The non-internal model method for capitalising counterparty credit

Basel Committee on Banking Supervision Consultative Document The non-internal model method for capitalising counterparty credit risk exposures Issued for comment by 27 September 2013 June 2013 This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2013. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISBN 92-9131-945-7 (print) ISBN 92-9197-945-7 (online) Contents The non-internal model method for capitalising counterparty credit risk exposures ........................................... 1 I. Background ....................................................................................................................................................................... 1 A. Basel III CCR framework ............................................................................................................................................... 1 B. Current non-internal models approaches ............................................................................................................. 1 C. Key objectives in reviewing the non-internal model method ....................................................................... 2 II. Proposed revisions ......................................................................................................................................................... 3 A. Replacement cost and NICA ....................................................................................................................................... 4 B. PFE add-ons ......................................................................................................................................................................

9 C. Time risk horizon ........................................................................................................................................................... 16 D. Recognition of excess collateral and negative mark-to-market ................................................................ 17 E. Aggregation across asset classes ........................................................................................................................... 18 III. Calibration........................................................................................................................................................................ 18 Overview and summary table of proposed add-ons ............................................................................................... 19 IV. Implication for the IMM shortcut method .......................................................................................................... 21 Annex I: Glossary of terms ........................................................................................................................................................... 22 Annex II: Application of the NIMM to sample portfolios ................................................................................................ 24 Annex III: Flow chart of steps to calculate [interest rate] add-on ................................................................................ 32 The non-internal method for capitalising counterparty credit risk exposures iii The non-internal model method for capitalising counterparty credit risk exposures I. Background A. Basel III CCR framework 1. The Basel II counterparty credit risk (CCR) framework for derivatives capitalises against the risk of losses due to counterparties defaulting before meeting all their contractual obligations on bilateral transactions. A two-step process is undertaken to capitalise this risk. First, a bank must calculate the credit exposures arising from bilateral transactions (ie what is likely to be lost when the counterparty 1 defaults), under exposure or Exposure at Default measures (EAD). Second, these EAD calculations enter the credit risk regime and are multiplied by the risk weight of the counterparty according to either the Standardised or the internal ratings based (IRB) approach. 2. The assessment of credit exposures for derivative transactions depends on the bilateral nature of these transactions, fluctuations in their market risk factors (eg prices, volatilities, and correlations) and legal netting sets and collateral agreements. Given these variables, specific and distinct approaches have been designed in the CCR framework to compute the EAD of derivative transactions. Firms can currently choose from three approaches to calculate EAD for derivatives: two non-internal model approaches with different degrees of complexity – the Current Exposure Method (CEM) and the Standardised Method (SM), – and one internal models approach requiring approval from supervisory authorities – the Internal Model Method (IMM). Each of these methods is computed at the netting set level (ie only the derivative transactions with the same counterparty that are subject to a legally enforceable netting arrangement are considered in the calculation of the credit exposures). B. Current non-internal models approaches Current Exposure Method (CEM) 3. The CEM is defined in section VII, Annex IV of the Basel II accord. Under the CEM, the EAD is calculated as the sum of the current market value of the instrument and a potential future exposure (PFE) add-on component that reflects...

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