Part Treatment of Credit Derivatives in the B - Banking (prudential standard) determination No. 5 of 2006 - Prudential Standard APS 112 - Capital Adequacy: Credit Risk - Treatment of Credit Derivatives in the Banking Book | Zoe
Banking (prudential standard) determination No. 5 of 2006 - Prudential Standard APS 112 - Capital Adequacy: Credit Risk
Treatment of Credit Derivatives in the BTreatment of Credit Derivatives in the Banking Book
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Treatment of Credit Derivatives in the Banking Book
This Guidance Note details the approach to be used by locally incorporated authorised deposit-taking institutions (ADIs) to determine the capital to be held against credit derivative instruments in the banking book. The capital adequacy rules pertaining to credit derivatives in ADIs’ trading books are described in Guidance Note AGN 113.4 Treatment of Credit Derivatives in the Trading Book (AGN 113.4).
When determining whether a credit derivative transaction should be allocated to the banking or trading book, consideration should be given to the trading book requirements detailed in Guidance Note AGN 113.1 The Trading Book and Trading Book Policy Statement.
The approach set out here is broadly consistent with the existing capital adequacy rules applied to other banking book instruments, with credit derivatives being regarded as similar to guarantees or other direct credit substitutes. APRA recognises that the relatively simple structure on which the existing rules are based constrains the ability to accommodate the flexibility of credit derivatives without undermining the efficacy of those rules. While the capital treatment is conservative, APRA is of the view that such an approach is justified given the uncertainties present in the global credit derivatives market.
While there are currently no internationally agreed capital adequacy guidelines for credit derivatives, work is continuing. It is APRA’s intention to be involved with, and closely monitor, any developments in this area and, if deemed necessary, amend this Guidance Note accordingly.
Scope
This Guidance Note applies to the most commonly traded credit derivatives: credit‑default swaps, total‑rate‑of‑return swaps,[14] credit‑linked notes and first‑to‑default baskets. APRA is aware that more complex credit derivative products will undoubtedly emerge. ADIs transacting in more complex credit derivatives or in structures with non‑standard features (such as those involving portfolios of reference obligations, other than first-to-default baskets) will be expected to approach APRA to discuss an appropriate capital treatment for such instruments. If, over time, these other types of credit derivative product are seen to become commonplace, APRA will, where practicable, incorporate the capital adequacy treatment of such products into this Guidance Note.
The evolution of instruments capable of transferring credit risk raises many important issues for prudential supervisors, many of which are common to a range of products. Of particular concern to APRA is the effect of credit derivatives on the transparency of individual credit portfolios. Since credit derivatives facilitate the transformation of credit risk profiles, large exposures and concentrations within ADIs’ portfolios may become increasingly difficult to identify. Where APRA considers a particular ADI to be undertaking significant credit derivative activity, as either a purchaser or seller of protection, such that large exposures and concentrations are a potential concern, APRA may require the ADI to adopt an alternative capital treatment to that which is described in this Guidance Note.
Under APRA’s current reporting framework, ADIs will be expected to provide APRA with details of credit derivative transactions that give rise to large exposures as required by the Large Exposures Return.
Where an ADI has purchased protection in the absence of an underlying asset (i.e. it has an open short position in the banking book), or where the protection is not recognised by this Guidance Note, the credit derivative is not taken into account for the purposes of capital adequacy. In general, ADIs with open short positions in credit derivatives are expected to include those positions in the trading book (refer AGN 113.4).[15]
Terminology
Credit derivatives are part of a broader family of instruments that enable users to transfer the credit risk of an asset from one party, the protection buyer, to another, the protection seller, in isolation from other risks.
