Consultation Paper: Basel III Enhanced Risk Coverage: Counterparty Credit Risk and related issues

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1 Summary of and response to submissions received on the Consultation Paper: Basel III Enhanced Risk Coverage: Counterparty Credit Risk and related issues This document summarises the main points made by the submissions received and sets out the Reserve Bank s response to those points. This paper is not a consultation document. December 2012

2 2 Introduction 1. In November 2012 the Reserve Bank consulted on its proposed implementation of the Basel III enhanced risk coverage: counterparty credit risk and related issues requirements. The consultation comprised the implementation of the remaining capitalrelated requirements of Basel III in New Zealand. 2. Stakeholders were alerted to the consultation by and a letter was sent to all New Zealand registered banks. The Reserve Bank received eight submissions in total. This feedback statement contains a summary of the main points made in the submissions and the Reserve Bank s response where appropriate. General 3. The general view was supportive of the implementation of the enhanced risk coverage requirements in New Zealand. Several respondents welcomed the close alignment with rules as set by the Basel Committee on Banking Supervision (BCBS) and the Australian Prudential Regulatory Authority (APRA). All respondents expressed concern regarding the compressed implementation timetable, with a minority citing practical and systems issues. Several respondents asked for the implementation date to be delayed by a few months or for the timetable to be aligned with APRA s. 4. The Reserve Bank has decided to delay the implementation date by three months to 31 March Credit Valuation Adjustment Q1: Do you think the CVA charge will adequately address the mark-tomarket risk of over-the-counter (OTC) derivative contracts? Q2: Would it be useful to have a simplified method for banks that have very little OTC derivative trading, e.g., a doubling of the existing CCR charge? Q3: What is the impact of the new CVA charge on your institution, including in terms of risk-weighted assets? Will it change your behaviour (perhaps by choosing different counterparties or maturities) or have unintended consequences? (Please give detailed cost information.)

3 3 5. Banks generally welcomed the alignment of the CVA requirement with APRA s and the international standard as devised by the BCBS. Some respondents agreed that the CVA charge would improve the way the counterparty credit risk capital charge reflects underlying mark-to-market risk, while others questioned this. One respondent argued for the introduction of an advanced CVA charge, while another saw CVA losses as an accounting construct and the CVA charge as effectively double-counting the existing credit risk charge. A few respondents argued that an illiquid domestic credit default swap (CDS) market made hedging in New Zealand more difficult and exposed New Zealand banks to the risk of CDS spreads being driven by offshore risks, which may not reflect New Zealand conditions. One bank asked for an offset for incurred CVA to be considered. 6. One bank agreed with the proposal to implement a simplified CVA method for banks with only very small counterparty credit risk exposures. However, other respondents were either against or indifferent to such a simplified method. Another respondent asked for the CVA formula to be restated when no CDS hedges are used. 7. Respondents who supplied information on the CVA s impact estimated that it would lead to an increase in overall risk-weighted assets (RWA) of between 0.7 percent and 3.1 percent. For some banks, the CVA appears to lead to a doubling of the existing default risk counterparty credit risk (CCR) charge. Several submitters stated that they would seek to manage the cost down by adjusting maturities, choosing more highly rated counterparties and using CDS hedges. 8. The Reserve Bank notes the points raised by respondents but considers the implementation of the CVA charge as compatible with its stated principles for implementing Basel III in New Zealand (e.g. adoption of the Basel III standards as a starting point, except where the standards are not appropriate for New Zealand circumstances). At this point in time, there are no plans for introducing the internal models method for estimating RWA for counterparty credit risk. The Reserve Bank will, however, consider an offset for incurred CVA in the P&L. 9. Given the lack of support for a simplified CVA and the potential difficulty of defining a threshold below which such a method could be used, the Reserve Bank sees no need for such a method to be included in the new requirements. However, the new standard will include simplified versions of the CVA formula for when the exposures are to one counterparty only and when there are no CVA hedges in place.

