Basics of Credit Derivatives

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BIS II proposals on credit derivatives
based on final version released June 2004

The BIS has issued the 3rd (and possibly the final) consultative paper on 29th April 2003 which made elaborate provisions on risk mitigations in general including credit derivatives. Most of these changes have been retained in the final draft.

The essential approach of the Basle II on credit derivatives is substitution approach - that is, the risk weight of the protection seller substitutes the risk weight of the underlying asset.

The new guidelines put in extensive eligibility conditions for the protection seller, have dropped restructuring to be a credit event in certain circumstances, have allowed asset mismatches in certain circumstances, etc.

By way of a general qualification, a credit derivative must be a direct claim on the protection seller and must be unconditional and irrevocable. The following are the further specific requirements in case of credit derivatives:

  • The credit events specified must at least include the following:
    • Failure to pay and analogous events with a grace period that is consistent with the grace period allowed as for the underlying credit
    • bankruptcy, insolvecy or inability to pay the amount, or admission in writing of its inability to pay, and analogous events
    • adverse restructuring of the terms, that is, 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).
    • In cases where restructuring is not included as a credit event, the amount of hedge is limited to 60%. In other words, 40% of the underlying exposure will be deemed as if it is unprotected.
  • Asset mismatches, that is, the reference obligation and the underlying asset being different, are allowed only if it is of the same obligor, and the underlying obligation ranks at par, or is senior to the reference obligation.
  • The credit derivative must not expire before the grace period to be given in an event of default.
  • In case of cash settlements, there must be robust valuation process in place.
  • The determination of a credit event having happened must be defintive and objective; in particular, the protection seller must not have the right to notify such event.

Asset mismatches

Asset mismatches, that is, the referece obligation in the credit derivative being diferent from hedged asset, the hedged asset and the reference obligation must be with the same obligor, and the reference obligation must be either ranking at par or junior to the hedged obligation.

Eligible protection sellers

The list of eligible protection providers is greatly expanded to include:

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

Capital charge

The capital charge is computed as usual by assigning the risk weight of the protection seller to the obligor.

Materiality thresholds are equivalent to the first loss, and are a deduction from capital straightaway.

The w factor contained in the initial drafts is not found in the April 2003 draft.

In case of tranched cover, that is, first loss, second loss or subsequent loss tranched out to different parties, the rules relating to securitisation framework will be applicable. As for securitisation framework, refer to our site http://vinodkothari.com.

 

 

This is the original write up before the CP3 issued in April 2003

Update
As per a Sept 2001 update from BIS, the Committee seems to have decided to remove the w factor charge and replace it with a supervisory charge. See our news report here.

 

BIS II refers to the revised standard on regulatory capital proposed by the Bank for International Settlements (BIS) in January 2001.

BIS-II lays down new criteria for credit derivatives to provide capital relief to the protection buyer and capital charge to the protection seller.

Para 117 to 145 of BIS -II provide for impact of guarantees and credit derivatives on bank capital.

As a general rule, no credit-protected exposure can lead to a higher capital requirement than identical asset which is unprotected. In other words, protection cannot be worse than the lack of it.

Basic qualifying conditions
In order to qualify as a credit protection under the norms, the credit derivative must satisfy 4 basic conditions:

  • Direct claim on the protection seller
  • Explicit and related to specific exposure, not an indefinite referenced asset
  • Irrevocable
  • Unconditional

The w factor
The notion of the W factor is based on the assumption that even with protection provided by the protection seller, there are still some risks on the obligor that are left unprotected.

The w factor in case of credit derivatives is assumed to be 15%.

Computation of risk weightage
The risk weight for a protected transaction is computed based on the weighted average of the risks of the obligor and the protection seller. In case of a fully protected exposure, the risk weightage is computed as follows:

r* = w x r + (1 - w) x g

where r* is the adjusted risk weightage to be computed;
w is the factor mentioned above
r is the risk weightage of the obligor
and g is the risk weightage of the protection seller.

So, assuming the risk weightage of the protection seller is 20% and that of the obligor is 100%, the risk weightage of the protected transaction is:

= 15% x 100% + 85% x 20% = 32%

In case the protection is available for a part of the amount of an exposure, the part protected is subject to the above formula and the balance is treated as unprotected.

In case of tranched protection
Quite common in credit derivatives and credit linked notes is to provide a tranched risk protection: first loss, second loss and subsequent losses being protected by different parties.

If a bank transfers junior risk and retains senior risk, the extent of junior risk transferred is taken as protected and the senior risk is taken as unprotected, risk-weighted at the weightage applicable to the obligor.

For the protection proviver, assumption of junior or first-loss risk leads to a reduction from capital.

If the transferring bank retains junior risk and transfers senior risk, the junior risk is deducted from the capital of the protection seller. For the protection buyer, the risk weightage will be based on the weighted average of the risks of the protection buyer and the obligor, based on a w factor of 15%.

Operational requirements
 There is a set of detailed operational requirements for credit derivatives, listed in Para 126-128 of the Standard. Notably, the BIS requires that credit event should be defined to include at least the following:

  • failure to pay the amounts due according to the reference asset specified in the contract;
  • a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals;
  • a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates;
  • a change in the ranking in the priority of payment of any obligation, causing the subordination of such obligation.

These definitions are not exactly the same as the ISDA definitions - for comparision, see our page here.

As per BIS, only credit default swaps and total rate of return swaps qualify for protection.