on securities firms may be treated as claims on banks provided these firms are subject to supervisory and regulatory arrangements comparable to those under this Framework (including, in particular, risk-based capital requirements).²⁷ Otherwise such claims would follow the rules for claims on corporates.

²⁷ That is, capital requirements that are comparable to those applied to banks in this Framework. Implicit in the meaning of the word “comparable” is that the securities firm (but not necessarily its parent) is subject to consolidated regulation and supervision with respect to any downstream affiliates.

6. Claims on corporates.

66. The table provided below illustrates the risk weighting of rated corporate claims, including claims on insurance companies. The standard risk weight for unrated claims on corporates will be 100%. No claim on an unrated corporate may be given a risk weight preferential to that assigned to its sovereign of incorporation.

Credit assessment	AAA to AA-	A+ to A-	BBB+ to BB-	Below BB-	Unrated
Risk weight	20%	50%	100%	150%	100%

67. Supervisory authorities should increase the standard risk weight for unrated claims where they judge that a higher risk weight is warranted by the overall default experience in their jurisdiction. As part of the supervisory review process, supervisors may also consider whether the credit quality of corporate claims held by individual banks should warrant a standard risk weight higher than 100%.

68. At national discretion, supervisory authorities may permit banks to risk weight all corporate claims at 100% without regard to external ratings. Where this discretion is exercised by the supervisor, it must ensure that banks apply a single consistent approach, i.e. either to use ratings wherever available or not at all. To prevent “cherry-picking” of external ratings, banks should obtain supervisory approval before utilising this option to risk weight all corporate claims at 100%.

7. Claims included in the regulatory retail portfolios.

69. Claims that qualify under the criteria listed in paragraph 70 may be considered as retail claims for regulatory capital purposes and included in a regulatory retail portfolio. Exposures included in such a portfolio may be risk-weighted at 75%, except as provided in paragraph 75 for past due loans.

70. To be included in the regulatory retail portfolio, claims must meet the following four criteria:

• Orientation criterion ─ The exposure is to an individual person or persons or to a small business;

• Product criterion ─ The exposure takes the form of any of the following: revolving credits and lines of credit (including credit cards and overdrafts), personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance) and small business facilities and commitments. Securities (such as bonds and equities), whether listed or not, are specifically excluded from this category. Mortgage loans are excluded to the extent that they qualify for treatment as claims secured by residential property (see paragraph 72).

• Granularity criterion ─ The supervisor must be satisfied that the regulatory retail portfolio is sufficiently diversified to a degree that reduces the risks in the portfolio, warranting the 75% risk weight. One way of achieving this may be to set a numerical limit that no aggregate exposure to one counterpart²⁸ can exceed 0.2% of the overall regulatory retail portfolio.

²⁸ Aggregated exposure means gross amount (i.e. not taking any credit risk mitigation into account) of all forms of debt exposures (e.g. loans or commitments) that individually satisfy the three other criteria. In addition, “to one counterpart” means one or several entities that may be considered as a single beneficiary (e.g. in the case of a small business that is affiliated to another small business, the limit would apply to the bank’s aggregated exposure on both businesses).

• Low value of individual exposures. The maximum aggregated retail exposure to one counterpart cannot exceed an absolute threshold of €1 million.

71. National supervisory authorities should evaluate whether the risk weights in paragraph 69 are considered to be too low based on the default experience for these types of exposures in their jurisdictions. Supervisors, therefore, may require banks to increase these risk weights as appropriate.

8. Claims secured by residential property.

72. Lending fully secured by mortgages on residential property that is or will be occupied by the borrower, or that is rented, will be risk weighted at 35%. In applying the 35% weight, the supervisory authorities should satisfy themselves, according to their national arrangements for the provision of housing finance, that this concessionary weight is applied restrictively for residential purposes and in accordance with strict prudential criteria, such as the existence of substantial margin of additional security over the amount of the loan based on strict valuation rules. Supervisors should increase the standard risk weight where they judge the criteria are not met.

73. National supervisory authorities should evaluate whether the risk weights in paragraph 72 are considered to be too low based on the default experience for these types of exposures in their jurisdictions. Supervisors, therefore, may require banks to increase these risk weights as appropriate.

9. Claims secured by commercial real estate.

74. In view of the experience in numerous countries that commercial property lending has been a recurring cause of troubled assets in the banking industry over the past few decades, the Committee holds to the view that mortgages on commercial real estate do not, in principle, justify other than a 100% weighting of the loans secured.²⁹

²⁹ The Committee, however, recognises that, in exceptional circumstances for well-developed and longestablished markets, mortgages on office and/or multi-purpose commercial premises and/or multi-tenanted commercial premises may have the potential to receive a preferential risk weight of 50% for the tranche of the loan that does not exceed the lower of 50% of the market value or 60% of the mortgage lending value of the property securing the loan. Any exposure beyond these limits will receive a 100% risk weight. This exceptional treatment will be subject to very strict conditions. In particular, two tests must be fulfilled, namely that (i) losses stemming from commercial real estate lending up to the lower of 50% of the market value or 60% of loan-to-value (LTV) based on mortgage-lending-value (MLV) must not exceed 0.3% of the outstanding loans in any given year; and that (ii) overall losses stemming from commercial real estate lending must not exceed 0.5% of the outstanding loans in any given year. This is, if either of these tests is not satisfied in a given year, the eligibility to use this treatment will cease and the original eligibility criteria would need to be satisfied again before it could be applied in the future. Countries applying such a treatment must publicly disclose that these and other additional conditions (that are available from the Basel Committee Secretariat) are met. When claims benefiting from such an exceptional treatment have fallen past due, they will be risk-weighted at 100%.

10. Past due loans.

75. The unsecured portion of any loan (other than a qualifying residential mortgage loan) that is past due for more than 90 days, net of specific provisions (including partial writeoffs), will be risk-weighted as follows: 30.³⁰

³⁰ Subject to national discretion, supervisors may permit banks to treat non-past due loans extended to counterparties subject to a 150% risk weight in the same way as past due loans described in paragraphs 75 to 77.

• 150% risk weight when specific provisions are less than 20% of the outstanding amount of the loan;

• 100% risk weight when specific provisions are no less than 20% of the outstanding amount of the loan;

• 100% risk weight when specific provisions are no less than 50% of the outstanding amount of the loan, but with supervisory discretion to reduce the risk weight to 50%.

76. For the purpose of defining the secured portion of the past due loan, eligible collateral and guarantees will be the same as for credit risk mitigation purposes (see Section II.B).³¹ Past due retail loans are to be excluded from the overall regulatory retail portfolio when assessing the granularity criterion specified in paragraph 70, for risk-weighting purposes.

³¹ There will be a transitional period of three years during which a wider range of collateral may be recognised, subject to national discretion.

77. In addition to the circumstances described in paragraph 75, where a past due loan is fully secured by those forms of collateral that are not recognised in paragraphs 145 and 146, a 100% risk weight may apply when provisions reach 15% of the outstanding amount of the loan. These forms of collateral are not recognised elsewhere in the standardised approach. Supervisors should set strict operational criteria to ensure the quality of collateral.

78. In the case of qualifying residential mortgage loans, when such loans are past due for more than 90 days they will be risk weighted at 100%, net of specific provisions. If such loans are past due but specific provisions are no less than 20% of their outstanding amount, the risk weight applicable to the remainder of the loan can be reduced to 50% at national discretion.

