CP16/22 – Implementation of the Basel 3.1 standards: Credit risk mitigation

Overview

5.1 This chapter sets out the Prudential Regulation Authority’s (PRA) proposals to implement the Basel 3.1 standards for credit risk mitigation (CRM), and to amend the PRA’s expectations in respect of CRM. The proposals set out in this chapter are relevant to firms using the standardised approach (SA) and the internal ratings based (IRB) approach to credit risk. The proposals relating to the ‘financial collateral comprehensive method’ (FCCM) volatility adjustments are also relevant to firms using the standardised approach to counterparty credit risk (SA-CCR).

5.2 The proposals in this chapter would:

• complement HM Treasury’s (HMT) proposed revocation of certain Capital Requirements Regulation (CRR) articles;
• introduce a new Credit Risk Mitigation (CRR) Part of the PRA Rulebook;
• insert an additional provision into the Counterparty Credit Risk (CRR) Part of the PRA Rulebook;
• amend Supervisory Statement (SS)17/13 ‘Credit risk mitigation’ (Appendix 15); and
• amend SS12/13 ‘Counterparty credit risk’ (Appendix 17).

5.3 CRM is a series of techniques used by a firm to reduce the credit risk associated with an exposure or exposures that the firm continues to hold. The CRR allows firms to reflect two forms of eligible CRM in their risk-weighted assets (RWA):

• funded credit protection (FCP): a type of CRM that reflects financial or non-financial collateral held against an exposure, which the firm can retain or liquidate in case of the default of a borrower or counterparty. It also includes the use of on-balance sheet netting and master netting agreements (MNA); and
• unfunded credit protection (UFCP): a type of CRM that reflects the promise from a third party to pay when a borrower or counterparty defaults.

5.4 Throughout this chapter, the PRA refers to the following CRM methods outlined in Table 1 below:

5.5 The Basel Committee on Banking Supervision (BCBS) identified the following weaknesses in the existing Basel standards, including, in relation to CRM:

• unnecessary complexity in the framework that could result in excessive variability in RWAs;^{footnote [4]} and
• the ability of firms to use internal estimates under the SA, which is contrary to one of the BCBS’s principles for revising the SA.^{footnote [5]}

5.6 To enhance the clarity and consistency of the CRM framework, and to address these weaknesses, the Basel 3.1 standards introduce a number of material changes impacting the treatment of FCP and UFCP under both the SA and the IRB approach.

5.7 The PRA supports the changes to the CRM framework that are set out in the Basel 3.1 standards. The PRA considers that the changes would improve the robustness, consistency and comparability of the use of CRM across firms and therefore proposes a number of changes to the CRM framework that are consistent with the Basel 3.1 standards.

5.8 The PRA considers that CRM is a complex part of the RWA framework, and therefore proposes certain additional amendments which the PRA considers would reduce complexity, improve coherence, and provide greater clarity to firms regarding the availability of CRM methods.

5.9 The PRA sets out a number of proposals relating to FCP in this chapter that are consistent with the Basel 3.1 standards. Key proposals include:

• under the SA, removal of certain methods for calculating the effects of FCP and amendments to the methods that remain available;
• under the FIRB approach, amendments to existing methods for calculating the effects of FCP, including new supervisory LGD values and collateral volatility adjustments; and
• under the AIRB approach, a new technique for calculating the effects of FCP where firms lack sufficient data.

5.10 The PRA also sets out a number of proposals relating to UFCP in this chapter that are consistent with the Basel 3.1 standards. Key proposals include:

• restrictions on existing methods where firms adjust PDs and/or obligor grades in IRB models; and
• new restrictions on recognising and modelling UFCP which would depend on the credit risk approach applicable to comparable direct exposures to the protection provider.

5.11 The proposals in this chapter are relevant to PRA-authorised banks, building societies, PRA-designated investment firms, and PRA-approved or PRA-designated financial holding companies or mixed financial holding companies (‘firms’). The proposals would not apply to UK banks and building societies that meet the Simpler-regime criteria and choose to be subject to the Transitional Capital Regime proposals.^{footnote [6]}

5.12 In this chapter, the PRA has set out details of its proposals where it proposes substantive changes to requirements and expectations relative to the existing approach. The PRA also proposes to make a number of other amendments in order to enhance the clarity and coherence of the framework. This includes consolidating some existing PRA rules into new Rulebook Parts. To the extent that the PRA does not propose to amend the existing approach, existing requirements and expectations would continue to apply.^{footnote [7]}

Methods for recognising CRM

5.13 This section sets out the PRA’s proposals relating to the availability of methods for recognising CRM. Further proposals relating to the application of the CRM methods themselves are set out in subsequent sections.

Overview

5.14 As set out in the chapter overview, the Basel 3.1 standards introduce a number of material changes to the CRM framework in order to reduce excessive variability of RWAs.

