Counterparty credit risk exposures
- Credit Risk Standardised Approach
- Internal Ratings-Based Approach
- Credit risk mitigation techniques and netting agreements
In accordance with the provisions of the Solvency Regulation (Solvabilitätsverordnung), two different approaches are used to quantify credit and counterparty credit risk, the Credit Risk Standardised Approach (CRSA) and the Internal Ratings-Based Approach (IRBA). Given the importance of credit risk mitigation techniques and netting agreements, the Solvency Regulation contains special rules for them. The same applies to rules for capturing risks arising from securitisations.
In order to calculate the credit equivalent amounts of risk exposures in derivatives, the Solvency Regulation provides for four procedures: the more simply structured original maturity method and marking-to-market method as well as the more complex approaches of the Standardised Method (SM) and the Internal Model Method (IMM). The SM can also be described as a standardised IMM which recognises certain core elements of the IMM and thus reflects credit risk considerably more precisely than the simpler procedures, but is less complicated to implement. With the IMM, credit equivalent amounts are calculated using an internal risk model that assesses the distribution of future positive market values of derivatives based on modelled market price movements. Since institutions have considerable discretion when using the IMM, this method, unlike the other aforementioned procedures, may only be used upon approval by supervisors.
Moreover, trading book institutions have to recognise the settlement risk from trading book positions when calculating the total capital charges for counterparty credit risk. Since here, unlike in the case of counterparty credit risk exposures, the focus is not on the risk of a counterparty defaulting but on technical risks, the total capital charge for such settlement risks is dependent on how long the settlement is delayed and on the amount of the difference between the settlement price and the underlying instruments' current market price in favour of the institution.
Credit Risk Standardised Approach
Under the Credit Risk Standardised Approach (CRSA) regulated by Part 2 Chapter 3 of the Solvency Regulation, the risk positions are assigned to supervisory asset classes (eg corporates, retail business) and (as a general rule) the appropriate risk weights are calculated based on external ratings. In addition, for credit assessments of central governments, institutions may also use the country classifications of export credit insurance agencies instead of external ratings.
External ratings may be used only if they are provided by prudentially recognised external credit assessment institutions (ECAIs). Depending on their external credit assessment, risk exposures that have to be assigned to certain asset classes are given one of the following risk weights: 0%, 10%, 20%, 50%, 100%, 150%, 350% and 1,250%. Notwithstanding the general coupling of risk weights to issue or issuer credit ratings, the risk weight for claims on banks depends on the external rating of the country of domicile. Because relatively few small and medium-sized institutions in Germany have an external rating, a corresponding option in the Banking Directive is exercised in national implementation. By contrast, unrated exposures or certain loans, such as retail or mortgage loans, will continue to be assigned a fixed weight.
Internal Ratings-Based Approach
Institutions may also calculate the regulatory capital charges for credit risk using a more risk-sensitive approach based on their own rating procedures, the Internal Ratings-Based Approach (IRBA), under which the risk weights are determined using borrower-based risk parameters (Part 2 Chapter 4 of the Solvency Regulation). Institutions can choose between a Foundation Approach (under which the institution only has to estimate the borrower's probability of default (PD)) and an Advanced Approach (under which the institution calculates not only the PD but also the loss given default (LGD), conversion factors for off-balance-sheet business and residual maturities). The risk weights are calculated for individual risk exposures using an IRBA based on individually estimated parameters and classified by given asset classes, using risk weighting formulas. Since the institutions themselves estimate the risk parameters using IRBAs, supervisory approval, which can be given based on an on-site approval examination, is necessary prior to using these approaches.
Credit risk mitigation techniques and netting agreements
The term "credit risk mitigation techniques" refers to institutions' collateral agreements that are used to reduce risk arising from credit positions. Part 2 Chapter 5 of the Solvency Regulation specifies whether and to what extent collateralisations are recognised.
In addition to financial collateral and guarantees of recognised protection providers, which all institutions may recognise, assignments of claims or physical collateral also count as risk mitigants when institutions use an IRBA (so-called IRBA institutions). Where Advanced IRBAs are used, the range of eligible collateral is even unlimited provided an institution can present reliable estimates of the value of the asset. For credit risk mitigation techniques to be recognised when calculating minimum capital requirements, however, institutions must comply with certain minimum qualitative requirements which are explicitly specified in the Solvency Regulation.
On condition that an eligible netting agreement has been concluded bilaterally with the respective contractual partner, derivative and non-derivative transactions with remargining (mostly repurchase and lending transactions) can, according to the provisions of the Solvency Regulation, be netted against one another. On-balance-sheet netting of mutual money claims and debts is also permitted. Moreover, if a cross-product netting agreement is in effect, institutions may take account of netting effects in the case of risk exposures from different product categories. Thus, it is permissible to net derivative counterparty credit risk exposures against non-derivative transactions with remargining or other repurchase, lending or comparable agreements involving securities or commodities. However, for such cross-product netting agreements, the use of the Internal Model Method, as the most risk-sensitive of all methods, is mandatory.
Institutions involved in a securitisation transaction as an originator, investor or sponsor must calculate risk-weighted exposure values for securitisation exposures, which they enter into in a securitisation transaction, according to the rules in Part 2 Chapter 6 of the Solvency Regulation. The rules cover both true-sale securitisation transactions and synthetic securitisation transactions.
When determining the securitisation risk weight, a distinction is made between CRSA and IRBA securitisation transactions. The classification of a securitisation transaction as a CRSA or IRBA securitisation transaction is determined by the credit risk approach that governs the type of asset being securitised (CRSA or IRBA). Mixed portfolios are classified according to whether CRSA or IRBA exposures predominate in the securitised portfolio. Any external ratings that exist for CRSA securitisation transactions are key to the securitisation risk weight. Unrated securitisation exposures are always to be given a weight of 1,250% or deducted from liable capital.
Parts of the securitisation rules have been tightened in the wake of the financial market crisis. One rule relates to risk retention in the case of sucuritisations (sections 18a and 18b of the Banking Act (Kreditwesengesetz)). Institutions (as investors) are allowed to take on securitisation risks only if the securitising institution (eg the originator) retains a percentage share of the risk. Moreover, investors must ensure compliance with the extensive due diligence standards, in particular with regard to the risk analyses to be conducted. To facilitate such analyses, originators and sponsors are required to disclose comprehensive information to investors about the retained risk and the data relevant to the securitised portfolio. In addition, originators and sponsors have to subject their securitised exposures to the same lending standards and procedures as unsecuritised loans. Supervisors can punish violations of the rules by imposing a higher risk weight on the securitised exposures in question.