11. Higher-risk categories.

79. The following claims will be risk weighted at 150% or higher:

• Claims on sovereigns, PSEs, banks, and securities firms rated below B-.

• Claims on corporates rated below BB-.

• Past due loans as set out in paragraph 75.

• Securitisation tranches that are rated between BB+ and BB- will be risk weighted at 350% as set out in paragraph 567.

80. National supervisors may decide to apply a 150% or higher risk weight reflecting the higher risks associated with some other assets, such as venture capital and private equity investments.

12. Other assets.

81. The treatment of securitisation exposures is presented separately in Section IV. The standard risk weight for all other assets will be 100%.³² Investments in equity or regulatory capital instruments issued by banks or securities firms will be risk weighted at 100%, unless deducted from the capital base according to Part 1.

³² However, at national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities can be treated as cash and therefore risk-weighted at 0%. In addition, cash items in the process of collection can be risk-weighted at 20%.

13. Off-balance sheet items.

82. Off-balance-sheet items under the standardised approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF). Counterparty risk weightings for OTC derivative transactions will not be subject to any specific ceiling.

83. Commitments with an original maturity up to one year and commitments with an original maturity over one year will receive a CCF of 20% and 50%, respectively. However, any commitments that are unconditionally cancellable at any time by the bank without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower’s creditworthiness, will receive a 0% CCF.³³

³³ In certain countries, retail commitments are considered unconditionally cancellable if the terms permit the bank to cancel them to the full extent allowable under consumer protection and related legislation.

83(i). Direct credit substitutes, e.g. general guarantees of indebtedness (including standby letters of credit serving as financial guarantees for loans and securities) and acceptances (including endorsements with the character of acceptances) will receive a CCF of 100%.

83(ii). Sale and repurchase agreements and asset sales with recourse,³⁴ where the credit risk remains with the bank will receive a CCF of 100%.

³⁴ These items are to be weighted according to the type of asset and not according to the type of counterparty with whom the transaction has been entered into.

84(i). Forward asset purchases, forward forward deposits and partly-paid shares and securities³⁵, which represent commitments with certain drawdown will receive a CCF of 100%.

³⁵ These items are to be weighted according to the type of asset and not according to the type of counterparty with whom the transaction has been entered into.

84(ii). Certain transaction-related contingent items (e.g. performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions) will receive a CCF of 50%.

85. For short-term self-liquidating trade letters of credit arising from the movement of goods (e.g. documentary credits collateralised by the underlying shipment), a 20% CCF will be applied to both issuing and confirming banks.

86. Where there is an undertaking to provide a commitment on an off-balance sheet item, banks are to apply the lower of the two applicable CCFs.

87. The credit equivalent amount of OTC derivatives and SFTs that expose a bank to counterparty credit risk is to be calculated under the rules set forth in Annex 4 of this Framework.

88. Banks must closely monitor securities, commodities, and foreign exchange transactions that have failed, starting the first day they fail. A capital charge to failed transactions must be calculated in accordance with Annex 3 of this Framework.

89. With regard to unsettled securities, commodities, and foreign exchange transactions, the Committee is of the opinion that banks are exposed to counterparty credit risk from trade date, irrespective of the booking or the accounting of the transaction. Therefore, banks are encouraged to develop, implement and improve systems for tracking and monitoring the credit risk exposure arising from unsettled transactions as appropriate for producing management information that facilitates action on a timely basis. Furthermore, when such transactions are not processed through a delivery-versus-payment (DvP) or payment-versus-payment (PvP) mechanism, banks must calculate a capital charge as set forth in Annex 3 of this Framework.

B. External credit assessment.

1. The recognition process.

90. National supervisors are responsible for determining whether an external credit assessment institution (ECAI) meets the criteria listed in the paragraph below. The assessments of ECAIs may be recognised on a limited basis, e.g. by type of claims or by jurisdiction. The supervisory process for recognising ECAIs should be made public to avoid unnecessary barriers to entry.

2. Eligibility criteria.

91. An ECAI must satisfy each of the following six criteria.

• Objectivity: The methodology for assigning credit assessments must be rigorous, systematic, and subject to some form of validation based on historical experience. Moreover, assessments must be subject to ongoing review and responsive to changes in financial condition. Before being recognised by supervisors, an assessment methodology for each market segment, including rigorous backtesting, must have been established for at least one year and preferably three years.

• Independence: An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. The assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating a conflict of interest.

• International access/Transparency: The individual assessments should be available to both domestic and foreign institutions with legitimate interests and at equivalent terms. In addition, the general methodology used by the ECAI should be publicly available.

• Disclosure: An ECAI should disclose the following information: its assessment methodologies, including the definition of default, the time horizon, and the meaning of each rating; the actual default rates experienced in each assessment category; and the transitions of the assessments, e.g. the likelihood of AA ratings becoming A over time.

• Resources: An ECAI should have sufficient resources to carry out high quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add value to the credit assessments. Such assessments should be based on methodologies combining qualitative and quantitative approaches.

• Credibility: To some extent, credibility is derived from the criteria above. In addition, the reliance on an ECAI’s external credit assessments by independent parties (investors, insurers, trading partners) is evidence of the credibility of the assessments of an ECAI. The credibility of an ECAI is also underpinned by the existence of internal procedures to prevent the misuse of confidential information. In order to be eligible for recognition, an ECAI does not have to assess firms in more than one country.

C. Implementation considerations.

1. The mapping process.

92. Supervisors will be responsible for assigning eligible ECAIs’ assessments to the risk weights available under the standardised risk weighting framework, i.e. deciding which assessment categories correspond to which risk weights. The mapping process should be objective and should result in a risk weight assignment consistent with that of the level of credit risk reflected in the tables above. It should cover the full spectrum of risk weights.

93. When conducting such a mapping process, factors that supervisors should assess include, among others, the size and scope of the pool of issuers that each ECAI covers, the range and meaning of the assessments that it assigns, and the definition of default used by the ECAI. In order to promote a more consistent mapping of assessments into the available risk weights and help supervisors in conducting such a process, Annex 2 provides guidance as to how such a mapping process may be conducted.

94. Banks must use the chosen ECAIs and their ratings consistently for each type of claim, for both risk weighting and risk management purposes. Banks will not be allowed to “cherry-pick” the assessments provided by different ECAIs.

95. Banks must disclose ECAIs that they use for the risk weighting of their assets by type of claims, the risk weights associated with the particular rating grades as determined by supervisors through the mapping process as well as the aggregated risk-weighted assets for each risk weight based on the assessments of each eligible ECAI.

2. Multiple assessments.

96. If there is only one assessment by an ECAI chosen by a bank for a particular claim, that assessment should be used to determine the risk weight of the claim.

97. If there are two assessments by ECAIs chosen by a bank which map into different risk weights, the higher risk weight will be applied.

98. If there are three or more assessments with different risk weights, the assessments corresponding to the two lowest risk weights should be referred to and the higher of those two risk weights will be applied.

3. Issuer versus issues assessment.

99. Where a bank invests in a particular issue that has an issue-specific assessment, the risk weight of the claim will be based on this assessment. Where the bank’s claim is not an investment in a specific assessed issue, the following general principles apply.