In this Guidance Note, the following terminology has been used when describing a credit derivative transaction:
(a) underlying asset – the asset which is being protected by the credit derivative;
(b) protection – this reflects the extent of risk transference from the protection buyer (or risk seller) to the protection seller (or risk buyer). The protection provided by a credit derivative reduces the amount of capital that must be held by the protection buyer to cover the credit risk on the underlying asset;
(c) reference entity – the legal entity whose credit risk is being transferred by the credit derivative. In the case of first‑to‑default baskets, the reference entity is not a single entity but a ‘basket’ or portfolio of reference entities;
(d) obligation – any financial obligation of the reference entity or of an entity that is unconditionally and irrevocably guaranteed by the reference entity, as defined under the terms of the credit derivative contract, on which a credit event must occur for the credit derivative to be triggered;
(e) credit events – events affecting the reference entity that trigger a credit‑event payment under the terms of the credit derivative contract;
(f) credit‑event payment – the amount that is paid following the occurrence of a credit event. The payment can be in the form of physical settlement (payment of par in exchange for physical delivery of a deliverable obligation of the reference entity) or cash settlement (payment of a fixed amount, or payment of the par value of the reference obligation less that obligation’s recovery value);
(g) deliverable obligation – any obligation of the reference entity that can be delivered, under the terms of the contract, if a credit event occurs. A deliverable obligation is relevant for credit derivatives that are to be physically settled; and
(h) reference obligation – the obligation which determines the amount of the credit-event payment. A reference obligation is relevant for obligations that are to be cash settled (on a par less recovery basis).
Calculating the amount of protection purchased or sold
An important component of the regulatory capital calculation for credit derivatives is the amount of protection purchased by the protection buyer or the amount of protection sold by the protection seller.
The types of credit event specified in the credit derivative contract determine the extent of risk transference from the protection buyer to the protection seller. To ensure that an event of default occurs on the underlying asset with a payment occurring under the terms of the credit derivative, the set of credit events should contain as wide a range of triggers as possible. If the set of credit events is restrictive, it is possible that the credit derivative hedge will transfer insufficient risk.
For capital adequacy purposes, an ADI will only be regarded as having purchased protection if the range of specified credit events is such that it is clear the credit risk of the underlying asset has been transferred to the protection seller.[16]
Where an ADI has sold protection using a credit derivative, it should be assumed that 100 per cent of the credit risk is purchased irrespective of the range of credit events specified.
The size and nature of any materiality thresholds specified in the credit derivative contract may also reduce the amount of credit risk transferred from the protection buyer to the protection seller. Materiality thresholds require a given level of loss to occur before the credit derivative is triggered. If these thresholds are set too high, it is possible that a significant loss could be incurred on the underlying asset without a credit-event payment being made.
When determining the amount of protection purchased using a credit derivative, the ADI should take into account any materiality thresholds written into the credit derivative contract, which may reduce the protection amount. An ADI will not be regarded as having purchased protection if there exist any materiality thresholds that require a comparatively high percentage of loss to occur before the credit derivative is triggered.
When determining the amount of protection sold by the credit derivative, the ADI should assume that any materiality thresholds written into the credit derivative contract do not reduce the acquired credit risk.
The type of credit‑event payment specified in the contract will also impact on the amount of protection purchased or sold under the credit derivative. Where the credit‑event payment is defined as the par value of the reference obligation less its recovery value (i.e. the credit derivative is cash settled), or there is payment of the par value of an obligation in exchange for its physical delivery, the amount of protection purchased or sold must be set equal to the par value of that obligation. Where the credit‑event payment is defined as a fixed amount, the amount of protection purchased or sold must be set equal to that amount. While APRA acknowledges that this latter approach may be conservative in some cases, it is not possible to adopt an alternative approach within the current capital adequacy framework.
Credit derivatives that include options to extend or reduce the term of the contract may affect the protection purchased or sold. Where embedded options exist in credit derivative contracts, an ADI must adopt the most conservative approach for the purposes of calculating regulatory capital. Application of this principle implies that:
(a) where an ADI as protection buyer has purchased an option to extend the contract term, the ADI may assume that the option will be exercised; where the option is to reduce the contract term, it can be assumed that the option will not be exercised;
(b) where an ADI as protection buyer has written an option to extend the contract term, the ADI must assume that the option will not be exercised; where the option is to reduce the contract term, it must be assumed that the option will be exercised;
(c) where an ADI as protection seller has purchased an option to extend the contract term, the ADI must assume that the option will be exercised; where the option is to reduce the contract term, it must be assumed that the option will not be exercised; and
(d) where an ADI as protection seller has written an option to extend the contract term, the ADI must assume that the option will be exercised; where the option is to reduce the contract term, it must be assumed that the option will not be exercised.
