Basel Committee on Banking Supervision

Banks can choose between two broad methodologies for calculating their risk-based capital requirements for credit risk. The first is the standardised approach, which is set out in chapters CRE20 to CRE22:

1. The standardised approach assigns standardised risk weights to exposures as described in this chapter, CRE20. Risk weighted assets are calculated as the product of the standardised risk weights and the exposure amount. Exposures should be risk-weighted net of specific provisions (including partial write-offs).
2. To determine the risk weights in the standardised approach for certain exposure classes, in jurisdictions that allow the use of external ratings for regulatory purposes, banks may, as a starting point, use assessments by external credit assessment institutions that are recognised as eligible for capital purposes by national supervisors. The requirements covering the use of external ratings are set out in chapter CRE21.¹
3. The credit risk mitigation techniques that are permitted to be recognised under the standardised approach are set out in chapter CRE22.

The second risk-weighted capital treatment for measuring credit risk, the internal ratings-based (IRB) approach, allows banks to use their internal rating systems for credit risk, subject to the explicit approval of the bank’s supervisor. The IRB approach is set out in CRE30 to CRE36.

The treatment of the following exposures is addressed in separate chapters of the credit risk standard:

1. Equity investments in funds are addressed in CRE60.
2. Securitisation exposures are addressed in CRE40 to CRE45.
3. Exposures to central counterparties are addressed in CRE54.
4. Exposures arising from unsettled transactions and failed trades are addressed in CRE70.

Consistent with the Committee's guidance on the assessment of credit risk² and paragraphs SRP20.12 to SRP20.14 of the supervisory review process standard, banks must perform due diligence to ensure that they have an adequate understanding, at origination and thereafter on a regular basis (at least annually), of the risk profile and characteristics of their counterparties. In cases where ratings are used, due diligence is necessary to assess the risk of the exposure for risk management purposes and whether the risk weight applied is appropriate and prudent.³ The sophistication of the due diligence should be appropriate to the size and complexity of banks' activities. Banks must take reasonable and adequate steps to assess the operating and financial performance levels and trends through internal credit analysis and/or other analytics outsourced to a third party, as appropriate for each counterparty. Banks must be able to access information about their counterparties on a regular basis to complete due diligence analyses.

For exposures to entities belonging to consolidated groups, due diligence should, to the extent possible, be performed at the solo entity level to which there is a credit exposure. In evaluating the repayment capacity of the solo entity, banks are expected to take into account the support of the group and the potential for it to be adversely impacted by problems in the group.

Banks should have in place effective internal policies, processes, systems and controls to ensure that the appropriate risk weights are assigned to counterparties. Banks must be able to demonstrate to their supervisors that their due diligence analyses are appropriate. As part of their supervisory review, supervisors should ensure that banks have appropriately performed their due diligence analyses, and should take supervisory measures where these have not been done.

Exposures to sovereigns and their central banks will be risk-weighted as follows:

At national discretion, a lower risk weight may be applied to banks’ exposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded⁴ in that currency.⁵ Where this discretion is exercised, other national supervisors may also permit their banks to apply the same risk weight to domestic currency exposures to this sovereign (or central bank) funded in that currency.

For the purpose of risk-weighting exposures to sovereigns, supervisors may recognise the country risk scores assigned by Export Credit Agencies (ECAs). To qualify, an ECA must publish its risk scores and subscribe to the methodology agreed by the Organisation for Economic Cooperation and Development (OECD). Banks may choose to use the risk scores published by individual ECAs that are recognised by their supervisor, or the consensus risk scores of ECAs participating in the “Arrangement on Officially Supported Export Credits”.⁶ The OECD-agreed methodology establishes eight risk score categories associated with minimum export insurance premiums. These ECA risk scores will correspond to risk weight categories as detailed below.

Exposures to the Bank for International Settlements, the International Monetary Fund, the European Central Bank, the European Union, the European Stability Mechanism and the European Financial Stability Facility may receive a 0% risk weight.

Exposures to domestic PSEs will be risk-weighted at national discretion, according to either of the following two options.

Subject to national discretion, exposures to certain domestic PSEs⁷ may also be treated as exposures to the sovereigns in whose jurisdictions the PSEs are established. Where this discretion is exercised, other national supervisors may allow their banks to risk-weight exposures to such PSEs in the same manner.

For the purposes of calculating capital requirements, a Multilateral Development Bank (MDB) is an institution created by a group of countries that provides financing and professional advice for economic and social development projects. MDBs have large sovereign memberships and may include both developed and/or developing countries. Each MDB has its own independent legal and operational status, but with a similar mandate and a considerable number of joint owners.

A 0% risk weight will be applied to exposures to MDBs that fulfil to the Committee’s satisfaction the eligibility criteria provided below.⁸ The Committee will continue to evaluate eligibility on a case-by-case basis. The eligibility criteria for MDBs risk-weighted at 0% are:

1. very high-quality long-term issuer ratings, ie a majority of an MDB’s external ratings must be AAA;⁹
2. either the shareholder structure comprises a significant proportion of sovereigns with long-term issuer external ratings of AA– or better, or the majority of the MDB’s fund-raising is in the form of paid-in equity/capital and there is little or no leverage;
3. strong shareholder support demonstrated by the amount of paid-in capital contributed by the shareholders; the amount of further capital the MDBs have the right to call, if required, to repay their liabilities; and continued capital contributions and new pledges from sovereign shareholders;
4. adequate level of capital and liquidity (a case-by-case approach is necessary in order to assess whether each MDB’s capital and liquidity are adequate); and,
5. strict statutory lending requirements and conservative financial policies, which would include among other conditions a structured approval process, internal creditworthiness and risk concentration limits (per country, sector, and individual exposure and credit category), large exposures approval by the board or a committee of the board, fixed repayment schedules, effective monitoring of use of proceeds, status review process, and rigorous assessment of risk and provisioning to loan loss reserve.

For exposures to all other MDBs, banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes will assign to their MDB exposures the corresponding “base” risk weights determined by the external ratings according to Table 5. Banks incorporated in jurisdictions that do not allow external ratings for regulatory purposes will risk-weight such exposures at 50%.

For the purposes of calculating capital requirements, a bank exposure is defined as a claim (including loans and senior debt instruments, unless considered as subordinated debt for the purposes of CRE20.60) on any financial institution that is licensed to take deposits from the public and is subject to appropriate prudential standards and level of supervision.¹⁰ The treatment associated with subordinated bank debt and equities is addressed in CRE20.53 to CRE20.60.

Bank exposures will be risk-weighted based on the following hierarchy:¹¹

1. External Credit Risk Assessment Approach (ECRA): This approach is for banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes. It applies to all their rated exposures to banks. Banks will apply CRE21.1 to CRE21.21 to determine which rating can be used and for which exposures.
2. Standardised Credit Risk Assessment Approach (SCRA): This approach is for all exposures of banks incorporated in jurisdictions that do not allow the use of external ratings for regulatory purposes. For exposures to banks that are unrated, this approach also applies to banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes.

Banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes will assign to their rated bank exposures¹² the corresponding “base” risk weights determined by the external ratings according to Table 6. Such ratings must not incorporate assumptions of implicit government support, unless the rating refers to a public bank owned by its government.¹³ Banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes must only apply SCRA for their unrated bank exposures, in accordance with CRE20.21.

Exposures to banks with an original maturity of three months or less, as well as exposures to banks that arise from the movement of goods across national borders with an original maturity of six months or less¹⁴ can be assigned a risk weight that correspond to the risk weights for short term exposures in Table 6.

Banks must perform due diligence to ensure that the external ratings appropriately and conservatively reflect the creditworthiness of the bank counterparties. If the due diligence analysis reflects higher risk characteristics than that implied by the external rating bucket of the exposure (ie AAA to AA–; A+ to A– etc), the bank must assign a risk weight at least one bucket higher than the "base" risk weight determined by the external rating. Due diligence analysis must never result in the application of a lower risk weight than that determined by the external rating.

Banks incorporated in jurisdictions that do not allow the use of external ratings for regulatory purposes will apply the SCRA to all their bank exposures. The SCRA also applies to unrated bank exposures for banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes. The SCRA requires banks to classify bank exposures into one of three risk-weight buckets (ie Grades A, B and C) and assign the corresponding risk weights in Table 7.¹⁵ For the purposes of the SCRA only, “published minimum regulatory requirements” in CRE20.22 to CRE20.30 excludes liquidity standards.

Grade A refers to exposures to banks, where the counterparty bank has adequate capacity to meet their financial commitments (including repayments of principal and interest) in a timely manner, for the projected life of the assets or exposures and irrespective of the economic cycles and business conditions.

A counterparty bank classified into Grade A must meet or exceed the published minimum regulatory requirements and buffers established by its national supervisor as implemented in the jurisdiction where it is incorporated, except for bank-specific minimum regulatory requirements or buffers that may be imposed through supervisory actions (eg via the Supervisory Review Process, SRP) and not made public. If such minimum regulatory requirements and buffers (other than bank-specific minimum requirements or buffers) are not publicly disclosed or otherwise made available by the counterparty bank, then the counterparty bank must be assessed as Grade B or lower.

If as part of its due diligence, a bank assesses that a counterparty bank does not meet the definition of Grade A in CRE20.22 and CRE20.23, exposures to the counterparty bank must be classified as Grade B or Grade C.

Grade B refers to exposures to banks, where the counterparty bank is subject to substantial credit risk, such as repayment capacities that are dependent on stable or favourable economic or business conditions.

A counterparty bank classified into Grade B must meet or exceed the published minimum regulatory requirements (excluding buffers) established by its national supervisor as implemented in the jurisdiction where it is incorporated, except for bank-specific minimum regulatory requirements that may be imposed through supervisory actions (eg via the Supervisory Review Process, SRP) and not made public. If such minimum regulatory requirements are not publicly disclosed or otherwise made available by the counterparty bank then the counterparty bank must be assessed as Grade C.

Banks will classify all exposures that do not meet the requirements outlined in CRE20.22 and CRE20.23 into Grade B, unless the exposure falls within Grade C under CRE20.28 to CRE20.30.

Grade C refers to higher credit risk exposures to banks, where the counterparty bank has material default risks and limited margins of safety. For these counterparties, adverse business, financial, or economic conditions are very likely to lead, or have led, to an inability to meet their financial commitments.

At a minimum, if any of the following triggers is breached, a bank must classify the exposure into Grade C:

1. The counterparty bank does not meet the criteria for being classified as Grade B with respect to its published minimum regulatory requirements, as set out in CRE20.25 and CRE20.26; or
2. Where audited financial statements are required, the external auditor has issued an adverse audit opinion or has expressed substantial doubt about the counterparty bank’s ability to continue as a going concern in its financial statements or audited reports within the previous 12 months.

Even if the triggers set out in CRE20.29 are not breached, a bank may assess that the counterparty bank meets the definition in CRE20.28. In that case, the exposure to such counterparty bank must be classified into Grade C.

Exposures to banks with an original maturity of three months or less, as well as exposures to banks that arise from the movement of goods across national borders with an original maturity of six months or less,¹⁶ can be assigned a risk weight that correspond to the risk weights for short term exposures in Table 7.

To reflect transfer and convertibility risk under the SCRA, a risk-weight floor based on the risk weight applicable to exposures to the sovereign of the country where the bank counterparty is incorporated will be applied to the risk weight assigned to bank exposures. The sovereign floor applies when: (i) the exposure is not in the local currency of the jurisdiction of incorporation of the debtor bank; and (ii) for a borrowing booked in a branch of the debtor bank in a foreign jurisdiction, when the exposure is not in the local currency of the jurisdiction in which the branch operates. The sovereign floor will not apply to short-term (ie with a maturity below one year) self-liquidating, trade-related contingent items that arise from the movement of goods.

Covered bonds are bonds issued by a bank or mortgage institution that are subject by law to special public supervision designed to protect bond holders. Proceeds deriving from the issue of these bonds must be invested in conformity with the law in assets which, during the whole period of the validity of the bonds, are capable of covering claims attached to the bonds and which, in the event of the failure of the issuer, would be used on a priority basis for the reimbursement of the principal and payment of the accrued interest.

In order to be eligible for the risk weights set out in CRE20.38, the underlying assets (the cover pool) of covered bonds as defined in CRE20.33 shall meet the requirements set out in CRE20.37 and shall include any of the following:

1. claims on, or guaranteed by, sovereigns, their central banks, public sector entities or multilateral development banks;
2. claims secured by residential real estate that meet the criteria set out in CRE20.71 and with a loan-to-value ratio of 80% or lower;
3. claims secured by commercial real estate that meets the criteria set out in CRE20.71 and with a loan-to-value ratio of 60% or lower; or
4. claims on, or guaranteed by banks that qualify for a 30% or lower risk weight. However, such assets cannot exceed 15% of covered bond issuances.

The nominal value of the pool of assets assigned to the covered bond instrument(s) by its issuer should exceed its nominal outstanding value by at least 10%. The value of the pool of assets for this purpose does not need to be that required by the legislative framework. However, if the legislative framework does not stipulate a requirement of at least 10%, the issuing bank needs to publicly disclose on a regular basis that their cover pool meets the 10% requirement in practice. In addition to the primary assets listed in this paragraph, additional collateral may include substitution assets (cash or short term liquid and secure assets held in substitution of the primary assets to top up the cover pool for management purposes) and derivatives entered into for the purposes of hedging the risks arising in the covered bond program.

The conditions set out in CRE20.34 and CRE20.35 must be satisfied at the inception of the covered bond and throughout its remaining maturity.

Exposures in the form of covered bonds are eligible for the treatment set out in CRE20.38, provided that the bank investing in the covered bonds can demonstrate to its national supervisors that:

1. it receives portfolio information at least on:
   1. the value of the cover pool and outstanding covered bonds;
   2. the geographical distribution and type of cover assets, loan size, interest rate and currency risks;
   3. the maturity structure of cover assets and covered bonds; and
   4. the percentage of loans more than 90 days past due; and
2. the issuer makes the information referred to in point (1) available to the bank at least semi-annually.

Covered bonds that meet the criteria set out in the CRE20.34 to CRE20.37 shall be risk-weighted based on the issue-specific rating or the issuer’s risk weight according to the rules outlined in CRE21.1 to CRE21.21. For covered bonds with issue-specific ratings,¹⁷ the risk weight shall be determined according to Table 8. For unrated covered bonds, the risk weight would be inferred from the issuer’s ECRA or SCRA risk weight according to Table 9.

Banks must perform due diligence to ensure that the external ratings appropriately and conservatively reflect the creditworthiness of the covered bond and the issuing bank. If the due diligence analysis reflects higher risk characteristics than that implied by the external rating bucket of the exposure (ie AAA to AA–; A+ to A– etc), the bank must assign a risk weight at least one bucket higher than the "base" risk weight determined by the external rating. Due diligence analysis must never result in the application of a lower risk weight than that determined by the external rating.

Exposures to securities firms and other financial institutions will be treated as exposures to banks provided that these firms are subject to prudential standards and a level of supervision equivalent to those applied to banks (including capital and liquidity requirements). National supervisors should determine whether the regulatory and supervisory framework governing securities firms and other financial institutions in their own jurisdictions is equivalent to that which is applied to banks in their own jurisdictions. Where the regulatory and supervisory framework governing securities firms and other financial institutions is determined to be equivalent to that applied to banks in a jurisdiction, other national supervisors may allow their banks to risk weight such exposures to securities firms and other financial institutions as exposures to banks. Exposures to all other securities firms and financial institutions will be treated as exposures to corporates.

For the purposes of calculating capital requirements, exposures to corporates include exposures (loans, bonds, receivables, etc) to incorporated entities, associations, partnerships, proprietorships, trusts, funds and other entities with similar characteristics, except those which qualify for one of the other exposure classes. The treatment associated with subordinated debt and equities of these counterparties is addressed in CRE20.53 to CRE20.62. The corporate exposure class includes exposures to insurance companies and other financial corporates that do not meet the definitions of exposures to banks, or securities firms and other financial institutions, as determined in CRE20.16 and CRE20.40 respectively. The corporate exposure class does not include exposures to individuals. The corporate exposure class differentiates between the following subcategories:

1. General corporate exposures;
2. Specialised lending exposures, as defined in CRE20.48.

For corporate exposures of banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes, banks will assign "base" risk weights according to Table 10.¹⁸ Banks must perform due diligence to ensure that the external ratings appropriately and conservatively reflect the creditworthiness of the counterparties. Banks which have assigned risk weights to their rated bank exposures based on CRE20.18 must assign risk weights for all their corporate exposures according to Table 10. If the due diligence analysis reflects higher risk characteristics than that implied by the external rating bucket of the exposure (ie AAA to AA–; A+ to A– etc), the bank must assign a risk weight at least one bucket higher than the "base" risk weight determined by the external rating. Due diligence analysis must never result in the application of a lower risk weight than that determined by the external rating.

Unrated corporate exposures of banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes will receive a 100% risk weight, with the exception of unrated exposures to corporate small or medium-sized entities (SMEs), as described in CRE20.47.

For corporate exposures of banks incorporated in jurisdictions that do not allow the use of external ratings for regulatory purposes, banks will assign a 100% risk weight to all corporate exposures, with the exception of:

1. exposures to corporates identified as “investment grade” in CRE20.46; and
2. exposures to corporate SMEs in CRE20.47.

Banks must apply the treatment set out in CRE20.44 to their corporate exposures if they have assigned risk weights to their rated bank exposures based on CRE20.21.

Banks in jurisdictions that do not allow the use of external ratings for regulatory purposes may assign a 65% risk weight to exposures to "investment grade" corporates. An "investment grade" corporate is a corporate entity that has adequate capacity to meet its financial commitments in a timely manner and its ability to do so is assessed to be robust against adverse changes in the economic cycle and business conditions. When making this determination, the bank should assess the corporate entity against the investment grade definition taking into account the complexity of its business model, performance against industry and peers, and risks posed by the entity's operating environment. Moreover, the corporate entity (or its parent company) must have securities outstanding on a recognised securities exchange.

