Under the German Banking Act, banks and financial services institutions are obliged to have an appropriate amount of own funds to meet their obligations to their creditors. The various risks arising from their business must be recorded in their trading book and in their banking book, weighted and backed by own funds. The rules as to how this should be done were announced by the German Federal Banking Supervisory Office (BAKred) in October 1997 in its Changes and Supplements to the Principles Concerning the Capital and Liquidity of Institutions which, for the most part, came into effect on October 1 1998. The essential item is the new Principle I which regulates capital requirements for market risks (foreign currency risks, commodity risks and position risks from trading book transactions) and counterparty risks (credit risks).
However, it was not clear from the wording of Principle I how credit derivatives fit into this system. Therefore, the BAKred recently issued two draft circulars (which it is discussing with the market participants), as follows:
- the draft circular of July 10 1998 deals with the Principle I treatment of credit derivatives; and
- the draft circular of September 14 1998 deals with the treatment of credit derivatives under the so-called large loans and million loans provisions of the Banking Act.
It is the purpose of these draft circulars to provide an interim regulation until international agreement on the capital treatment of credit derivatives has been reached, and the BAKred explicitly took into account the interim results of the relevant sub-committee of the Basle Committee for Banking Supervision.
The BAKred's Draft Principle I Circular deals with the following six subjects:
- the allocation of credit derivatives to either the trading book or the banking book—credit swaps and total return swaps with underlying security may be allocated to the trading book. If the underlying is a loan, they may only be allocated to the banking book. In the case of credit-linked notes, the protection buyer (issuer of the notes) must include them in its banking book while the protection seller may record them in its trading book;
- the conditions for recognition of a hedging effect deriving from the use of the credit derivative in question—the validity of the risk transfer must be ensured and there must be a certain degree of similarity between the reference asset and the asset to be secured by the credit derivative transaction;
- the treatment of a maturity mismatch between the credit derivative and the asset to be secured—with the exception of total return swaps, the BAKred intends to ignore the protection effect of credit derivatives in the case of a maturity mismatch. This point may be subject to further discussions between the industry and the BAKred;
- the banking book treatment of credit derivatives—with respect to credit swaps and total return swaps the treatment will be similar to the treatment of guarantees. Credit-linked notes will on the protection buyer's side be treated as cash collateral (unconvincing because the protection buyer has received the funds already and has no credit risk left). On the protection seller's side, credit-linked notes will be weighted with the higher of the credit risk of the protection buyer or of the obligor;
- the trading book treatment of credit derivatives—there will be different rules on the treatment of total return swaps, credit swaps and credit-linked notes, involving the necessity to show synthetic positions in fictitious floating rate notes;
- rules on how to deal with the counterparty default risk in the trading book—with regard to total return swaps, both parties must cover their counterparty risk, with respect to credit swaps only the protection buyer must do so, and with regard to credit-linked notes there is no counterparty risk needed to be covered. So-called add-on factors will be applied in the context of the market valuation method used to measure counterparty risk, in the BAKred's view, by reference to share price-related risk. This may be subject to further discussions because an interest rate add-on factor would be more appropriate.
Under the rules set out in the BAKred's second draft circular, hedging effects are acknowledged in the context of large loans provisions to a much lesser extent than under the capital rules. Credit-linked notes may be considered as cash collateral if the refinancing funds are shown to be used to secure the risk asset and if there is no maturity mismatch between the secured asset and the notes. From the protection seller's point of view, the notes must be considered as a loan to the protection buyer as well as a loan to the reference obligor. Total return swaps and credit swaps may be recognized as a guarantee, but only in exceptional cases. The protection seller will have to take into consideration, in the case of a total return swap, a loan to the protection buyer as well as a loan to the reference obligor, and, in the case of a credit swap, a loan to the reference obligor.
With respect to the million loans provisions, protection buyers must take into consideration a loan to the protection seller in the case of a total return swap. A protection seller must take into consideration a loan to the protection buyer and a loan to the reference obligor in the case of credit-linked notes and of total return swaps, whereas credit swaps are only considered a loan to the reference obligor.
The BAKred intends to issue final and binding versions of its circulars this year.