Where an ADI purchases credit protection through an eligible credit derivative, it may substitute the risk weight of the counterparty with the risk weight of the credit protection seller for the covered portion of the exposure.[33] The uncovered portion of the exposure must be risk-weighted according to the risk weight applicable to the original counterparty.
For the purposes of CRM, eligible credit derivatives are limited to:
single-name credit-default swaps; and
certain total-rate-of-return swaps.
Where an ADI purchases credit protection through a total-rate-of-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 must not be recognised.
Cash-funded credit linked notes issued by an ADI against exposures in the banking book that satisfy the minimum requirements for credit derivatives as detailed in this Attachment (with the exception of eligible credit protection providers set out in paragraph 12 of this Attachment) may be treated as cash-collateralised transactions under Attachment G to this Prudential Standard.
Where an ADI buys credit protection through a credit derivative that forms part of a synthetic securitisation, the requirements detailed in APS 120 apply.
Minimum requirements
To be recognised as eligible CRM, a credit derivative must:
represent a direct claim on the protection seller;
be explicitly referenced to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible;
be irrevocable, except in the case of non-payment by a protection purchaser of money due in respect of the credit protection contract. The credit derivative contract must not include any clause that would allow the protection seller to unilaterally cancel the protection of the credit derivative, or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure;[34]
be unconditional. The credit derivative contract must not include any clauses that are outside the direct control of the ADI, and the credit events specified in the contract must not prevent the protection seller from being obliged to pay out in a timely manner in the event that the borrower of the underlying exposure fails to make the due payment(s);
at a minimum, specify the following as credit events under the terms of the credit derivative contract:
the failure to pay an amount due under the terms of the underlying exposure that is in effect at the time of such failure;
the bankruptcy, insolvency or inability of the borrower of the underlying exposure to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as those debts become due, or analogous events; and
subject to paragraph 9 of this Attachment, the restructuring of the underlying exposure, including any forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. write-off, provision for a defaulted exposure or other similar debit to the profit and loss account of the ADI);
not terminate prior to the expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay; and
clearly identify those parties responsible for determining whether a credit event has occurred. This determination must not be the sole right of the protection seller. An ADI buying the credit protection must have the right and ability to inform the protection seller of the occurrence of a credit event.
Where the credit derivative is based on cash settlement, the ADI must have a robust valuation process in order to reliably estimate losses on the reference obligation specified in the credit derivative contract, including a defined period for obtaining post credit event valuations of the reference obligation.
Where an ADI purchases credit protection and an existing credit exposure of the ADI is the deliverable obligation under the credit derivative contract, the terms of the underlying exposure must allow for its transfer to the protection seller. If the protection purchaser's right and 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.
An exception to paragraph 7 of this Attachment applies where there is a restriction on the transfer of the existing credit exposure and this restriction only applies in the event of restructuring. In this case, the limit described in paragraph 9 of this Attachment applies as if restructuring of the underlying exposure was not included within the terms of the credit derivatives contract.
If restructuring of the underlying exposure is not included within the terms of the credit derivative contract but all other requirements of paragraphs 5 to 7 of this Attachment are met, an ADI may recognise 60 per cent of the lesser of the amount of the credit protection purchased and the amount of the underlying exposure.
Where there is a mismatch between the underlying obligation and the reference obligation under the credit derivative, including the obligation used for the purposes of determining the cash settlement value or the deliverable obligation, an ADI may only recognise the credit derivative as eligible CRM if the following conditions are satisfied:
the reference obligation ranks pari passu with, or is junior to the underlying obligation; and
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.
Where there is a mismatch between the underlying obligation and the obligation used for the purposes of determining whether a credit event has occurred, an ADI may only recognise the credit derivative as eligible CRM if the following conditions are satisfied:
the obligation used to determine whether a credit event has occurred ranks pari passu with, or is junior to, the underlying obligation; and
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.
Eligible credit protection providers
An ADI must only recognise credit protection provided by the following entities:
sovereigns;
banks;
other entities that are externally rated, where credit protection is provided to a non-securitisation exposure. This includes credit protection provided by parent, subsidiary and affiliate companies where they have a lower risk weight than the borrower; and
where credit protection is provided to a securitisation exposure, other entities with a credit rating grade of three or better and that were externally rated two or better at the time the credit protection was provided. This also includes credit protection provided by parent, subsidiary and affiliated companies where they have a lower risk weight than the borrower.
Materiality thresholds
Where a credit derivative provides for a materiality threshold on payments below which no payment will be made in the event of loss, it is equivalent to a retained first loss position and must be deducted from Common Equity Tier 1 Capital in accordance with APS 111. This deduction will be capped at the amount of capital the ADI would be required to hold against the full value of the underlying exposure.