5.15 The PRA proposes to introduce three frameworks of methods for recognising CRM based on the nature of the credit protection and the credit risk approach applied to the exposures. The first framework would cover recognition of FCP for exposures that give rise to counterparty credit risk, the second framework would cover recognition of FCP for exposures that do not give rise to counterparty credit risk, and the final framework would cover recognition of UFCP.

5.16 The most significant changes proposed by the PRA relating to the availability of methods for recognising CRM include:

• withdrawal of the option to use own-estimate volatility adjustments in the FCCM for firms using all credit risk approaches (FCCM with use of supervisory volatility adjustments would remain available);
• restricting the use of the internal models approach for master netting agreements to firms using the FIRB and AIRB approaches and extending this approach to cover single transactions, in addition to the existing scope of transactions subject to MNAs (renamed as the ‘SFT VaR method’);
• introduction of a new integrated approach to collateral recognition for firms using the FIRB approach, which would incorporate and update existing methods for recognising financial and non-financial collateral (the foundation collateral method);
• introduction of new restrictions on the availability of methods for recognising the effect of UFCP, based on the credit risk approach that would be applied to comparable exposures to the protection provider, as well as the credit risk approach that applies to the exposure itself; and
• withdrawal of the ‘double default’ approach for recognising the effect of UFCP in the IRB approach.

5.17 The PRA proposes to clarify that firms may choose to disregard CRM across all credit risk approaches and CRM methods.

5.18 The application of CRM methods by firms using the IRB approach is subject to risk weight floors as specified in the Basel 3.1 standards. Further details of the PRA’s proposals relating to these floors are set out in Chapter 4.

5.19 The PRA proposes to introduce a rule requiring firms which would recognise both FCP and UFCP in respect of the same exposure to do so in an appropriate manner that is consistent with the frameworks for recognising FCP and UFCP that are set out in this chapter.

5.20 The PRA proposes to clarify in the Credit Risk Mitigation (CRR) Part that the review that firms are required to undertake to confirm the legal effectiveness and enforceability of CRM must be repeated as necessary to help ensure ongoing enforceability.

Funded credit protection: exposures that give rise to counterparty credit risk

5.21 The PRA considers that the existing interaction between the requirements in the Credit risk mitigation chapter of the CRR, the Counterparty credit risk chapter of the CRR, and the Counterparty Credit Risk (CRR) Part is excessively complex. This can lead to uncertainty as to which methods are available to firms, resulting in the inconsistent application of methods across firms. It can also result in opportunities for firms to ‘cherry-pick’ methods in order to reduce RWAs.

5.22 With the aim of simplifying the framework, the PRA proposes the following framework of methods for FCP recognition for exposures that give rise to counterparty credit risk (the proposed framework is summarised in Chart 1 below):

• for derivative exposures, the PRA proposes to retain existing methods with no changes (regardless of the approach to credit risk used). Derivative exposures would continue to be subject to the requirements currently set out in the Counterparty credit risk chapter of the CRR and the Counterparty Credit Risk (CRR) Part;
• for SFTs and any other exposures within the scope of an IMM permission, FCP would only be recognised in accordance with the IMM (regardless of the approach to credit risk used);
• the internal models approach for master netting agreements would be renamed the ‘SFT VaR method’.^{footnote [8]} For exposures within the scope of an SFT VaR method permission, FCP would only be recognised in accordance with that method. The SFT VaR method would not be available where firms are applying the SA as set out in paragraph 5.25;
• for all other exposures that give rise to counterparty credit risk and that are subject to the SA, FCP would be recognised by either adjusting risk weights in accordance with the FCSM or by adjusting exposure values in accordance with the FCCM. Firms using the FCSM would not be permitted to recognise MNAs and would instead treat each exposure subject to a MNA as a single transaction; and
• for all other exposures that give rise to counterparty credit risk that are subject to the IRB approach, FCP would be recognised by adjusting exposure values in line with the FCCM.

Use of own-estimate volatility adjustments within FCCM

5.23 The PRA proposes to withdraw the use of own-estimate volatility adjustments within FCCM for all firms, which would align with the Basel 3.1 standards. The PRA proposes that all firms using FCCM instead use specified supervisory volatility adjustments.

5.24 For exposures subject to the SA, the proposed withdrawal of own-estimate volatility adjustments is intended to eliminate this aspect of modelling from the SA credit risk framework. This is because the PRA considers firms using the SA generally find it challenging to develop robust own-estimate volatility adjustment models within the FCCM. For exposures subject to the IRB approach, the PRA does not consider it necessary to retain own-estimate volatility adjustments within FCCM, because of its proposals relating to the SFT VaR method that are set out below.