• In circumstances where the borrower has a specific assessment for an issued debt — but the bank’s claim is not an investment in this particular debt — a high quality credit assessment (one which maps into a risk weight lower than that which applies to an unrated claim) on that specific debt may only be applied to the bank’s unassessed claim if this claim ranks pari passu or senior to the claim with an assessment in all respects. If not, the credit assessment cannot be used and the unassessed claim will receive the risk weight for unrated claims.

• In circumstances where the borrower has an issuer assessment, this assessment typically applies to senior unsecured claims on that issuer. Consequently, only senior claims on that issuer will benefit from a high quality issuer assessment. Other unassessed claims of a highly assessed issuer will be treated as unrated. If either the issuer or a single issue has a low quality assessment (mapping into a risk weight equal to or higher than that which applies to unrated claims), an unassessed claim on the same counterparty will be assigned the same risk weight as is applicable to the low quality assessment.

100. Whether the bank intends to rely on an issuer- or an issue-specific assessment, the assessment must take into account and reflect the entire amount of credit risk exposure the bank has with regard to all payments owed to it.³⁶

³⁶ For example, if a bank is owed both principal and interest, the assessment must fully take into account and reflect the credit risk associated with repayment of both principal and interest.

101. In order to avoid any double counting of credit enhancement factors, no supervisory recognition of credit risk mitigation techniques will be taken into account if the credit enhancement is already reflected in the issue specific rating (see paragraph 114).

4. Domestic currency and foreign currency assessments.

102. Where unrated exposures are risk weighted based on the rating of an equivalent exposure to that borrower, the general rule is that foreign currency ratings would be used for exposures in foreign currency. Domestic currency ratings, if separate, would only be used to risk weight claims denominated in the domestic currency.³⁷

³⁷ However, when an exposure arises through a bank’s participation in a loan that has been extended, or has been guaranteed against convertibility and transfer risk, by certain MDBs, its convertibility and transfer risk can be considered by national supervisory authorities to be effectively mitigated. To qualify, MDBs must have preferred creditor status recognised in the market and be included in footnote 24. In such cases, for risk weighting purposes, the borrower’s domestic currency rating may be used instead of its foreign currency rating. In the case of a guarantee against convertibility and transfer risk, the local currency rating can be used only for the portion that has been guaranteed. The portion of the loan not benefiting from such a guarantee will be risk-weighted based on the foreign currency rating.

5. Short-term/long-term assessments.

103. For risk-weighting purposes, short-term assessments are deemed to be issuespecific. They can only be used to derive risk weights for claims arising from the rated facility. They cannot be generalised to other short-term claims, except under the conditions of paragraph 105. In no event can a short-term rating be used to support a risk weight for an unrated long-term claim. Short-term assessments may only be used for short-term claims against banks and corporates. The table below provides a framework for banks’ exposures to specific short-term facilities, such as a particular issuance of commercial paper:

Credit assessment	A-1/P-138	A-2/P-2	A-3/P-3	Others39
Risk weight	20%	50%	100%	150%

³⁸ The notations follow the methodology used by Standard & Poor’s and by Moody’s Investors Service. The A-1 rating of Standard & Poor’s includes both A-1+ and A-1-.

³⁹ This category includes all non-prime and B or C ratings.

104. If a short-term rated facility attracts a 50% risk-weight, unrated short-term claims cannot attract a risk weight lower than 100%. If an issuer has a short-term facility with an assessment that warrants a risk weight of 150%, all unrated claims, whether long-term or short-term, should also receive a 150% risk weight, unless the bank uses recognised credit risk mitigation techniques for such claims.

105. In cases where national supervisors have decided to apply option 2 under the standardised approach to short term interbank claims to banks in their jurisdiction, the interaction with specific short-term assessments is expected to be the following:

• The general preferential treatment for short-term claims, as defined under paragraphs 62 and 64, applies to all claims on banks of up to three months original maturity when there is no specific short-term claim assessment.

• When there is a short-term assessment and such an assessment maps into a risk weight that is more favourable (i.e. lower) or identical to that derived from the general preferential treatment, the short-term assessment should be used for the specific claim only. Other short-term claims would benefit from the general preferential treatment.

• When a specific short-term assessment for a short term claim on a bank maps into a less favourable (higher) risk weight, the general short-term preferential treatment for interbank claims cannot be used. All unrated short-term claims should receive the same risk weighting as that implied by the specific short-term assessment.

106. When a short-term assessment is to be used, the institution making the assessment needs to meet all of the eligibility criteria for recognising ECAIs as presented in paragraph 91 in terms of its short-term assessment.

6. Level of application of the assessment.

107. External assessments for one entity within a corporate group cannot be used to risk weight other entities within the same group.

7. Unsolicited ratings.

108. As a general rule, banks should use solicited ratings from eligible ECAIs. National supervisory authorities may, however, allow banks to use unsolicited ratings in the same way as solicited ratings. However, there may be the potential for ECAIs to use unsolicited ratings to put pressure on entities to obtain solicited ratings. Such behaviour, when identified, should cause supervisors to consider whether to continue recognising such ECAIs as eligible for capital adequacy purposes.

D. The standardised approach - credit risk mitigation.

1. Overarching issues.

(i) Introduction

109. Banks use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralised by first priority claims, in whole or in part with cash or securities, a loan exposure may be guaranteed by a third party, or a bank may buy a credit derivative to offset various forms of credit risk. Additionally banks may agree to net loans owed to them against deposits from the same counterparty.

110. Where these techniques meet the requirements for legal certainty as described in paragraph 117 and 118 below, the revised approach to CRM allows a wider range of credit risk mitigants to be recognised for regulatory capital purposes than is permitted under the 1988 Accord.

(ii) General remarks

111. The framework set out in this Section II is applicable to the banking book exposures in the standardised approach. For the treatment of CRM in the IRB approach, see Section III.

112. The comprehensive approach for the treatment of collateral (see paragraphs 130 to 138 and 145 to 181) will also be applied to calculate the counterparty risk charges for OTC derivatives and repo-style transactions booked in the trading book.

113. No transaction in which CRM techniques are used should receive a higher capital requirement than an otherwise identical transaction where such techniques are not used.

114. The effects of CRM will not be double counted. Therefore, no additional supervisory recognition of CRM for regulatory capital purposes will be granted on claims for which an issue-specific rating is used that already reflects that CRM. As stated in paragraph 100 of the section on the standardised approach, principal-only ratings will also not be allowed within the framework of CRM.

115. While the use of CRM techniques reduces or transfers credit risk, it simultaneously may increase other risks (residual risks). Residual risks include legal, operational, liquidity and market risks. Therefore, it is imperative that banks employ robust procedures and processes to control these risks, including strategy; consideration of the underlying credit; valuation; policies and procedures; systems; control of roll-off risks; and management of concentration risk arising from the bank’s use of CRM techniques and its interaction with the bank’s overall credit risk profile. Where these risks are not adequately controlled, supervisors may impose additional capital charges or take other supervisory actions as outlined in Pillar 2.

116. The Pillar 3 requirements must also be observed for banks to obtain capital relief in respect of any CRM techniques.

(iii) Legal certainty

117. In order for banks to obtain capital relief for any use of CRM techniques, the following minimum standards for legal documentation must be met.

