Application of own credit risk adjustments to derivatives

Basel Committee on Banking Supervision Consultative Document Application of own credit risk adjustments to derivatives Issued for comment by 17 February 2012 December 2011 This publication is available on the BIS website (www.bis.org ). © Bank for International Settlements 2011. All rights reserved. Brief excerpts may be reproduced or translated provided the source is cited. ISBN 92-9131-079-4 (print) ISBN 92-9197-079-4 (online) Contents Application of own credit risk adjustments to derivatives..........................................................1 Executive Summary..................................................................................................................1 Background...............................................................................................................................1 Issue for derivatives..................................................................................................................2 Proposed approach: Full deduction of DVA..............................................................................3 Annex: Alternative approaches considered ..............................................................................4 (a) Recognition of initial DVA assuming a linear decay......................................4 (b) Derecognition of DVA changes due to the bank’s own creditworthiness ......4 (c) Adjustment based on liquidation claim and balance sheet value..................5 Derecognition of

derivatives valuation adjustments due to own credit-risk Application of own credit risk adjustments to derivatives The Basel Committee welcomes comments on all aspects of this consultative document by Friday 17 February 2012 . Comments should be sent by e-mail to baselcommittee@bis.org. Alternatively, comments may be addressed to the following address: Basel Committee on Banking Supervision, Bank for International Settlements, Centralbahnplatz 2, CH-4002 Basel, Switzerland. All comments may be published on the BIS website unless a commenter specifically requests confidential treatment. Executive Summary Paragraph 75 of the Basel III rules text requires banks to “[d]erecognise in the calculation of Common Equity Tier 1, all unrealised gains and losses that have resulted from changes in 1 the fair value of liabilities that are due to changes in the bank’s own credit risk.” This rule ensures that an increase in credit risk of a bank does not lead to a reduction in the value of its liabilities, and thereby an increase in its common equity. This overarching principle applies to debt issued by banks and also has implications for the treatment of fair valued derivatives. However, the application of paragraph 75 to derivatives is not straightforward since their valuations depend on a range of factors other than the 2 bank’s own creditworthiness, such as interest rates and other market factors that can affect the exposures value. It is not easy to separate out changes in value that are only due to changes in a bank’s own credit risk. This consultative paper includes a brief discussion of various options that the Basel Committee has considered to apply the underlying concept of paragraph 75 to over-the- 3 counter (OTC) derivatives (and securities financing transactions (SFTs) ). It proposes that debit valuation adjustments (DVAs) for these products should be fully deducted in the calculation of Common Equity Tier 1 (CET1). Background The Basel Committee published in June 2004 a press release titled “Regulatory capital in 4 light of forthcoming changes in accounting standards”. It stated that “the Committee … examined the appropriate regulatory treatment of any gains and losses arising from changes in an institution’s own credit risk as a result of applying the fair value option to its liabilities. 1 Paragraph 75 of “Basel III: A global regulatory framework for more resilient banks and banking systems” (published in December 2010 and revised in June 2011), available at www.bis.org/publ/bcbs189.pdf. 2 The bank’s creditworthiness can be measured...

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