Credit derivatives that include provisions to vary the cash flows paid or received (e.g. step‑up provisions) may also affect the protection purchased or sold. At this stage, ADIs transacting in credit derivatives containing these types of provisions should approach APRA to discuss an appropriate capital treatment.
Credit-default swaps
Where protection is purchased using a credit‑default swap referenced to a single reference entity, an ADI may replace the risk weight of the underlying asset with the risk weight of the protection seller. The amount of protection that may be recognised is bound by the requirements outlined in paragraphs 11-20 and 27‑35.
Where 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. In this case, the risk weight that must be applied to the exposure is the risk weight attached 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.
Total-rate-of-return swaps
Where protection is purchased using a total‑rate‑of‑return swap, an ADI may replace the risk weight of the underlying asset with the risk weight of the protection seller. The amount of protection that may be recognised is bound by the requirements outlined in paragraphs 11‑20 and 27‑35.
Protection sold via a total-rate-of-return swap should be included in an ADI’s trading book.
Credit-linked notes
Where protection is purchased using a credit‑linked note, the ADI may replace the risk weight of the underlying asset with the risk weight of any funded protection acquired.[17] The amount of protection that may be recognised is bound by the amount of funding received and by the requirements outlined in paragraphs 11‑20 and 27‑35.
Where protection is sold via a credit‑linked note, the ADI acquires an exposure to both the reference entity and the protection buyer, with the amount of the exposure being the face value of the note.[18] To account for this exposure, the higher of the risk weights applicable to the reference asset and the protection buyer must be applied to the exposure.
First-to-default baskets
Where an ADI has purchased protection using a credit derivative that is referenced to more than one entity and that protection terminates after a credit event occurs on one or more of those entities (i.e. a first‑to‑default basket product), protection is only recognised against one entity in the basket. The ADI may choose which entity is protected, with the risk weight of that entity being replaced by the risk weight of the protection seller. The amount of protection that may be recognised is bound by the requirements outlined in paragraphs 11‑20 and 27‑35.
Where an ADI has sold protection using a first‑to‑default basket product, capital must be held against all the reference entities in the basket. The risk‑weighted exposure arising from the credit derivative will be the sum of the individual risk‑weighted exposures in the basket, with the amount of capital held capped at the maximum payout possible under the contract. An example of this treatment is provided in the Attachment.
Asset mismatches
Where an ADI has purchased protection using a credit derivative and the reference obligation (in the case of cash settlement), or deliverable obligation(s) (in the case of physical settlement), is different from the underlying asset, the amount of protection provided by the credit derivative may not be sufficient to constitute an effective hedge. For this reason, APRA requires a range of criteria to be met before the protection buyer can apply the treatment specified in paragraphs 21, 23, 25 or 27.
For credit derivative hedges requiring physical settlement, if the underlying asset is a deliverable obligation under the terms of the credit derivative contract, the ADI will be regarded as having purchased protection. Where this is not the case, the guidelines for cash settlement, detailed in paragraph 31 below, will apply.
For credit derivative hedges requiring cash settlement, an ADI may recognise the protection acquired under a credit derivative if the following criteria are met:
(e) the underlying asset and the reference obligation are obligations of the same reference entity or the underlying asset is an obligation of an entity that is unconditionally and irrevocably guaranteed by the reference entity to the credit derivative contract;
(f) the underlying asset is an obligation under the terms of the credit derivative contract; and
(g) the reference obligation is ranked pari passu or lower, in seniority of claim, relative to the underlying asset.