118. All documentation used in collateralised transactions and for documenting onbalance sheet netting, guarantees and credit derivatives must be binding on all parties and legally enforceable in all relevant jurisdictions. Banks must have conducted sufficient legal review to verify this and have a well founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability.

2. Overview of Credit Risk Mitigation Techniques⁴⁰.

⁴⁰ See Annex 10 for an overview of methodologies for the capital treatment of transactions secured by financial collateral under the standardised and IRB approaches.

(i) Collateralised transactions

119. A collateralised transaction is one in which:

• banks have a credit exposure or potential credit exposure; and

• that credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty⁴¹ or by a third party on behalf of the counterparty.

⁴¹ In this section “counterparty” is used to denote a party to whom a bank has an on- or off-balance sheet credit exposure or a potential 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 OTC derivatives contract.

120. Where banks take eligible financial collateral (e.g. cash or securities, more specifically defined in paragraphs 145 and 146 below), they are allowed to reduce their credit exposure to a counterparty when calculating their capital requirements to take account of the risk mitigating effect of the collateral.

Overall framework and minimum conditions

121. Banks may opt for either the simple approach, which, similar to the 1988 Accord, substitutes the risk weighting of the collateral for the risk weighting of the counterparty for the collateralised portion of the exposure (generally subject to a 20% floor), or for the comprehensive approach, which allows fuller offset of collateral against exposures, by effectively reducing the exposure amount by the value ascribed to the collateral. Banks may operate under either, but not both, approaches in the banking book, but only under the comprehensive approach in the trading book. Partial collateralisation is recognised in both approaches. Mismatches in the maturity of the underlying exposure and the collateral will only be allowed under the comprehensive approach.

122. However, before capital relief will be granted in respect of any form of collateral, the standards set out below in paragraphs 123 to 126 must be met under either approach.

123. In addition to the general requirements for legal certainty set out in paragraphs 117 and 118, the legal mechanism by which collateral is pledged or transferred must ensure that the bank has the right to liquidate or take legal possession of it, in a timely manner, in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Furthermore banks must take all steps necessary to fulfil those requirements under the law applicable to the bank’s interest in the collateral for obtaining and maintaining an enforceable security interest, e.g. by registering it with a registrar, or for exercising a right to net or set off in relation to title transfer collateral.

124. In order for collateral to provide protection, the credit quality of the counterparty and the value of the collateral must not have a material positive correlation. For example, securities issued by the counterparty ─ or by any related group entity ─ would provide little protection and so would be ineligible.

125. Banks must have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly.

126. Where the collateral is held by a custodian, banks must take reasonable steps to ensure that the custodian segregates the collateral from its own assets.

127. A capital requirement will be applied to a bank on either side of the collateralised transaction: for example, both repos and reverse repos will be subject to capital requirements. Likewise, both sides of a securities lending and borrowing transaction will be subject to explicit capital charges, as will the posting of securities in connection with a derivative exposure or other borrowing.

128. Where a bank, acting as an agent, arranges a repo-style transaction (i.e. repurchase/reverse repurchase and securities lending/borrowing transactions) between a customer and a third party and provides a guarantee to the customer that the third party will perform on its obligations, then the risk to the bank is the same as if the bank had entered into the transaction as a principal. In such circumstances, a bank will be required to calculate capital requirements as if it were itself the principal.

The simple approach

129. In the simple approach the risk weighting of the collateral instrument collateralising or partially collateralising the exposure is substituted for the risk weighting of the counterparty. Details of this framework are provided in paragraphs 182 to 185.

The comprehensive approach

130. In the comprehensive approach, when taking collateral, banks will need to calculate their adjusted exposure to a counterparty for capital adequacy purposes in order to take account of the effects of that collateral. Using haircuts, banks are required to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either,⁴² occasioned by market movements. This will produce volatility adjusted amounts for both exposure and collateral. Unless either side of the transaction is cash, the volatility adjusted amount for the exposure will be higher than the exposure and for the collateral it will be lower.

⁴² Exposure amounts may vary where, for example, securities are being lent.

131. Additionally where the exposure and collateral are held in different currencies an additional downwards adjustment must be made to the volatility adjusted collateral amount to take account of possible future fluctuations in exchange rates.

132. Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral amount (including any further adjustment for foreign exchange risk), banks shall calculate their risk-weighted assets as the difference between the two multiplied by the risk weight of the counterparty. The framework for performing these calculations is set out in paragraphs 147 to 150.

133. In principle, banks have two ways of calculating the haircuts: (i) standard supervisory haircuts, using parameters set by the Committee, and (ii) own-estimate haircuts, using banks’ own internal estimates of market price volatility. Supervisors will allow banks to use own-estimate haircuts only when they fulfil certain qualitative and quantitative criteria.

134. A bank may choose to use standard or own-estimate haircuts independently of the choice it has made between the standardised approach and the foundation IRB approach to credit risk. However, if banks seek to use their own-estimate haircuts, they must do so for the full range of instrument types for which they would be eligible to use own-estimates, the exception being immaterial portfolios where they may use the standard supervisory haircuts.

135. The size of the individual haircuts will depend on the type of instrument, type of transaction and the frequency of marking-to-market and remargining. For example, repostyle transactions subject to daily marking-to-market and to daily remargining will receive a haircut based on a 5-business day holding period and secured lending transactions with daily mark-to-market and no remargining clauses will receive a haircut based on a 20-business day holding period. These haircut numbers will be scaled up using the square root of time formula depending on the frequency of remargining or marking-to-market.

136. For certain types of repo-style transactions (broadly speaking government bond repos as defined in paragraphs 170 and 171) supervisors may allow banks using standard supervisory haircuts or own-estimate haircuts not to apply these in calculating the exposure amount after risk mitigation.

137. The effect of master netting agreements covering repo-style transactions can be recognised for the calculation of capital requirements subject to the conditions in paragraph 173.

138. As a further alternative to standard supervisory haircuts and own-estimate haircuts banks may use VaR models for calculating potential price volatility for repo-style transactions and other similar SFTs, as set out in paragraphs 178 to 181 (i) below. Alternatively, subject to supervisory approval, they may also calculate, for these transactions, an expected positive exposure, as set forth in Annex 4 of this Framework.

(ii) On-balance sheet netting

139. Where banks have legally enforceable netting arrangements for loans and deposits they may calculate capital requirements on the basis of net credit exposures subject to the conditions in paragraph 188.

(iii) Guarantees and credit derivatives

140. Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and supervisors are satisfied that banks fulfil certain minimum operational conditions relating to risk management processes they may allow banks to take account of such credit protection in calculating capital requirements.

141. A range of guarantors and protection providers are recognised. As under the 1988 Accord, a substitution approach will be applied. Thus only guarantees issued by or protection provided by entities with a lower risk weight than the counterparty will lead to reduced capital charges since the protected portion of the counterparty exposure is assigned the risk weight of the guarantor or protection provider, whereas the uncovered portion retains the risk weight of the underlying counterparty.

142. Detailed operational requirements are given below in paragraphs 189 to 193.

(iv) Maturity mismatch

143. Where the residual maturity of the CRM is less than that of the underlying credit exposure a maturity mismatch occurs. Where there is a maturity mismatch and the CRM has an original maturity of less than one year, the CRM is not recognised for capital purposes. In other cases where there is a maturity mismatch, partial recognition is given to the CRM for regulatory capital purposes as detailed below in paragraphs 202 to 205. Under the simple approach for collateral maturity mismatches will not be allowed.

