Credit Risk: From Transaction to Portfolio Management

being after the 1998 accord. With this as a qualification we move onto

consider the case of credit derivatives within the banking book according

to the 1998 rules.

It should be borne in mind that the regulatory requirements provided

by the Basel Committee are used as the minimum standard adopted

by local regulators. Furthermore because credit derivatives were not

covered in the original accord there is some flexibility in the precise

treatment. However all local regimes share the treatment of a short pro-

tection credit derivative as a long artificial position in the reference

asset, in which case the Basel weights reviewed above apply.

A buyer of protection constructing a hedge on a cash position (i.e. an

owner of the underlying asset) is usually granted capital relief provided

it can be demonstrated that the credit risk has been transferred to the

protection seller. In practice this means that the capital allocation is

determined from the category of the counterparty selling protection. For

example if the reference is a corporate (requiring 100 per cent of the

nominal) and the hedge is purchased through an OECD member bank,

then the charge falls to 20 per cent of the nominal adjusted by the risk

ratio of 1.6 per cent from 8 per cent.

There is a major shortcoming inherent, which is the relevant prob-

ability of default is not the OECD bank but rather the joint default prob-

ability. Further, there is no regulatory gain in buying protection from

a corporate enjoying a better rating than the bank.

On the positive side the amount attracting a charge is lower than the

notional and equal to the difference between the notional and the recov-

ery value. There is also a difference in treatment for an asset partially

hedged in terms of the protection having a shorter maturity than the

asset leading to a forward exposure. Typically two different weights are

employed. We refer the reader to section two within the chapter on

the credit risk of libor products where maturity ‘adjustments’ are dis-

cussed in detail.

Regulatory capital example

We introduce one of the applications of TRORS to exploit regulatory

inefficiencies. The regulatory environment has a great effect on the

effective return earned by an off balance sheet item. In Table 3.14 we

illustrate the situation of a bank entering a TROR with different coun-

terparties. On the one hand the regulators require 100 per cent risk

weighting whereas on the other the risk weighting is only 20 per cent.

The asset income in each situation is identical to 60 bps. This should

mean the banks indifference to the counterparty, but because of the

176 Credit risk: from transaction to portfolio management