Risk Library
   Documents by Author
     Committees at the Bank for International...
       The Treatment of Potential Exposure For ...
         The treatment of potential exposure for ...
         Annex










 

The Treatment of Potential Exposure For Off-Balance-Sheet Items

Annex

Text amending the Capital Accord

The following text is to substitute for the section beginning on p. 23 of Annex 3 of the 1988 Capital Accord. It recognises the effects of netting in the calculation of the add-ons, expands the matrix of add-on factors, and also incorporates the language of the July 1994 amendment recognising bilateral netting in the calculation of current exposure. Footnotes are as they would appear in the amended 1988 Capital Accord.

Forwards, swaps, purchased options and similar derivative contracts

The treatment of forwards, swaps, purchased options and similar derivative contracts needs special attention because banks are not exposed to credit risk for the full face value of their contracts, but only to the potential cost of replacing the cash flow (on contracts showing positive value) if the counterparty defaults. The credit equivalent amounts will depend inter alia on the maturity of the contract and on the volatility of the rates and prices underlying that type of instrument. Instruments traded on exchanges may be excluded where they are subject to daily receipt and payment of cash variation margin. Options purchased over the counter are included with the same conversion factors as other instruments.

Despite the wide range of different instruments in the market, the theoretical basis for assessing the credit risk on all of them has been the same. It has consisted of an analysis of the behaviour of matched pairs of swaps under different volatility assumptions. Interest rate contracts are defined to include single-currency interest rate swaps, basis swaps, forward rate agreements, interest rate futures, interest rate options purchased and similar instruments. Exchange rate contracts include cross-currency interest rate swaps, forward foreign exchange contracts, currency futures, currency options purchased and similar instruments. Exchange rate contracts with an original maturity of 14 calendar days or less may be excluded. Gold contracts are treated the same as exchange rate contracts for the purpose of calculating credit risk except that contracts with original maturity of 14 calendar days or less are included. Precious metals other than gold receive a separate treatment and include forwards, swaps, purchased options and similar derivative contracts that are based on precious metals (e.g. silver, platinum, and palladium). Other commodities are also treated separately and include forwards, swaps, purchased options and similar derivative contracts based on energy contracts, agricultural contracts, base metals (e.g. aluminium, copper, and zinc), and any other non-precious metal commodity contracts. Equity contracts include forwards, swaps, purchased options and similar derivative contracts based on individual equities or on equity indices.

The current exposure method

The G-10 supervisory authorities are of the view that the best way to assess the credit risk on these items is to ask banks to calculate the current replacement cost by marking contracts to market, thus capturing the current exposure without any need for estimation, and then adding a factor (the "add-on") to reflect the potential future exposure over the remaining life of the contract. It has been agreed that, in order to calculate the credit equivalent amount of these instruments under this current exposure method, a bank would sum:

- the total replacement cost (obtained by "marking to market") of all its contracts with positive value and

- an amount for potential future credit exposure calculated on the basis of the total notional principal amount of its book, split by residual maturity as follows:


Residual Maturity

Interest Rate
Exchange Rate And Gold

Equity
Precious Metals
Except Gold
Other Commodities
One year or less
0.0%
1.0%
6.0%
7.0%
10.0%
Over one year
to five years
0.5%
5.0%
8.0%
7.0%
12.0%
Over five years
1.5%
7.5%
10.0%
8.0%
15.0%

Notes:

1. For contracts with multiple exchanges of principal, the factors are to be multiplied by the number of remaining payments in the contract.

2. For contracts that are structured to settle outstanding exposure following specified payment dates and where the terms are reset such that the market value of the contract is zero on these specified dates, the residual maturity would be set equal to the time until the next reset date. In the case of interest rate contracts with remaining maturities of more than one year that meet the above criteria, the add-on factor is subject to a floor of 0.5%.

3. Forwards, swaps, purchased options and similar derivative contracts not covered by any of the columns of this matrix are to be treated as "other commodities."

4. No potential future credit exposure would be calculated for single currency floating/floating interest rate swaps; the credit exposure on these contracts would be evaluated solely on the basis of their mark-to-market value.

Supervisors will take care to ensure that the add-ons are based on effective rather than apparent notional amounts. In the event that the stated notional amount is leveraged or enhanced by the structure of the transaction, banks must use the effective notional amount when determining potential future exposure.

The original exposure method

At national supervisory discretion, banks may also use a simpler alternative method for interest rate and foreign exchange related contracts, whereby the potential credit exposure is estimated against each type of contract and a notional capital weight allotted, no matter what the market value of the contract might be at a particular reporting date. The original exposure method may be used until market risk-related capital requirements are implemented, at which time the original exposure method will cease to be available for banks supervised according to this Accord. Banks that engage in forwards, swaps, purchased options or similar derivative contracts based on equities, precious metals except gold, or other commodities are required to apply the current exposure method.