Where an ADI has sold protection using a credit-default swap or credit-linked note in the banking book, and hedged that exposure with another credit derivative, the ADI will be regarded as protected if the hedged credit derivative and the hedging credit derivative are equal and opposite transactions in all respects (when a maturity mismatch exists, i.e. the credit derivatives are equal and opposite in all respects other than tenor, paragraphs 33-35 apply).[19]
Maturity mismatches
Where an ADI has purchased protection using a credit derivative and the maturity of the credit derivative contract is less than the maturity of the underlying asset, the amount of protection that is recognised for capital adequacy purposes must be reduced. The amount of this reduction depends on the residual maturity of the credit derivative relative to the residual maturity of the underlying exposure. For example, in the case of a ten‑year exposure hedged by a credit derivative with a residual maturity of nine years, 90 per cent of the exposure may be risk weighted on the basis of the protection seller, with the remaining 10 per cent risk weighted on the basis of the underlying exposure.
At a minimum, the credit derivative would need to have a residual maturity of at least one year to be eligible for this treatment.
Where an ADI has purchased protection using a credit derivative and the maturity of the credit derivative contract is greater than the maturity of the underlying asset, the amount of protection that is recognised for capital adequacy is unaffected by the maturity mismatch.
Currency mismatches
Where a credit derivative contract is denominated in a different currency to the underlying asset, the amount of protection purchased (as defined in paragraphs 11‑20 above) must be valued at the current exchange rate. Where the value of that protection (valued in terms of the currency of the underlying asset) is equal to or greater than the value of the underlying asset, the underlying asset may be regarded as protected. Where the mark-to-market value of that protection is less than the value of the underlying asset, the residual must be risk weighted on the basis of the underlying asset. For example, if protection on an Australian dollar denominated underlying asset is purchased via a credit derivative that pays US dollars if triggered, the amount of protection is the US dollar payment valued at the current exchange rate.
Attachment
Example
Capital Adequacy Treatment of the Protection Seller in a First-to-Default Basket Product in the Banking Book (Paragraph 28)
Assume an ADI sells protection on a basket of 10 reference entities, each risk weighted at 100%.
The terms of the credit derivative contract require the ADI to pay $100 if a credit event occurs on any one of the 10 reference entities, after which time the product will terminate.
The ADI is exposed to the 10 entities in the credit derivative basket. The amount of the exposure is $100 (because this is the amount the ADI stands to lose if a credit event occurs on any one of the 10 entities in the basket).
As per paragraph 28, the sum of the risk weights applicable to all the entities in the basket must be applied to the exposure to determine the risk‑weighted exposure. Since all entities in the basket are risk weighted at 100%, the risk‑weighted exposure of the ADI is 10 100% $100 = $1,000. The amount of capital to be held against this risk‑weighted exposure is $80 (8% of $1,000).
The amount of capital held against the exposure is capped at the maximum payout possible under the contract. The maximum payout in this example is $100. Since the amount of capital required to be held against this exposure is $80, the cap will not take effect.
Suppose that the basket contained 13 entities with exposures to each entity required to be risk weighted at 100%. The risk‑weighted exposure of the ADI in this case is 13 100% $100 = $1,300. The amount of capital that would normally be held against this risk‑weighted exposure is $104 (8% of $1,300). Since the Guidance Note allows the amount of capital held against the product to be capped at the maximum possible payout, the ADI need hold only $100 in capital against the position. This equates to a risk‑weighted exposure of $1,250 (i.e. $100 1/0.08). Hence, $1,250 should be added to the risk‑weighted assets of the ADI.
Notes to the Banking (prudential standard) determination No. 5 of 2006
Note: Prudential Standard APS 112 – Capital Adequacy: Credit Risk
Note 1
Note: The Banking (prudential standard) determination No. 5 of 2006 – Prudential Standard APS 112 – Capital Adequacy: Credit Risk (in force under paragraphs 11AF(1)(a) and (b) of the Banking Act 1959) as shown in this compilation is amended as indicated in the Tables below.