High cost credit protection: statement issued by the Basel Committee

16 December 2011

Recent transactions have raised concerns among supervisors about potential regulatory capital arbitrage related to some credit protection transactions. Given the supervisory concerns related to such transactions, this statement is intended to alert banks that supervisors will closely scrutinise such transactions in both the specific context of the evaluation of credit risk transfer within the securitisation framework, as well as within the broader context of the Basel Pillar 2 supervisory review process and assessment of capital adequacy.

Background

The Basel capital framework recognises that credit risk mitigation techniques can significantly reduce credit risk and can serve as an effective risk management tool. In particular, paragraph 140 of the framework establishes that where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and supervisors are satisfied that banks fulfil certain minimum operational conditions relating to risk management processes, banks may take account of such credit protection in calculating capital requirements.

Nevertheless, the Committee notes that there exists potential for capital arbitrage within the credit risk mitigation framework, including the use of credit risk mitigation for securitisation exposures, particularly when (i) there is a delay in recognising losses and the costs of protection in earnings while (ii) the bank receives an immediate regulatory capital benefit in the form of a lower risk weight on an exposure on which it is nominally transferring risk. In some instances, the premiums or fees and other direct or indirect costs paid for certain credit protection, combined with other terms and conditions, call into question the degree of credit risk mitigation or credit risk transfer of the transaction. Rather than contributing to a prudent risk management strategy, the primary effect of these high-cost credit protection transactions may be to structure the premiums and fees so to receive favourable risk-based capital treatment in the short term and defer recognition of losses over an extended period, without meaningful risk mitigation or transfer of risk.

For example, consider a bank that purchases credit protection on a first-loss retained securitisation position where the cost of protection is equal to the recorded value of the securitisation tranche on which protection is being purchased or where the terms and conditions of the contract ensure that the premiums paid throughout the life of the contract will equal the amount of the realised losses. Regulatory capital arbitrage may exist where the immediate capital relief recognised for credit protection purchased ultimately will be offset by the premiums paid and recognised in earnings over the life of the contract.

While the example above focuses on the use of credit risk mitigation in a securitisation transaction, arbitrage opportunities exist more generally under the credit risk mitigation framework. However, arbitrage opportunities are more likely to occur when credit risk mitigation techniques are used for securitisation transactions, where the difference in the risk weight before and after buying protection can be very large.

Supervisory response and areas of heightened concern

In response to these concerns, the Committee is clarifying that supervisors will consider the cost of credit protection that has not yet been recognised in earnings when assessing whether credit protection purchased should be recognised for purposes of regulatory capital, including whether a bank meets the Basel standards for significant credit risk transference within the securitisation framework contained in paragraphs 554(a) and 555(d) of the Basel comprehensive framework. In order for exposures to be de-recognised for risk-based capital purposes under the securitisation framework, significant credit risk associated with the securitised exposures must be transferred to third parties. Material costs of credit protection should be considered in this analysis. 1

More generally, banks and supervisors should consider the relevant costs of protection purchased - whether in the context of the Basel securitisation framework or within the credit risk mitigation framework - when assessing a bank's capital adequacy. Furthermore, banks should analyse and document the economic substance of credit protection transactions that have unusually high-cost or innovative features to assess the degree of risk transference and the associated impact on the bank's overall capital adequacy. Banks should bring to the attention of their supervisor any innovative positions which fall under this guidance to ensure they are subject to appropriate prudential treatment. The analysis also should specify how the transaction aligns with the bank's overall risk management strategy.

In evaluating the degree of credit risk mitigation or credit risk transfer of a transaction, banks should consider, and supervisors will assess, the following factors, among others, as applicable:

Supervisors also should focus more attention on credit protection transactions that exhibit the characteristics noted below.

Conclusion

The guidance provided above is intended to ensure that the costs, as well as the benefits, of purchased credit protection are appropriately recognised in regulatory and other capital adequacy assessments. These considerations are intended to provide supervisors with the tools necessary to effectively assess the degree of risk transference of certain credit protection transactions, while also providing the flexibility to deal with the variety of transaction structures that have been observed in the market, as well as those that might appear in the future. The Basel Committee will continue to monitor developments with respect to high-cost credit protection transactions and will consider taking a more comprehensive Pillar 1 approach to these transactions.

 

1 For example, in the assessment of significant credit risk transference under paragraphs 554(a) and 555(d), supervisors should consider these unrecognised premia as a retained position. These premia could be quantified for purposes of such an analysis in a number of ways, including through an appropriately conservative present value calculation.