Credit derivatives are contracts intended to transfer credit risk on loans, bonds and other assets (the underlying assets) from the protection buyer to the protection seller. Under these contracts, the payment or other obligations of the protection seller are triggered by credit events affecting the reference asset.
A credit derivative may be funded or unfunded, depending on whether the protection seller is required to make payment before the occurrence of a credit event. The capital adequacy and large exposures treatment afforded to these contracts clearly affects their attractiveness as risk management instruments. However, there are no internationally agreed regulations explicitly covering credit derivatives under the Basle Accord and EU directives.
The Financial Services Authority (FSA), which has recently assumed responsibility from the Bank of England for the supervision of UK banks, has now issued its report on credit derivatives. New banking supervisory policy guidelines will become effective from the end of September 1998. The guidelines may assist UK banks which are protection buyers in the following principal areas.
Trading book treatment of illiquid assets
The trading book treatment of corporate credit risk is more favourable than that under the banking book. In a reversal of the Bank of England's previous policy, the FSA has decided that credit default products with a loan as a reference asset may be included in the trading book. However, because of the difficulty in valuing mark to market illiquid instruments, the FSA may require significant extra capital to be held against the uncertainty in valuation.
The FSA has clarified when a bank may reduce or transfer its risk-weighted exposure to the underlying asset in circumstances where the reference asset is not the same as the underlying asset (an asset mismatch) or where there is a maturity or currency mismatch between the credit derivative and the reference/underlying asset.
Where there is a maturity mismatch between a credit default product or credit-linked note and the reference asset, a bank will not be required to report a specific risk position for both the credit derivative and the reference asset. However, as the unhedged forward credit exposure is treated as a forward commitment to buy the reference asset, no benefit is recognized for the maturity mismatched hedge.
Interest rate add-ons will be used to calculate counterparty exposure for an unfunded credit derivative where the reference asset is a qualifying debt item (typically securities of investment grade). This is less conservative than the alternative equity add-ons (as the volatility of bond exposures is not expected to be higher than that of equity of the same issuer).