(v) Miscellaneous

144. Treatments for pools of credit risk mitigants and first- and second-to-default credit derivatives are given in paragraphs 206 to 210 below.

3. Collateral

(i) Eligible financial collateral

145. The following collateral instruments are eligible for recognition in the simple approach:

(a) Cash (as well as certificates of deposit or comparable instruments issued by the lending bank) on deposit with the bank which is incurring the counterparty exposure.⁴³, ⁴⁴

⁴³ Cash funded credit linked notes issued by the bank against exposures in the banking book which fulfil the criteria for credit derivatives will be treated as cash collateralised transactions.

⁴⁴ When cash on deposit, certificates of deposit or comparable instruments issued by the lending bank are held as collateral at a third-party bank in a non-custodial arrangement, if they are openly pledged/assigned to the lending bank and if the pledge/assignment is unconditional and irrevocable, the exposure amount covered by the collateral (after any necessary haircuts for currency risk) will receive the risk weight of the third-party bank.

(b) Gold.

(c) Debt securities rated by a recognised external credit assessment institution where these are either:

• at least BB- when issued by sovereigns or PSEs that are treated as sovereigns by the national supervisor; or

• at least BBB- when issued by other entities (including banks and securities firms); or

• at least A-3/P-3 for short-term debt instruments.

(d) Debt securities not rated by a recognised external credit assessment institution where these are:

• issued by a bank; and

• listed on a recognised exchange; and

• classified as senior debt; and

• all rated issues of the same seniority by the issuing bank must be rated at least BBB- or A-3/P-3 by a recognised external credit assessment institution; and

• the bank holding the securities as collateral has no information to suggest that the issue justifies a rating below BBB- or A-3/P-3 (as applicable); and

• the supervisor is sufficiently confident about the market liquidity of the security.

(e) Equities (including convertible bonds) that are included in a main index.

(f) Undertakings for Collective Investments in Transferable Securities (UCITS) and mutual funds where:

• a price for the units is publicly quoted daily; and

• the UCITS/mutual fund is limited to investing in the instruments listed in this paragraph.⁴⁵

⁴⁵ However, the use or potential use by a UCITS/mutual fund of derivative instruments solely to hedge investments listed in this paragraph and paragraph 146 shall not prevent units in that UCITS/mutual fund from being eligible financial collateral.

146. The following collateral instruments are eligible for recognition in the comprehensive approach:

(a) All of the instruments in paragraph 145;

(b) Equities (including convertible bonds) which are not included in a main index but which are listed on a recognised exchange;

(c) UCITS/mutual funds which include such equities.

(ii) The comprehensive approach

Calculation of capital requirement

147. For a collateralised transaction, the exposure amount after risk mitigation is calculated as follows:

E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]}
where:

E* = the exposure value after risk mitigation

E = current value of the exposure

He = haircut appropriate to the exposure

C = the current value of the collateral received

Hc = haircut appropriate to the collateral

Hfx = haircut appropriate for currency mismatch between the collateral and exposure

148. The exposure amount after risk mitigation will be multiplied by the risk weight of the counterparty to obtain the risk-weighted asset amount for the collateralised transaction.

149. The treatment for transactions where there is a mismatch between the maturity of the counterparty exposure and the collateral is given in paragraphs 202 to 205.

150. Where the collateral is a basket of assets, the haircut on the basket will be where a_i is the weight of the assest (as measured by units of currency) in the basket and H_i the haircut applicable to that asset.

Standard supervisory haircuts

151. These are the standard supervisory haircuts (assuming daily mark-to-market, daily remargining and a 10-business day holding period), expressed as percentages:

⁴⁶ Includes PSEs which are treated as sovereigns by the national supervisor.

⁴⁷ Multilateral development banks receiving a 0% risk weight will be treated as sovereigns.

⁴⁸ Includes PSEs which are not treated as sovereigns by the national supervisor.

⁴⁹ Eligible cash collateral specified in paragraph 145 (a).

152. The standard supervisory haircut for currency risk where exposure and collateral are denominated in different currencies is 8% (also based on a 10-business day holding period and daily mark-to-market).

153. For transactions in which the bank lends non-eligible instruments (e.g. noninvestment grade corporate debt securities), the haircut to be applied on the exposure should be the same as the one for equity traded on a recognised exchange that is not part of a main index.

Own estimates for haircuts

154. Supervisors may permit banks to calculate haircuts using their own internal estimates of market price volatility and foreign exchange volatility. Permission to do so will be conditional on the satisfaction of minimum qualitative and quantitative standards stated in paragraphs 156 to 165. When debt securities are rated BBB-/A-3 or higher, supervisors may allow banks to calculate a volatility estimate for each category of security. In determining relevant categories, institutions must take into account (a) the type of issuer of the security, (b) its rating, (c) its residual maturity, and (d) its modified duration. Volatility estimates must be representative of the securities actually included in the category for that bank. For debt securities rated below BBB-/A-3 or for equities eligible as collateral (lightly shaded boxes in the above table), the haircuts must be calculated for each individual security.

155. Banks must estimate the volatility of the collateral instrument or foreign exchange mismatch individually: estimated volatilities for each transaction must not take into account the correlations between unsecured exposure, collateral and exchange rates (see paragraphs 202 to 205 for the approach to maturity mismatches).

Quantitative criteria

156. In calculating the haircuts, a 99^th percentile, one-tailed confidence interval is to be used.

157. The minimum holding period will be dependent on the type of transaction and the frequency of remargining or marking to market. The minimum holding periods for different types of transactions are presented in paragraph 167. Banks may use haircut numbers calculated according to shorter holding periods, scaled up to the appropriate holding period by the square root of time formula.

158. Banks must take into account the illiquidity of lower-quality assets. The holding period should be adjusted upwards in cases where such a holding period would be inappropriate given the liquidity of the collateral. They should also identify where historical data may understate potential volatility, e.g. a pegged currency. Such cases must be dealt with by subjecting the data to stress testing.

159. The choice of historical observation period (sample period) for calculating haircuts shall be a minimum of one year. For banks that use a weighting scheme or other methods for the historical observation period, the “effective” observation period must be at least one year (that is, the weighted average time lag of the individual observations cannot be less than 6 months).

160. Banks should update their data sets no less frequently than once every three months and should also reassess them whenever market prices are subject to material changes. This implies that haircuts must be computed at least every three months. The supervisor may also require a bank to calculate its haircuts using a shorter observation period if, in the supervisor's judgement, this is justified by a significant upsurge in price volatility.

161. No particular type of model is prescribed. So long as each model used captures all the material risks run by the bank, banks will be free to use models based on, for example, historical simulations and Monte Carlo simulations.

Qualitative criteria

162. The estimated volatility data (and holding period) must be used in the day-to-day risk management process of the bank.

163. Banks should have robust processes in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system.

164. The risk measurement system should be used in conjunction with internal exposure limits.

165. An independent review of the risk measurement system should be carried out regularly in the bank’s own internal auditing process. A review of the overall risk management process should take place at regular intervals (ideally not less than once a year) and should specifically address, at a minimum:

• the integration of risk measures into daily risk management;

• the validation of any significant change in the risk measurement process;

• the accuracy and completeness of position data;

• the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; and

• the accuracy and appropriateness of volatility assumptions.

