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