The Austrian regulator, the Financial Market Authority (FMA), has implemented EU Directive 2006/48/EC relating to credit institutions, bringing in the Regulation on the Solvency of Credit Institutions (for credit risk mitigation see Annex VIII of that Directive). The Solvency Regulation (Solvabilitätsverordnung – SolvaV) sets out detailed rules on the risk weighting of a credit institution's exposure. In addition to collateral in rem (also including financial collateral) and netting, a credit institution may accept personal collateral in order to mitigate credit risk.
Guarantees and credit derivatives are eligible personal collateral. The following credit derivatives may be used for the purpose of credit risk mitigation: (i) credit default swaps, (ii) total return swaps, and (iii) credit-linked notes to the extent they are cash funded (Art 98 SolvaV).
In essence, credit institutions may use personal collateral from the following collateral providers: central governments and central banks, regional governments and local authorities, certain multilateral development banks (such as IFC or EBRD) and international organisations, certain public sector entities, credit institutions and other undertakings that have been assigned an external rating with credit quality step 2 or higher (and in certain cases, if the credit institution's internal ratings-based approach rates the undertaking as if it had an external rating with credit quality step 2 or higher).
Counter-guarantees by central or regional governments, multilateral development banks or other public sector entities are in principle also eligible as personal collateral (as an exemption of the principle of direct credit protection).
Credit risk mitigation is available for the amount secured – it is the obligation of the protection provider. In the case of credit derivatives, the value of the collateral is reduced, if restructuring is not defined as a credit event.
If the credit institution uses the standardised approach to credit risk, the risk weighting as to the protection provider is to be applied in lieu of the risk weighting of the principal obligor. If the credit institution uses the internal ratings-based approach, the probability of default (PD) of the protection provider is to be applied to calculate the risk-weighted exposure (or possibly also a PD between the protection provider and the PD of the borrower).
All personal collateral (guarantees and credit derivatives) need to fulfil the following prerequisites:
- They must provide direct credit protection.
- The amount and extent of credit protection must be clearly defined.
- Credit protection must be legally effective and enforceable (legal opinion).
- There must be no clauses the fulfilment of which is outside the lender's direct control and which would allow the protection provider to cancel the protection unilaterally or to increase the effective cost of credit protection as a result of deteriorating credit quality of the protected exposure, or allow reduction of maturity of credit protection.
A guarantee needs to fulfil the following additional prerequisites:
- Payment upon qualifying default or non-payment by the underlying obligor.
- There must be no obligation to first pursue the primary obligor.
- The obligation must be assumed in writing.
- Personal collateral must cover all types of payment.
Credit derivates need to fulfil the following additional prerequisites:
- Credit events need to include failure to pay, insolvency or inability of the obligor to pay its debts, or restructuring (if restructuring is excluded, the amount of risk mitigation is reduced).
- In the case of cash settlement, a robust valuation process is needed to estimate loss probability in a clearly defined period of time.
- In the case of physical settlement the transfer of the underlying obligation must be possible. If consent is required, the consent must not be unreasonably withheld.
- A clear definition on who is responsible for determining the credit event; the determination must not be the sole responsibility of the protection provider.