Corporate SMEs are defined as corporate exposures where the reported annual sales for the consolidated group of which the corporate counterparty is a part is less than or equal to €50 million for the most recent financial year. In some jurisdictions (eg emerging economies), national supervisors might deem it appropriate to define SMEs in a more conservative manner (ie with a lower level of sales). For unrated exposures to corporate SMEs in jurisdictions that allow the use of external ratings for regulatory purposes, and for all exposures to corporate SMEs in jurisdictions that do not allow the use of external ratings for regulatory purposes, an 85% risk weight will be applied. Exposures to SMEs that meet the criteria in CRE20.65(1) to CRE20.65(3) will be treated as regulatory retail SME exposures and risk weighted at 75%.

A corporate exposure will be treated as a specialised lending exposure if such lending possesses some or all of the following characteristics, either in legal form or economic substance:

1. The exposure is not related to real estate and is within the definitions of object finance, project finance or commodities finance under CRE20.49. If the activity is related to real estate, the treatment would be determined in accordance with CRE20.69 to CRE20.91;
2. The exposure is typically to an entity (often a special purpose vehicle (SPV)) that was created specifically to finance and/or operate physical assets;
3. The borrowing entity has few or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed. The primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of the borrowing entity; and
4. The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates.

Exposures described in CRE20.48 will be classified in one of the following three subcategories of specialised lending:

1. Project finance refers to the method of funding in which the lender looks primarily to the revenues generated by a single project, both as the source of repayment and as security for the loan. This type of financing is usually for large, complex and expensive installations such as power plants, chemical processing plants, mines, transportation infrastructure, environment, media, and telecoms. Project finance may take the form of financing the construction of a new capital installation, or refinancing of an existing installation, with or without improvements.
2. Object finance refers to the method of funding the acquisition of equipment (eg ships, aircraft, satellites, railcars, and fleets) where the repayment of the loan is dependent on the cash flows generated by the specific assets that have been financed and pledged or assigned to the lender.
3. Commodities finance refers to short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities (eg crude oil, metals, or crops), where the loan will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the loan.

Banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes will assign to their specialised lending exposures the risk weights determined by the issue-specific external ratings, if these are available, according to Table 10. Issuer ratings must not be used (ie CRE21.12 does not apply in the case of specialised lending exposures).

For specialised lending exposures for which an issue-specific external rating is not available, and for all specialised lending exposures of banks incorporated in jurisdictions that do not allow the use of external ratings for regulatory purposes, the following risk weights will apply:

1. Object and commodities finance exposures will be risk-weighted at 100%;
2. Project finance exposures will be risk-weighted at 130% during the pre-operational phase and 100% during the operational phase. Project finance exposures in the operational phase which are deemed to be high quality, as described in CRE20.52, will be risk weighted at 80%. For this purpose, operational phase is defined as the phase in which the entity that was specifically created to finance the project has
   1. a positive net cash flow that is sufficient to cover any remaining contractual obligation, and
   2. declining long-term debt.

A high quality project finance exposure refers to an exposure to a project finance entity that is able to meet its financial commitments in a timely manner and its ability to do so is assessed to be robust against adverse changes in the economic cycle and business conditions. The following conditions must also be met:

1. The project finance entity is restricted from acting to the detriment of the creditors (eg by not being able to issue additional debt without the consent of existing creditors);
2. The project finance entity has sufficient reserve funds or other financial arrangements to cover the contingency funding and working capital requirements of the project;
3. The revenues are availability-based¹⁹ or subject to a rate-of-return regulation or take-or-pay contract;
4. The project finance entity's revenue depends on one main counterparty and this main counterparty shall be a central government, PSE or a corporate entity with a risk weight of 80% or lower;
5. The contractual provisions governing the exposure to the project finance entity provide for a high degree of protection for creditors in case of a default of the project finance entity;
6. The main counterparty or other counterparties which similarly comply with the eligibility criteria for the main counterparty will protect the creditors from the losses resulting from a termination of the project;
7. All assets and contracts necessary to operate the project have been pledged to the creditors to the extent permitted by applicable law; and
8. Creditors may assume control of the project finance entity in case of its default.

The treatment described in CRE20.57 to CRE20.60 applies to subordinated debt, equity and other regulatory capital instruments issued by either corporates or banks, provided that such instruments are not deducted from regulatory capital or risk-weighted at 250% according to CAP30, or risk weighted at 1250% according to CRE20.62. It also excludes equity investments in funds treated under CRE60.

Equity exposures are defined on the basis of the economic substance of the instrument. They include both direct and indirect ownership interests,²⁰ whether voting or non-voting, in the assets and income of a commercial enterprise or of a financial institution that is not consolidated or deducted. An instrument is considered to be an equity exposure if it meets all of the following requirements:

1. It is irredeemable in the sense that the return of invested funds can be achieved only by the sale of the investment or sale of the rights to the investment or by the liquidation of the issuer;
2. It does not embody an obligation on the part of the issuer; and
3. It conveys a residual claim on the assets or income of the issuer.

In addition to instruments classified as equity as a result of paragraph CRE20.54, the following instruments must be categorised as an equity exposure:

1. An instrument with the same structure as those permitted as Tier 1 capital for banking organisations.
2. An instrument that embodies an obligation on the part of the issuer and meets any of the following conditions:
   1. The issuer may defer indefinitely the settlement of the obligation;
   2. The obligation requires (or permits at the issuer’s discretion) settlement by issuance of a fixed number of the issuer’s equity shares;
   3. The obligation requires (or permits at the issuer’s discretion) settlement by issuance of a variable number of the issuer’s equity shares and (ceteris paribus) any change in the value of the obligation is attributable to, comparable to, and in the same direction as, the change in the value of a fixed number of the issuer’s equity shares;²¹ or,
   4. The holder has the option to require that the obligation be settled in equity shares, unless either (i) in the case of a traded instrument, the supervisor is content that the bank has demonstrated that the instrument trades more like the debt of the issuer than like its equity, or (ii) in the case of non-traded instruments, the supervisor is content that the bank has demonstrated that the instrument should be treated as a debt position. In cases (i) and (ii), the bank may decompose the risks for regulatory purposes, with the consent of the supervisor.

Debt obligations and other securities, partnerships, derivatives or other vehicles structured with the intent of conveying the economic substance of equity ownership are considered an equity holding.²² This includes liabilities from which the return is linked to that of equities.²³ Conversely, equity investments that are structured with the intent of conveying the economic substance of debt holdings or securitisation exposures would not be considered an equity holding.²⁴

Banks will assign a risk weight of 400% to speculative unlisted equity exposures described in CRE20.58 and a risk weight of 250% to all other equity holdings, with the exception of those equity holdings referred to in CRE20.59.

Speculative unlisted equity exposures are defined as equity investments in unlisted companies that are invested for short-term resale purposes or are considered venture capital or similar investments which are subject to price volatility and are acquired in anticipation of significant future capital gains.²⁵

National supervisors may allow banks to assign a risk weight of 100% to equity holdings made pursuant to national legislated programmes that provide significant subsidies for the investment to the bank and involve government oversight and restrictions on the equity investments. Such treatment can only be accorded to equity holdings up to an aggregate of 10% of the bank’s Total capital. Examples of restrictions are limitations on the size and types of businesses in which the bank is investing, allowable amounts of ownership interests, geographical location and other pertinent factors that limit the potential risk of the investment to the bank.

Banks will assign a risk weight of 150% to subordinated debt and capital instruments other than equities. Any liabilities that meet the definition of “other TLAC liabilities” in CAP30.3 to CAP30.5 and that are not deducted from regulatory capital are considered to be subordinated debt for the purposes of this paragraph.

Notwithstanding the risk weights specified in CRE20.57 to CRE20.60, the risk weight for investments in significant minority- or majority-owned and –controlled commercial entities depends upon the application of two materiality thresholds:

1. for individual investments, 15% of the bank’s capital; and
2. for the aggregate of such investments, 60% of the bank’s capital.

Investments in significant minority- or majority-owned and –controlled commercial entities below the materiality thresholds in CRE20.61 must be risk-weighted as specified in CRE20.54 to CRE20.60. Investments in excess of the materiality thresholds must be risk-weighted at 1250%.

The retail exposure class excludes exposures within the real estate exposure class. The retail exposure class includes the following types of exposures:

1. exposures to an individual person or persons; and
2. exposures to SMEs (as defined in CRE20.47) that meet the “regulatory retail” criteria set out in CRE20.65(1) to CRE20.65(3) below. Exposures to SMEs that do not meet these criteria will be treated as corporate SMEs exposures under CRE20.47.

Exposures within the retail exposure class will be treated according to CRE20.65 to CRE20.67 below. For the purpose of determining risk weighted assets, the retail exposure class consists of the follow three sets of exposures:

1. “Regulatory retail” exposures that do not arise from exposures to “transactors” (as defined in CRE20.66).
2. “Regulatory retail” exposures to “transactors”.
3. “Other retail” exposures.

“Regulatory retail” exposures are defined as retail exposures that meet all of the criteria listed below:

1. Product criterion: the exposure takes the form of any of the following: revolving credits and lines of credit (including credit cards, charge cards and overdrafts), personal term loans and leases (eg instalment loans, auto loans and leases, student and educational loans, personal finance) and small business facilities and commitments. Mortgage loans, derivatives and other securities (such as bonds and equities), whether listed or not, are specifically excluded from this category.
2. Low value of individual exposures: the maximum aggregated exposure to one counterparty cannot exceed an absolute threshold of €1 million.
3. Granularity criterion: no aggregated exposure to one counterparty²⁶ can exceed 0.2%²⁷ of the overall regulatory retail portfolio, unless national supervisors have determined another method to ensure satisfactory diversification of the regulatory retail portfolio. Defaulted retail exposures are to be excluded from the overall regulatory retail portfolio when assessing the granularity criterion.

“Transactors” are obligors in relation to facilities such as credit cards and charge cards where the balance has been repaid in full at each scheduled repayment date for the previous 12 months. Obligors in relation to overdraft facilities would also be considered as transactors if there has been no drawdown over the previous 12 months.

“Other retail” exposures are defined as exposures to an individual person or persons that do not meet all of the regulatory retail criteria in CRE20.65.

The risk weights that apply to exposures in the retail asset class are as follows:

1. Regulatory retail exposures that do not arise from exposures to transactors (as defined in CRE20.66) will be risk weighted at 75%.
2. Regulatory retail exposures that arise from exposures to transactors (as defined in CRE20.66) will be risk weighted at 45%.
3. Other retail exposures will be risk weighted at 100%.

Real estate is immovable property that is land, including agricultural land and forest, or anything treated as attached to land, in particular buildings, in contrast to being treated as movable/personal property. The real estate exposure asset class consists of:

1. Exposures secured by real estate that are classified as “regulatory real estate” exposures.
2. Exposures secured by real estate that are classified as “other real estate” exposures.
3. Exposures that are classified as “land acquisition, development and construction” (ADC) exposures.

"Regulatory real estate" exposures consist of:

1. "Regulatory residential real estate" exposures that are not "materially dependent on cash flows generated by the property".
2. "Regulatory residential real estate" exposures that are "materially dependent on cash flows generated by the property".
3. "Regulatory commercial real estate" exposures that are not "materially dependent on cash flows generated by the property".
4. "Regulatory commercial real estate" exposures that are "materially dependent on cash flows generated by the property".

For an exposure secured by real estate to be classified as a “regulatory real estate” exposure, the loan must meet the following requirements:

1. Finished property: the exposure must be secured by a fully completed immovable property. This requirement does not apply to forest and agricultural land. Subject to national discretion, supervisors may allow this criteria to be met by loans to individuals that are secured by residential property under construction or land upon which residential property would be constructed, provided that: (i) the property is a one-to-four family residential housing unit that will be the primary residence of the borrower and the lending to the individual is not, in effect, indirectly financing land acquisition, development and construction exposures described in CRE20.90; or (ii) sovereign or PSEs involved have the legal powers and ability to ensure that the property under construction will be finished.
2. Legal enforceability: any claim on the property taken must be legally enforceable in all relevant jurisdictions. The collateral agreement and the legal process underpinning it must be such that they provide for the bank to realise the value of the property within a reasonable time frame.
3. Claims over the property: the loan is a claim over the property where the lender bank holds a first lien over the property, or a single bank holds the first lien and any sequentially lower ranking lien(s) (ie there is no intermediate lien from another bank) over the same property. However, in jurisdictions where junior liens provide the holder with a claim for collateral that is legally enforceable and constitute an effective credit risk mitigant, junior liens held by a different bank than the one holding the senior lien may also be recognised.²⁸ In order to meet the above requirements, the national frameworks governing liens should ensure the following: (i) each bank holding a lien on a property can initiate the sale of the property independently from other entities holding a lien on the property; and (ii) where the sale of the property is not carried out by means of a public auction, entities holding a senior lien take reasonable steps to obtain a fair market value or the best price that may be obtained in the circumstances when exercising any power of sale on their own (ie it is not possible for the entity holding the senior lien to sell the property on its own at a discounted value in detriment of the junior lien).²⁹
4. Ability of the borrower to repay: the borrower must meet the requirements set according to CRE20.73.
5. Prudent value of property: the property must be valued according to the criteria in CRE20.74 to CRE20.76 for determining the value in the loan-to-value ratio (LTV). Moreover, the value of the property must not depend materially on the performance of the borrower.
6. Required documentation: all the information required at loan origination and for monitoring purposes must be properly documented, including information on the ability of the borrower to repay and on the valuation of the property.

The risk weights for regulatory real estate exposures will apply to jurisdictions where structural factors result in sustainably low credit losses associated with the exposures to the real estate market. National supervisors should evaluate whether the risk weights in the corresponding risk weight tables are too low for these types of exposures in their jurisdictions based on default experience and other factors such as market price stability. Supervisors may require banks in their jurisdictions to increase these risk weights as appropriate.

National supervisors should ensure that banks put in place underwriting policies with respect to the granting of mortgage loans that include the assessment of the ability of the borrower to repay. Underwriting policies must define a metric(s) (such as the loan’s debt service coverage ratio) and specify its (their) corresponding relevant level(s) to conduct such assessment.³⁰ Underwriting policies must also be appropriate when the repayment of the mortgage loan depends materially on the cash flows generated by the property, including relevant metrics (such as an occupancy rate of the property). National supervisors may provide guidance on appropriate definitions and levels for these metrics in their jurisdictions.

The LTV is the amount of the loan divided by the value of the property. When calculating the LTV, the loan amount will be reduced as the loan amortises. The value of the property will be maintained at the value measured at origination, with the following exceptions:

1. The national supervisors elect to require banks to revise the property value downward. If the value has been adjusted downwards, a subsequent upwards adjustment can be made but not to a higher value than the value at origination.
2. The value must be adjusted if an extraordinary, idiosyncratic event occurs resulting in a permanent reduction of the property value.
3. Modifications made to the property that unequivocally increase its value could also be considered in the LTV.

The LTV must be prudently calculated in accordance with the following requirements:

1. Amount of the loan: includes the outstanding loan amount and any undrawn committed amount of the mortgage loan.³¹ The loan amount must be calculated gross of any provisions and other risk mitigants, except for pledged deposits accounts with the lending bank that meet all requirements for on-balance sheet netting and have been unconditionally and irrevocably pledged for the sole purposes of redemption of the mortgage loan.³²
2. Value of the property: the valuation must be appraised independently³³ using prudently conservative valuation criteria. To ensure that the value of the property is appraised in a prudently conservative manner, the valuation must exclude expectations on price increases and must be adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan. National supervisors should provide guidance setting out prudent valuation criteria where such guidance does not already exist under national law. If a market value can be determined, the valuation should not be higher than the market value.³⁴

A guarantee or financial collateral may be recognised as a credit risk mitigant in relation to exposures secured by real estate if it qualifies as eligible collateral under the credit risk mitigation framework. This may include mortgage insurance³⁵ if it meets the operational requirements of the credit risk mitigation framework for a guarantee. Banks may recognise these risk mitigants in calculating the exposure amount; however, the LTV bucket and risk weight to be applied to the exposure amount must be determined before the application of the appropriate credit risk mitigation technique.

A “regulatory residential real estate” exposure is a regulatory real estate exposure that is secured by a property that has the nature of a dwelling and satisfies all applicable laws and regulations enabling the property to be occupied for housing purposes (ie residential property).³⁶

A “regulatory commercial real estate” exposure is regulatory real estate exposure that is not a regulatory residential real estate exposure.

Regulatory real estate exposures (both residential and commercial) are classified as exposures that are “materially dependent on cash flows generated by the property” when the prospects for servicing the loan materially depend on the cash flows generated by the property securing the loan rather than on the underlying capacity of the borrower to service the debt from other sources. The primary source of these cash flows would generally be lease or rental payments, or the sale of the property. The distinguishing characteristic of these exposures compared to other regulatory real estate exposures is that both the servicing of the loan and the prospects for recovery in the event of default depend materially on the cash flows generated by the property securing the exposure.

It is expected that the material dependence condition, set out in CRE20.79 above, would predominantly apply to loans to corporates, SMEs or SPVs, but is not restricted to those borrower types. As an example, a loan may be considered materially dependent if more than 50% of the income from the borrower used in the bank's assessment of its ability to service the loan is from cash flows generated by the residential property. National supervisors may provide further guidance setting out criteria on how material dependence should be assessed for specific exposure types.

