Isda and BMA propose 35% charge for restructuring risk

The first draft of Basel II did not allow any capital relief for loans hedged with CDS without restructuring protection, but the Committee changed its stance in its third consultative paper (CP3) in May, and asked for industry input regarding a fair charge for restructuring risk.

"[We provided] an estimate of how much capital being exposed to restructuring risk and being hedged to other types of default risk should attract under their IRB framework," says Emmanuelle Sebton, head of risk management and co-head of Isda’s London office. "We have what we call the discount factor, which tells you what the charge for pure restructuring risk should be, and we set it equal to 35% of the full default risk. We provided [the Committee] with some data to justify that. There’s not much data around, but we looked at ratings agency reports, research reports from large credit derivatives dealers, and pooled data from those sources to come up with it."

Isda and the BMA also asked the Committee to reconsider applying Basel II’s maturity adjustment – which requires more capital for longer-dated exposures – to short-term exposures under the internal ratings based (IRB) approach.

"We haven’t really focused on the treatment of very short-term exposures before, but we’ve been drawn to it by the way paragraph 292 of CP3 was drafted,” Sebton says, referring to a provision that could apply the maturity adjustment to instruments like repos, short-term loans and other instruments. “The IRB maturity adjustment is not suitable for short-dated exposures and hence should not be applied; what should be done should centre on adjusting the probability of default for exposures with a maturity below one year," she says.

The associations also reiterated some arguments they have made in the past. They said that the 5% add-on for CDS referencing investment-grade underlyings is too high and recommend it be reduced to 3%. They argued that that the 80% risk offset for CDS used to hedge trading book exposures is arbitrary and risk insensitive.

They also repeated their objections to CP3’s handling of value-at-risk back-testing “exceptions” – that is, when a VaR model’s results diverges from actual results during a back-test. CP3 requires that banks scale up the results of their VaR models, based on the number of exceptions, by multipliers that run from 1x to 3x. The associations say the multipliers are punitive and could discourage the use of VaR models.

The associations also argued that, under Pillar 2, the Committee should strive to ensure firms that operate in more than one jurisdiction should not be subject to “duplicative review”. Rather, the associations advocate the designation of lead supervisors to oversee these firms on a global basis.

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