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The Application of Basel II to Trading Activities and the Treatment of Double Default Effects

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The Application of Basel II to Trading Activities and the Treatment of Double Default Effects Basel Committee on Banking Supervision The Application of Basel II to Trading Activities and the Treatment of Double Default Effects July 2005 Requests for copies of publications, or for additions/changes to the mailing list, should be sent to: Bank for International Settlements Press & Communications CH-4002 Basel, Switzerland E-mail: [email protected] Fax: +41 61 280 9100 and +41 61 280 8100 © Bank for International Settlements 2005. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISBN print: 92-9131-682-2 ISBN web: 92-9197-682-2 Table of Contents Introduction...............................................................................................................................1 I. Introduction......................................................................................................................3 II. Common aspects of the three measures of exposure for CCR.......................................4 A. Characteristics of instruments subject to a CCR-related capital charge ................4 B. Measures of CCR: Expected Positive Exposure, Expected Exposure, and Potential Future Exposure......................................................................................4 C. Relationship with the Revised Framework text on credit risk mitigation ................5 D. Netting sets ............................................................................................................5 E. Cross-product netting.............................................................................................6 III. Summary of internal model method ................................................................................7 A. Overview of calculation of EAD..............................................................................7 B. Effective EPE .........................................................................................................8 C. Time horizon ..........................................................................................................9 D. The alpha multiplier..............................................................................................10 E. Risk-neutral vs. actual distributions......................................................................10 F. Maturity adjustment..............................................................................................11 G. Margin agreements ..............................................................................................11 H. Loss given default ................................................................................................11 I. Supervisory approval ...........................................................................................11 IV. Summary of non-internal model methods: Current Exposure and Standardised Methods.........................................................................................................................12 A. The Current Exposure Method.............................................................................12 B. The Standardised Method....................................................................................13 V. Pillar 2 ...........................................................................................................................18 A. Existing versus new risks introduced by the use of EPE .....................................18 B. Specific issues related to CCR to be addressed under supervisory review.........18 VI. Pillar 3 ...........................................................................................................................19 VII. Rules text: Treatment for determining the exposure amount or EAD for counterparty credit risk .......................................................................................................................19 A. Pillar 1 ..................................................................................................................19 1. Definitions and general terminology............................................................19 2. Scope of application....................................................................................22 3. Cross-product netting rules.........................................................................23 4. Approval to adopt an internal modelling method to estimate EAD..............25 5. Internal Model Method: measuring exposure and minimum requirements .26 6. Standardised Method ................................................................................. 34 7. Current Exposure Method .......................................................................... 39 B. The Second Pillar – Supervisory Review Process .............................................. 40 C. The Third Pillar – Market Discipline..................................................................... 43 I. Introduction................................................................................................................... 45 II. Scope and operational requirements............................................................................ 46 A. Protection providers ............................................................................................ 47 B. Obligors ............................................................................................................... 47 C. Forms of protection ............................................................................................. 48 D. Dilution risk.......................................................................................................... 48 III. Calculation of capital requirements............................................................................... 49 A. Theoretical framework......................................................................................... 49 B. Correlation parameters........................................................................................ 49 C. Calculation of risk-weighted assets ..................................................................... 50 D. Maturity effects .................................................................................................... 50 E. Stress testing....................................................................................................... 51 IV. Pillar 2........................................................................................................................... 51 V. Pillar 3........................................................................................................................... 51 VI. Rules............................................................................................................................. 51 A. Operational requirements.................................................................................... 51 Operational requirements for recognition of double default................................. 51 B. Calculation of capital requirements ..................................................................... 54 Calculation of risk-weighted assets for exposures subject to the double default framework .................................................................................................. 54 C. Calculation of expected losses............................................................................ 55 D. Stress testing....................................................................................................... 55 E. Pillar 2 ................................................................................................................. 55 I. Introduction................................................................................................................... 57 II. Effective Maturity .......................................................................................................... 57 III. Scope of Application..................................................................................................... 59 IV. Rules............................................................................................................................. 59 A. Exemptions from the one-year floor .................................................................... 60 B. Local market-dependent exemptions from the one-year floor............................. 60 C. Maturity calculation of a netting set exclusively containing transactions exempt from the one-year floor (revised paragraph 323)................................................. 60 I. Introduction................................................................................................................... 62 II. Summary of improvements to the trading book regulatory regime ............................... 63 III. Minimum capital requirements under Pillar 1................................................................ 64 A. Capital charges related to the trading book/banking book boundary ...................64 B. Further prudent valuation guidance .....................................................................65 C. Trading book capital treatment for specific risk under the standardised methodology.........................................................................................................66 D. Trading book capital treatment under the internal models approach ...................66 IV. Supervisory review process under Pillar 2 ....................................................................68 A. Comprehensive assessment of risks
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