Proportional and tranched cover
Where there is partial coverage of an underlying exposure by a credit derivative and the protected and unprotected portions are of equal seniority (i.e. the ADI buying credit protection and the protection seller share losses on a pro rata basis), capital relief will be afforded on a proportional basis. This means that the protected portion of the underlying exposure will receive the capital treatment applicable to eligible credit derivatives with the remainder treated as unprotected.
Where there is partial coverage of an underlying exposure by a credit derivative and there is a difference in seniority between the protected and unprotected portions of the underlying exposure, then the arrangement is considered to be a synthetic securitisation and is subject to the requirements set out in APS 120.
Currency mismatch
A currency mismatch exists where an ADI has purchased credit protection using a credit derivative and the credit derivative is denominated in a different currency from that in which the underlying exposure is denominated. In this case the amount of the exposure deemed to be protected (Ga) must be reduced by the application of a haircut (Hfx) as follows:
Start formula G subscript a equals G times open bracket 1 minus H subscript fx close bracket end formula.
where:
G = nominal amount of the credit derivative
Hfx = haircut appropriate for the currency mismatch between the credit derivative and the underlying exposure.
Where there is a currency mismatch, an ADI must apply a haircut of 8 per cent (based on a 10 business day holding period and daily marking-to-market). The haircut must be adjusted depending on the actual frequency of revaluation of the currency mismatch, in accordance with paragraph 32 of Attachment G to this Prudential Standard.
Maturity mismatch
A maturity mismatch exists where the residual maturity of a credit derivative is less than the maturity of the underlying exposure.
Where there is a maturity mismatch, a credit derivative may only be recognised as eligible CRM where the original maturity of the credit derivative is greater than or equal to 12 months and the residual maturity is greater than or equal to 3 months.
Where credit protection provided by a single protection seller to the same underlying exposure has different maturities, an ADI must divide the exposure into separate covered portions for risk-weighting purposes.
For the purpose of determining maturity:
the effective maturity of the underlying exposure must be calculated using the longest possible remaining time before the counterparty is scheduled to fulfil its obligation; and
for the credit derivative, an ADI that purchases credit protection must take into account any clause or incentive within the credit derivative contract that may reduce its maturity so that the shortest possible effective maturity is used.
Where there is a maturity mismatch, an ADI must apply the following adjustment:
Start formula P subscript a equals P times start fraction t minus 0.25 over T minus 0.25 end fraction end formula.
where:
Pa = value of the amount of credit protection adjusted for maturity mismatch
P = the amount of credit protection adjusted for any haircuts (in which case, P = Ga as determined in paragraph 16 of this Attachment)
t = min (T, residual maturity of the credit derivative) expressed in years
T = min (5, residual maturity of the underlying exposure) expressed in years.
Sold credit protection
An ADI that sells credit protection that is not detailed in paragraphs 29 and 30 of this Attachment must, prior to execution of the relevant credit derivative contract, undertake a written assessment of the appropriate Regulatory Capital treatment for the transaction. The ADI must notify APRA prior to execution and provide its written assessment to APRA upon request. The ADI must apply the treatment set out in its written assessment unless APRA determines an alternative methodology for calculating the Regulatory Capital treatment.
Where an ADI uses total-rate-of-return swaps to hedge a banking book credit exposure in accordance with the requirements set out in this Attachment, those transactions must be included in the ADI’s banking book. All other total-rate-of-return swaps must be included in an ADI’s trading book.
Any instruments that would give rise to a net short credit or equity position in the banking book must be included in an ADI's trading book.[35]
An ADI that has sold credit protection using a credit derivative must, for capital adequacy purposes, assume that 100 per cent of the credit risk is purchased irrespective of the range of specified credit events.
An ADI that sells credit protection using a credit derivative containing an embedded option to extend the term of the credit derivative must assume the longest possible effective maturity of the credit derivative. This is regardless of any contractual arrangements that may give either the protection buyer or the protection seller the incentive to reduce the contract term.
When determining the amount of credit protection sold, an ADI must assume that any materiality thresholds included in the credit derivative contract do not reduce the acquired credit risk.
Credit-default swaps
Where credit protection is sold via a credit-default swap referenced to a single reference entity, the ADI acquires an exposure to the credit risk of that entity. The risk weight that must be applied to the exposure is the risk weight that would otherwise apply to the reference entity. The amount of the exposure is the maximum possible amount payable under the terms of the credit derivative contract if a credit event were to occur.
First- and second-to-default basket credit derivatives
An ADI which sells credit protection through a first-to-default or second-to-default credit derivative, must apply the following capital requirements to these exposures:
for first-to-default credit derivatives, the risk weights of the assets included in the basket must be aggregated up to a maximum of 1250 per cent and multiplied by the nominal amount of the protection provided by the credit derivative to obtain the risk-weighted asset amount; and
for second-to-default credit derivatives, the treatment is similar; however, in aggregating the risk weights, the asset with the lowest risk-weighted amount can be excluded from the calculation. This treatment applies respectively for nth-to-default credit derivatives, for which the n-assets with the lowest risk-weighted amounts can be excluded from the calculation.