Basel II: Credit Risk Mitigation

18 October 2006

Charles Proctor


In June 2006 the Basel Committee on Banking Supervision issued a comprehensive and final document on International Convergence of Capital Measurement and Capital Standards - A Revised Framework ("Basel II"). Basel II is designed to replace the Basel Capital Accord of 1988 (the "1988 Accord"). In the European Union, implementation of Basel II will be achieved via the so-called Capital Requirements Directive and the national legislation to be introduced in compliance with that Directive.

Although Basel II is generally - and rightly - portrayed as a major reform in the field of capital adequacy, it should be appreciated that a number of the original features of the 1988 Accord have been retained. For example, the definition of eligible capital and the requirement for banks to hold own funds equivalent to at least eight per cent of their risk-weighted assets are notable survivors of the 1988 Accord. It was nevertheless necessary radically to revise the 1988 Accord, partly because of rapid developments in the financial markets themselves and partly because the risks faced by banks have become more clearly understood. Thus, for example, whilst the composition of capital and the eight per cent figure remain essentially intact, the risk-weighting of assets will become a much more sophisticated process. Furthermore, whilst the 1988 Accord focused essentially on credit risk, Basel II adopts a much broader approach to a variety of other potential threats to a bank's capital base.

The objectives of this briefing are:

a) to provide an overview of the new capital adequacy régime; and

b) to provide an explanation of the new rules on credit risk mitigation and to examine techniques which may serve to reduce a bank's capital requirements.

Structure of Basel II

Basel II rests on three "pillars":

a) The first pillar deals with minimum capital and the various approaches to credit risk (Standardised Approach and Internal Ratings Based Approach). It also requires a charge to capital to be made in respect of operational risk (including losses which may flow from inadequate or failed internal processes, systems risk and fraud) and market risk (that is, the risk of loss from market price movements on interest rate/equity assets in the trading book, and foreign exchange/commodities risk generally).

b) The second pillar deals with the supervisory review process. It is designed to provide the necessary responsibility and surveillance mechanisms for the capital adequacy rules in the first pillar and to provide incentives for the adoption of improved risk management techniques.

c) The third pillar addresses market discipline and is principally aimed at disclosure requirements. These will afford to the market the information necessary to assess the capital adequacy and risk exposures of a bank. Adequate disclosure becomes more important under Basel II because, as will be seen, the greater use of internal methodologies effectively allows banks to exercise their own judgment in determining their own capital requirements. Transparency is thus the price to be paid for the greater flexibility offered by the first pillar.

This remainder of this briefing is exclusively concerned with the first pillar, namely credit risk and the procedures which may be available to mitigate that risk. The precise application and impact of credit risk mitigation techniques to some extent depends on the particular approach which an institution is to adopt for risk weighting purposes. It is thus necessary briefly to outline the new methodologies created by Basel II for the assessment of credit risk.

Capital Adequacy under Basel II

Basel II allows to banks a choice between two broad methodologies for calculating their capital requirements in relation to credit risk.

The Standardised Approach

The Standardised Approach is in many respects the "default option"; banks will have to use this approach unless the alternative is approved by its supervisor. The Standardised Approach measures credit risk by reference to pre-set percentages of the risks attributable to individual claims. The applicable percentages are, in their turn, determined by reference to ratings provided by approved external credit assessment agencies (e.g. Moodys; Standard & Poor's).

By way of example, Basel II provides for a zero per cent risk weighting for claims on sovereign governments and central banks which enjoy an AAA rating. This percentage increases according to the attributable rating, and governments/central banks which are unrated attract a risk weighting of 100 per cent. Corporates with an AAA rating attract a 20 per cent risk weighting, again increasing to 100 per cent for unrated companies.

Other variations apply for different types of counterparty, and the percentages may change where a facility is secured on residential or other real estate. Nevertheless, the essential principle remains the same. The risk weighting must be ascertained by reference to objective criteria which may to some extent rely on external rating agencies but are outside the control of the institution concerned. The Standardised Approach in some respects mirrors the "formulaic" system which applied under the 1988 Accord, although even here the use of external rating agency assessments will provide a greater degree of risk sensitivity in relation to individual exposures.

The Internal Ratings-Based Approach

Under the IRB Approach, banks may use their own internal risk evaluations in setting the capital requirement applicable to particular exposures.

The risk elements involved in such assessments include (i) the probability of default ("PD"), (ii) loss given default ("LGD"), (iii) exposure at default ("EAD") and (iv) effective maturity ("M"). These risk components form a part of the calculation of the risk weighting to be applied to particular exposures within defined asset classes.

A further layer of complexity is added by the sub-division of the IRB Approach into the "foundation" and "advanced" approaches. In general terms, banks opting for the "foundation" approach use their own estimates of PD, but the other elements are to be based on assessments provided by the regulator. Under the "advanced" approach, banks must use their own estimates of M and also have the option to use their own estimates of PD, LGD and EAD.