Adjustment for different holding periods and non daily mark-to-market or remargining

166. For some transactions, depending on the nature and frequency of the revaluation and remargining provisions, different holding periods are appropriate. The framework for collateral haircuts distinguishes between repo-style transactions (i.e. repo/reverse repos and securities lending/borrowing), “other capital-market-driven transactions” (i.e. OTC derivatives transactions and margin lending) and secured lending. In capital-market-driven transactions and repo-style transactions, the documentation contains remargining clauses; in secured lending transactions, it generally does not.

167. The minimum holding period for various products is summarised in the following table.

Transaction type	Minimum holding period	Condition
Repo-style transaction	five business days	daily remargining
Other capital market transactions	ten business days	daily remargining
Secured lending	twenty business days	daily revaluation

168. When the frequency of remargining or revaluation is longer than the minimum, the minimum haircut numbers will be scaled up depending on the actual number of business days between remargining or revaluation using the square root of time formula below:

Where:

H = haircut

H_M = haircut under the minimum holding period

T_M = minimum holding period for the type of transaction

N_R = actual number of business days between remargining for capital market transactions or revaluation for secured transactions.

When a bank calculates the volatility on a T_N day holding period which is different from the specified minimum holding period T_M, the H_M will be calculated using the square root of time formula:

T_N = holding period used by the bank for deriving H_N

H_N = haircut based on the holding period T_N

169. For example, for banks using the standard supervisory haircuts, the 10-business day haircuts provided in paragraph 151 will be the basis and this haircut will be scaled up or down depending on the type of transaction and the frequency of remargining or revaluation using the formula below:

Where:

H = haircut

H₁₀ = 10-business day standard supervisory haircut for instrument

N_R = actual number of business days between remargining for capital market transactions or revaluation for secured transactions.

T_M = minimum holding period for the type of transaction

Conditions for zero H

170. For repo-style transactions where the following conditions are satisfied, and the counterparty is a core market participant, supervisors may choose not to apply the haircuts specified in the comprehensive approach and may instead apply a haircut of zero. This carve-out will not be available for banks using the modelling approaches as described in paragraphs 178 to 181 (i).

(a) Both the exposure and the collateral are cash or a sovereign security or PSE security qualifying for a 0% risk weight in the standardised approach;⁵⁰

⁵⁰ Note that where a supervisor has designated domestic-currency claims on its sovereign or central bank to be eligible for a 0% risk weight in the standardised approach, such claims will satisfy this condition.

(b) Both the exposure and the collateral are denominated in the same currency;

(c) Either the transaction is overnight or both the exposure and the collateral are marked-to-market daily and are subject to daily remargining;

(d) Following a counterparty’s failure to remargin, the time that is required between the last mark-to-market before the failure to remargin and the liquidation⁵¹ of the collateral is considered to be no more than four business days;

⁵¹ This does not require the bank to always liquidate the collateral but rather to have the capability to do so within the given time frame.

(e) The transaction is settled across a settlement system proven for that type of transaction;

(f) The documentation covering the agreement is standard market documentation for repo-style transactions in the securities concerned;

(g) The transaction is governed by documentation specifying that if the counterparty fails to satisfy an obligation to deliver cash or securities or to deliver margin or otherwise defaults, then the transaction is immediately terminable; and

(h) Upon any default event, regardless of whether the counterparty is insolvent or bankrupt, the bank has the unfettered, legally enforceable right to immediately seize and liquidate the collateral for its benefit.

171. Core market participants may include, at the discretion of the national supervisor, the following entities:

(a) Sovereigns, central banks and PSEs;

(b) Banks and securities firms;

(c) Other financial companies (including insurance companies) eligible for a 20% risk weight in the standardised approach;

(d) Regulated mutual funds that are subject to capital or leverage requirements;

(e) Regulated pension funds; and

(f) Recognised clearing organisations.

172. Where a supervisor applies a specific carve-out to repo-style transactions in securities issued by its domestic government, then other supervisors may choose to allow banks incorporated in their jurisdiction to adopt the same approach to the same transactions.

Treatment of repo-style transactions covered under master netting agreements

173. The effects of bilateral netting agreements covering repo-style transactions will be recognised on a counterparty-by-counterparty basis if the agreements are legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of whether the counterparty is insolvent or bankrupt. In addition, netting agreements must:

(a) provide the non-defaulting party the right to terminate and close-out in a timely manner all transactions under the agreement upon an event of default, including in the event of insolvency or bankruptcy of the counterparty;

(b) provide for the netting of gains and losses on transactions (including the value of any collateral) terminated and closed out under it so that a single net amount is owed by one party to the other;

(c) allow for the prompt liquidation or setoff of collateral upon the event of default; and

(d) be, together with the rights arising from the provisions required in (a) to (c) above, legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of the counterparty's insolvency or bankruptcy.

174. Netting across positions in the banking and trading book will only be recognised when the netted transactions fulfil the following conditions:

(a) All transactions are marked to market daily;⁵² and

(b) The collateral instruments used in the transactions are recognised as eligible financial collateral in the banking book.

⁵² The holding period for the haircuts will depend as in other repo-style transactions on the frequency of margining.

175. The formula in paragraph 147 will be adapted to calculate the capital requirements for transactions with netting agreements.

176. For banks using the standard supervisory haircuts or own-estimate haircuts, the framework below will apply to take into account the impact of master netting agreements.

E* = max {0, [(Σ(E) – Σ(C)) + Σ (Es x Hs) +Σ (Efx x Hfx)]}⁵³

⁵³ The starting point for this formula is the formula in paragraph 147 which can also be presented as the following: E* = max {0, [(E – C) + (E x He) + (C x Hc) + (C x Hfx)]}.

where:

E* = the exposure value after risk mitigation

E = current value of the exposure

C = the value of the collateral received

Es = absolute value of the net position in a given security

Hs = haircut appropriate to Es

Efx = absolute value of the net position in a currency different from the settlement currency

Hfx = haircut appropriate for currency mismatch

177. The intention here is to obtain a net exposure amount after netting of the exposures and collateral and have an add-on amount reflecting possible price changes for the securities involved in the transactions and for foreign exchange risk if any. The net long or short position of each security included in the netting agreement will be multiplied by the appropriate haircut. All other rules regarding the calculation of haircuts stated in paragraphs 147 to 172 equivalently apply for banks using bilateral netting agreements for repo-style transactions.

Use of models

178. As an alternative to the use of standard or own-estimate haircuts, banks may be permitted to use a VaR models approach to reflect the price volatility of the exposure and collateral for repo-style transactions, taking into account correlation effects between security positions. This approach would apply to repo-style transactions covered by bilateral netting agreements on a counterparty-by-counterparty basis. At the discretion of the national supervisor, firms are also eligible to use the VaR model approach for margin lending transactions, if the transactions are covered under a bilateral master netting agreement that meets the requirements of paragraphs 173 and 174. The VaR models approach is available to banks that have received supervisory recognition for an internal market risk model according to paragraph 718 (LXX). Banks which have not received supervisory recognition for use of models according to paragraph 718 (LXX) can separately apply for supervisory recognition to use their internal VaR models for calculation of potential price volatility for repo-style transactions. Internal models will only be accepted when a bank can prove the quality of its model to the supervisor through the backtesting of its output using one year of historical data. Banks must meet the model validation requirement of paragraph 43 of Annex 4 to use VaR for repo-style and other SFTs. In addition, other transactions similar to repostyle transactions (like prime brokerage) and that meet the requirements for repo-style transactions, are also eligible to use the VaR models approach provided the model used meets the operational requirements set forth in Section I.F of Annex 4.

