Basel scraps 'w' charge from pillar 1

Basel has had serious doubts about whether the credit risks in certain forms of credit protection, like collateralisations, credit guarantees and credit derivatives, have really been reduced or transferred to third parties. The Committee believes that there are often residual risk elements, including counterparty risk, which could result in risks not being completely laid off. It set up capital charges under pillar 1 of its proposed new capital accord published in January to counter these concerns.

A fierce industry debate followed, with members of the financial services industry arguing that any residual risks were already included in the Basel II proposals in the form of collateral haircuts and operational risk requirements. They argued that the Basel Committee was effectively charging twice for the same risk.

The Committee’s Capital Group has now ceded the point. “The Capital Group believes the most effective way forward would be to treat this residual risk under the proposed framework's second pillar, ie the supervisory review process, rather than using the ‘w’ factor under the first pillar, ie minimum capital requirements,” said the Basel Committee.

The Capital Group believes this approach will provide a simple, practical and risk sensitive framework for treating credit risk mitigation techniques. Its new proposals mirror its treatment of interest rate risk in the banking book.

The International Swaps and Derivatives Association (Isda) said it strongly welcomed the Committee’s decision. “Isda viewed the ‘w’ charge as double-counting risk.”

It added that a specific charge for credit risk mitigation transactions was also unjustified since losses experienced on repo and credit derivatives trades had been minimal and contract documentation was both enforceable and effective.

The Basel Committee said it would be working over the coming months to provide an overall framework for credit risk mitigation techniques that provides sufficient capital to cover the risks involved.