Oct 10

Basel II: Credit Risk Mitigation

by David Harper, CFA, FRM, CIPM

FRM |

basel2_crmIntro2

Learning Outcome

  • LO 68.11: Explain how credit risk mitigation techniques are addressed in the Basel II Accord.

Mitigation gives partial protection to counterparty exposures

Basel II makes a big effort to incorporate credit risk mitigants. Mitigants give protection to an exposure and include:

  • Collateral:the bank must be able to liquidate or take legal possession. Further, counterparty and the collateral must not be "materially correlated" or the collateral is ineligible
  • On-balance sheet netting
  • Guarantees
  • Credit derivatives

As with credit risk generally under the first pillar, there are two approaches to credit risk mitigation (CRM): standardized and internal ratings-based (IRB):

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Standardized CRM includes either simple or comprehensive

The standardized approach includes two sub-approaches: simple and comprehensive:

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The simple approach is substitution: the risk weight of the collateral is substituted for the risk weight of the counterparty. In the comprehensive approach, the exposure is approximately reduced by the value of the collateral. Put another way:

  • Simple: exposure is the same, risk-weight is reduced (but not less than 20%)
  • Comprehensive: risk weight is the same, exposure is reduced

 

Comprehensive standardized estimates a conservative net exposure (exposure - collateral)

Before three adjustments, the comprehensive approach is simply netting the collateral: adjusted exposure (E*) = counterparty exposure (E) - collateral (C). But there exists basis risk: over time, the value of the collateral and the exposure may diverge. So, haircuts are applied to each: the counterparty exposure is increased and collateral is decreased. This produces "volatility-adjusted exposures." Finally, if there is a currency mismatch between the two, this is another haircut. All of the haircuts serve to conservatively increase the net exposure, so we are left with:

E* = (E + Haircut) - (C - Haircut - FX Haircut)

 

CRM under IRB naturally reduces LGD

Recall the internal ratings-based (IRB) approach relies on a function of four key inputs: probability of default (PD), loss given default (LGD), exposure at default (EAD), and maturity (M). It is natural that under IRB mitigation is handled in the LGD; i.e., valid mitigation ought to reduce LGD.

Under the foundation IRB,

  • Senior claims on corporates, sovereigns and banks are assigned a 45% LGD.
  • Subordinated claims on corporates, sovereigns and banks are assigned a 75% LGD.

Some "eligible" collateral may be effectively haircut such that LGD* (collateralized LGD) = LGD x (E*/E), where E* is the exposure after risk mitigation.

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Summary takeaways for FRM candidates

  • A key "fix" (improvement) in Basel II over the original accord is recognition of CRM
  • Mitigants include collateral, netting, guarantees and derivatives
  • In all cases, CRM must qualify; e.g., documented, legally enforceable
  • As with credit risk, two broad approaches: standardized and IRB. Within standardized, two sub-approaches: simple and comprehensive
  • Simple standardized substitutes the risk weight of counterparty with risk weight of collateral
  • Comprehensive standardizes reduces the exposure by the collateral - but increases this net exposure with three haircuts: increase the exposure, decrease the collateral, and (if applicable) decrease collateral for currency mismatch

Comments

  1. abid 01 Feb 2008

    Dear Sir
    I am a banker and need such risk mitigation tools to update my self

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