SFT VaR method

5.25 The PRA proposes that the SFT VaR method would not be available for exposures subject to the SA, because the PRA considers that firms using the SA generally find it challenging to develop robust SFT VaR method models. The PRA does not propose any changes to the availability of the IMM, which would align with the Basel 3.1 standards.

5.26 The PRA proposes to extend the SFT VaR method to also cover single transactions, to align with the Basel 3.1 standards, in order to replace the use of own-estimate volatility adjustments within FCCM for firms using the IRB approach.

Recognition in exposure value and risk weights

5.27 The PRA considers that the overall effect of the proposals in this section would be that, with the exception of firms applying the FCSM, firms would only be able to recognise FCP for exposures that give rise to counterparty credit risk through adjustments to the exposure value. This would represent a change to the existing position, where firms can recognise FCP through adjustments to LGD in some circumstances, including through AIRB models.

5.28 The PRA considers that adjusting the exposure value is generally the most appropriate mechanism for recognising FCP where exposures give rise to counterparty credit risk. But the PRA also considers that it is appropriate for firms using the SA to continue to be able to use the FCSM to adjust risk weights for such exposures. Firms would need to make a single choice between the FCSM and the FCCM for all exposures on SA, as explained in paragraph 5.33.

Summary of proposed framework

5.29 The proposed framework for recognition of FCP on exposures that give rise to counterparty credit risk is outlined in the chart below:

Chart 1: Summary of the proposed framework for recognition of FCP on exposures that give rise to counterparty credit risk

Question 33: Do you have any comments on the PRA’s proposals for recognising FCP for exposures that give rise to counterparty credit risk?

Funded credit protection: exposures that do not give rise to counterparty credit risk

5.30 The PRA considers that there is currently excessive complexity in the CRM framework for recognition of FCP in respect of exposures that do not give rise to counterparty credit risk (eg secured loans).

5.31 The PRA proposes that, in order to simplify the framework, the following methods would apply where firms choose to recognise CRM for exposures that do not give rise to counterparty credit risk (the proposed framework is summarised visually in Chart 2 below):

• on-balance sheet netting would be recognised through adjustments to exposure value only under the SA and IRB approach. The PRA proposes to clarify the mechanics of how on-balance sheet netting impacts exposure value calculations;
• for exposures subject to the SA:
  • financial collateral would be recognised by either adjusting risk weights in accordance with the FCSM or by adjusting exposure values in accordance with the FCCM. Firms would be required to make a single choice between the FCSM and the FCCM for all exposures subject to the SA, as explained in paragraph 5.33 of this section;
  • non-financial collateral would continue to not be recognised in the CRM framework, however certain SA risk weights would continue to reflect the existence of non-financial collateral (eg the SA risk weights for immovable property); and
  • collateral that is currently classed as OFCP would continue to be recognised under a standalone method. The PRA proposes to refer to this as the ‘OFCP method’;
• for exposures subject to the FIRB approach:
  • financial and non-financial collateral would be recognised by an integrated method for adjusting LGD values known as the ‘foundation collateral method’. This method would align with the FCCM for financial collateral and replace existing foundation LGD values for non-financial collateral. Further details about the PRA’s proposals for the foundation collateral method is set out in ‘Funded credit protection’ section; and
  • collateral in the form of OFCP would be recognised using the OFCP method;
• for exposures subject to the AIRB approach, firms would continue to reflect financial and non-financial collateral using the LGD modelling collateral method. Use of alternative CRM methods to recognise financial and non-financial collateral, such as those available for exposures subject to the SA or the FIRB approach, would not be permitted; and
• for exposures subject to the slotting approach, collateral would not be recognised via the CRM framework but would instead continue to be reflected in the assignment of exposures to slotting categories.

Use of own-estimate volatility adjustments in the FCCM

5.32 The PRA proposes to withdraw the option for firms to use own-estimate volatility adjustments in the FCCM for exposures that do not give rise to counterparty credit risk, in line with the approach for exposures that give rise to counterparty credit risk set out above. The PRA does not propose, however, to introduce any alternatives for modelling volatility adjustments in the FCCM for exposures not subject to counterparty credit risk under either the SA or the FIRB approach. This would align with the Basel 3.1 standards, and reflects the complexity of modelling in this area. The FCCM with use of supervisory volatility adjustments would remain available.

Use of the FCSM and the FCCM

5.33 The PRA proposes to continue to permit firms using the SA to make a choice between either applying the FCSM or the FCCM for all exposures. The PRA also proposes to clarify that firms with IRB permissions that use the SA for certain exposures would also be required to make a choice between these two methods for all exposures subject to the SA.

Summary of proposed framework

5.34 The PRA considers that the proposals in this section would bring clarity to the framework and would reduce ‘cherry-picking’ opportunities. The proposed framework for recognition of FCP on exposures that do not give rise to counterparty credit risk is outlined in the chart below: