66.A collateralised transaction is one in which:

1. (i)Banks have a credit exposure or potential credit exposure; and
2. (ii)Credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty.

67.Where banks take eligible financial collateral (e.g., cash or securities, more specifically as per section IV C (a)), they are allowed to reduce their credit exposure to a counterparty when calculating their capital requirements to take account of the risk mitigating effect of the collateral.

Overall framework

68.Banks may opt for either the simple approach (described further in Section IV C(c)), which substitutes the risk weighting of the collateral for the risk weighting of the counterparty for the collateralised portion of the exposure (generally subject to a 20% floor), or for the Comprehensive Approach (described further in Section IV C(b)), which allows fuller offset of collateral against exposures, by effectively reducing the exposure amount by the value ascribed to the collateral.

69.Partial collateralisation is recognised in both approaches.

70.Mismatches in the maturity of the underlying exposure and the collateral shall only be allowed under the comprehensive approach.

71.Banks shall operate under either the simple approach or comprehensive approach, but not both approaches, in the banking book, but only under the comprehensive approach in the trading book.

72.Banks that intend to apply the comprehensive approach require prior approval from the Central Bank.

Minimum Conditions

73.The minimum conditions set out below must be met before capital relief will be granted in respect of any form of collateral under either the simple approach or comprehensive approach.

74.In addition to the general requirements for legal certainty set out above at paragraph 59 to 65, the legal mechanism by which collateral is pledged or transferred shall ensure that the bank has the right to liquidate or take legal possession of it, in a timely manner, in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Furthermore, banks shall take all steps necessary to fulfil those requirements under the law applicable to the bank’s interest in the collateral for obtaining and maintaining an enforceable security interest, e.g., by registering it with a registrar, or for exercising a right to net or set off in relation to title transfer collateral.

75.In order for collateral to provide protection, the credit quality of the counterparty and the value of the collateral must not have a material positive correlation (for example, securities issued by the counterparty - or by any related group entity - would provide little protection and so would be ineligible).

76.Banks shall have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly.

77.Where the collateral is held by a custodian, banks shall take reasonable steps to ensure that the custodian segregates the collateral from its own assets.

78.A capital requirement shall be applied to a bank on either side of the collateralised transaction (for example, both repos and reverse repos shall be subject to capital requirements). Likewise, both sides of a securities lending and borrowing transaction shall be subject to explicit capital charges, as shall the posting of securities in connection with a derivative exposure or other borrowing.

79.Where a bank, acting as an agent, arranges a repo-style transaction (i.e., repurchase/reverse repurchase and securities lending/borrowing transactions) between a customer and a third party and provides a guarantee to the customer that the third party will perform on its obligations, then the risk to the bank shall be the same as if the bank had entered into the transaction as a principal. In such circumstances, a bank shall be required to calculate capital requirements as if it were itself the principal.

The simple approach

80.In the simple approach the risk weighting of the collateral instrument collateralising or partially collateralising the exposure shall be substituted for the risk weighting of the counterparty. Details of this framework are provided further below at section IV C (c).

The comprehensive approach

81.In the comprehensive approach, when taking collateral, banks shall calculate their adjusted exposure amount to a counterparty for capital adequacy purposes in order to take account of the effects of that collateral. Using haircuts, banks shall adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either, occasioned by market movements (exposure amounts may vary, for example where securities are being lent.) This will produce volatility-adjusted amounts for both exposure and collateral. Unless either side of the transaction is cash, the volatility-adjusted amount for the exposure shall be higher than the exposure and for the collateral, it shall be lower.

82.Where the exposure and collateral are held in different currencies an additional downwards adjustment shall be made to the volatility adjusted collateral amount to take account of possible future fluctuations in exchange rates.

83.Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral amount (including any further adjustment for foreign exchange risk), banks shall calculate their risk-weighted assets as the difference between the two multiplied by the risk weight of the counterparty. The framework for performing these calculations is set out further below in paragraph 97 to 100.

84.Banks shall use the standard supervisory haircuts and the parameters therein as set by the Central Bank. The use of own-estimate haircuts that rely on banks own internal estimates of market price volatility is prohibited.

85.The size of the individual haircuts shall depend on the type of instrument, type of transaction and the frequency of marking-to-market and re-margining (for example, repo style transactions subject to daily marking-to-market and to daily re-margining will receive a haircut based on a 5-business day holding period and secured lending transactions with daily mark-to-market and no re-margining clauses will receive a haircut based on a 20-business day holding period. These haircut numbers will be scaled up using the square root of time formula depending on the frequency of re-margining or marking-to-market).

86.For certain types of repo-style transactions (broadly speaking government bond repos) banks are permitted in certain cases not to apply the standard supervisory haircuts in calculating the exposure amount after risk mitigation. Paragraph 108 lists cases where such treatment is allowed.

87.The effect of master netting agreements covering repo-style transactions can be recognised for the calculation of capital requirements subject to the conditions specified in Paragraph 110.

On-balance sheet netting

88.Where banks have legally enforceable netting arrangements for loans and deposits they may calculate capital requirements on the basis of net credit exposures subject to the conditions in paragraphs 120.

Guarantees and credit derivatives

89.Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and the Central Bank is satisfied that banks fulfil certain minimum operational conditions relating to risk management processes, banks are allowed to take account of such credit protection in calculating capital requirements.

90.A range of guarantors and protection providers are recognized by the Central Bank. A substitution approach shall be applied. Thus only guarantees issued by or protection provided by entities with a lower risk weight than the counterparty will lead to reduced capital charges since the protected portion of the counterparty exposure is assigned the risk weight of the guarantor or protection provider, whereas the uncovered portion retains the risk weight of the underlying counterparty. Detailed operational requirements for the recognition of guarantees and credit derivatives are given below in paragraphs 122 to 128.

Maturity mismatch

91.Where the residual maturity of the CRM is less than that of the underlying credit exposure a maturity mismatch occurs.

92.Where there is a maturity mismatch and the CRM has an original maturity of less than one year, the CRM shall not be recognised for capital purposes. In other cases where there is a maturity mismatch, partial recognition shall be given to the CRM for regulatory capital purposes as detailed below in paragraphs 137 to 140.

93.Under the simple approach, such partial recognition is not allowed for collateral maturity mismatches.

Miscellaneous

94.The treatments for pools of credit risk mitigants and first- and second-to-default credit derivatives are given in paragraphs 141 to 145.