As exceptions to the definition contained in CRE20.79 above, the following types of regulatory real estate exposures are not classified as exposures that are materially dependent on cash flows generated by the property:

1. An exposure secured by a property that is the borrower’s primary residence;
2. An exposure secured by an income-producing residential housing unit, to an individual who has mortgaged less than a certain number of properties or housing units, as specified by national supervisors;
3. An exposure secured by residential real estate property to associations or cooperatives of individuals that are regulated under national law and exist with the only purpose of granting its members the use of a primary residence in the property securing the loans; and
4. An exposure secured by residential real estate property to public housing companies and not-for-profit associations regulated under national law that exist to serve social purposes and to offer tenants long-term housing.

For regulatory residential real estate exposures that are not materially dependent on cash flow generated by the property, the risk weight to be assigned to the total exposure amount will be determined based on the exposure’s LTV ratio in Table 11 below. The use of the risk weights in Table 11 is referred to as the “whole loan” approach.

As an alternative to the whole loan approach for regulatory residential real estate exposures that are not materially dependent on cash flows generated by the property, jurisdictions may apply the “loan splitting” approach. Under the loan splitting approach, the risk weight of 20% is applied to the part of the exposure up to 55% of the property value and the risk weight of the counterparty (as prescribed in CRE20.89(1)) is applied to the residual exposure.³⁷ Where there are liens on the property that are not held by the bank, the treatment is as follows:

1. Where a bank holds the junior lien and there are senior liens not held by the bank, to determine the part of the bank’s exposure that is eligible for the 20% risk weight, the amount of 55% of the property value should be reduced by the amount of the senior liens not held by the bank. For example, for a loan of €70,000 to an individual secured on a property valued at €100,000, where there is also a senior ranking lien of €10,000 held by another institution, the bank will apply a risk weight of 20% to €45,000 (=max(€55,000 - €10,000, 0)) of the exposure and, according to CRE20.89(1), a risk weight of 75% to the residual exposure of €25,000.
2. Where liens not held by the bank rank pari passu with the bank’s lien, to determine the part of the bank’s exposure that is eligible for the 20% risk weight, the amount of 55% of the property value, reduced by the amount of more senior liens not held by the bank (if any), should be reduced by the product of: (i) 55% of the property value, reduced by the amount of any senior liens (if any, both held by the bank and held by other institutions); and (ii) the amount of liens not held by the bank that rank pari passu with the bank’s lien divided by the sum of all pari passu liens. For example, for a loan of €70,000 to an individual secured on a property valued at €100,000, where there is also a pari passu ranking lien of €10,000 held by another institution, the bank will apply a risk weight of 20% to €48,125 (=€55,000 - €55,000 * €10,000/€80,000) of the exposure and, according to CRE20.89(1), a risk weight of 75% to the residual exposure of €21,875. If both the loan and the bank’s lien is only €30,000 and there is additionally a more senior lien of €10,000 not held by the bank, the property value remaining available is €33,750 (= (€55,000 - €10,000) - ((€55,000 - €10,000) * €10,000/(€10,000+€30,000)), and the bank will apply a risk weight of 20% to €30,000.

For regulatory residential real estate exposures that are materially dependent on cash flows generated by the property, the risk weight to be assigned to the total exposure amount will be determined based on the exposure’s LTV ratio in Table 12 below.

For regulatory commercial real estate exposures that are not materially dependent on cash flow generated by the property, the risk weight to be assigned to the total exposure amount will be determined based on the exposure’s LTV in Table 13 below (which sets out a whole loan approach). The risk weight of the counterparty for the purposes of Table 13 below and CRE20.86 below is prescribed in CRE20.89(1).

As an alternative to the whole loan approach for regulatory commercial real estate exposures that are not materially dependent on cash flows generated by the property, jurisdictions may apply the “loan splitting” approach. Under the loan splitting approach, the risk weight of 60% or the risk weight of the counterparty, whichever is lower, is applied to the part of the exposure up to 55% of the property value³⁸ , and the risk weight of the counterparty is applied to the residual exposure.

For regulatory commercial real estate exposures that are materially dependent on cash flows generated by the property³⁹ , the risk weight to be assigned to the total exposure amount will be determined based on the exposure’s LTV in Table 14 below. ⁴⁰

An “other real estate” exposure is an exposure within the real estate asset class that is not a regulatory real estate exposure (as defined in CRE20.71 above) and is not a land ADC exposure (as defined in CRE20.90 below).

Other real estate exposures are risk weighted as follows:

1. The risk weight of the counterparty is used for other real estate exposures that are not materially dependent on the cash flows generated by the property. For exposures to individuals the risk weight applied will be 75%. For exposures to SMEs, the risk weight applied will be 85%. For exposures to other counterparties, the risk weight applied is the risk weight that would be assigned to an unsecured exposure to that counterparty.
2. The risk weight of 150% is used for other real estate exposures that are materially dependent on the cash flows generated by the property.

Land ADC exposures⁴¹ refers to loans to companies or SPVs financing any of the land acquisition for development and construction purposes, or development and construction of any residential or commercial property. ADC exposures will be risk-weighted at 150%, unless they meet the criteria in CRE20.91.

ADC exposures to residential real estate may be risk weighted at 100%, provided that the following criteria are met:

1. prudential underwriting standards meet the requirements in CRE20.71 (ie the requirements that are used to classify regulatory real estate exposures) where applicable;
2. pre-sale or pre-lease contracts amount to a significant portion of total contracts or substantial equity at risk.⁴² Pre-sale or pre-lease contracts must be legally binding written contracts and the purchaser/renter must have made a substantial cash deposit which is subject to forfeiture if the contract is terminated. Equity at risk should be determined as an appropriate amount of borrower-contributed equity to the real estate’s appraised as-completed value.

For unhedged retail and residential real estate exposures to individuals where the lending currency differs from the currency of the borrower’s source of income, banks will apply a 1.5 times multiplier to the applicable risk weight according to CRE20.63 to CRE20.68 and CRE20.82 to CRE20.84, subject to a maximum risk weight of 150%.

For the purposes of CRE20.92, an unhedged exposure refers to an exposure to a borrower that has no natural or financial hedge against the foreign exchange risk resulting from the currency mismatch between the currency of the borrower's income and the currency of the loan. A natural hedge exists where the borrower, in its normal operating procedures, receives foreign currency income that matches the currency of a given loan (eg remittances, rental incomes, salaries). A financial hedge generally includes a legal contract with a financial institution (eg forward contract). For the purposes of application of the multiplier, only these natural or financial hedges are considered sufficient where they cover at least 90% of the loan instalment, regardless of the number of hedges.

Off-balance sheet items will be converted into credit exposure equivalents through the use of credit conversion factors (CCF). In the case of commitments, the committed but undrawn amount of the exposure would be multiplied by the CCF. For these purposes, commitment means any contractual arrangement that has been offered by the bank and accepted by the client to extend credit, purchase assets or issue credit substitutes.⁴³ It includes any such arrangement that can be unconditionally cancelled by the bank at any time without prior notice to the obligor. It also includes any such arrangement that can be cancelled by the bank if the obligor fails to meet conditions set out in the facility documentation, including conditions that must be met by the obligor prior to any initial or subsequent drawdown under the arrangement. Counterparty risk weightings for over-the-counter (OTC) derivative transactions will not be subject to any specific ceiling.

A 100% CCF will be applied to the following items:

1. Direct credit substitutes, eg general guarantees of indebtedness (including standby letters of credit serving as financial guarantees for loans and securities) and acceptances (including endorsements with the character of acceptances).
2. Sale and repurchase agreements and asset sales with recourse⁴⁴ where the credit risk remains with the bank.
3. The lending of banks’ securities or the posting of securities as collateral by banks, including instances where these arise out of repo-style transactions (ie repurchase/reverse repurchase and securities lending/securities borrowing transactions). The risk-weighting treatment for counterparty credit risk must be applied in addition to the credit risk charge on the securities or posted collateral, where the credit risk of the securities lent or posted as collateral remains with the bank. This paragraph does not apply to posted collateral related to derivative transactions that is treated in accordance with the counterparty credit risk standards.
4. Forward asset purchases, forward forward deposits and partly paid shares and securities,  which represent commitments with certain drawdown.
5. Off-balance sheet items that are credit substitutes not explicitly included in any other category.

A 50% CCF will be applied to note issuance facilities and revolving underwriting facilities regardless of the maturity of the underlying facility.

A 50% CCF will be applied to certain transaction-related contingent items (eg performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions).

A 40% CCF will be applied to commitments, regardless of the maturity of the underlying facility, unless they qualify for a lower CCF.

A 20% CCF will be applied to both the issuing and confirming banks of short-term self-liquidating trade letters of credit arising from the movement of goods (eg documentary credits collateralised by the underlying shipment). Short term in this context means with a maturity below one year.

A 10% CCF will be applied to commitments that are unconditionally cancellable at any time by the bank without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower’s creditworthiness. National supervisors should evaluate various factors in the jurisdiction, which may constrain banks’ ability to cancel the commitment in practice, and consider applying a higher CCF to certain commitments as appropriate.

Where there is an undertaking to provide a commitment on an off-balance sheet item, banks are to apply the lower of the two applicable CCFs.⁴⁵

For exposures that give rise to counterparty credit risk according to CRE51.4 (ie OTC derivatives, exchange-traded derivatives, long settlement transactions and securities financing transactions), the exposure amount to be used in the determination of RWA is to be calculated under the rules set out in CRE50 to CRE54.

A bank providing credit protection through a first-to-default or second-to-default credit derivative is subject to capital requirements on such instruments. For first-to-default credit derivatives, the risk weights of the assets included in the basket must be aggregated up to a maximum of 1250% and multiplied by the nominal amount of the protection provided by the credit derivative to obtain the risk-weighted asset amount. For second-to-default credit derivatives, the treatment is similar; however, in aggregating the risk weights, the asset with the lowest risk-weighted amount can be excluded from the calculation. This treatment applies respectively for nth-to-default credit derivatives, for which the n-1 assets with the lowest risk-weighted amounts can be excluded from the calculation.

For risk-weighting purposes under the standardised approach, a defaulted exposure is defined as one that is past due for more than 90 days, or is an exposure to a defaulted borrower. A defaulted borrower is a borrower in respect of whom any of the following events have occurred:

1. Any material credit obligation that is past due for more than 90 days. Overdrafts will be considered as being past due once the customer has breached an advised limit or been advised of a limit smaller than current outstandings;
2. Any material credit obligation is on non-accrued status (eg the lending bank no longer recognises accrued interest as income or, if recognised, makes an equivalent amount of provisions);
3. A write-off or account-specific provision is made as a result of a significant perceived decline in credit quality subsequent to the bank taking on any credit exposure to the borrower;
4. Any credit obligation is sold at a material credit-related economic loss;
5. A distressed restructuring of any credit obligation (ie a restructuring that may result in a diminished financial obligation caused by the material forgiveness, or postponement, of principal, interest or (where relevant) fees) is agreed by the bank;
6. The borrower’s bankruptcy or a similar order in respect of any of the borrower’s credit obligations to the banking group has been filed;
7. The borrower has sought or has been placed in bankruptcy or similar protection where this would avoid or delay repayment of any of the credit obligations to the banking group; or
8. Any other situation where the bank considers that the borrower is unlikely to pay its credit obligations in full without recourse by the bank to actions such as realising security.

For retail exposures, the definition of default can be applied at the level of a particular credit obligation, rather than at the level of the borrower. As such, default by a borrower on one obligation does not require a bank to treat all other obligations to the banking group as defaulted.

With the exception of residential real estate exposures treated under CRE20.107, the unsecured or unguaranteed portion of a defaulted exposure shall be risk-weighted net of specific provisions and partial write-offs as follows:

1. 150% risk weight when specific provisions are less than 20% of the outstanding amount of the loan; and
2. 100% risk weight when specific provisions are equal or greater than 20% of the outstanding amount of the loan.⁴⁶

Defaulted residential real estate exposures where repayments do not materially depend on cash flows generated by the property securing the loan shall be risk-weighted net of specific provisions and partial write-offs at 100%. Guarantees or financial collateral which are eligible according to the credit risk mitigation framework might be taken into account in the calculation of the exposure in accordance with CRE20.76.

For the purpose of defining the secured or guaranteed portion of the defaulted exposure, eligible collateral and guarantees will be the same as for credit risk mitigation purposes (see CRE22).

CAP30.32 specifies a deduction treatment for the following exposures: significant investments in the common shares of unconsolidated financial institutions, mortgage servicing rights, and deferred tax assets that arise from temporary differences. The exposures are deducted in the calculation of Common Equity Tier 1 if they exceed the thresholds set out in CAP30.32 and CAP30.33. A 250% risk weight applies to the amount of the three “threshold deduction” items listed in CAP30.32 that are not deducted by CAP30.32 or CAP30.33.

The standard risk weight for all other assets will be 100%, with the exception of the following exposures:

1. A 0% risk weight will apply to:
   1. cash owned and held at the bank or in transit; and
   2. gold bullion held at the bank or held in another bank on an allocated basis, to the extent the gold bullion assets are backed by gold bullion liabilities.
2. A 20% risk weight will apply to cash items in the process of collection.

In jurisdictions that allow the use of external ratings for regulatory purposes, only credit assessments from credit rating agencies recognised as external credit assessment institutions (ECAIs) will be allowed. National supervisors are responsible for determining on a continuous basis whether an ECAI meets the criteria listed in CRE21.2 and recognition should only be provided in respect of ECAI ratings for types of exposure where all criteria and conditions are met. National supervisors should also take into account the criteria and conditions provided in the International Organization of Securities Commissions' Code of Conduct Fundamentals for Credit Rating Agencies⁴⁷ when determining ECAI eligibility. The supervisory process for recognising ECAIs should be made public to avoid unnecessary barriers to entry.

An ECAI must satisfy each of the following eight criteria.

1. Objectivity: The methodology for assigning external ratings must be rigorous, systematic, and subject to some form of validation based on historical experience. Moreover, external ratings must be subject to ongoing review and responsive to changes in financial condition. Before being recognised by supervisors, a rating methodology for each market segment, including rigorous backtesting, must have been established for at least one year and preferably three years.
2. Independence: An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. In particular, an ECAI should not delay or refrain from taking a rating action based on its potential effect (economic, political or otherwise). The rating process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the credit rating agency may be seen as creating a conflict of interest. Furthermore, an ECAI should separate operationally, legally and, if practicable, physically its rating business from other businesses and analysts.
3. International access/transparency: The individual ratings, the key elements underlining the ratings assessments and whether the issuer participated in the rating process should be publicly available on a non-selective basis, unless they are private ratings, which should be at least available to both domestic and foreign institutions with legitimate interest and on equivalent terms. In addition, the ECAI’s general procedures, methodologies and assumptions for arriving at ratings should be publicly available.
4. Disclosure: An ECAI should disclose the following information: its code of conduct; the general nature of its compensation arrangements with assessed entities; any conflict of interest, the ECAI's compensation arrangements, its rating assessment methodologies, including the definition of default, the time horizon, and the meaning of each rating; the actual default rates experienced in each assessment category; and the transitions of the ratings, eg the likelihood of AA ratings becoming A over time. A rating should be disclosed as soon as practicably possible after issuance. When disclosing a rating, the information should be provided in plain language, indicating the nature and limitation of credit ratings and the risk of unduly relying on them to make investments.
5. Resources: An ECAI should have sufficient resources to carry out high-quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add value to the credit assessments. In particular, ECAIs should assign analysts with appropriate knowledge and experience to assess the creditworthiness of the type of entity or obligation being rated. Such assessments should be based on methodologies combining qualitative and quantitative approaches.
6. Credibility: To some extent, credibility is derived from the criteria above. In addition, the reliance on an ECAI’s external ratings by independent parties (investors, insurers, trading partners) is evidence of the credibility of the ratings of an ECAI. The credibility of an ECAI is also underpinned by the existence of internal procedures to prevent the misuse of confidential information. In order to be eligible for recognition, an ECAI does not have to assess firms in more than one country.
7. No abuse of unsolicited ratings: ECAIs must not use unsolicited ratings to put pressure on entities to obtain solicited ratings. Supervisors should consider whether to continue recognising such ECAIs as eligible for capital adequacy purposes, if such behaviour is identified.
8. Cooperation with the supervisor: ECAIs should notify the supervisor of significant changes to methodologies and provide access to external ratings and other relevant data in order to support initial and continued determination of eligibility.

Regarding the disclosure of conflicts of interest referenced in CRE21.2(4) above, at a minimum, the following situations and their influence on the ECAI’s credit rating methodologies or credit rating actions shall be disclosed:

1. The ECAI is being paid to issue a credit rating by the rated entity or by the obligor, originator, underwriter, or arranger of the rated obligation;
2. The ECAI is being paid by subscribers with a financial interest that could be affected by a credit rating action of the ECAI;
3. The ECAI is being paid by rated entities, obligors, originators, underwriters, arrangers, or subscribers for services other than issuing credit ratings or providing access to the ECAI’s credit ratings;
4. The ECAI is providing a preliminary indication or similar indication of credit quality to an entity, obligor, originator, underwriter, or arranger prior to being hired to determine the final credit rating for the entity, obligor, originator, underwriter, or arranger; and
5. The ECAI has a direct or indirect ownership interest in a rated entity or obligor, or a rated entity or obligor has a direct or indirect ownership interest in the ECAI.

Regarding the disclosure of an ECAI's compensation arrangements referenced in CRE21.2(4) above:

1. An ECAI should disclose the general nature of its compensation arrangements with rated entities, obligors, lead underwriters, or arrangers.
2. When the ECAI receives from a rated entity, obligor, originator, lead underwriter, or arranger compensation unrelated to its credit rating services, the ECAI should disclose such unrelated compensation as a percentage of total annual compensation received from such rated entity, obligor, lead underwriter, or arranger in the relevant credit rating report or elsewhere, as appropriate.
3. An ECAI should disclose in the relevant credit rating report or elsewhere, as appropriate, if it receives 10% or more of its annual revenue from a single client (eg a rated entity, obligor, originator, lead underwriter, arranger, or subscriber, or any of their affiliates).

