Operational Requirements For Guarantees-Credit and Risk Managment-Lecture Notes, Study notes of Credit and Risk Management

Download Operational Requirements For Guarantees-Credit and Risk Managment-Lecture Notes and more Study notes Credit and Risk Management in PDF only on Docsity! LECTURE – 25 OPERATIONAL REQUIREMENTS FOR GUARANTEES In order for a guarantee to be recognized, the following conditions must be satisfied: 1. on the qualifying default/non-payment of the obligor, the lender may in a timely manner pursue the guarantor for monies outstanding under the loan, rather than having to continue to pursue the obligor. The act of the guarantor making a payment under the guarantee grants the guarantor the right to pursue the obligor for monies outstanding under the loan; 2. the guarantee is an explicitly documented obligation assumed by the guarantor; 3. for the proportion of the exposure covered, the guarantor covers all payments the underlying obligor is expected to make under the loan/exposure, notional amount etc; and 4. the guarantee must be legally enforceable in all relevant jurisdictions. Operational Requirements for Credit Derivatives In order for protection from a credit derivative to be recognized, the following conditions must be satisfied: 1. The credit events specified by the contracting parties must at a minimum include:  failure to pay the amounts due according to reference asset specified in the contract;  a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals;  a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates;  a change in the ranking in the priority of payment of any obligation, causing the subordination of such obligation. 2. Contracts allowing for cash settlement are recognized for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There must also be a clearly specified period for obtaining post-credit-event valuations of the reference asset, typically no more than 30 days. 3. The credit protection must be legally enforceable in all relevant jurisdictions; 4. Default events must be triggered by any material event, e.g. failure to make payment over a certain period or filing for bankruptcy or protection from creditors; 5. The grace period in the credit derivative contract must not be longer than the grace period agreed upon under the loan agreement; 6. The protection purchaser must have the right/ability to transfer the underlying exposure to protection provider, if required for settlement; 7. The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event; Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees will be eligible for recognition. The following exception applies. Where a bank buying credit protection through a total return swap records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by an addition to reserves) the credit protection will not be recognized. Other types of credit derivatives will not be eligible for this treatment at this time. Further work is expected in this area. Sovereign Guarantees As described in pervious lectures, a lower risk weight may be applied at national discretion to banks. Exposures to the sovereign (or central bank) of incorporation denominated in domestic currency and funded in that currency. National authorities may extend this treatment to portions of claims guaranteed docsity.com by the sovereign (or central bank), where the guarantee is denominated in domestic currency and the exposure is funded in that currency. Maturity Mismatches A maturity mismatch occurs when the residual maturity of a hedge is less than that of the underlying exposure. There may be sound economic reasons for acquiring a hedge with a maturity mismatch. For example, a bank may have only a short-term concern in respect of the credit quality of a particular counterparty. Therefore, it may seek to hedge only the front-end credit risk i.e. the counterparty risk in the first year or so of the exposure. The Committee does not wish to discourage such partial hedging but seeks to adopt a prudent approach to the maturity risks arising. Currency Mismatches Where the credit exposure is denominated in a currency that differs from that in which the underlying exposure is denominated, there is a currency mismatch. This currency mismatch is a contingent risk: for a bank to suffer loss, the borrower must fail to pay and the exchange rates must move adversely. This contingent risk should be distinguished from outright FX risk. Collateral / On-Balance Sheet Netting A bank must disclose gross exposures, the amount of exposure secured by collateral and netted by on- balance sheet netting contracts, and risk-weighted assets excluding and including the effects of collateral/on-balance sheet netting. These aggregate values must be split into risk weight bucket/internal risk grade. A bank must disclose the methodologies used (i.e. simple/comprehensive, standard supervisory/own estimate haircuts). A bank must describe its overall strategy and process for managing collateral including, in particular, the monitoring of collateral value over time. Key internal policies for the recognition of collateral, including, for example, the ratio of underlying exposure to collateral (i.e. LTV ratio) and maturity mismatches, must also be broadly described. A bank must disclose the amount of exposure covered by guarantees/credit derivatives and risk weighted assets excluding and including the effects of guarantees/credit derivatives. These values must be disclosed by risk weight bucket/internal risk grade and by type of guarantor/protection provider. A bank must provide information on its strategy and process for monitoring the continuing credit worthiness of protection providers and administering the guarantees and credit derivatives along the lines required for collateralized transactions. Credit Risk: The Internal Ratings-Based Approach Banks must apply the securitization framework for determining regulatory capital requirements on exposures arising from traditional and synthetic securitizations or similar structures that contain features common to both. Since securitizations may be structured in many different ways, the capital treatment of a securitization exposure must be determined on the basis of its economic substance rather than its legal form. Similarly, supervisors will look to the economic substance of a transaction to determine whether it should be subject to the securitization framework for purposes of determining regulatory capital. Banks are encouraged to consult with their national supervisors when there is uncertainty about whether a given transaction should be considered a securitization. For example, transactions involving cash flows from real estate (e.g. rents) may be considered specialized lending exposures, if warranted. A traditional securitization is a structure where the cash flow from an underlying pool of exposures is used to service at least two different stratified risk positions or tranches reflecting different degrees of credit risk. Payments to the investors depend upon the performance of the specified underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures. The stratified / tranched structures that characterize securitizations differ from ordinary senior/subordinated debt instruments in that junior securitization tranches can absorb losses without interrupting contractual payments to more senior tranches, whereas subordination in a senior/subordinated debt structure is a matter of priority of rights to the proceeds of liquidation. docsity.com