Technology July 17, 2013

Basel Method for Counterparty Credit Risk Exposure Calculation a Departure From Current Standard

BY Rachel Alembakis
The Basel Committee’s proposed non-internal model method (NIMM) for calculating counterparty credit risk exposures is a departure from the current standard and groups trades in narrow hedging sets, according to Jean-Marc Schwob, product manager, Adaptiv, at Sungard.

The Basel Committee has released a discussion paper, BCBS254, which outlines a methodology to replace the Current Exposure Method and the Standardised Method. The Basel Committee says the new non-internal model method improves on risk sensitivity by differentiating between margined and unimagined trades. The committee is accepting public comment on the proposal until 27 September.

“The non-internal model method that they’ve come up with in the paper I think is going to have a major impact on the banks wishing to implement it, because it’s quite different to the methodology that’s currently out there,” Schwob says. “Banks will have to put trades into hedging sets and start bucketing the trades in ways that you didn’t have to before. Previously, you could measure the exposures on a trade level and aggregate with a few subtleties relating to netting. But with this new method, in the first step of the calculation you put the trades in a hedging bucket, and then do calculations from aggregate numbers within the different sets.”

The NIMM breaks asset classes down into four hedging sets - a subset of transactions within an asset class that share common attributes, according to the paper. The four hedging sets are interest rate derivatives, foreign exchange derivatives, credit derivatives and equity derivatives and commodity derivatives.

“The definition of hedging sets is in some respects very crude, very narrow,” Schwob says. “For example, if you look at foreign exchange, the paper says banks must establish hedging sets in each currency. For foreign exchange, you have to use hedging sets based on currency pairs. Banks can’t offset the portfolio dynamics between currencies and currency pairs, which is quite conservative and quite crude. In some areas, the hedging sets are broader. For example, equities and commodities – they are sets of all equities and all commodities, and all credit derivatives will be in the same hedging sets, albeit with partial offsetting based on fixed correlation parameters. But it’s quite arbitrary.”

The Basel Committee has also been updated to take into account market volatilities in recent years and provides recognition of netting benefits, but Schwob says the NIMM doesn’t take into account the volatility of underlying assets.

“There is no recognition of the volatility of the underlying assets,” Schwob says. “The paper imposes a set of fixed weighting factors applying to various groups of asset classes. For example, all interest rates will have a single weighting factor no matter how volatile an interest rate might be. Foreign exchange will have a single volatility factor. All equities, all commodities will have a single volatility factor. I would have liked to see Basel give some recognition to volatility, with individual volatility to individual assets. It’s not rocket science.”

The goal of the new methodology is not to cause banks to hold more or less capital, but rather to result in better, more risk-sensitive calculations, Schwob says. He notes that the Basel Committee is pushing for collateralisation of derivatives exposures as well. However, there is the potential for unintended consequences as a result of the formula’s calculations, he says.

“There is going to be some weighting of option deals by a flat 50%, no matter how much in or out of the money they are, and that means that if you have an option, you will only have to hold half the capital,” Schwob says. “That will open up the spectre of regulatory arbitrage: for example, in-the-money options which are really behaving like forward deals but will have 50% capital on them compared to a forward deal – it could cause a perverse effect to encourage banks to use way-in-the-money options instead of forwards, and options are inherently more risky”

Because the non-internal model methodology will remain quite crude, there will still be a strong incentive for banks to pursue the internal models methodology (IMM) because although the process to get an IMM approved is harder than using the non-internal methodology, IMM does represent best practice, Schwob says.

“European jurisdictions are looking at approving for IMM – Europe is a bit more open to internal models,” he says. “The UK has opened up the door to this. But it is still an onerous process and it’s a large project that you need to satisfy your regulators about a lot of things before they approve – you have to show data integrity, quality of management, quality of systems, quality of models, and so on. In view of the fact that this new methodology isn’t going to help banks much in terms of capital, I suspect that there is going to be a strong case for getting IMM approval. If you do get IMM approval, for a large bank with a well diversified portfolio of trades, you will get some significant capital benefits from using the internal models.”

Schwob noted that the Australian Prudential Regulation Authority has so far been reluctant to consider IMM approval for Australian banks, possibly because of the “black box” nature of the process, and regulators’ general suspicion of internal models following the financial crisis.
“None of the Australian banks have obtained IMM approval,” he says. “One reason is because APRA appear to be dragging their feet. APRA need to get comfortable with internal models and it is a bit of a black box problem.”

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