Financial institutions have a range of regulations and controls, a pri- mary one is the level of capital that a bank holds to provide a cushion for the activities the banking engages on. This should not be confused with the use of reserves which also guard against losses. Capital is set aside to cushion against ‘unexpected’, or very rare, losses. Of course there is the crucial element of how ‘unexpected’ is defined – it could be determined through a combination of assessing historical losses and informed selection. Setting aside too much capital would be inefficient.
The decision is taken out of the managers hands and replaced by the work of a banking supervisor. Such then, is the remit of the Bank for International Settlements (BIS), who set out the terms within the EC Solvency Ratio and Capital Adequacy Directive (1992).
The banking activities are divided for purposes of regulatory treatment into a banking portfolioand a trading portfolio.The distinction is one of holding period, the former relate mainly to loans held by the bank for
Table 3.12 Cumulative default probabilities.
Default probabilities from the ‘bootstrap’ process
Maturity Risk free Hazard Survival Default
(%) rate (%) probability (%) probability (%)
6 months 2.6 1.66 99.17 0.83
1 year 2.6 1.66 97.54 1.63
2 year 2.6 1.66 95.93 1.61
3 year 2.6 1.66 94.36 1.58
Table 3.13 Three year annuity.
Cumulative default probability
Risk free Annuity Defaulted Total PV
DF payment payment
6 months 0.9871 R*0.0083 R*0.00819
1 year 0.9743 A*0.9754 R*0.0163 A*0.9504R*0.0159
2 year 0.9493 A*0.9593 R*0.0161 A*0.9107R*0.0152
3 year 0.9250 A*0.9436 R*0.0158 A*0.8728R*0.0146
Total 2.734*A0.0539*R
extended periods. The trading book consists of more liquid bonds and assets held for shorter periods because of either market making or brokerage activities. The trading book is furthermore required to be marked-to-market.
We begin by discussing the banking book. Under the requirements all cash and off balance sheet instruments in the bank’s portfolio will be assigned a risk weighting, based on their perceived credit risk, which determines the level of capital set against them. This is known as BIS1 or the Basel Capital Ratios.
The methodology is as follows, each asset is banded into different risk categories, these grades are loosely connected with the probability of the issuer defaulting on their obligation. This percentage is multi- plied by a further percentage, the so-called ‘8 per cent rule’. To deter- mine the capital set aside we multiply this percentage by the notional outstanding.
The details of the risk weights are as follows:
• Sovereign debt for member countries of the OECD will receive a 0 per cent risk weight (this means the bank does not need to reserve any capital against these assets).
• The senior debt for OECD banks receives a 20 per cent risk weight.
Then a 1.6 per cent charge on the notional.
• Loans are treated according to whether they are either drawn or not. If the loan is not committed then a 50 per cent risk weight is employed. If the revolver funds then the bank would assign 100 per cent. Then a 8 per cent charge on the notional.
• For corporate debt and non-OECD sovereigns, assign a 100 per cent risk weight. Then a 8 per cent charge on the notional.
For example if we consider a bond issued by an OECD bank, with a maturity of 6 years and a notional of €25 000 000 then the appropriate risk weight is 20 per cent, multiplying this by the notional gives us the risk adjusted balance of $5 000 000. We then multiply by the risk asset ration of 1.6 per cent to arrive at the risk capital amount of €80 000.
These weights are a first attempt to create ‘a one fits all’ system of rat- ing. As such there are major shortcomings, in particular some rather strange consequences have arisen. These include the case of Turkey – which is an OECD member and thus incurs a 0 per cent risk weight.
Their debt however trades at a very large spread to the risk free rate.
Another unforeseen consequence is the removal of high-grade cor- porate loans from balance sheets because they all carry the same charge.
Regulatory treatment of credit derivatives is currently in a state of flux and a revised framework is due. One of the difficulties is they came into
being after the 1998 accord. With this as a qualification we move onto consider the case of credit derivatives within the banking book according to the 1998 rules.
It should be borne in mind that the regulatory requirements provided by the Basel Committee are used as the minimum standard adopted by local regulators. Furthermore because credit derivatives were not covered in the original accord there is some flexibility in the precise treatment. However all local regimes share the treatment of a short pro- tection credit derivative as a long artificial position in the reference asset, in which case the Basel weights reviewed above apply.
A buyer of protection constructing a hedge on a cash position (i.e. an owner of the underlying asset) is usually granted capital relief provided it can be demonstrated that the credit risk has been transferred to the protection seller. In practice this means that the capital allocation is determined from the category of the counterparty selling protection. For example if the reference is a corporate (requiring 100 per cent of the nominal) and the hedge is purchased through an OECD member bank, then the charge falls to 20 per cent of the nominal adjusted by the risk ratio of 1.6 per cent from 8 per cent.
There is a major shortcoming inherent, which is the relevant prob- ability of default is not the OECD bank but rather the joint default prob- ability. Further, there is no regulatory gain in buying protection from a corporate enjoying a better rating than the bank.
On the positive side the amount attracting a charge is lower than the notional and equal to the difference between the notional and the recov- ery value. There is also a difference in treatment for an asset partially hedged in terms of the protection having a shorter maturity than the asset leading to a forward exposure. Typically two different weights are employed. We refer the reader to section two within the chapter on the credit risk of libor products where maturity ‘adjustments’ are dis- cussed in detail.
Regulatory capital example
We introduce one of the applications of TRORS to exploit regulatory inefficiencies. The regulatory environment has a great effect on the effective return earned by an off balance sheet item. In Table 3.14 we illustrate the situation of a bank entering a TROR with different coun- terparties. On the one hand the regulators require 100 per cent risk weighting whereas on the other the risk weighting is only 20 per cent.
The asset income in each situation is identical to 60 bps. This should mean the banks indifference to the counterparty, but because of the
inefficiencies in the way these counterparties are treated from a regu- latory perspective means the capital assignment differs and hence the return.