179. The quantitative and qualitative criteria for recognition of internal market risk models for repo-style transactions and other similar transactions are in principle the same as in paragraphs 718 (LXXIV) to 718 (LXXVI). With regard to the holding period, the minimum will be 5-business days for repo-style transactions, rather than the 10-business days in paragraph 718 (LXXVI) (c). For other transactions eligible for the VaR models approach, the 10-business day holding period will be retained. The minimum holding period should be adjusted upwards for market instruments where such a holding period would be inappropriate given the liquidity of the instrument concerned.

180. (Deleted)

181. The calculation of the exposure E* for banks using their internal model will be the following:

E* = max {0, [(ΣE – ΣC) + VaR output from internal model]}

In calculating capital requirements banks will use the previous business day’s VaR number.

181 (i). Subject to supervisory approval, instead of using the VaR approach, banks may also calculate an expected positive exposure for repo-style and other similar SFTs, in accordance with the Internal Model Method set out in Annex 4 of this Framework.

(iii) The simple approach

Minimum conditions

182. For collateral to be recognised in the simple approach, the collateral must be pledged for at least the life of the exposure and it must be marked to market and revalued with a minimum frequency of six months. Those portions of claims collateralised by the market value of recognised collateral receive the risk weight applicable to the collateral instrument. The risk weight on the collateralised portion will be subject to a floor of 20% except under the conditions specified in paragraphs 183 to 185. The remainder of the claim should be assigned to the risk weight appropriate to the counterparty. A capital requirement will be applied to banks on either side of the collateralised transaction: for example, both repos and reverse repos will be subject to capital requirements.

Exceptions to the risk weight floor

183. Transactions which fulfil the criteria outlined in paragraph 170 and are with a core market participant, as defined in 171, receive a risk weight of 0%. If the counterparty to the transactions is not a core market participant the transaction should receive a risk weight of 10%.

184. OTC derivative transactions subject to daily mark-to-market, collateralised by cash and where there is no currency mismatch should receive a 0% risk weight. Such transactions collateralised by sovereign or PSE securities qualifying for a 0% risk weight in the standardised approach can receive a 10% risk weight.

185. The 20% floor for the risk weight on a collateralised transaction will not be applied and a 0% risk weight can be applied where the exposure and the collateral are denominated in the same currency, and either:

• the collateral is cash on deposit as defined in paragraph 145 (a); or

• the collateral is in the form of sovereign/PSE securities eligible for a 0% risk weight, and its market value has been discounted by 20%.

(iv) Collateralised OTC derivatives transactions

186. Under the Current Exposure Method, the calculation of the counterparty credit risk charge for an individual contract will be as follows:

counterparty charge = [(RC + add-on) – CA] x r x 8%

where:

RC = the replacement cost,

add-on = the amount for potential future exposure calculated according to paragraph 92(i) and 92(ii) of Annex 4,

C_A = the volatility adjusted collateral amount under the comprehensive approach prescribed in paragraphs 147 to 172, or zero if no eligible collateral is applied to the transaction, and

r = the risk weight of the counterparty.

187. When effective bilateral netting contracts are in place, RC will be the net replacement cost and the add-on will be A_Net as calculated according to paragraphs 96(i) to 96(vi) of Annex 4. The haircut for currency risk (Hfx) should be applied when there is a mismatch between the collateral currency and the settlement currency. Even in the case where there are more than two currencies involved in the exposure, collateral and settlement currency, a single haircut assuming a 10-business day holding period scaled up as necessary depending on the frequency of mark-to-market will be applied.

187(i). As an alternative to the Current Exposure Method for the calculation of the counterparty credit risk charge, banks may also use the Standardised Method and, subject to supervisory approval, the Internal Model Method as set out in Annex 4 of this Framework.

4. On-balance sheet netting

188. Where a bank,

(a) has a well-founded legal basis for concluding that the netting or offsetting agreement is enforceable in each relevant jurisdiction regardless of whether the counterparty is insolvent or bankrupt;

(b) is able at any time to determine those assets and liabilities with the same counterparty that are subject to the netting agreement;

(c) monitors and controls its roll-off risks; and

(d) monitors and controls the relevant exposures on a net basis,

it may use the net exposure of loans and deposits as the basis for its capital adequacy calculation in accordance with the formula in paragraph 147. Assets (loans) are treated as exposure and liabilities (deposits) as collateral. The haircuts will be zero except when a currency mismatch exists. A 10-business day holding period will apply when daily mark-to-market is conducted and all the requirements contained in paragraphs 151, 169, and 202 to 205 will apply.

5. Guarantees and credit derivatives

(i) Operational requirements

Operational requirements common to guarantees and credit derivatives

189. A guarantee (counter-guarantee) or credit derivative must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible. Other than non-payment by a protection purchaser of money due in respect of the credit protection contract it must be irrevocable; there must be no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure.⁵⁴ It must also be unconditional; there should be no clause in the protection contract outside the direct control of the bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due.

⁵⁴ Note that the irrevocability condition does not require that the credit protection and the exposure be maturity matched; rather that the maturity agreed ex ante may not be reduced ex post by the protection provider. Paragraph 203 sets forth the treatment of call options in determining remaining maturity for credit protection.

Additional operational requirements for guarantees

190. In addition to the legal certainty requirements in paragraphs 117 and 118 above, in order for a guarantee to be recognised, the following conditions must be satisfied:

(a) On the qualifying default/non-payment of the counterparty, the bank may in a timely manner pursue the guarantor for any monies outstanding under the documentation governing the transaction. The guarantor may make one lump sum payment of all monies under such documentation to the bank, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The bank must have the right to receive any such payments from the guarantor without first having to take legal actions in order to pursue the counterparty for payment.

(b) The guarantee is an explicitly documented obligation assumed by the guarantor.

(c) Except as noted in the following sentence, the guarantee covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments etc. Where a guarantee covers payment of principal only, interests and other uncovered payments should be treated as an unsecured amount in accordance with paragraph 198.

Additional operational requirements for credit derivatives

191. In order for a credit derivative contract to be recognised, the following conditions must be satisfied:

(a) The credit events specified by the contracting parties must at a minimum cover:

• failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation);

• bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and

• restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account). When restructuring is not specified as a credit event, refer to paragraph 192.

(b) If the credit derivative covers obligations that do not include the underlying obligation, section (g) below governs whether the asset mismatch is permissible.

(c) The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay, subject to the provisions of paragraph 203.

(d) Credit derivatives allowing for cash settlement are recognised for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There must be a clearly specified period for obtaining post-creditevent valuations of the underlying obligation. If the reference obligation specified in the credit derivative for purposes of cash settlement is different than the underlying obligation, section (g) below governs whether the asset mismatch is permissible.

(e) If the protection purchaser’s right/ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation must provide that any required consent to such transfer may not be unreasonably withheld.

(f) The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event.

(g) A mismatch between the underlying obligation and the reference obligation under the credit derivative (i.e. the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if (1) the reference obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.