Supervisors will be responsible for assigning eligible ECAIs’ ratings to the risk weights available under the standardised risk weighting framework, ie deciding which rating categories correspond to which risk weights. The mapping process should be objective and should result in a risk weight assignment consistent with that of the level of credit risk reflected in the tables above. It should cover the full spectrum of risk weights.

When conducting such a mapping process, factors that supervisors should assess include, among others, the size and scope of the pool of issuers that each ECAI covers, the range and meaning of the ratings that it assigns, and the definition of default used by the ECAI.

In order to promote a more consistent mapping of ratings into the available risk weights and help supervisors in conducting such a process, Standardised approach - implementing the mapping process (April 2019) provides guidance as to how such a mapping process may be conducted.

Banks must use the chosen ECAIs and their ratings consistently for all types of exposure where they have been recognised by their supervisor as an eligible ECAI, for both risk-weighting and risk management purposes. Banks are not allowed to “cherry-pick” the ratings provided by different ECAIs and to arbitrarily change the use of ECAIs.

If there is only one rating by an ECAI chosen by a bank for a particular exposure, that rating should be used to determine the risk weight of the exposure.

If there are two ratings by ECAIs chosen by a bank that map into different risk weights, the higher risk weight will be applied.

If there are three or more ratings with different risk weights, the two ratings that correspond to the lowest risk weights should be referred to. If these give rise to the same risk weight, that risk weight should be applied. If different, the higher risk weight should be applied.

Where a bank invests in a particular issue that has an issue-specific rating, the risk weight of the exposure will be based on this rating. Where the bank’s exposure is not an investment in a specific rated issue, the following general principles apply.

1. In circumstances where the borrower has a specific rating for an issued debt – but the bank’s exposure is not an investment in this particular debt – a high-quality credit rating (one which maps into a risk weight lower than that which applies to an unrated exposure) on that specific debt may only be applied to the bank’s unrated exposure if this exposure ranks in all respects pari passu or senior to the exposure with a rating. If not, the external rating cannot be used and the unassessed exposure will receive the risk weight for unrated exposures.
2. In circumstances where the borrower has an issuer rating, this rating typically applies to senior unsecured exposures to that issuer. Consequently, only senior exposures to that issuer will benefit from a high-quality issuer rating. Other unassessed exposures of a highly rated issuer will be treated as unrated. If either the issuer or a single issue has a low-quality rating (mapping into a risk weight equal to or higher than that which applies to unrated exposures), an unassessed exposure to the same counterparty that ranks pari passu or is subordinated to either the senior unsecured issuer rating or the exposure with a low-quality rating will be assigned the same risk weight as is applicable to the low-quality rating.
3. In circumstances where the issuer has a specific high-quality rating (one which maps into a lower risk weight) that only applies to a limited class of liabilities (such as a deposit rating or a counterparty risk rating), this may only be used in respect of exposures that fall within that class.

Whether the bank intends to rely on an issuer- or an issue-specific rating, the rating must take into account and reflect the entire amount of credit risk exposure the bank has with regard to all payments owed to it. For example, if a bank is owed both principal and interest, the rating must fully take into account and reflect the credit risk associated with repayment of both principal and interest.

In order to avoid any double-counting of credit enhancement factors, no supervisory recognition of credit risk mitigation techniques will be taken into account if the credit enhancement is already reflected in the issue specific rating (see CRE22.5).

Where exposures are risk-weighted based on the rating of an equivalent exposure to that borrower, the general rule is that foreign currency ratings would be used for exposures in foreign currency. Domestic currency ratings, if separate, would only be used to risk-weight exposures denominated in the domestic currency.⁴⁸

For risk-weighting purposes, short-term ratings are deemed to be issue-specific. They can only be used to derive risk weights for exposures arising from the rated facility. They cannot be generalised to other short-term exposures, except under the conditions of CRE21.18. In no event can a short-term rating be used to support a risk weight for an unrated long-term exposure. Short-term ratings may only be used for short-term exposures against banks and corporates. The table^{49 50} below provides a framework for banks’ exposures to specific short-term facilities, such as a particular issuance of commercial paper:

If a short-term rated facility attracts a 50% risk-weight, unrated short-term exposures cannot attract a risk weight lower than 100%. If an issuer has a short-term facility with an external rating that warrants a risk weight of 150%, all unrated exposures, whether long-term or short-term, should also receive a 150% risk weight, unless the bank uses recognised credit risk mitigation techniques for such exposures.

In cases where short-term ratings are available, the following interaction with the general preferential treatment for short-term exposures to banks as described in CRE20.19 will apply:

1. The general preferential treatment for short-term exposures applies to all exposures to banks of up to three months original maturity when there is no specific short-term exposure rating.
2. When there is a short-term rating and such a rating maps into a risk weight that is more favourable (ie lower) or identical to that derived from the general preferential treatment, the short-term rating should be used for the specific exposure only. Other short-term exposures would benefit from the general preferential treatment.
3. When a specific short-term rating for a short term exposure to a bank maps into a less favourable (higher) risk weight, the general short-term preferential treatment for interbank exposures cannot be used. All unrated short-term exposures should receive the same risk weighting as that implied by the specific short-term rating.

When a short-term rating is to be used, the institution making the assessment needs to meet all of the eligibility criteria for recognising ECAIs, as described in CRE21.2, in terms of its short-term ratings.

External ratings for one entity within a corporate group cannot be used to risk-weight other entities within the same group.

As a general rule, banks should use solicited ratings from eligible ECAIs. National supervisors may allow banks to use unsolicited ratings in the same way as solicited ratings if they are satisfied that the credit assessments of unsolicited ratings are not inferior in quality to the general quality of solicited ratings.

Banks use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralised by first-priority claims, in whole or in part with cash or securities, a loan exposure may be guaranteed by a third party, or a bank may buy a credit derivative to offset various forms of credit risk. Additionally banks may agree to net loans owed to them against deposits from the same counterparty.⁵¹

The framework set out in this chapter is applicable to banking book exposures that are risk-weighted under the standardised approach.

No transaction in which credit risk mitigation (CRM) techniques are used shall receive a higher capital requirement than an otherwise identical transaction where such techniques are not used.

The requirements of the disclosure standard (DIS40) must be fulfilled for banks to obtain capital relief in respect of any CRM techniques.

The effects of CRM must not be double-counted. Therefore, no additional supervisory recognition of CRM for regulatory capital purposes will be granted on exposures for which the risk weight already reflects that CRM. Consistent with CRE21.13, principal-only ratings will also not be allowed within the CRM framework.

While the use of CRM techniques reduces or transfers credit risk, it may simultaneously increase other risks (ie residual risks). Residual risks include legal, operational, liquidity and market risks. Therefore, banks must employ robust procedures and processes to control these risks, including strategy; consideration of the underlying credit; valuation; policies and procedures; systems; control of roll-off risks; and management of concentration risk arising from the bank’s use of CRM techniques and its interaction with the bank’s overall credit risk profile. Where these risks are not adequately controlled, supervisors may impose additional capital charges or take other supervisory actions as outlined in the supervisory review process standard (SRP).

In order for CRM techniques to provide protection, the credit quality of the counterparty must not have a material positive correlation with the employed CRM technique or with the resulting residual risks (as defined in CRE22.6). For example, securities issued by the counterparty (or by any counterparty-related entity) provide little protection as collateral and are thus ineligible.

In the case where a bank has multiple CRM techniques covering a single exposure (eg a bank has both collateral and a guarantee partially covering an exposure), the bank must subdivide the exposure into portions covered by each type of CRM technique (eg portion covered by collateral, portion covered by guarantee) and the risk-weighted assets of each portion must be calculated separately. When credit protection provided by a single protection provider has differing maturities, they must be subdivided into separate protection as well.

In order for banks to obtain capital relief for any use of CRM techniques, all documentation used in collateralised transactions, on-balance sheet netting agreements, guarantees and credit derivatives must be binding on all parties and legally enforceable in all relevant jurisdictions. Banks must have conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability.

For the purposes of calculating risk-weighted assets, a maturity mismatch occurs when the residual maturity of a credit protection arrangement (eg hedge) is less than that of the underlying exposure.

In the case of financial collateral, maturity mismatches are not allowed under the simple approach (see CRE22.33).

Under the other approaches, when there is a maturity mismatch the credit protection arrangement may only be recognised if the original maturity of the arrangement is greater than or equal to one year, and its residual maturity is greater than or equal to three months. In such cases, credit risk mitigation may be partially recognised as detailed below in CRE22.13.

When there is a maturity mismatch with recognised credit risk mitigants, the following adjustment applies, where:

1. P_a = value of the credit protection adjusted for maturity mismatch
2. P = credit protection amount (eg collateral amount, guarantee amount) adjusted for any haircuts
3. t = min {T, residual maturity of the credit protection arrangement expressed in years}
4. T = min {five years, residual maturity of the exposure expressed in years}

The maturity of the underlying exposure and the maturity of the hedge must both be defined conservatively. The effective maturity of the underlying must be gauged as the longest possible remaining time before the counterparty is scheduled to fulfil its obligation, taking into account any applicable grace period. For the hedge, (embedded) options that may reduce the term of the hedge must be taken into account so that the shortest possible effective maturity is used. For example: where, in the case of a credit derivative, the protection seller has a call option, the maturity is the first call date. Likewise, if the protection buyer owns the call option and has a strong incentive to call the transaction at the first call date, for example because of a step-up in cost from this date on, the effective maturity is the remaining time to the first call date.

Currency mismatches are allowed under all approaches. Under the simple approach there is no specific treatment for currency mismatches, given that a minimum risk weight of 20% (floor) is generally applied. Under the comprehensive approach and in case of guarantees and credit derivatives, a specific adjustment for currency mismatches is prescribed in CRE22.52 and CRE22.82 to CRE22.83, respectively.

A collateralised transaction is one in which:

1. banks have a credit exposure or a potential credit exposure; and
2. that credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty.

Where banks take eligible financial collateral, they may reduce their regulatory capital requirements through the application of CRM techniques.⁵²

Banks may opt for either:

1. The simple approach, which replaces the risk weight of the counterparty with the risk weight of the collateral for the collateralised portion of the exposure (generally subject to a 20% floor); or
2. The comprehensive approach, which allows a more precise offset of collateral against exposures, by effectively reducing the exposure amount by a volatility-adjusted value ascribed to the collateral.

Detailed operational requirements for both the simple approach and comprehensive approach are given in CRE22.32 to CRE22.65. Banks may operate under either, but not both, approaches in the banking book.

For collateralised OTC transactions, exchange traded derivatives and long settlement transactions, banks may use the standardised approach for counterparty credit risk (CRE52) or the internal models method (CRE53) to calculate the exposure amount, in accordance with CRE22.66 to CRE22.67.

Where banks have legally enforceable netting arrangements for loans and deposits that meet the conditions in CRE22.68 and CRE22.69 they may calculate capital requirements on the basis of net credit exposures as set out in that paragraph.

Where guarantees or credit derivatives fulfil the minimum operational conditions set out in CRE22.70 to CRE22.72, banks may take account of the credit protection offered by such credit risk mitigation techniques in calculating capital requirements.

A range of guarantors and protection providers are recognised and a substitution approach applies for capital requirement calculations. Only guarantees issued by or protection provided by entities with a lower risk weight than the counterparty lead to reduced capital charges for the guaranteed exposure, since the protected portion of the counterparty exposure is assigned the risk weight of the guarantor or protection provider, whereas the uncovered portion retains the risk weight of the underlying counterparty.

Detailed conditions and operational requirements for guarantees and credit derivatives are given in CRE22.70 to CRE22.84.

Before capital relief is granted in respect of any form of collateral, the standards set out below in CRE22.26 to CRE22.31 must be met, irrespective of whether the simple or the comprehensive approach is used. Banks that lend securities or post collateral must calculate capital requirements for both of the following: (i) the credit risk or market risk of the securities, if this remains with the bank; and (ii) the counterparty credit risk arising from the risk that the borrower of the securities may default.

The legal mechanism by which collateral is pledged or transferred must ensure that the bank has the right to liquidate or take legal possession of it, in a timely manner, in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Additionally, banks must take all steps necessary to fulfil those requirements under the law applicable to the bank’s interest in the collateral for obtaining and maintaining an enforceable security interest, eg by registering it with a registrar, or for exercising a right to net or set off in relation to the title transfer of the collateral.

Banks must have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly.

Banks must ensure that sufficient resources are devoted to the orderly operation of margin agreements with OTC derivative and securities-financing counterparties, as measured by the timeliness and accuracy of its outgoing margin calls and response time to incoming margin calls. Banks must have collateral risk management policies in place to control, monitor and report:

1. the risk to which margin agreements expose them (such as the volatility and liquidity of the securities exchanged as collateral);
2. the concentration risk to particular types of collateral;
3. the reuse of collateral (both cash and non-cash) including the potential liquidity shortfalls resulting from the reuse of collateral received from counterparties; and
4. the surrender of rights on collateral posted to counterparties.

Where the collateral is held by a custodian, banks must take reasonable steps to ensure that the custodian segregates the collateral from its own assets.

A capital requirement must be applied on both sides of a transaction. For example, both repos and reverse repos will be subject to capital requirements. Likewise, both sides of a securities lending and borrowing transaction will be subject to explicit capital charges, as will the posting of securities in connection with derivatives exposures or with any other borrowing transaction.

Where a bank, acting as an agent, arranges a repo-style transaction (ie repurchase/reverse repurchase and securities lending/borrowing transactions) between a customer and a third party and provides a guarantee to the customer that the third party will perform on its obligations, then the risk to the bank is the same as if the bank had entered into the transaction as a principal. In such circumstances, a bank must calculate capital requirements as if it were itself the principal.

Under the simple approach, the risk weight of the counterparty is replaced by the risk weight of the collateral instrument collateralising or partially collateralising the exposure.

For collateral to be recognised in the simple approach, it must be pledged for at least the life of the exposure and it must be marked to market and revalued with a minimum frequency of six months. Those portions of exposures collateralised by the market value of recognised collateral receive the risk weight applicable to the collateral instrument. The risk weight on the collateralised portion is subject to a floor of 20% except under the conditions specified in CRE22.36 to CRE22.39. The remainder of the exposure must be assigned the risk weight appropriate to the counterparty. Maturity mismatches are not allowed under the simple approach (see CRE22.10 to CRE22.11).

The following collateral instruments are eligible for recognition in the simple approach:

1. Cash (as well as certificates of deposit or comparable instruments issued by the lending bank) on deposit with the bank that is incurring the counterparty exposure.^{53 54}
2. Gold.
3. In jurisdictions that allow the use of external ratings for regulatory purposes:
   1. Debt securities rated⁵⁵ by a recognised external credit assessment institution (ECAI) where these are either:
      (i)

      at least BB– when issued by sovereigns or public sector entities (PSEs) that are treated as sovereigns by the national supervisor; or

      (ii)

      at least BBB– when issued by other entities (including banks and other prudentially regulated financial institutions); or

      (iii)

      at least A-3/P-3 for short-term debt instruments.

   2. Debt securities not rated by a recognised ECAI where these are:
      (i)

      issued by a bank; and

      (ii)

      listed on a recognised exchange; and

      (iii)

      classified as senior debt; and

      (iv)

      all rated issues of the same seniority by the issuing bank are rated at least BBB– or A-3/P-3 by a recognised ECAI; and

      (v)

      the bank holding the securities as collateral has no information to suggest that the issue justifies a rating below BBB– or A-3/P-3 (as applicable); and

      (vi)

      the supervisor is sufficiently confident that the market liquidity of the security is adequate.

4. In jurisdictions that do not allow the use of external ratings for regulatory purposes, the following securities will be eligible provided that the supervisor is sufficiently confident that the market liquidity of the security is adequate:
   1. Debt securities issued by sovereigns or PSEs that are treated as sovereigns by the national supervisor;
   2. Debt securities issued by banks assigned to Grade A under the standardised credit risk assessment approach;
   3. Other debt securities issued by “investment grade” entities as defined in CRE22.76, and
   4. Securitisation exposures with a risk weight of less than 100% in the Securitisation Standardised Approach set out in CRE41.
5. Equities (including convertible bonds) that are included in a main index.
6. Undertakings for Collective Investments in Transferable Securities (UCITS) and mutual funds where:
   1. a price for the units is publicly quoted daily; and
   2. the UCITS/mutual fund is limited to investing in the instruments listed in this paragraph.⁵⁶

Resecuritisations as defined in the securitisation chapters (CRE40 to CRE45) are not eligible financial collateral.

Repo-style transactions that fulfil all of the following conditions are exempted from the risk-weight floor under the simple approach:

1. Both the exposure and the collateral are cash or a sovereign security or PSE security qualifying for a 0% risk weight under the standardised approach (CRE20);
2. Both the exposure and the collateral are denominated in the same currency;
3. Either the transaction is overnight or both the exposure and the collateral are marked to market daily and are subject to daily remargining;
4. Following a counterparty’s failure to remargin, the time that is required between the last mark-to-market before the failure to remargin and the liquidation of the collateral is considered to be no more than four business days;
5. The transaction is settled across a settlement system proven for that type of transaction;
6. The documentation covering the agreement is standard market documentation for repo-style transactions in the securities concerned;
7. The transaction is governed by documentation specifying that if the counterparty fails to satisfy an obligation to deliver cash or securities or to deliver margin or otherwise defaults, then the transaction is immediately terminable; and
8. Upon any default event, regardless of whether the counterparty is insolvent or bankrupt, the bank has the unfettered, legally enforceable right to immediately seize and liquidate the collateral for its benefit.

Core market participants may include, at the discretion of the national supervisor, the following entities:

1. Sovereigns, central banks and PSEs;
2. Banks and securities firms;
3. Other financial companies (including insurance companies) eligible for a 20% risk weight in the standardised approach;
4. Regulated mutual funds that are subject to capital or leverage requirements;
5. Regulated pension funds; and
6. Qualifying central counterparties.