Given the enhanced sophistication of the IRB Approach and its reliance on internal risk assessments, it should be noted that it is subject to numerous conditions and can only be used with the regulator's approval. That approval will only be forthcoming if the bank's risk rating systems meet stated minimum criteria. The advanced approach will not in any event be available before 2008.

Credit Risk Mitigation

It has already been noted that the 1988 Accord was relatively limited in its scope and application. It is also fair to observe that the 1988 Accord paid only limited attention to the whole subject of credit risk mitigation and the techniques available to banks to reduce their effective exposures and, hence, their overall capital requirements. Indeed, the Basel Committee's commentary on the 1988 Accord acknowledged that "... the framework recognises the importance of collateral in reducing credit risk, but only to a limited extent. In view of the varying practices among banks in different countries for taking collateral and different experiences of the stability of physical or financial collateral values, it has not been found possible to develop a basis for recognising collateral generally in the weighting system..." As a result, the 1988 Accord only allowed for the recognition of collateral consisting of securities issued by OECD central governments or by certain multilateral development banks. Likewise, a lower weighting for loans could be achieved where a guarantee had been given by an OECD government or bank. The 1988 Accord thus adopted a very limited and cautious approach to the whole subject of credit risk mitigation.

Basel II offers a stark contrast and adopts a radically different approach. In line with its overall purpose, the document takes account of the techniques open to banks to secure their exposures and is thus much more "risk-sensitive" in that respect. On the other hand, it imposes detailed requirements designed to ensure that the use of such techniques is soundly based in each case.

Techniques of Credit Risk Mitigation

Banks may use various techniques which reduce their exposure to individual customers and transactions. The taking of guarantees and security to support the obligations of the primary borrower pre-dates capital adequacy rules by many centuries. The desire to avoid loss is simply a feature of prudent banking and is by no means intimately associated with the lender's capital position.

Basel II does, of course, recognise the value of security and guarantees as a form of credit risk mitigation. But if such techniques are to be effective in a capital adequacy context, then it must be clear that the relevant arrangement is legally robust.

It thus becomes necessary to consider both the qualifying forms of credit risk mitigation and the legal certainty tests which must be met if the desired capital treatment is to be achieved. In this context, Basel II offers two broad forms of credit mitigation techniques. The essential distinction lies between "funded" and "unfunded" credit protection.

Funded Credit Protection

Nature of Funded Credit Protection

The notion of "funded" credit protection suggests an arrangement under which the bank has recourse to cash or some other asset in order to recover the moneys owing to it. As a result, the concept of funded credit protection refers to the nature of the asset which forms the available security; it is concerned with the credit standing of the issuer of the collateral or its value, rather than the credit standing of the provider.

With this in mind, Basel II allows for various forms of funded credit protection, including:

a) on balance sheet netting. On balance sheet netting of mutual claims/reciprocal cash balances between the bank and the counterparty create effective security and may accordingly be recognised as an acceptable form of credit risk mitigation;

b) collateral. The following assets which are deposited with or retained by a bank may be treated as funded credit protection:

(i) cash or cash equivalent instruments;

(ii) gold;

(iii) debt securities of governments/central banks which meet stated credit quality criteria;

(iv) debt securities issued by banks, local authorities and certain other entities which meet stated credit quality criteria;

(v) short term debt securities with an acceptable rating;

(vi) equities or convertible bonds included on a main index; and

(vii) units in a collective investment scheme, provided that they have a daily price quotation and invest only in instruments which are themselves eligible for recognition under (i) - (vi) above.

Whilst the above forms of collateral may be recognised by any institution, certain additional forms of security may also be effective for these purposes if the bank adopts particular methods/approaches to capital adequacy. For example:

a) An institution using the comprehensive approach to collateral may also treat as eligible:

(i) equities/convertible bonds not included on a main index but which are quoted on a recognised stock exchange; and

(ii) collective investment schemes which have a daily price quote and which invest solely in the collateral noted in (i) above.

b) An institution which adopts the IRB Approach may, in addition, treat the following types of security as eligible:

(i) real estate, provided that the borrower is expected to fund repayment from other sources, rather than the cashflows from the property itself (although the regulator may waive this aspect in relation to commercial real estate within its own territory, provided that losses have not exceeded certain thresholds); and

(ii) receivables linked to a commercial transaction and with a maturity of less than one year.

Legal Requirements for Funded Credit Protection

Unsurprisingly, an arrangement can only be taken into account as funded credit protection if it meets certain legal requirements. In particular:

a) it must be enforceable in all relevant jurisdictions notwithstanding the insolvency of the counterparty or any custodian;

b) the lender must be able to satisfy the regulator that it has adequate risk management processes to control any risks arising from the use of risk mitigation techniques;

c) the bank must have the legal right to take possession of the security and to liquidate it upon the occurrence of a default;

d) collateral issued by an entity related to the counterparty would generally be ineligible for these purposes;

e) there are further detailed requirements for individual forms of collateral (e.g., netting agreements, security over cash etc.)

