17.3 Exposure Under Basel II

A main emphasis of the Basel II framework is on instruments with relatively fixed exposures, such as loans. Chapter 11 discusses the computation of economic capital, illustrating the additional complexity posed by derivatives, due to effects such as random exposures, correlation of exposures and wrong-way risk. However, we have discussed that there also exist reasonable theoretical foundations for replacing derivatives exposures by their loan-equivalent values and an additional “alpha” multiplier (Section 11.3.4).

The Basel II framework very much follows the loan-equivalent style for derivatives with minimum capital requirements for counterparty risk in OTC derivatives and securities financing transactions (SFTs), calculated by applying Basel II rules for corporate, sovereign and bank exposures (BCBS, 2006). In applying these rules to counterparty risk in OTC derivatives and SFTs, there are different methods of varying complexity for calculating EAD:

  • the current exposure method (CEM);
  • the standardised method (SM);
  • the internal model method (IMM).

The first two approaches above are normally referred to as the non-IMM methods. These methods are designed to provide a simple and workable supervisory algorithm for those banks that are not able to model credit exposure internally. In addition, there are separate approaches to handle repo transactions. All of these approaches will be described below.

EAD is calculated at the netting set level. From the Basel ...

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