Repo transactions that fulfil the requirement in CRE22.36 receive a 10% risk weight, as an exemption to the risk weight floor described in CRE22.33. If the counterparty to the transaction is a core market participant, banks may apply a risk weight of 0% to the transaction.

The 20% floor for the risk weight on a collateralised transaction does not apply and a 0% risk weight may be applied to the collateralised portion of the exposure where the exposure and the collateral are denominated in the same currency, and either:

1. the collateral is cash on deposit as defined in CRE22.34(1); or
2. the collateral is in the form of sovereign/PSE securities eligible for a 0% risk weight, and its market value has been discounted by 20%.

In the comprehensive approach, when taking collateral, banks must calculate their adjusted exposure to a counterparty in order to take account of the risk mitigating effect of that collateral. Banks must use the applicable supervisory haircuts to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either,⁵⁷ as occasioned by market movements. Unless either side of the transaction is cash or a zero haircut is applied, the volatility-adjusted exposure amount is higher than the nominal exposure and the volatility-adjusted collateral value is lower than the nominal collateral value.

The size of the haircuts that banks must use depends on the prescribed holding period for the transaction. For the purposes of CRE22, the holding period is the period of time over which exposure or collateral values are assumed to move before the bank can close out the transaction. The supervisory prescribed minimum holding period is used as the basis for the calculation of the standard supervisory haircuts.

The holding period, and thus the size of the individual haircuts depends on the type of instrument, type of transaction, residual maturity and the frequency of marking to market and remargining as provided in CRE22.49 to CRE22.51. For example, repo-style transactions subject to daily marking-to-market and to daily remargining will receive a haircut based on a 5-business day holding period and secured lending transactions with daily mark-to-market and no remargining clauses will receive a haircut based on a 20-business day holding period. Haircuts must be scaled up using the square root of time formula depending on the actual frequency of remargining or marking to market. This formula is included in CRE22.59.

Additionally, where the exposure and collateral are held in different currencies, banks must apply an additional haircut to the volatility-adjusted collateral amount in accordance with CRE22.52 and CRE22.82 to CRE22.83 to take account of possible future fluctuations in exchange rates.

The effect of master netting agreements covering securities financing transactions (SFTs) can be recognised for the calculation of capital requirements subject to the conditions and requirements in CRE22.62 to CRE22.65. Where SFTs are subject to a master netting agreement whether they are held in the banking book or trading book, a bank may choose not to recognise the netting effects in calculating capital. In that case, each transaction will be subject to a capital charge as if there were no master netting agreement.

The following collateral instruments are eligible for recognition in the comprehensive approach:

1. All of the instruments listed in CRE22.34;
2. Equities and convertible bonds that are not included in a main index but which are listed on a recognised security exchange;
3. UCITS/mutual funds which include the instruments in point (2).

For a collateralised transaction, the exposure amount after risk mitigation is calculated using the formula that follows, where:

1. E* = the exposure value after risk mitigation
2. E = current value of the exposure
3. H_e = haircut appropriate to the exposure
4. C = the current value of the collateral received
5. H_c = haircut appropriate to the collateral
6. H_fx = haircut appropriate for currency mismatch between the collateral and exposure

In the case of maturity mismatches, the value of the collateral received (collateral amount) must be adjusted in accordance with CRE22.10 to CRE22.14.

The exposure amount after risk mitigation (E*) must be multiplied by the risk weight of the counterparty to obtain the risk-weighted asset amount for the collateralised transaction.

In jurisdictions that allow the use of external ratings for regulatory purposes, the following supervisory haircuts (assuming daily mark-to-market, daily remargining and a 10-business day holding period), expressed as percentages, must be used to determine the haircuts appropriate to the collateral (H_c) and to the exposure (H_e):

In jurisdictions that do not allow the use of external ratings for regulatory purposes, the following supervisory haircuts (assuming daily mark-to-market, daily remargining and a 10-business day holding period), expressed as percentages, must be used to determine the haircuts appropriate to the collateral (H_c) and to the exposure (H_e):

In paragraphs CRE22.49 to CRE22.50:

1. “Sovereigns” includes: PSEs that are treated as sovereigns by the national supervisor, as well as multilateral development banks receiving a 0% risk weight.
2. “Other issuers” includes: PSEs that are not treated as sovereigns by the national supervisor.
3. “Securitisation exposures” refers to exposures that meet the definition set forth in the securitisation framework.
4. “Cash in the same currency” refers to eligible cash collateral specified in CRE22.34(1).

The haircut for currency risk (H_fx) where exposure and collateral are denominated in different currencies is 8% (also based on a 10-business day holding period and daily mark-to-market).

For SFTs and secured lending transactions, a haircut adjustment may need to be applied in accordance with CRE22.56 to CRE22.59.

For SFTs in which the bank lends, or posts as collateral, non-eligible instruments, the haircut to be applied on the exposure must be 30%. For transactions in which the bank borrows non-eligible instruments, credit risk mitigation may not be applied.

Where the collateral is a basket of assets, the haircut (H) on the basket must be calculated using the formula that follows, where:

1. a_i is the weight of the asset (as measured by units of currency) in the basket
2. H_i the haircut applicable to that asset

For some transactions, depending on the nature and frequency of the revaluation and remargining provisions, different holding periods and thus different haircuts must be applied. The framework for collateral haircuts distinguishes between repo-style transactions (ie repo/reverse repos and securities lending/borrowing), ”other capital markets-driven transactions” (ie OTC derivatives transactions and margin lending) and secured lending. In capital-market-driven transactions and repo-style transactions, the documentation contains remargining clauses; in secured lending transactions, it generally does not.

The minimum holding period for various products is summarised in the following table:

Regarding the minimum holding periods set out in CRE22.57, if a netting set includes both repo-style and other capital market transactions, the minimum holding period of ten business days must be used. Furthermore, a higher minimum holding period must be used in the following cases:

1. For all netting sets where the number of trades exceeds 5,000 at any point during a quarter, a 20 business day minimum holding period for the following quarter must be used.
2. For netting sets containing one or more trades involving illiquid collateral, a minimum holding period of 20 business days must be used. "Illiquid collateral" must be determined in the context of stressed market conditions and will be characterised by the absence of continuously active markets where a counterparty would, within two or fewer days, obtain multiple price quotations that would not move the market or represent a price reflecting a market discount. Examples of situations where trades are deemed illiquid for this purpose include, but are not limited to, trades that are not marked daily and trades that are subject to specific accounting treatment for valuation purposes (eg repo-style transactions referencing securities whose fair value is determined by models with inputs that are not observed in the market).
3. If a bank has experienced more than two margin call disputes on a particular netting set over the previous two quarters that have lasted longer than the bank's estimate of the margin period of risk (as defined in CRE50.19), then for the subsequent two quarters the bank must use a minimum holding period that is twice the level that would apply excluding the application of this sub-paragraph.

When the frequency of remargining or revaluation is longer than the minimum, the minimum haircut numbers must be scaled up depending on the actual number of business days between remargining or revaluation. The 10-business day haircuts provided in CRE22.49 to CRE22.51 are the default haircuts and these haircuts must be scaled up or down using the formula below, where:

1. H = haircut
2. H₁₀ = 10-business day haircut for instrument
3. T_M = minimum holding period for the type of transaction.
4. N_R = actual number of business days between remargining for capital market transactions or revaluation for secured transactions

For repo-style transactions with core market participants as defined in CRE22.37 and that satisfy the conditions in CRE22.36 supervisors may apply a haircut of zero.

Where, under the comprehensive approach, a supervisor applies a specific carve-out to repo-style transactions in securities issued by its domestic government, other supervisors may choose to allow banks incorporated in their jurisdiction to adopt the same approach to the same transactions.

The effects of bilateral netting agreements covering SFTs may be recognised on a counterparty-by-counterparty basis if the agreements are legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of whether the counterparty is insolvent or bankrupt. In addition, netting agreements must:

1. provide the non-defaulting party the right to terminate and close out in a timely manner all transactions under the agreement upon an event of default, including in the event of insolvency or bankruptcy of the counterparty;
2. provide for the netting of gains and losses on transactions (including the value of any collateral) terminated and closed out under it so that a single net amount is owed by one party to the other;
3. allow for the prompt liquidation or set-off of collateral upon the event of default; and
4. be, together with the rights arising from the provisions required in (1) to (3) above, legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of the counterparty’s insolvency or bankruptcy.

Netting across positions in the banking and trading book may only be recognised when the netted transactions fulfil the following conditions:

1. All transactions are marked to market daily;⁵⁸ and
2. The collateral instruments used in the transactions are recognised as eligible financial collateral in the banking book.

The formula in CRE22.65 will be used to calculate the counterparty credit risk capital requirements for SFTs with netting agreements. This formula includes the current exposure, an amount for systematic exposure of the securities based on the net exposure, an amount for the idiosyncratic exposure of the securities based on the gross exposure, and an amount for currency mismatch. All other rules regarding the calculation of haircuts under the comprehensive approach stated in CRE22.40 to CRE22.61 equivalently apply for banks using bilateral netting agreements for SFTs.

Banks using standard supervisory haircuts for SFTs conducted under a master netting agreement must use the formula that follows to calculate their exposure amount, where:

1. E* is the exposure value of the netting set after risk mitigation
2. E_i is the current value of all cash and securities lent, sold with an agreement to repurchase or otherwise posted to the counterparty under the netting agreement
3. C_j is the current value of all cash and securities borrowed, purchased with an agreement to resell or otherwise held by the bank under the netting agreement
4. 
5. 
6. E_s is the net current value of each security issuance under the netting set (always a positive value)
7. H_s is the haircut appropriate to E_s as described in tables of CRE22.49 to CRE22.51, as applicable
   1. H_s has a positive sign if the security is lent, sold with an agreement to repurchased, or transacted in manner similar to either securities lending or a repurchase agreement
   2. H_s has a negative sign if the security is borrowed, purchased with an agreement to resell, or transacted in a manner similar to either a securities borrowing or reverse repurchase agreement
8. N is the number of security issues contained in the netting set (except that issuances where the value Es is less than one tenth of the value of the largest Es in the netting set are not included the count)
9. E_fx is the absolute value of the net position in each currency fx different from the settlement currency
10. H_fx is the haircut appropriate for currency mismatch of currency fx

Under the standardised approach for counterparty credit risk (SA-CCR, CRE52), the calculation of the counterparty credit risk charge for an individual contract will be calculated using the following formula, where:

1. Alpha = 1.4
2. RC = the replacement cost calculated according to CRE52.3 to CRE52.20
3. PFE = the amount for potential future exposure calculated according to CRE52.21 to CRE52.73

As an alternative to the SA-CCR for the calculation of the counterparty credit risk charge, banks may also use the internal models method as set out in CRE53, subject to supervisory approval.

A bank may use the net exposure of loans and deposits as the basis for its capital adequacy calculation in accordance with the formula in CRE22.46, when the bank:

1. has a well-founded legal basis for concluding that the netting or offsetting agreement is enforceable in each relevant jurisdiction regardless of whether the counterparty is insolvent or bankrupt;
2. is able at any time to determine those assets and liabilities with the same counterparty that are subject to the netting agreement;
3. monitors and controls its roll-off risks; and
4. monitors and controls the relevant exposures on a net basis,

When calculating the net exposure described in the paragraph above, assets (loans) are treated as exposure and liabilities (deposits) as collateral. The haircuts are zero except when a currency mismatch exists. A 10-business day holding period applies when daily mark-to-market is conducted. For on-balance sheet netting, the requirements in CRE22.49 and CRE22.59 and CRE22.10 to CRE22.14 must be applied.

If conditions set below are met, banks can substitute the risk weight of the counterparty with the risk weight of the guarantor.

A guarantee (counter-guarantee) or credit derivative must satisfy the following requirements:

1. it represents a direct claim on the protection provider;
2. it is explicitly referenced to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible;
3. other than non-payment by a protection purchaser of money due in respect of the credit protection contract it is irrevocable;
4. there is no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover, change the maturity agreed ex post, or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure;
5. it must be unconditional; there should be no clause in the protection contract outside the direct control of the bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the underlying counterparty fails to make the payment(s) due.

In the case of maturity mismatches, the amount of credit protection that is provided must be adjusted in accordance with CRE22.10 to CRE22.14.

In addition to the legal certainty requirements in CRE22.9, in order for a guarantee to be recognised, the following requirements must be satisfied:

1. On the qualifying default/non-payment of the counterparty, the bank may in a timely manner pursue the guarantor for any monies outstanding under the documentation governing the transaction. The guarantor may make one lump sum payment of all monies under such documentation to the bank, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The bank must have the right to receive any such payments from the guarantor without first having to take legal action in order to pursue the counterparty for payment.
2. The guarantee is an explicitly documented obligation assumed by the guarantor.
3. Except as noted in the following sentence, the guarantee covers all types of payments the underlying counterparty is expected to make under the documentation governing the transaction, for example notional amount, margin payments, etc. Where a guarantee covers payment of principal only, interests and other uncovered payments must be treated as an unsecured amount in accordance with the rules for proportional cover described in CRE22.80.

In addition to the legal certainty requirements in CRE22.9, in order for a credit derivative contract to be recognised, the following requirements must be satisfied:

1. The credit events specified by the contracting parties must at a minimum cover:
   1. failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation);
   2. bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and
   3. restructuring⁵⁹ of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (ie write-off, specific provision or other similar debit to the profit and loss account).
2. If the credit derivative covers obligations that do not include the underlying obligation, point (7) below governs whether the asset mismatch is permissible.
3. The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay. In the case of a maturity mismatch, the provisions of CRE22.10 to CRE22.14 must be applied.
4. Credit derivatives allowing for cash settlement are recognised for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There must be a clearly specified period for obtaining post-credit-event valuations of the underlying obligation. If the reference obligation specified in the credit derivative for purposes of cash settlement is different from the underlying obligation, section (7) below governs whether the asset mismatch is permissible.
5. If the protection purchaser’s right/ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation must provide that any required consent to such transfer may not be unreasonably withheld.
6. The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event.
7. A mismatch between the underlying obligation and the reference obligation under the credit derivative (ie the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if:
   1. the reference obligation ranks pari passu with or is junior to the underlying obligation; and
   2. the underlying obligation and reference obligation share the same obligor (ie the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.
8. A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if:
   1. the latter obligation ranks pari passu with or is junior to the underlying obligation; and
   2. the underlying obligation and reference obligation share the same obligor (ie the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.

When the restructuring of the underlying obligation is not covered by the credit derivative, but the other requirements in CRE22.74 are met, partial recognition of the credit derivative will be allowed. If the amount of the credit derivative is less than or equal to the amount of the underlying obligation, 60% of the amount of the hedge can be recognised as covered. If the amount of the credit derivative is larger than that of the underlying obligation, then the amount of eligible hedge is capped at 60% of the amount of the underlying obligation.

Credit protection given by the following entities can be recognised when they have a lower risk weight than the counterparty:

1. Sovereign entities,⁶⁰ PSEs, multilateral development banks (MDBs), banks, securities firms and other prudentially regulated financial institutions with a lower risk weight than the counterparty;⁶¹
2. In jurisdictions that allow the use of external ratings for regulatory purposes:
   1. other entities that are externally rated except when credit protection is provided to a securitisation exposure. This would include credit protection provided by a parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor;
   2. when credit protection is provided to a securitisation exposure, other entities that currently are externally rated BBB– or better and that were externally rated A– or better at the time the credit protection was provided. This would include credit protection provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor.
3. In jurisdictions that do not allow the use of external ratings for regulatory purposes:
   1. Other entities, defined as “investment grade” meaning they have adequate capacity to meet their financial commitments (including repayments of principal and interest) in a timely manner, irrespective of the economic cycle and business conditions. When making this determination, the bank should assess the entity against the investment grade definition taking into account the complexity of its business model, performance against industry and peers, and risks posed by the entity’s operating environment. Moreover, the following conditions will have to be met:
      (i)

      For corporate entities (or the entity’s parent company), they must have securities outstanding on a recognised securities exchange;

      (ii)

      The creditworthiness of these “investment grade entities” is not positively correlated with the credit risk of the exposures for which they provided guarantees.

   2. Parent, subsidiary and affiliate companies of the obligor where their creditworthiness is not positively correlated with the credit risk of the exposures for which they provided guarantees. For an intra-group company to be recognised as eligible guarantor, the credit risk of the whole group should be taken into account.

Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees are eligible for recognition.⁶² The following exception applies: where a bank buys credit protection through a total return swap and records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by an addition to reserves), the credit protection will not be recognised.

First-to-default and all other nth-to-default credit derivatives (ie by which a bank obtains credit protection for a basket of reference names and where the first- or nth–to-default among the reference names triggers the credit protection and terminates the contract) are not eligible as a credit risk mitigation technique and therefore cannot provide any regulatory capital relief. In transactions in which a bank provided credit protection through such instruments, it shall apply the treatment described in CRE20.103.

The general risk-weight treatment for transactions in which eligible credit protection is provided is as follows:

1. The protected portion is assigned the risk weight of the protection provider. The uncovered portion of the exposure is assigned the risk weight of the underlying counterparty.
2. Materiality thresholds on payments below which the protection provider is exempt from payment in the event of loss are equivalent to retained first-loss positions. The portion of the exposure that is below a materiality threshold must be assigned a risk weight of 1250% by the bank purchasing the credit protection.

Where losses are shared pari passu on a pro rata basis between the bank and the guarantor, capital relief is afforded on a proportional basis, ie the protected portion of the exposure receives the treatment applicable to eligible guarantees/credit derivatives, with the remainder treated as unsecured.

