Strengthening the resilience of the banking sector1 Proposed changes to Counterparty Credit Risk in Basel Accord Presentation to PRMIA/ISDA seminar London, March Maxine Nelson, FSA

Strengthening the resilience of the banking sector 2 Agenda Background Proposed changes summary CVA loss charge Central counterparties Asset value correlation Wrong way risk Margin period of risk Collateral management Backtesting Stress testing Shortcut method Alpha Conclusion

Strengthening the resilience of the banking sector 3 What is CCR? Bilateral risk of loss Value of exposure changes over time as market risk factors change Applies to –OTC derivatives –Securities financing transactions The counterparty credit risk is defined as the risk that the counterparty to a transaction could default before the final settlement of the transaction’s cash flows.

Strengthening the resilience of the banking sector 4 What is calculated under CCR rules? A loan equivalent Exposure at Default (EAD) 3 ways of calculating EAD –CCR mark to market method –CCR standardised method –CCR Internal Model Method (IMM) Changes generally focus on IMM –IMM uses “Effective Expected Positive Exposure” (EEPE) “metric” times Alpha –EEPE assumes diversification, granularity and no wrong-way risk

Strengthening the resilience of the banking sector 5 Strengthening capital requirements Raise capital buffer Reduce procyclicality Strengthen risk management Incentives to move bilateral OTC derivatives to central counterparties

Strengthening the resilience of the banking sector 6 Key Issues Identified Credit valuation adjustments (CVA) causing large mark-to- market losses Higher correlation between financial institution asset correlation Central counterparties not sufficiently used Wrong way risk not adequately captured Long close-out periods for large netting sets; complex trades; illiquid collateral Initial margin increased (in-dept amount) Securitisations risky Backtesting Stress testing Use of own estimates of alpha

Strengthening the resilience of the banking sector 7 CVA Charge CVA VaR not currently practical Bond equivalent approach –Market risk framework – P&L from CVA as being long a hypothetical bond issued by the counterparty where: – Notional of the “bond” total EAD of a counterparty (treated as fixed) – Maturity of the “bond” Effective Maturity (M) of the longest dated netting set of a counterparty – Time horizon one year Regulatory framework does not capture volatility of CVA losses

Strengthening the resilience of the banking sector 8 Central Counterparties Incentivise the use of CCPs Increased capital for non-CCP deals Exposure for trades with CCP – Zero exposure to remain for exposures to MtM and posted collateral – Developing non-zero capital charges for default /guarantee fund exposures – in line with BIPRU Update CPSS/IOSCO requirements Need strong risk management procedures for preferable capital treatment

Strengthening the resilience of the banking sector 9 AVCs for financial firms were 25% or more higher than AVCs for non-financial firms 1.25x multiplier for financial firms AVC AVCs between financial firms would be 15%-30% Non-linear relationship between capital and AVC Broad definition of financial firms includes banks, broker dealers, hedge funds, highly levered entities Applies to all exposures to financial (e.g. loans) – not just CCR Asset Value Correlations (AVC) Financial institutions more correlated

Strengthening the resilience of the banking sector 10 General wrong way risk Calculate EEPE using parameters from more conservative of – Recent experience – Period of stress Reduces cyclicality Positive correlation between PD and market risk factors

Strengthening the resilience of the banking sector 11 General wrong way risk (continued) Stress testing To identify general WWR Monitor WWR by region, industry, etc Part of senior management MI Manage the risk Positive correlation between PD and market risk factors

Strengthening the resilience of the banking sector 12 Specific WWR charges for: – Single name credit default swaps – Equity derivatives referencing single counterparty Specific wrong way risk Legal connection between underlying and counterparty

Strengthening the resilience of the banking sector 13 Margin Period of Risk Losses due to longer close-outs and “fire sales”

Strengthening the resilience of the banking sector 14 Collateral Management No benefit from collateral agreements with downgrade triggers to be made explicit Controls for reuse of collateral If can’t model collateral jointly with exposure –Calculate own haircuts under the standard of financial collateral comprehensive method with own haircut – Use supervisory haircuts estimates Collateral management practices not robust

Strengthening the resilience of the banking sector 15 Performance of collateral management department –Data integrity –Reuse of collateral –Collateral concentration tracked –Timely and accurate collateral calls –Regular reporting Collateral Management (cont.) Collateral management practices not robust

Strengthening the resilience of the banking sector 16 Securitisations double haircut of corporate collateral with same rating Resecuritisations ineligible as collateral Collateral Management (cont.) Securitisation collateral riskier

Strengthening the resilience of the banking sector 17 More explicit requirements for: Senior management involvement Part of risk management Independent review Acceptable criteria When testing must be carried out Range of tests needed Back testing Shortcomings in back-testing approaches

Strengthening the resilience of the banking sector 18 Senior management engagement Multi-factor stress testing Quarterly joint movement of exposure and PD Exposure stress testing Regular reporting Severe shocks – impact on capital resources and requirements Less severe shocks for day-to-day monitoring Reverse stress tests Stress testing Existing risk management not adequate to help prevent unforeseen losses

Strengthening the resilience of the banking sector 19 Shortcut method Allows Effective EPE to be calculated by banks that could not model EPE with margin agreements (but can otherwise model EPE) Adjusted to reflect collateral not received at t = 0 Collateral at t = 0 not reflected appropriately

Strengthening the resilience of the banking sector 20 Alpha is a broad brush adjustment multiplied by effective EPE to derive EAD Insufficient evidence exists to recalibrate Alpha Nature of portfolio risk suggests Alpha floors (1.4 standard; 1.2 own estimate) should be maintained Concern exists over mis-specifications in Alpha own estimates Enhanced requirements to avoid mis-specification in models when banks use their own estimates of Alpha Alpha Mis-specification of alpha numerator

Strengthening the resilience of the banking sector 21 Counterparty Credit Risk Changes Further questions? and your supervisor

Strengthening the resilience of the banking sector 22 Wrap-up Proposed changes summary CVA loss charge Asset value correlation Central counterparties Wrong way risk Margin period of risk Collateral management Backtesting Stress testing Shortcut method Alpha