4 4 Asset Value Correlation Multiplier Q4: Do you agree that the AVC will lead to a more accurate reflection of risk in terms of capital for relevant exposures? Q5: Are there any reasons as to why the Reserve Bank should not implement this (the AVC) component of Basel III? Q6: What will be the impact of the AVC on your organisation? (Please give detailed cost information, including the impact on RWA, and where relevant distinguish between the short term and long term impact.) 10. The vast majority of respondents who replied to this part of the consultation agreed that the AVC multiplier would lead to a more accurate reflection of the risks arising from exposures to big or unregulated financial institutions. One bank argued that the proposed AVC multiplier suggested that there were fundamental issues with the existing firm size and correlation factors and that certain industries and firm sizes already attracted more capital. None of the banks to whom the AVC multiplier will apply, i.e., the internal models banks, made this comment, although some pointed out that this requirement came on top of what they considered to be already conservative capital requirements in New Zealand. 11. The affected banks asked for clarification as to the definition of an unregulated financial institution and for confirmation of whether the threshold for a big financial institution was US$ 100bn, as opposed to a comparable threshold expressed in either AUS$ or NZ$. 12. The impact of the AVC multiplier was reported to be between approximately 0.5 and 1.5 percent of RWA. It should be noted that the high end of the range reported here might be an outlier and that some submitters stated that these figures were best estimates based on conservative assumptions about the counterparties that would be captured by this requirement. 13. The new standard will contain a definition of what is considered an unregulated financial institution. The Reserve Bank will seek to align this definition with that employed by APRA. Furthermore, the Reserve Bank has decided that the threshold for what constitutes a large financial institution is NZ$ 120bn.

5 5 Margining and collateral management; revised standards and supervisory haircuts for securitisation collateral; collateralised counterparties and holding periods Q7: Do you have any concerns about the introduction of a qualitative collateral management requirement as outlined in paragraph 20? Q8: Do you have any comments, particularly as regards the costs and benefits, about the Reserve Bank s proposal to adopt the Basel III requirements in relation to securitisation collateral? Q9: Do you have any comments on the proposal regarding collateralised counterparties and holding period? 14. Respondents concurred with or were indifferent to the qualitative margining and collateral management requirements proposed by the Reserve Bank. Most banks reported not having any securitization collateral and were comfortable with the new securitisation requirements. To the extent that submitters commented on the longer holding periods, feedback was either positive or it expressed comfort that the new requirement would not pose a problem. Treatment of highly leveraged counterparties and managing wrong way risk Q10: Do you have any comments as regards the requirement on the treatment of highly leveraged counterparties and those whose assets are mainly traded? Q11: Do you have any comments on the new requirements to identify and manage instances of wrong way risk? 15. Two responses noted the close alignment between the Reserve Bank s definition of a highly leveraged counterparty, or one whose assets are mainly traded, with that proposed by the BCBS and APRA, but argued that further guidance would be useful to ensure that the right institutions are captured. 16. Also two submitters requested clarification as to the instruments to which WWR would apply and what significant WWR meant. In addition, two respondents asked whether

6 6 WWR was a qualitative requirement or whether it had a direct impact on the estimation of the EAD for capital. 17. The Reserve Bank will assess the scope for further guidance on highly leveraged counterparties and institutions whose assets are mainly traded. 18. The wrong way risk requirement specifically applies to derivative instruments. However the Reserve Bank expects banks to thoroughly assess the risks affecting all instruments they hold. The wrong way risk requirement as currently proposed does not have a direct impact on the estimation of EAD or capital. Central counterparties Q12: Do you agree that the new requirements for exposures to qualifying central counterparties better reflect the actual risk and encourage more trades to be conducted via QCCPs? Do you plan to make greater use of CCPs? Q13: How do you envisage your bank accessing qualifying central counterparties? Q14: What are the likely costs in terms of, for example, additional capital or providing legal certainty for exposures to QCCPs through an intermediary? 19. Banks were generally of the opinion that the new requirements would lead to more trades being cleared on a (qualifying) central counterparty (QCCP). There was agreement that the new risk-weight for exposures to QCCPs rightly reflects that these exposures are not completely risk free, although some respondents questioned the basis for applying a 2 percent risk-weight and saw the figure as simplistic. Several banks mentioned that the Dodd-Frank legislation in the US would oblige them to use QCCPs. 20. Banks stated that access to a QCCP would occur through an intermediary, with most banks stating their intention to use at least two intermediaries. There was general agreement that costs and capital requirements would increase but only one bank reported cost estimates. The Reserve Bank has noted the estimated additional costs but does not wish to report them in this paper due to the small sample size, the incompleteness of the estimates and the wide range given. There was some agreement that the increase in costs would arise from extra fees, e.g., broker and margin fees, and legal costs.

7 7 Reliance on external credit ratings and minimizing cliff effects Q15: Do you have any comments on this proposal? 21. There were no objections to the Reserve Bank s proposal to not implement the measures outlined in the consultation document on external credit ratings reliance and minimising cliff effects. One bank commented that the Basel III requirement was not necessarily less conservative than previous requirements and was intended to make banks think more about their credit exposures. However, the respondent concurred that the materiality was negligible and did not object to the Reserve Bank s proposed decision. Summary 22. Based on the feedback received, the Reserve Bank has decided to delay the implementation date to 31 March The threshold for applying the AVC multiplier to large financial institutions will be NZ$ 120bn. Over the coming weeks the Reserve Bank will address the other points made by respondents as outlined above.