Where the bank transfers a portion of the risk of an exposure in one or more tranches to a protection seller or sellers and retains some level of the risk of the loan, and the risk transferred and the risk retained are of different seniority, banks may obtain credit protection for either the senior tranches (eg the second-loss portion) or the junior tranche (eg the first-loss portion). In this case the rules as set out in the securitisation standard apply.

Where the credit protection is denominated in a currency different from that in which the exposure is denominated – ie there is a currency mismatch – the amount of the exposure deemed to be protected must be reduced by the application of a haircut H_FX, using the formula that follows, where:

1. G = nominal amount of the credit protection
2. H_FX = haircut appropriate for currency mismatch between the credit protection and underlying obligation

The currency mismatch haircut for a 10-business day holding period (assuming daily marking to market) is 8%. This haircut must be scaled up using the square root of time formula, depending on the frequency of revaluation of the credit protection as described in CRE22.59.

As specified in CRE20.8, a lower risk weight may be applied at national discretion to a bank’s exposures to the sovereign (or central bank) where the bank is incorporated and where the exposure is denominated in domestic currency and funded in that currency. National supervisors may extend this treatment to portions of exposures guaranteed by the sovereign (or central bank), where the guarantee is denominated in the domestic currency and the exposure is funded in that currency. An exposure may be covered by a guarantee that is indirectly counter-guaranteed by a sovereign. Such an exposure may be treated as covered by a sovereign guarantee provided that:

1. the sovereign counter-guarantee covers all credit risk elements of the exposure;
2. both the original guarantee and the counter-guarantee meet all operational requirements for guarantees, except that the counter-guarantee need not be direct and explicit to the original exposure; and
3. the supervisor is satisfied that the cover is robust and that no historical evidence suggests that the coverage of the counter-guarantee is less than effectively equivalent to that of a direct sovereign guarantee.

This chapter describes the internal ratings-based (IRB) approach for credit risk. Subject to certain minimum conditions and disclosure requirements, banks that have received supervisory approval to use the IRB approach may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure. The risk components include measures of the probability of default (PD), loss given default (LGD), the exposure at default (EAD), and effective maturity (M). In some cases, banks may be required to use a supervisory value as opposed to an internal estimate for one or more of the risk components.

The IRB approach is based on measures of unexpected losses (UL) and expected losses. The risk-weight functions, as outlined in CRE31, produce capital requirements for the UL portion. Expected losses are treated separately, as outlined in CRE35.

In this chapter, first the asset classes (eg corporate exposures and retail exposures) eligible for the IRB approach are defined. Second, there is a description of the risk components to be used by banks by asset class. Third, the requirements are outlined that relate to a bank’s adoption of the IRB approach at the asset class level and the related roll-out requirements. In cases where an IRB treatment is not specified, the risk weight for those other exposures is 100%, except when a 0% risk weight applies under the standardised approach, and the resulting risk-weighted assets are assumed to represent UL only. Moreover, banks must apply the risk weights referenced in CRE20.61, CRE20.62 and CRE20.109 of the standardised approach to the exposures referenced in those paragraphs (that is, investments that are assessed against certain materiality thresholds).

Under the IRB approach, banks must categorise banking-book exposures into broad classes of assets with different underlying risk characteristics, subject to the definitions set out below. The classes of assets are (a) corporate, (b) sovereign, (c) bank, (d) retail, and (e) equity. Within the corporate asset class, five sub-classes of specialised lending are separately identified. Within the retail asset class, three sub-classes are separately identified. Within the corporate and retail asset classes, a distinct treatment for purchased receivables may also apply provided certain conditions are met. For the equity asset class the IRB approach is not permitted, as outlined further below.

The classification of exposures in this way is broadly consistent with established bank practice. However, some banks may use different definitions in their internal risk management and measurement systems. While it is not the intention of the Committee to require banks to change the way in which they manage their business and risks, banks are required to apply the appropriate treatment to each exposure for the purposes of deriving their minimum capital requirement. Banks must demonstrate to supervisors that their methodology for assigning exposures to different classes is appropriate and consistent over time.

In general, a corporate exposure is defined as a debt obligation of a corporation, partnership, or proprietorship. Banks are permitted to distinguish separately exposures to small or medium-sized entities (SME), as defined in CRE31.8.

In addition to general corporates, within the corporate asset class five sub-classes of specialised lending (SL) are identified. Such lending possesses all the following characteristics, in legal form or economic substance:

1. The exposure is typically to an entity (often a special purpose entity (SPE)) that was created specifically to finance and/or operate physical assets,
2. The borrowing entity has little or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed;
3. The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates; and
4. As a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise.

The five sub-classes of SL are project finance (PF), object finance (OF), commodities finance (CF), income-producing real estate (IPRE) lending, and high-volatility commercial real estate (HVCRE) lending. Each of these sub-classes is defined below.

PF is a method of funding in which the lender looks primarily to the revenues generated by a single project, both as the source of repayment and as security for the exposure. This type of financing is usually for large, complex and expensive installations that might include, for example, power plants, chemical processing plants, mines, transportation infrastructure, environment, and telecommunications infrastructure. Project finance may take the form of financing of the construction of a new capital installation, or refinancing of an existing installation, with or without improvements.

In such transactions, the lender is usually paid solely or almost exclusively out of the money generated by the contracts for the facility’s output, such as the electricity sold by a power plant. The borrower is usually an SPE that is not permitted to perform any function other than developing, owning, and operating the installation. The consequence is that repayment depends primarily on the project’s cash flow and on the collateral value of the project’s assets. In contrast, if repayment of the exposure depends primarily on a well-established, diversified, credit-worthy, contractually obligated end user for repayment, it is considered a secured exposure to that end-user.

OF refers to a method of funding the acquisition of physical assets (eg ships, aircraft, satellites, railcars, or fleets) where the repayment of the exposure is dependent on the cash flows generated by the specific assets that have been financed and pledged or assigned to the lender. A primary source of these cash flows might be rental or lease contracts with one or several third parties. In contrast, if the exposure is to a borrower whose financial condition and debt-servicing capacity enables it to repay the debt without undue reliance on the specifically pledged assets, the exposure should be treated as a collateralised corporate exposure.

CF refers to structured short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities (eg crude oil, metals, or crops), where the exposure will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the exposure. This is the case when the borrower has no other activities and no other material assets on its balance sheet. The structured nature of the financing is designed to compensate for the weak credit quality of the borrower. The exposure’s rating reflects its self-liquidating nature and the lender’s skill in structuring the transaction rather than the credit quality of the borrower.

The Committee believes that such lending can be distinguished from exposures financing the reserves, inventories, or receivables of other more diversified corporate borrowers. Banks are able to rate the credit quality of the latter type of borrowers based on their broader ongoing operations. In such cases, the value of the commodity serves as a risk mitigant rather than as the primary source of repayment.

IPRE lending refers to a method of providing funding to real estate (such as, office buildings to let, retail space, multifamily residential buildings, industrial or warehouse space, or hotels) where the prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset. The primary source of these cash flows would generally be lease or rental payments or the sale of the asset. The borrower may be, but is not required to be, an SPE, an operating company focused on real estate construction or holdings, or an operating company with sources of revenue other than real estate. The distinguishing characteristic of IPRE versus other corporate exposures that are collateralised by real estate is the strong positive correlation between the prospects for repayment of the exposure and the prospects for recovery in the event of default, with both depending primarily on the cash flows generated by a property.

HVCRE lending is the financing of commercial real estate that exhibits higher loss rate volatility (ie higher asset correlation) compared to other types of SL. HVCRE includes:

1. Commercial real estate exposures secured by properties of types that are categorised by the national supervisor as sharing higher volatilities in portfolio default rates;
2. Loans financing any of the land acquisition, development and construction (ADC) phases for properties of those types in such jurisdictions; and
3. Loans financing ADC of any other properties where the source of repayment at origination of the exposure is either the future uncertain sale of the property or cash flows whose source of repayment is substantially uncertain (eg the property has not yet been leased to the occupancy rate prevailing in that geographic market for that type of commercial real estate), unless the borrower has substantial equity at risk. Commercial ADC loans exempted from treatment as HVCRE loans on the basis of certainty of repayment or borrower equity are, however, ineligible for the additional reductions for SL exposures described in CRE33.4.

Where supervisors categorise certain types of commercial real estate exposures as HVCRE in their jurisdictions, they are required to make public such determinations. Other supervisors need to ensure that such treatment is then applied equally to banks under their supervision when making such HVCRE loans in that jurisdiction.

This asset class covers all exposures to counterparties treated as sovereigns under the standardised approach. This includes sovereigns (and their central banks), certain public sector entities (PSEs) identified as sovereigns in the standardised approach, multilateral development banks (MDBs) that meet the criteria for a 0% risk weight and referred to in the first footnote of CRE20.14 of the standardised approach, and the entities referred to in CRE20.10 of the standardised approach.

This asset class covers exposures to banks as defined in CRE20.16 of the standardised approach for credit risk and those securities firms and other financial institutions set out in CRE20.40 of the standardised approach for credit risk that are treated as exposures to banks. Bank exposures also include covered bonds as defined in CRE20.33 as well as claims on all domestic PSEs that are not treated as exposures to sovereigns under the standardised approach, and MDBs that do not meet the criteria for a 0% risk weight under the standardised approach (ie MDBs that are not listed in the first footnote to CRE20.14 of the standardised approach). This asset class also includes exposures to the entities listed in this paragraph that are in the form of subordinated debt or regulatory capital instruments (which form their own asset class within the standardised approach), provided that such instruments: (i) do not fall within the scope of equity exposures as defined in CRE30.26; (ii) are not deducted from regulatory capital or risk-weighted at 250% according to CAP30; and (iii) are not risk weighted at 1250% according to CRE20.62.

An exposure is categorised as a retail exposure if it meets all of the criteria set out in CRE30.20 (which relate to the nature of the borrower and value of individual exposures) and all of the criteria set out in CRE30.22 (which relate to the size of the pool of exposures).

The criteria related to the nature of the borrower and value of the individual exposures are as follows:

1. Exposures to individuals – such as revolving credits and lines of credit (eg credit cards, overdrafts, or retail facilities secured by financial instruments) as well as personal term loans and leases (eg instalment loans, auto loans and leases, student and educational loans, personal finance, or other exposures with similar characteristics) – are generally eligible for retail treatment regardless of exposure size, although supervisors may wish to establish exposure thresholds to distinguish between retail and corporate exposures.
2. Where a loan is a residential mortgage⁶³ (including first and subsequent liens, term loans and revolving home equity lines of credit) it is eligible for retail treatment regardless of exposure size so long as the credit is:
   1. an exposure to an individual;⁶⁴ or
   2. an exposure to associations or cooperatives of individuals that are regulated under national law and exist with the only purpose of granting its members the use of a primary residence in the property securing the loan.
3. Where loans are extended to small businesses and managed as retail exposures they are eligible for retail treatment provided the total exposure of the banking group to a small business borrower (on a consolidated basis where applicable) is less than €1 million. Small business loans extended through or guaranteed by an individual are subject to the same exposure threshold.

It is expected that supervisors provide flexibility in the practical application of the thresholds set out in CRE30.20, such that banks are not forced to develop extensive new information systems simply for the purpose of ensuring perfect compliance. It is, however, important for supervisors to ensure that such flexibility (and the implied acceptance of exposure amounts in excess of the thresholds that are not treated as violations) is not being abused.

The criteria related to the size of the pool of exposures are as follows:

1. The exposure must be one of a large pool of exposures, which are managed by the bank on a pooled basis.
2. Where a loan gives rise to a small business exposure below €1 million, it may be treated as retail exposures if the bank treats such exposures in its internal risk management systems consistently over time and in the same manner as other retail exposures. This requires that such an exposure be originated in a similar manner to other retail exposures. Furthermore, it must not be managed individually in a way comparable to corporate exposures, but rather as part of a portfolio segment or pool of exposures with similar risk characteristics for purposes of risk assessment and quantification. However, this does not preclude retail exposures from being treated individually at some stages of the risk management process. The fact that an exposure is rated individually does not by itself deny the eligibility as a retail exposure.

Within the retail asset class category, banks are required to identify separately three sub-classes of exposures:

1. residential mortgage loans, as defined above;
2. qualifying revolving retail exposures, as defined in the following paragraph; and
3. all other retail exposures.

All of the following criteria must be satisfied for a sub-portfolio to be treated as a qualifying revolving retail exposure (QRRE). These criteria must be applied at a sub-portfolio level consistent with the bank’s segmentation of its retail activities generally. Segmentation at the national or country level (or below) should be the general rule.

1. The exposures are revolving, unsecured, and uncommitted (both contractually and in practice). In this context, revolving exposures are defined as those where customers’ outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the bank.
2. The exposures are to individuals.
3. The maximum exposure to a single individual in the sub-portfolio is €100,000 or less.
4. Because the asset correlation assumptions for the QRRE risk-weight function are markedly below those for the other retail risk-weight function at low PD values, banks must demonstrate that the use of the QRRE risk-weight function is constrained to portfolios that have exhibited low volatility of loss rates, relative to their average level of loss rates, especially within the low PD bands.
5. Data on loss rates for the sub-portfolio must be retained in order to allow analysis of the volatility of loss rates.
6. The supervisor must concur that treatment as a qualifying revolving retail exposure is consistent with the underlying risk characteristics of the sub-portfolio.

The QRRE sub-class is split into exposures to transactors and revolvers. A QRRE transactor is an exposure to an obligor that meets the definition set out in CRE20.64 of the standardised approach. That is, the exposure is to an obligor in relation to a facility such as credit card or charge card where the balance has been repaid in full at each scheduled repayment date for the previous 12 months, or the exposure is in relation to an overdraft facility if there have been no drawdowns over the previous 12 months. All exposures that are not QRRE transactors are QRRE revolvers, including QRRE exposures with less than 12 months of repayment history.

This asset class covers exposures to equities as defined in CRE20.54 to CRE20.56 of the standardised approach for credit risk.

Eligible purchased receivables are divided into retail and corporate receivables as defined below.

Purchased retail receivables, provided the purchasing bank complies with the IRB rules for retail exposures, are eligible for the top-down approach as permitted within the existing standards for retail exposures. The bank must also apply the minimum operational requirements as set forth in chapters CRE34 and CRE36.

In general, for purchased corporate receivables, banks are expected to assess the default risk of individual obligors as specified in CRE31.3 to CRE31.12 consistent with the treatment of other corporate exposures. However, the top-down approach may be used, provided that the purchasing bank’s programme for corporate receivables complies with both the criteria for eligible receivables and the minimum operational requirements of this approach. The use of the top-down purchased receivables treatment is limited to situations where it would be an undue burden on a bank to be subjected to the minimum requirements for the IRB approach to corporate exposures that would otherwise apply. Primarily, it is intended for receivables that are purchased for inclusion in asset-backed securitisation structures, but banks may also use this approach, with the approval of national supervisors, for appropriate on-balance sheet exposures that share the same features.

Supervisors may deny the use of the top-down approach for purchased corporate receivables depending on the bank’s compliance with minimum requirements. In particular, to be eligible for the proposed ‘top-down’ treatment, purchased corporate receivables must satisfy the following conditions:

1. The receivables are purchased from unrelated, third party sellers, and as such the bank has not originated the receivables either directly or indirectly.
2. The receivables must be generated on an arm’s-length basis between the seller and the obligor. (As such, intercompany accounts receivable and receivables subject to contra-accounts between firms that buy and sell to each other are ineligible.⁶⁵ )
3. The purchasing bank has a claim on all proceeds from the pool of receivables or a pro-rata interest in the proceeds.⁶⁶
4. National supervisors must also establish concentration limits above which capital charges must be calculated using the minimum requirements for the bottom-up approach for corporate exposures. Such concentration limits may refer to one or a combination of the following measures: the size of one individual exposure relative to the total pool, the size of the pool of receivables as a percentage of regulatory capital, or the maximum size of an individual exposure in the pool.

The existence of full or partial recourse to the seller does not automatically disqualify a bank from adopting this top-down approach, as long as the cash flows from the purchased corporate receivables are the primary protection against default risk as determined by the rules in CRE34.4 to CRE34.7 for purchased receivables and the bank meets the eligibility criteria and operational requirements.

For each of the asset classes covered under the IRB framework, there are three key elements:

1. Risk components: estimates of risk parameters provided by banks, some of which are supervisory estimates.
2. Risk-weight functions: the means by which risk components are transformed into risk-weighted assets and therefore capital requirements.
3. Minimum requirements: the minimum standards that must be met in order for a bank to use the IRB approach for a given asset class.

For certain asset classes, the Committee has made available two broad approaches: a foundation and an advanced approach. Under the foundation approach (F-IRB approach), as a general rule, banks provide their own estimates of PD and rely on supervisory estimates for other risk components. Under the advanced approach (A-IRB approach), banks provide their own estimates of PD, LGD and EAD, and their own calculation of M, subject to meeting minimum standards. For both the foundation and advanced approaches, banks must always use the risk-weight functions provided in this Framework for the purpose of deriving capital requirements. The full suite of approaches is described below.

For exposures to equities, as defined in CRE30.26 above, the IRB approaches are not permitted (see CRE30.43). In addition, the A-IRB approach cannot be used for the following:

1. Exposures to general corporates (ie exposures to corporates that are not classified as specialised lending) belonging to a group with total consolidated annual revenues greater than €500m.
2. Exposures in the bank asset class CRE30.18, and other securities firms and financial institutions (including insurance companies and any other financial institutions in the corporate asset class).

In making the assessment for the revenue threshold in CRE30.34 above, the amounts must be as reported in the audited financial statements of the corporates or, for corporates that are part of consolidated groups, their consolidated groups (according to the accounting standard applicable to the ultimate parent of the consolidated group). The figures must be based on the average amounts calculated over the prior three years, or on the latest amounts updated every three years by the bank.

