Using guarantees and credit derivatives to reduce credit risk capital requirements under the New Basel Capital Accord

Erik Heitfield

INTRODUCTION

New bank capital adequacy standards being developed by the Basel Committee on Banking Supervision are intended to align minimum regulatory capital requirements more closely with the underlying economic risks faced by banks. Since financial guarantees and credit derivatives are designed to provide protection against credit risk, the Basel Committee has proposed allowing banks to use these instruments to reduce regulatory capital requirements. This chapter examines the Basel Committee’s proposed capital treatment for hedged credit exposures under the new Capital Accord (Basel II) and compares this treatment with a stylised portfolio credit risk model.

The next section of this chapter provides a brief overview of the development and objectives of Basel II. At the new Accord’s core is a simple portfolio credit risk model that we call the ASRF/Merton model. Basel II uses this model to set regulatory capital charges for unhedged credit exposures that take into account cross-exposure differences in credit risk parameters measuring default probabilities and recovery rates. The section entitled “The Advanced Internal Ratings Based Approach” describes the ASRF/Merton model in