(h) A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if (1) the latter obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or crossacceleration clauses are in place.

192. When the restructuring of the underlying obligation is not covered by the credit derivative, but the other requirements in paragraph 191 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 recognised 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.⁵⁵

⁵⁵ The 60% recognition factor is provided as an interim treatment, which the Committee intends to refine prior to implementation after considering additional data.

193. Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees will be eligible for recognition. 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 recognised. The treatment of first-todefault and second-to-default products is covered separately in paragraphs 207 to 210.

194. Other types of credit derivatives will not be eligible for recognition at this time.⁵⁶

⁵⁶ Cash funded credit linked notes issued by the bank against exposures in the banking book which fulfil the criteria for credit derivatives will be treated as cash collateralised transactions.

(ii) Range of eligible guarantors (counter-guarantors)/protection providers

195. Credit protection given by the following entities will be recognised:

• sovereign entities,⁵⁷ PSEs, banks⁵⁸ and securities firms with a lower risk weight than the counterparty;

⁵⁷ This includes the Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community, as well as those MDBs referred to in footnote 24.

⁵⁸ This includes other MDBs.

• other entities rated A- or better. This would include credit protection provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor.

(iii) Risk weights

196. 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.

197. Materiality thresholds on payments below which no payment is made in the event of loss are equivalent to retained first loss positions and must be deducted in full from the capital of the bank purchasing the credit protection.

Proportional cover

198. Where the amount guaranteed, or against which credit protection is held, is less than the amount of the exposure, and the secured and unsecured portions are of equal seniority, i.e. the bank and the guarantor share losses on a pro-rata basis capital relief will be afforded on a proportional basis: i.e. the protected portion of the exposure will receive the treatment applicable to eligible guarantees/credit derivatives, with the remainder treated as unsecured.

Tranched cover

199. Where the bank transfers a portion of the risk of an exposure in one or more tranches to a protection seller or sellers and retains some level of risk of the loan and the risk transferred and the risk retained are of different seniority, banks may obtain credit protection for either the senior tranches (e.g. second loss portion) or the junior tranche (e.g. first loss portion). In this case the rules as set out in Section IV (Credit risk ─ securitisation framework) will apply.

(iv) Currency mismatches

200. Where the credit protection is denominated in a currency different from that in which the exposure is denominated — i.e. there is a currency mismatch — the amount of the exposure deemed to be protected will be reduced by the application of a haircut H_FX, i.e.

G_A = G x (1 – H_FX)

where:

G = nominal amount of the credit protection

H_FX = haircut appropriate for currency mismatch between the credit protection and underlying obligation.

The appropriate haircut based on a 10-business day holding period (assuming daily marking-to-market) will be applied. If a bank uses the supervisory haircuts it will be 8%. The haircuts must be scaled up using the square root of time formula, depending on the frequency of revaluation of the credit protection as described in paragraph 168.

(v) Sovereign guarantees and counter-guarantees

201. As specified in paragraph 54, a lower risk weight may be applied at national discretion to a bank’s exposures to the sovereign (or central bank) where the bank is incorporated and where the exposure is denominated in domestic currency and funded in that currency. National authorities may extend this treatment to portions of claims guaranteed by the sovereign (or central bank), where the guarantee is denominated in the domestic currency and the exposure is funded in that currency. A claim may be covered by a guarantee that is indirectly counter-guaranteed by a sovereign. Such a claim may be treated as covered by a sovereign guarantee provided that:

(a) the sovereign counter-guarantee covers all credit risk elements of the claim;

(b) both the original guarantee and the counter-guarantee meet all operational requirements for guarantees, except that the counter-guarantee need not be direct and explicit to the original claim; and

(c) the supervisor is satisfied that the cover is robust and that no historical evidence suggests that the coverage of the counter-guarantee is less than effectively equivalent to that of a direct sovereign guarantee.

6. Maturity mismatches

202. For the purposes of calculating risk-weighted assets, a maturity mismatch occurs when the residual maturity of a hedge is less than that of the underlying exposure.

(i) Definition of maturity

203. The maturity of the underlying exposure and the maturity of the hedge should both be defined conservatively. The effective maturity of the underlying should 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 which may reduce the term of the hedge should be taken into account so that the shortest possible effective maturity is used. Where a call is at the discretion of the protection seller, the maturity will always be at the first call date. If the call is at the discretion of the protection buying bank but the terms of the arrangement at origination of the hedge contain a positive incentive for the bank to call the transaction before contractual maturity, the remaining time to the first call date will be deemed to be the effective maturity. For example, where there is a step-up in cost in conjunction with a call feature or where the effective cost of cover increases over time even if credit quality remains the same or increases, the effective maturity will be the remaining time to the first call.

(ii) Risk weights for maturity mismatches

204. As outlined in paragraph 143, hedges with maturity mismatches are only recognised when their original maturities are greater than or equal to one year. As a result, the maturity of hedges for exposures with original maturities of less than one year must be matched to be recognised. In all cases, hedges with maturity mismatches will no longer be recognised when they have a residual maturity of three months or less.

205. When there is a maturity mismatch with recognised credit risk mitigants (collateral, on-balance sheet netting, guarantees and credit derivatives) the following adjustment will be applied.

Pa = P x (t – 0.25) / (T – 0.25)

where:

Pa = value of the credit protection adjusted for maturity mismatch

P = credit protection (e.g. collateral amount, guarantee amount) adjusted for any haircuts

t = min (T, residual maturity of the credit protection arrangement) expressed in years

T = min (5, residual maturity of the exposure) expressed in years

7. Other items related to the treatment of CRM techniques

(i) Treatment of pools of CRM techniques

206. In the case where a bank has multiple CRM techniques covering a single exposure (e.g. a bank has both collateral and guarantee partially covering an exposure), the bank will be required to subdivide the exposure into portions covered by each type of CRM technique (e.g. portion covered by collateral, portion covered by guarantee) and the risk-weighted assets of each portion must be calculated separately. When credit protection provided by a single protection provider has differing maturities, they must be subdivided into separate protection as well.

(ii) First-to-default credit derivatives

207. There are cases where a bank obtains credit protection for a basket of reference names and where the first default among the reference names triggers the credit protection and the credit event also terminates the contract. In this case, the bank may recognise regulatory capital relief for the asset within the basket with the lowest risk-weighted amount, but only if the notional amount is less than or equal to the notional amount of the credit derivative.

208. With regard to the bank providing credit protection through such an instrument, if the product has an external credit assessment from an eligible credit assessment institution, the risk weight in paragraph 567 applied to securitisation tranches will be applied. If the product is not rated by an eligible external credit assessment institution, the risk weights of the assets included in the basket will be aggregated up to a maximum of 1250% and multiplied by the nominal amount of the protection provided by the credit derivative to obtain the risk-weighted asset amount.

(iii) Second-to-default credit derivatives

209. In the case where the second default among the assets within the basket triggers the credit protection, the bank obtaining credit protection through such a product will only be able to recognise any capital relief if first-default-protection has also be obtained or when one of the assets within the basket has already defaulted.

210. For banks providing credit protection through such a product, the capital treatment is the same as in paragraph 208 above with one exception. The exception is that, in aggregating the risk weights, the asset with the lowest risk weighted amount can be excluded from the calculation.