Risk Weight of Credit Default Swaps

I’m sure I’ve referenced this somewhere in this blog, but I can’t find it!

Page 768 of the enormous Commercial Bank Examination Manual states:

For risk-based capital purposes, total-rate-ofreturn swaps and credit-default swaps generally should be treated as off-balance-sheet direct credit substitutes. The notional amount of a contract should be converted at 100 percent to determine the credit-equivalent amount to be included in the risk-weighted assets of a guarantor. A bank that provides a guarantee through a credit derivative transaction should assign its credit exposure to the risk category appropriate to the obligor of the reference asset or any collateral. On the other hand, a bank that owns the underlying asset upon which effective credit protection has been acquired through a credit derivative may, under certain circumstances, assign the unamortized portion of the underlying asset to the risk category appropriate to the guarantor (for example, the 20 percent risk category if the guarantor is an OECD bank).

Whether the credit derivative is considered an eligible guarantee for purposes of risk-based capital depends on the actual degree of credit protection. The amount of credit protection actually provided by a credit derivative may be limited depending on the terms of the arrangement. In this regard, for example, a relatively restrictive definition of a default event or a materiality threshold that requires a comparably high percentage of loss to occur before the guarantor is obliged to pay could effectively limit the amount of credit risk actually transferred
in the transaction. If the terms of the credit derivative arrangement significantly limit the degree of risk transference, then the beneficiary bank cannot reduce the risk weight of the ‘‘protected’’ asset to that of the guarantor bank. On the other hand, even if the transfer of credit risk is limited, a bank providing limited credit protection through a credit derivative should
hold appropriate capital against the underlying exposure while it is exposed to the credit risk of the reference asset.

It should be noted, however, that in the States the notional value of the swaps does not affect the Leverage Ratio.

The Risk-Weighting is the same in Canada, according to the Capital Adequacy Guidelines:

The face amount (notional principal amount) of off-balance sheet instruments does not always reflect the amount of credit risk in the instrument. To approximate the potential credit exposure of non-derivative instruments, the notional amount is multiplied by the appropriate credit conversion factor (CCF) to derive a credit equivalent amount25. The credit equivalent amount is treated in a manner similar to an on-balance sheet instrument and is assigned the risk weight appropriate to the counterparty or, if relevant, the guarantor or collateral. The categories of credit conversion factors are outlined below.
100% Conversion factor
• Direct credit substitutes (general guarantees of indebtedness and guarantee-type instruments, including standby letters of credit serving as financial guarantees for, or supporting, loans and securities),

However, off-balance-sheet instruments such as CDSs do count towards assets in the calculation of the Assets to Capital multiple.

Leave a Reply

You must be logged in to post a comment.