Under the foundation approach, banks must provide their own estimates of PD associated with each of their borrower grades, but must use supervisory estimates for the other relevant risk components. The other risk components are LGD, EAD and M.⁶⁷

Under the advanced approach, banks must calculate the effective maturity (M)⁶⁸ and provide their own estimates of PD, LGD and EAD.

There is an exception to this general rule for the five sub-classes of assets identified as SL.

Banks that do not meet the requirements for the estimation of PD under the corporate foundation approach for their SL exposures are required to map their internal risk grades to five supervisory categories, each of which is associated with a specific risk weight. This version is termed the ‘supervisory slotting criteria approach’.

Banks that meet the requirements for the estimation of PD are able to use the foundation approach to corporate exposures to derive risk weights for all classes of SL exposures except HVCRE. At national discretion, banks meeting these requirements for HVCRE exposures are able to use a foundation approach that is similar in all respects to the corporate approach, with the exception of a separate risk-weight function as described in CRE31.11.

Banks that meet the requirements for the estimation of PD, LGD and EAD are able to use the advanced approach to corporate exposures to derive risk weights for all classes of SL exposures except HVCRE. At national discretion, banks meeting these requirements for HVCRE exposure are able to use an advanced approach that is similar in all respects to the corporate approach, with the exception of a separate risk-weight function as described in CRE31.11.

For retail exposures, banks must provide their own estimates of PD, LGD and EAD. There is no foundation approach for this asset class.

All equity exposures are subject to the approach set out in CRE20.57 of the standardised approach for credit risk, with the exception of equity investments in funds that are subject to the requirements set out in CRE60.

The treatment potentially straddles two asset classes. For eligible corporate receivables, both a foundation and advanced approach are available subject to certain operational requirements being met. As noted in CRE30.29, for corporate purchased receivables banks are in general expected to assess the default risk of individual obligors. The bank may use the A-IRB treatment for purchased corporate receivables CRE34.6 to CRE34.7 only for exposures to individual corporate obligors that are eligible for the A-IRB approach according to CRE30.34 and CRE30.35. Otherwise, the F-IRB treatment for purchased corporate receivables should be used. For eligible retail receivables, as with the retail asset class, only the A-IRB approach is available.

Once a bank adopts an IRB approach for part of its holdings within an asset class, it is expected to extend it across all holdings within that asset class. In this context, the relevant assets classes are as follows:

1. Sovereigns
2. Banks
3. Corporates (excluding specialised lending and purchased receivables)
4. Specialised lending
5. Corporate purchased receivables
6. QRRE
7. Retail residential mortgages
8. Other retail (excluding purchased receivables)
9. Retail purchased receivables

The Committee recognises that, for many banks, it may not be practicable for various reasons to implement the IRB approach for an entire asset class across all business units at the same time. Furthermore, once on IRB, data limitations may mean that banks can meet the standards for the use of own estimates of LGD and EAD for some but not all of their exposures within an asset class at the same time (for example, exposures that are in the same asset class, but are in different business units).

As such, supervisors may allow banks to adopt a phased rollout of the IRB approach across an asset class. The phased rollout includes: (i) adoption of IRB across the asset class within the same business unit; (ii) adoption of IRB for the asset class across business units in the same banking group; and (iii) move from the foundation approach to the advanced approach for certain risk components where use of the advanced approach is permitted. However, when a bank adopts an IRB approach for an asset class within a particular business unit, it must apply the IRB approach to all exposures within that asset class in that unit.

If a bank intends to adopt an IRB approach to an asset class, it must produce an implementation plan, specifying to what extent and when it intends to roll out the IRB approaches within the asset class and business units. The plan should be realistic, and must be agreed with the supervisor. It should be driven by the practicality and feasibility of moving to the more advanced approaches, and not motivated by a desire to adopt an approach that minimises its capital charge. During the roll-out period, supervisors will ensure that no capital relief is granted for intra-group transactions which are designed to reduce a banking group’s aggregate capital charge by transferring credit risk among entities on the standardised approach, foundation and advanced IRB approaches. This includes, but is not limited to, asset sales or cross guarantees.

Some exposures that are immaterial in terms of size and perceived risk profile within their asset class may be exempt from the requirements in the previous two paragraphs, subject to supervisory approval. Capital requirements for such operations will be determined according to the standardised approach, with the national supervisor determining whether a bank should hold more capital under the supervisory review process standard (SRP) for such positions.

Banks adopting an IRB approach for an asset class are expected to continue to employ an IRB approach for that asset class. A voluntary return to the standardised or foundation approach is permitted only in extraordinary circumstances, such as divestiture of a large fraction of the bank’s credit-related business in that asset class, and must be approved by the supervisor.

Given the data limitations associated with SL exposures, a bank may remain on the supervisory slotting criteria approach for one or more of the PF, OF, CF, IPRE or HVCRE sub-classes, and move to the foundation or advanced approach for the other sub-classes. However, a bank should not move to the advanced approach for the HVCRE sub-class without also doing so for material IPRE exposures at the same time.

Irrespective of the materiality, exposures to central counterparties arising from over-the-counter derivatives, exchange traded derivatives transactions and securities financing transactions must be treated according to the dedicated treatment laid down in CRE54.

This chapter presents the calculation of risk weighted assets under the internal ratings-based (IRB) approach for: (i) corporate, sovereign and bank exposures; and (ii) retail exposures. Risk weighted assets are designed to address unexpected losses from exposures. The method of calculating expected losses, and for determining the difference between that measure and provisions, is described CRE35.

Regarding the risk-weight functions for deriving risk weighted assets set out in this chapter:

1. Probability of default (PD) and loss-given-default (LGD) are measured as decimals
2. Exposure at default (EAD) is measured as currency (eg euros), except where explicitly noted otherwise
3. ln denotes the natural logarithm
4. N(x) denotes the cumulative distribution function for a standard normal random variable (ie the probability that a normal random variable with mean zero and variance of one is less than or equal to x). The normal cumulative distribution function is, for example, available in Excel as the function NORMSDIST.
5. G(z) denotes the inverse cumulative distribution function for a standard normal random variable (ie the value of x such that N(x) = z). The inverse of the normal cumulative distribution function is, for example, available in Excel as the function NORMSINV.

The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD (described in CRE36.83) and the bank’s best estimate of expected loss (described in CRE36.86). The risk-weighted asset amount for the defaulted exposure is the product of K, 12.5, and the EAD.

The derivation of risk-weighted assets is dependent on estimates of the PD, LGD, EAD and, in some cases, effective maturity (M), for a given exposure.

For exposures not in default, the formula for calculating risk-weighted assets is as follows (illustrative risk weights are shown in CRE99):

Regarding the formula set out in CRE31.5 above, M is the effective maturity, calculated according to CRE32.43 to CRE32.54, and the following term is used to refer to a specific part of the capital requirements formula:

A multiplier of 1.25 is applied to the correlation parameter of all exposures to financial institutions meeting the following criteria:

1. Regulated financial institutions whose total assets are greater than or equal to USD100 billion. The most recent audited financial statement of the parent company and consolidated subsidiaries must be used in order to determine asset size. For the purpose of this paragraph, a regulated financial institution is defined as a parent and its subsidiaries where any substantial legal entity in the consolidated group is supervised by a regulator that imposes prudential requirements consistent with international norms. These include, but are not limited to, prudentially regulated Insurance Companies, Broker/Dealers, Banks, Thrifts and Futures Commission Merchants.
2. Unregulated financial institutions, regardless of size. Unregulated financial institutions are, for the purposes of this paragraph, legal entities whose main business includes: the management of financial assets, lending, factoring, leasing, provision of credit enhancements, securitisation, investments, financial custody, central counterparty services, proprietary trading and other financial services activities identified by supervisors.

Under the IRB approach for corporate credits, banks will be permitted to separately distinguish exposures to SME borrowers (defined as corporate exposures where the reported sales for the consolidated group of which the firm is a part is less than €50 million) from those to large firms. A firm-size adjustment (ie 0.04 x (1 – (S – 5) / 45)) is made to the corporate risk weight formula for exposures to SME borrowers. S is expressed as total annual sales in millions of euros with values of S falling in the range of equal to or less than €50 million or greater than or equal to €5 million. Reported sales of less than €5 million will be treated as if they were equivalent to €5 million for the purposes of the firm-size adjustment for SME borrowers.

Subject to national discretion, supervisors may allow banks, as a failsafe, to substitute total assets of the consolidated group for total sales in calculating the SME threshold and the firm-size adjustment. However, total assets should be used only when total sales are not a meaningful indicator of firm size.

Regarding project finance, object finance, commodities finance and income-producing real estate sub-asset classes of specialised lending (SL):

1. Banks that meet the requirements for the estimation of PD will be able to use the foundation IRB (F-IRB) approach for the corporate asset class to derive risk weights for SL sub-classes. As specified in CRE33.2, banks that do not meet the requirements for the estimation of PD will be required to use the supervisory slotting approach.
2. Banks that meet the requirements for the estimation of PD, LGD and EAD (where relevant) will be able to use the advanced IRB (A-IRB) approach for the corporate asset class to derive risk weights for SL sub-classes.

Regarding the high volatility commercial real estate (HVCRE) sub-asset class of specialised lending, banks that meet the requirements for the estimation of PD and whose supervisor has chosen to implement a foundation or advanced approach to HVCRE exposures will use the same formula for the derivation of risk weights that is used for other SL exposures, except that they will apply the following asset correlation formula:

Banks that do not meet the requirements for estimation of LGD or EAD for HVCRE exposures must use the supervisory parameters for LGD and EAD for corporate exposures, or use the supervisory slotting approach.

There are three separate risk-weight functions for retail exposures, as defined in CRE31.14 to CRE31.16. Risk weights for retail exposures are based on separate assessments of PD and LGD as inputs to the risk-weight functions. None of the three retail risk-weight functions contain the full maturity adjustment component that is present in the risk-weight function for exposures to banks, sovereigns and corporates. Illustrative risk weights are shown in CRE99.

For exposures defined in CRE30.19 that are not in default and are secured or partly secured⁶⁹ by residential mortgages, risk weights will be assigned based on the following formula:

For qualifying revolving retail exposures as defined in CRE30.23 and CRE30.24 that are not in default, risk weights are defined based on the following formula:

For all other retail exposures that are not in default, risk weights are assigned based on the following function, which allows correlation to vary with PD:

This chapter presents the calculation of the risk components (PD, LGD, EAD, M) that are used in the formulas set out in CRE31. In calculating these components, the legal certainty standards for recognising credit risk mitigation under the standardised approach to credit risk (CRE22) apply for both the foundation and advanced internal ratings-based (IRB) approaches.

This section, CRE32.2 to CRE32.56, sets out the calculation of the risk components for corporate, sovereign and bank exposures. In the case of an exposure that is guaranteed by a sovereign, the floors that apply to the risk components do not apply to that part of the exposure covered by the sovereign guarantee (ie any part of the exposure that is not covered by the guarantee is subject to the relevant floors).

For corporate, sovereign and bank exposures, the PD is the one-year PD associated with the internal borrower grade to which that exposure is assigned. The PD of borrowers assigned to a default grade(s), consistent with the reference definition of default, is 100%. The minimum requirements for the derivation of the PD estimates associated with each internal borrower grade are outlined in CRE36.77 to CRE36.79.

With the exception of exposures in the sovereign asset class, the PD for each exposure that is used as input into the risk weight formula and the calculation of expected loss must not be less than 0.05%.

A bank must provide an estimate of the LGD for each corporate, sovereign and bank exposure. There are two approaches for deriving this estimate: a foundation approach and an advanced approach. As noted in CRE30.34, the advanced approach is not permitted for exposures to certain entities.

Under the foundation approach, senior claims on sovereigns, banks, securities firms and other financial institutions (including insurance companies and any financial institutions in the corporate asset class) that are not secured by recognised collateral will be assigned a 45% LGD. Senior claims on other corporates that are not secured by recognised collateral will be assigned a 40% LGD.

All subordinated claims on corporates, sovereigns and banks will be assigned a 75% LGD. A subordinated loan is a facility that is expressly subordinated to another facility. At national discretion, supervisors may choose to employ a wider definition of subordination. This might include economic subordination, such as cases where the facility is unsecured and the bulk of the borrower’s assets are used to secure other exposures.

In addition to the eligible financial collateral recognised in the standardised approach, under the F-IRB approach some other forms of collateral, known as eligible IRB collateral, are also recognised. These include receivables, specified commercial and residential real estate, and other physical collateral, where they meet the minimum requirements set out in CRE36.131 to CRE36.147. For eligible financial collateral, the requirements are identical to the operational standards as set out in the credit risk mitigation section of the standardised approach (see CRE22).

The simple approach to collateral presented in the standardised approach is not available to banks applying the IRB approach.

The LGD applicable to a collateralised transaction (LGD*) must be calculated as the exposure weighted average of the LGD applicable to the unsecured part of an exposure (LGD_U) and the LGD applicable to the collateralised part of an exposure (LGD_S). Specifically, the formula that follows must be used, where:

1. E is the current value of the exposure (ie cash lent or securities lent or posted). In the case of securities lent or posted the exposure value has to be increased by applying the appropriate haircuts (H_E) according to the comprehensive approach for financial collateral.
2. E_S is the current value of the collateral received after the application of the haircut applicable for the type of collateral (H_c) and for any currency mismatches between the exposure and the collateral, as specified in CRE32.11 to CRE32.12. E_S is capped at the value of E ∙ (1+H_E).
3. E_U = E ∙ (1+H_E) - E_s. The terms E_U and E_S are only used to calculate LGD*. Banks must continue to calculate EAD without taking into account the presence of any collateral, unless otherwise specified.
4. LGD_U is the LGD applicable for an unsecured exposure, as set out in CRE32.6 and CRE32.7.
5. LGD_S is the LGD applicable to exposures secured by the type of collateral used in the transaction, as specified in CRE32.11.

The following table specifies the LGD_S and haircuts applicable in the formula set out in CRE32.10:

When eligible collateral is denominated in a different currency to that of the exposure, the haircut for currency risk is the same haircut that applies in the comprehensive approach (CRE22.52 of the standardised approach).

Banks that lend securities or post collateral must calculate capital requirements for both of the following: (i) the credit risk or market risk of the securities, if this remains with the bank; and (ii) the counterparty credit risk arising from the risk that the borrower of the securities may default. CRE32.37 to CRE32.43 set out the calculation the EAD arising from transactions that give rise to counterparty credit risk. For such transactions the LGD of the counterparty must be determined using the LGD specified for unsecured exposures, as set out in CRE32.6 and CRE32.7.

In the case where a bank has obtained multiple types of collateral it may apply the formula set out in CRE32.10 sequentially for each individual type of collateral. In doing so, after each step of recognising one individual type of collateral, the remaining value of the unsecured exposure (E_U) will be reduced by the adjusted value of the collateral (E_S) recognised in that step. In line with CRE32.10, the total of E_S across all collateral types is capped at the value of E ∙ (1+H_E) . This results in the formula that follows, where for each collateral type i:

1. LGD_Si is the LGD applicable to that form of collateral (as specified in CRE32.11).
2. E_Si is the current value of the collateral received after the application of the haircut applicable for the type of collateral (H_c) (as specified in CRE32.11).

Subject to certain additional minimum requirements specified below (and the conditions set out in CRE30.34), supervisors may permit banks to use their own internal estimates of LGD for corporate and sovereign exposures. LGD must be measured as the loss given default as a percentage of the EAD. Banks eligible for the IRB approach that are unable to meet these additional minimum requirements must utilise the foundation LGD treatment described above.

The LGD for each corporate exposure that is used as input into the risk weight formula and the calculation of expected loss must not be less than the parameter floors indicated in the table below (the floors do not apply to the LGD for exposures in the sovereign asset class):

The LGD floors for secured exposures in the table above apply when the exposure is fully secured (ie the value of collateral after the application of haircuts exceeds the value of the exposure). The LGD floor for a partially secured exposure is calculated as a weighted average of the unsecured LGD floor for the unsecured portion and the secured LGD floor for the secured portion. That is, the following formula should be used to determine the LGD floor, where:

1. LGD_{U floor} and LGD_{S floor} are the floor values for fully unsecured and fully secured exposures respectively, as specified in the table in CRE32.16.
2. The other terms are defined as set out in CRE32.10 and CRE32.11.

In cases where a bank has met the conditions to use their own internal estimates of LGD for a pool of unsecured exposures, and takes collateral against one of these exposures, it may not be able to model the effects of the collateral (ie it may not have enough data to model the effect of the collateral on recoveries). In such cases, the bank is permitted to apply the formula set out in CRE32.10 or CRE32.14, with the exception that the LGD_U term would be the bank’s own internal estimate of the unsecured LGD. To adopt this treatment the collateral must be eligible under the F-IRB and the bank’s estimate of LGD_U must not take account of any effects of collateral recoveries.

The minimum requirements for the derivation of LGD estimates are outlined in CRE36.83 to CRE36.88.

Banks that want to recognise the effects of master netting agreements on repo-style transactions for capital purposes must apply the methodology outlined in CRE32.38 for determining E* for use as the EAD in the calculation of counterparty credit risk. For banks using the advanced approach, own LGD estimates would be permitted for the unsecured equivalent amount (E*) used to calculate counterparty credit risk. In both cases banks, in addition to counterparty credit risk, must also calculate the capital requirements relating to any credit or market risk to which they remain exposed arising from the underlying securities in the master netting agreement.

There are two approaches for recognition of credit risk mitigation (CRM) in the form of guarantees and credit derivatives in the IRB approach: a foundation approach for banks using supervisory values of LGD, and an advanced approach for those banks using their own internal estimates of LGD.

Under either approach, CRM in the form of guarantees and credit derivatives must not reflect the effect of double default (see CRE36.102). As such, to the extent that the CRM is recognised by the bank, the adjusted risk weight will not be less than that of a comparable direct exposure to the protection provider. Consistent with the standardised approach, banks may choose not to recognise credit protection if doing so would result in a higher capital requirement.