Effect of Funded Credit Protection

If a bank holds an eligible form of funded credit protection and the various legal requirements have been met, what are the consequences for the bank's capital adequacy position? Three points may be noted in this context:

a) under the "simple" approach to collateral, the risk weighting of the collateral is substituted for that of the counterparty (usually subject to a minimum weighting of 20 per cent). The simple approach to collateral is not available to banks using the IRB approach to capital adequacy; and

b) under the "comprehensive approach" to collateral, eligible financial collateral reduces the counterparty exposure. The value of the collateral is subject to haircuts (reflecting market/exchange rate volatility) and may have to be adjusted from time to time. This results in an adjusted exposure (E*). A bank adopting the Standardised Approach must then assign to E* a risk weight amount for the relevant counterparty. In contrast, a bank using the foundation IRB approach will usually apply E* to adjust LGD in relation to that exposure. The comprehensive approach must be used for exposures in the trading book;

c) different calculation requirements may apply where an IRB foundation bank takes security over eligible real estate or receivables.

Unfunded Credit Protection

Nature of Unfunded Credit Protection

Unfunded credit protection includes guarantees and credit derivatives.

As the title suggests, "unfunded" credit protection involves an unsecured obligation of a third party. It is implicit in this concept that the entity providing the credit protection is more creditworthy than the primary borrower, thus allowing a reduction in the capital which the bank must ascribe to the transaction at hand.

Since no specific asset is available by way of security in the context of unfunded credit protection, it follows that the rules focus on (i) the creditworthiness and reliability of the provider and (ii) the validity and enforceability of that party's obligations.

As a result, credit protection is only "eligible" for these purposes if it is provided by an appropriate counterparty. These include:

a) national governments/central banks;

b) regional or local governments;

c) multilateral development banks;

d) certain international organisations;

e) banks; and

f) other corporates which meet stipulated credit requirements.

Legal Requirements for Unfunded Credit Protection

Once again, the arrangements must meet certain minimum legal criteria if they are to qualify as unfunded credit protection.

Quite apart from the general reliability of the counterparty, the relevant documentation must provide a sufficient degree of legal certainty as to the level of the credit protection.

Where the credit protection consists of a guarantee:

a) the guarantee must be an explicit, documented, clearly defined and unconditional obligation of the guarantor;

b) the guarantee must be legally effective in all relevant jurisdictions;

c) the protection provider must not have any rights to vary, cancel or reduce the scope of the guarantee;

d) the lender must have a right of direct recourse following default, without any need to take proceedings against the primary borrower;

e) the guarantee should preferably cover all of the obligations of the primary borrower under the transaction. In the event of a mismatch, then the eligible value of the guarantee must be adjusted to reflect that fact.

Where the credit protection consists of a credit derivative:

a) only credit default swaps and total return swaps providing credit protection equivalent to a guarantee will be eligible for these purposes;

b) the credit events justifying a demand must include non-payment, insolvency and any restructuring involving the underlying obligation;

c) where the derivative is to be cash settled, there must be a robust and time-limited procedure for the purpose of fixing the necessary valuation;

d) if the derivative is to be settled by delivery, then the underlying obligation must be freely transferable or the obligor's consent must not be unreasonably withheld;

e) the determination of the existence of a credit event must not be a matter for the sole discretion or decision of the protection provider;

f) a mismatch between the underlying obligation and the reference instrument (i.e.the obligation to be used in determining whether a credit event has occurred) is only permitted if certain specified conditions are met.

Effect of Unfunded Credit Protection

The proportion of the exposure covered by the relevant guarantee or credit derivative is assigned the risk weighting applicable to the protection provider. Any residual or "uncovered" portion of the exposure does, of course, remain subject to the risk weighting of the underlying counterparty.


What conclusions can be drawn from this analysis?

First of all, Basel II is a complex document. It makes a concerted effort to link capital adequacy with real risks inherent in banking business. In doing this, however, the rules inevitably become more detailed and sophisticated than was formerly the case.

Secondly, the qualification criteria for eligible credit protection are relatively stringent. Considerable emphasis is placed on a legally robust framework to ensure that risk mitigation is genuine and effective. On the other hand, a degree of flexibility has been introduced because new instruments - such as credit derivatives - have now been recognised for these purposes.
Finally, banks seeking to use credit mitigation techniques will have to pay very close attention to the detailed structure and wording of their documentation to ensure that it will comply with the eligibility criteria set out in Basel II. Banks will need to ensure that their internal procedures are sufficient to secure compliance in each case.