In order to arrive at the credit equivalent amount using this original exposure method, a bank would simply apply one of the following two sets of conversion factors to the notional principal amounts of each instrument according to the nature of the instrument and its maturity:

Maturity
Interest Rate Contracts
Exchange Rate
Contracts and Gold
One year or less
0.5%
2.0%
Over one year to two years
1.0%
5.0%
(i.e. 2% + 3%)
For each additional year
1.0%
3.0%

Bilateral netting

Careful consideration has been given to the issue of bilateral netting, i.e., weighting the net rather than the gross claims with the same counterparties arising out of the full range of forwards, swaps, options and similar derivative contracts. The Committee is concerned that if a liquidator of a failed counterparty has (or may have) the right to unbundle netted contracts, demanding performance on those contracts favourable to the failed counterparty and defaulting on unfavourable contracts, there is no reduction in counterparty risk.

Accordingly, it has been agreed for capital adequacy purposes that:

  1. Banks may net transactions subject to novation under which any obligation between a bank and its counterparty to deliver a given currency on a given value date is automatically amalgamated with all other obligations for the same currency and value date, legally substituting one single amount for the previous gross obligations.
  2. Banks may also net transactions subject to any legally valid form of bilateral netting not covered in (a), including other forms of novation.
  3. In both cases (a) and (b), a bank will need to satisfy its national supervisor that it has:

    1. a netting contract or agreement with the counterparty which creates a single legal obligation, covering all included transactions, such that the bank would have either a claim to receive or obligation to pay only the net sum of the positive and negative mark-to-market values of included individual transactions in the event a counterparty fails to perform due to any of the following: default, bankruptcy, liquidation or similar circumstances;

    2. written and reasoned legal opinions that, in the event of a legal challenge, the relevant courts and administrative authorities would find the bank's exposure to be such a net amount under:

      • the law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of the jurisdiction in which the branch is located;

      • the law that governs the individual transactions; and

      • the law that governs any contract or agreement necessary to effect the netting.

      The national supervisor, after consultation when necessary with other relevant supervisors, must be satisfied that the netting is enforceable under the laws of each of the relevant jurisdictions;

    3. procedures in place to ensure that the legal characteristics of netting arrangements are kept under review in the light of possible changes in relevant law.

      Contracts containing walkaway clauses will not be eligible for netting for the purpose of calculating capital requirements pursuant to this Accord. A walkaway clause is a provision which permits a non-defaulting counterparty to make only limited payments, or no payment at all, to the estate of a defaulter, even if the defaulter is a net creditor.

      For banks using the current exposure method, credit exposure on bilaterally netted forward transactions will be calculated as the sum of the net mark-to-market replacement cost, if positive, plus an add-on based on the notional underlying principal. The add-on for netted transactions (ANet) will equal the weighted average of the gross add-on (AGross) and the gross add-on adjusted by the ratio of net current replacement cost to gross current replacement cost (NGR). This is expressed through the following formula:

      ANet=0.4*AGross+0.6*NGR*AGross

      where

      NGR=level of net replacement cost/level of gross replacement cost for transactions subject to legally enforceable netting agreements

      The scale of the gross add-ons to apply in this formula will be the same as those for non-netted transactions as set out in this Annex. The Committee will continue to review the scale of add-ons to make sure they are appropriate. For purposes of calculating potential future credit exposure to a netting counterparty for forward foreign exchange contracts and other similar contracts in which notional principal is equivalent to cash flows, notional principal is defined as the net receipts falling due on each value date in each currency. The reason for this is that offsetting contracts in the same currency maturing on the same date will have lower potential future exposure as well as lower current exposure.

      The original exposure method may also be used for transactions subject to netting agreements which meet the above legal requirements until market risk-related capital requirements are implemented. The conversion factors to be used during the transitional period when calculating the credit exposure of bilaterally netted transactions will be as follows:

      Maturity
      Interest Rate Contracts
      Exchange Rate
      Contracts
      One year or less
      0.35%
      1.5%
      Over one year to two years
      0.75%
      3.75%
      (i.e. 1.5% + 2.25%)
      For each additional year
      0.75%
      2.25%

      These factors represent a reduction of approximately 25% from those on page 29 of the Accord. For purposes of calculating the credit exposure to a netting counterparty during the transitional period for forward foreign exchange contracts and other similar contracts in which notional principal is equivalent to cash flows, the credit conversion factors on page 29 of the Accord could be applied to the notional principal, which would be defined as the net receipts falling due on each value date in each currency. In no case could the reduced factors above be applied to net notional amounts.

      Risk weighting

      Once the bank has calculated the credit equivalent amounts, whether according to the current or the original exposure method, they are to be weighted according to the category of counterparty in the same way as in the main framework, including concessionary weighting in respect of exposures backed by eligible guarantees and collateral. In addition, since most counterparties in these markets, particularly for long-term contracts, tend to be first-class names, it has been agreed that a 50 per cent. weight will be applied in respect of counterparties which would otherwise attract a 100 per cent. weight. However, the Committee will keep a close eye on the credit quality of participants in these markets and reserves the right to raise the weights if average credit quality deteriorates or if loss experience increases.

Contact us * Risk Library * Documents by Author * Committees at the Bank for International Settlement (BIS) * The Treatment of Potential Exposure For Off-Balance-Sheet Items