For banks using the foundation approach for LGD, the approach to guarantees and credit derivatives closely follows the treatment under the standardised approach as specified in CRE22.70 to CRE22.84. The range of eligible guarantors is the same as under the standardised approach except that companies that are internally rated may also be recognised under the foundation approach. To receive recognition, the requirements outlined in CRE22.70 to CRE22.75 of the standardised approach must be met.

Eligible guarantees from eligible guarantors will be recognised as follows:

1. For the covered portion of the exposure, a risk weight is derived by taking:
   1. the risk-weight function appropriate to the type of guarantor, and
   2. the PD appropriate to the guarantor’s borrower grade.
2. The bank may replace the LGD of the underlying transaction with the LGD applicable to the guarantee taking into account seniority and any collateralisation of a guaranteed commitment. For example, when a bank has a subordinated claim on the borrower but the guarantee represents a senior claim on the guarantor this may be reflected by using an LGD applicable for senior exposures (see CRE32.6) instead of an LGD applicable for subordinated exposures.
3. In case the bank applies the standardised approach to direct exposures to the guarantor it may only recognise the guarantee by applying the standardised approach to the covered portion of the exposure.

The uncovered portion of the exposure is assigned the risk weight associated with the underlying obligor.

Where partial coverage exists, or where there is a currency mismatch between the underlying obligation and the credit protection, it is necessary to split the exposure into a covered and an uncovered amount. The treatment in the foundation approach follows that outlined in CRE22.80 to CRE22.81 of the standardised approach, and depends upon whether the cover is proportional or tranched.

Banks using the advanced approach for estimating LGDs may reflect the risk-mitigating effect of guarantees and credit derivatives through either adjusting PD or LGD estimates. Whether adjustments are done through PD or LGD, they must be done in a consistent manner for a given guarantee or credit derivative type. In doing so, banks must not include the effect of double default in such adjustments. Thus, the adjusted risk weight must not be less than that of a comparable direct exposure to the protection provider. In case the bank applies the standardised approach to direct exposures to the guarantor it may only recognise the guarantee by applying the standardised approach to the covered portion of the exposure. In case the bank applies the F-IRB approach to direct exposures to the guarantor it may only recognise the guarantee by determining the risk weight for the comparable direct exposure to the guarantor according to the F-IRB approach.

A bank relying on own-estimates of LGD has the option to adopt the treatment outlined in CRE32.23 to CRE32.26 above for banks under the F-IRB approach, or to make an adjustment to its LGD estimate of the exposure to reflect the presence of the guarantee or credit derivative. Under this option, there are no limits to the range of eligible guarantors although the set of minimum requirements provided in CRE36.104 to CRE36.105 concerning the type of guarantee must be satisfied. For credit derivatives, the requirements of CRE36.110 to CRE36.111 must be satisfied.⁷⁰ For exposures for which a bank has permission to use its own estimates of LGD, the bank may recognise the risk mitigating effects of first-to-default credit derivatives, but may not recognise the risk mitigating effects of second-to-default or more generally nth-to-default credit derivatives.

The following sections apply to both on and off-balance sheet positions. All exposures are measured gross of specific provisions or partial write-offs. The EAD on drawn amounts should not be less than the sum of: (i) the amount by which a bank’s regulatory capital would be reduced if the exposure were written-off fully; and (ii) any specific provisions and partial write-offs. When the difference between the instrument’s EAD and the sum of (i) and (ii) is positive, this amount is termed a discount. The calculation of risk-weighted assets is independent of any discounts. Under the limited circumstances described in CRE35.4, discounts may be included in the measurement of total eligible provisions for purposes of the EL-provision calculation set out in CRE35.

On-balance sheet netting of loans and deposits will be recognised subject to the same conditions as under CRE22.68 of the standardised approach. Where currency or maturity mismatched on-balance sheet netting exists, the treatment follows the standardised approach, as set out in CRE22.10 and CRE22.12 to CRE22.15.

For off-balance sheet items there are two approaches for the estimation of EAD: a foundation approach and an advanced approach. When only the drawn balances of revolving facilities have been securitised, banks must ensure that they continue to hold required capital against the undrawn balances associated with the securitised exposures.

In the foundation approach, EAD is calculated as the committed but undrawn amount multiplied by a credit conversion factor (CCF). In the advanced approach, EAD for undrawn commitments may be calculated as the committed but undrawn amount multiplied by a CCF or derived from direct estimates of total facility EAD. In both the foundation approach and advanced approaches, the definition of commitments is the same as in the standardised approach, as set out in CRE20.94.

The types of instruments and the CCFs applied to them under the F-IRB approach are the same as those in the standardised approach, as set out in CRE20.94 to CRE20.101.

The amount to which the CCF is applied is the lower of the value of the unused committed credit line, and the value that reflects any possible constraining of the availability of the facility, such as the existence of a ceiling on the potential lending amount which is related to a borrower’s reported cash flow. If the facility is constrained in this way, the bank must have sufficient line monitoring and management procedures to support this contention.

Where a commitment is obtained on another off-balance sheet exposure, banks under the foundation approach are to apply the lower of the applicable CCFs.

Banks which meet the minimum requirements for use of their own estimates of EAD (see CRE36.89 to CRE36.98) will be allowed for exposures for which A-IRB is permitted (see CRE30.33) to use their own internal estimates of EAD for undrawn revolving commitments⁷¹ to extend credit, purchase assets or issue credit substitutes provided the exposure is not subject to a CCF of 100% in the foundation approach (see CRE32.33). Standardised approach CCFs must be used for all other off-balance sheet items (for example, undrawn non-revolving commitments), and must be used where the minimum requirements for own estimates of EAD are not met. The EAD for each exposure that is not in the sovereign asset class that is used as input into the risk weight formula and the calculation of expected loss is subject to a floor that is the sum of: (i) the on balance sheet amount; and (ii) 50% of the off balance sheet exposure using the applicable CCF in the standardised approach.

For exposures that give rise to counterparty credit risk according to CRE51.4 (ie OTC derivatives, exchange-traded derivatives, long settlement transactions and securities financing transactions (SFTs)), the EAD is to be calculated under the rules set forth in CRE50 to CRE54.

For SFTs, banks may recognise a reduction in the counterparty credit risk requirement arising from the effect of a master netting agreement providing that it satisfies the criteria set out in CRE22.62 and CRE22.63 of the standardised approach. The bank must calculate E*, which is the exposure to be used for the counterparty credit risk requirement taking account of the risk mitigation of collateral received, using the formula set out in CRE22.65 of the standardised approach. In calculating risk-weighted assets and expected loss (EL) amounts for the counterparty credit risk arising from the set of transactions covered by the master netting agreement, E* must be used as the EAD of the counterparty.

As an alternative to the use of standard haircuts for the calculation of the counterparty credit risk requirement for SFTs set out in CRE32.38, banks may be permitted to use a value-at-risk (VaR) models approach to reflect price volatility of the exposures and the financial collateral. This approach can take into account the correlation effects between security positions. This approach applies to single SFTs and SFTs covered by netting agreements on a counterparty-by-counterparty basis, both under the condition that the collateral is revalued on a daily basis. This holds for the underlying securities being different and unrelated to securitisations. The master netting agreement must satisfy the criteria set out in CRE22.62 and CRE22.63 of the standardised approach. The VaR models approach is available to banks that have received supervisory recognition for an internal market risk model according to MAR30.2. Banks which have not received market risk model recognition can separately apply for supervisory recognition to use their internal VaR models for the calculation of potential price volatility for SFTs, provided the model meets the requirements of MAR30.2. Although the market risk standards have changed from a 99% VaR to a 97.5% expected shortfall, the VaR models approach to SFTs retains the use of a 99% VaR to calculate the counterparty credit risk for SFTs. The VaR model needs to capture risk sufficient to pass the backtesting and profit and loss attribution tests of MAR30.4. The default risk charge of MAR33.18 to MAR33.39 is not required in the VaR model for SFTs.

The quantitative and qualitative criteria for recognition of internal market risk models for SFTs are in principle the same as in MAR30.5 to MAR30.16 and MAR33.1 to MAR33.12. The minimum liquidity horizon or the holding period for SFTs is 5 business days for margined repo-style transactions, rather than the 10 business days in MAR33.12. For other transactions eligible for the VaR models approach, the 10 business day holding period will be retained. The minimum holding period should be adjusted upwards for market instruments where such a holding period would be inappropriate given the liquidity of the instrument concerned.

The calculation of the exposure E* for banks using their internal model to calculate their counterparty credit risk requirement will be as follows, where banks will use the previous day's VaR number:

Subject to supervisory approval, instead of using the VaR approach, banks may also calculate an effective expected positive exposure for repo-style and other similar SFTs, in accordance with the internal models method set out in the counterparty credit risk standards.

As in the standardised approach, for transactions where the conditions in CRE22.36 are met, and in addition, the counterparty is a core market participant as specified in CRE22.37, supervisors may choose not to apply the haircuts specified under the comprehensive approach, but instead to apply a zero H. A netting set that contains any transaction that does not meet the requirements in CRE22.36 of the standardised approach is not eligible for this treatment.

Effective maturity (M) will be 2.5 years for exposures to which the bank applies the foundation approach, except for repo-style transactions where the effective maturity is 6 months (ie M=0.5). National supervisors may choose to require all banks in their jurisdiction (those using the foundation and advanced approaches) to measure M for each facility using the definition provided below.

Banks using any element of the A-IRB approach are required to measure effective maturity for each facility as defined below. However, national supervisors may allow the effective maturity to be fixed at 2.5 years (the “fixed maturity treatment”) for facilities to certain smaller domestic corporate borrowers if the reported sales (ie turnover) as well as total assets for the consolidated group of which the firm is a part of are less than €500 million. The consolidated group has to be a domestic company based in the country where the fixed maturity treatment is applied. If adopted, national supervisors must apply the fixed maturity treatment to all IRB banks using the advanced approach in that country, rather than on a bank-by-bank basis.

Except as noted in CRE32.51, the effective maturity (M) is subject to a floor of one year and a cap of 5 years.

For an instrument subject to a determined cash flow schedule, effective maturity M is defined as follows, where CF_t denotes the cash flows (principal, interest payments and fees) contractually payable by the borrower in period t:

If a bank is not in a position to calculate the effective maturity of the contracted payments as noted above, it is allowed to use a more conservative measure of M such as that it equals the maximum remaining time (in years) that the borrower is permitted to take to fully discharge its contractual obligation (principal, interest, and fees) under the terms of loan agreement. Normally, this will correspond to the nominal maturity of the instrument.

For derivatives subject to a master netting agreement, the effective maturity is defined as the weighted average maturity of the transactions within the netting agreement. Further, the notional amount of each transaction should be used for weighting the maturity.

For revolving exposures, effective maturity must be determined using the maximum contractual termination date of the facility. Banks must not use the repayment date of the current drawing.

The one-year floor, set out in CRE32.46 above, does not apply to certain short-term exposures, comprising fully or nearly-fully collateralised⁷² capital market-driven transactions (ie OTC derivatives transactions and margin lending) and repo-style transactions (ie repos/reverse repos and securities lending/borrowing) with an original maturity of less than one year, where the documentation contains daily remargining clauses. For all eligible transactions the documentation must require daily revaluation, and must include provisions that must allow for the prompt liquidation or setoff of the collateral in the event of default or failure to re-margin. The maturity of such transactions must be calculated as the greater of one-day, and the effective maturity (M, consistent with the definition above), except for transactions subject to a master netting agreement, where the floor is determined by the minimum holding period for the transaction type, as required by CRE32.54.

The one-year floor, set out in CRE32.46 above, also does not apply to the following exposures:

1. Short-term self-liquidating trade transactions. Import and export letters of credit and similar transactions should be accounted for at their actual remaining maturity.
2. Issued as well as confirmed letters of credit that are short term (ie have a maturity below one year) and self-liquidating.

In addition to the transactions considered in CRE32.51 above, other short-term exposures with an original maturity of less than one year that are not part of a bank’s ongoing financing of an obligor may be eligible for exemption from the one-year floor. After a careful review of the particular circumstances in their jurisdictions, national supervisors should define the types of short-term exposures that might be considered eligible for this treatment. The results of these reviews might, for example, include transactions such as:

1. Some capital market-driven transactions and repo-style transactions that might not fall within the scope of CRE32.51.
2. Some trade finance transactions that are not exempted by CRE32.52.
3. Some exposures arising from settling securities purchases and sales. This could also include overdrafts arising from failed securities settlements provided that such overdrafts do not continue more than a short, fixed number of business days.
4. Some exposures arising from cash settlements by wire transfer, including overdrafts arising from failed transfers provided that such overdrafts do not continue more than a short, fixed number of business days.
5. Some exposures to banks arising from foreign exchange settlements.
6. Some short-term loans and deposits.

For transactions falling within the scope of CRE32.51 subject to a master netting agreement, the effective maturity is defined as the weighted average maturity of the transactions. A floor equal to the minimum holding period for the transaction type set out in CRE22.57 of the standardised approach will apply to the average. Where more than one transaction type is contained in the master netting agreement a floor equal to the highest holding period will apply to the average. Further, the notional amount of each transaction should be used for weighting maturity.

Where there is no explicit definition, the effective maturity (M) assigned to all exposures is set at 2.5 years unless otherwise specified in CRE32.44.

The treatment of maturity mismatches under IRB is identical to that in the standardised approach (see CRE22.10 to CRE22.14).

This section, CRE32.57 to CRE32.67, sets out the calculation of the risk components for retail exposures. In the case of an exposure that is guaranteed by a sovereign, the floors that apply to the risk components do not apply to that part of the exposure covered by the sovereign guarantee (ie any part of the exposure that is not covered by the guarantee is subject to the relevant floors).

For each identified pool of retail exposures, banks are expected to provide an estimate of the PD and LGD associated with the pool, subject to the minimum requirements as set out in CRE36. Additionally, the PD for retail exposures is the greater of: (i) the one-year PD associated with the internal borrower grade to which the pool of retail exposures is assigned; and (ii) 0.1% for qualifying revolving retail exposure (QRRE) revolvers (see CRE30.24 for the definition of QRRE revolvers) and 0.05% for all other exposures. The LGD for each exposure that is used as input into the risk weight formula and the calculation of expected loss must not be less than the parameter floors indicated in the table below:

Regarding the LGD parameter floors set out in the table above, the LGD floors for partially secured exposures in the “other retail” category should be calculated according to the formula set out in CRE32.17. The LGD floor for residential mortgages is fixed at 5%, irrespective of the level of collateral provided by the property.

Banks may reflect the risk-reducing effects of guarantees and credit derivatives, either in support of an individual obligation or a pool of exposures, through an adjustment of either the PD or LGD estimate, subject to the minimum requirements in CRE36.100 to CRE36.111. Whether adjustments are done through PD or LGD, they must be done in a consistent manner for a given guarantee or credit derivative type. In case the bank applies the standardised approach to direct exposures to the guarantor it may only recognise the guarantee by applying the standardised approach risk weight to the covered portion of the exposure.

Consistent with the requirements outlined above for corporate and bank exposures, banks must not include the effect of double default in such adjustments. The adjusted risk weight must not be less than that of a comparable direct exposure to the protection provider. Consistent with the standardised approach, banks may choose not to recognise credit protection if doing so would result in a higher capital requirement.

Both on- and off-balance sheet retail exposures are measured gross of specific provisions or partial write-offs. The EAD on drawn amounts should not be less than the sum of: (i) the amount by which a bank’s regulatory capital would be reduced if the exposure were written-off fully; and (ii) any specific provisions and partial write-offs. When the difference between the instrument’s EAD and the sum of (i) and (ii) is positive, this amount is termed a discount. The calculation of risk-weighted assets is independent of any discounts. Under the limited circumstances described in CRE35.4, discounts may be included in the measurement of total eligible provisions for purposes of the EL-provision calculation set out in chapter CRE35.

On-balance sheet netting of loans and deposits of a bank to or from a retail customer will be permitted subject to the same conditions outlined in CRE22.68 and CRE22.69 of the standardised approach. The definition of commitment is the same as in the standardised approach, as set out in CRE20.94. Banks must use their own estimates of EAD for undrawn revolving commitments to extend credit, purchase assets or issue credit substitutes provided the exposure is not subject to a CCF of 100% in the standardised approach (see CRE20.92) and the minimum requirements in CRE36.89 to CRE36.99 are satisfied. Foundation approach CCFs must be used for all other off-balance sheet items (for example, undrawn non-revolving commitments), and must be used where the minimum requirements for own estimates of EAD are not met.

Regarding own estimates of EAD, the EAD for each exposure that is used as input into the risk weight formula and the calculation of expected loss is subject to a floor that is the sum of: (i) the on balance sheet amount; and (ii) 50% of the off balance sheet exposure using the applicable CCF in the standardised approach.

For retail exposures with uncertain future drawdown such as credit cards, banks must take into account their history and/or expectation of additional drawings prior to default in their overall calibration of loss estimates. In particular, where a bank does not reflect conversion factors for undrawn lines in its EAD estimates, it must reflect in its LGD estimates the likelihood of additional drawings prior to default. Conversely, if the bank does not incorporate the possibility of additional drawings in its LGD estimates, it must do so in its EAD estimates.

When only the drawn balances of revolving retail facilities have been securitised, banks must ensure that they continue to hold required capital against the undrawn balances associated with the securitised exposures using the IRB approach to credit risk for commitments.

To the extent that foreign exchange and interest rate commitments exist within a bank’s retail portfolio for IRB purposes, banks are not permitted to provide their internal assessments of credit equivalent amounts. Instead, the rules for the standardised approach continue to apply.

This chapter sets out the calculation of risk weighted assets and expected losses for specialised lending (SL) exposures subject to the supervisory slotting approach. The method for determining the difference between expected losses and provisions is set out in CRE35.