Allen & Overy Briefing Paper No.3 Standardised Approach to Credit Risk in the Banking Book

Allen & Overy Briefing Paper No.3 Standardised Approach to Credit Risk in the Banking Book

STANDARDISED APPROACH TO CREDIT RISK IN THE BANKING BOOK This briefing paper is part of a series of briefings on the Capital Requirements Directive (CRD) and its implementation in the UK via the General Prudential sourcebook (GENPRU) and the Prudential sourcebook for Banks, Building Societies and Investment Firms (BIPRU). This briefing is for general guidance only and does not constitute definitive advice. NOTE: the UK FSA Handbook provisions referred to in this briefing are based on "intelligent copy-out" of the CRD. They should therefore be consistent in very broad terms with the CRD, and therefore the rules in other EEA States. Health warning: the CRD contains a large number of discretions for member states in implementing the CRD. The regime in other member states may therefore differ in a number of respects. Do not rely on this briefing as an accurate guide to regulatory capital in EEA member states outside the UK. BACKGROUND AND SCOPE The recast Banking Consolidation Directive (recast BCD) includes a revised framework for the risk weighting of credit risk in the banking book, including two approaches the Standardised approach and the Internal Ratings Based approach (IRB Approach) (split into the Foundation IRB approach (FIRB approach) and the Advanced IRB approach (AIRB approach)). The simplest approach the Standardised Approach is used by most small banks. The IRB approach is discussed in Regulatory Capital Briefing 4 (Internal Ratings Based approach to Credit Risk in the Banking Book). This briefing deals with the banking book risk weighting of assets. Trading book risk weighting is described in Regulatory Capital Briefing 8 (Trading Book). KEY CHANGES The Standardised approach is similar in structure to the Basle I approach, with assets being risk-weighted by type. However, risk-weighting is made more sensitive by utilising external credit rating agencies' credit ratings to determine risk weights where available. SOURCES Recast BCD Articles 90-93, Annex VIII; BIPRU Chapter 3 and 13. PREVIOUS EUROPEAN POSITION The BCD required risk-weighting of assets by category of exposure (eg sovereign, regulated entity, other corporate) with a percentage risk weight determined by reference to the category of exposure and (in respect of off-balance sheet exposures) a further percentage applied to off-balance sheet exposures. PREVIOUS FSA REQUIREMENTS Different rules applied across the various prudential sourcebooks. In respect of banks, the FSA's policy was set out in IPRU (BANK). Allen & Overy 2008 1 www.allenovery.com/regulatorycapital

Risk weighting was as follows: 0% cash, cash collateralised exposures, exposures to Zone A and Zone B sovereigns and central banks, and multilateral development banks (MDBs) 20% exposures to EEA and Zone A banks, investment firms, public sector entities (PSEs), clearing houses and exchanges 50% residential mortgages and mortgage-backed securities (MBS) other exposures In respect of off-balance sheet exposures, a further percentage by way of credit conversion factor (CCF) was to be applied on the following basis: direct credit substitutes 50% performance bonds, bid bonds, warranties and standby letters of credit, note issuance facilities and revolving underwriting facilities, and other commitments with an original maturity of over one year 0% other commitments with a maturity of up to one year The old rules provided for the recognition of collateral, guarantees and credit derivatives to reduce the resultant risk weight, subject to certain conditions (see Regulatory Capital Briefings 5 (Funded Credit Risk Mitigation in the Banking Book) and 6 (Unfunded Credit Risk Mitigation in the Banking Book: Guarantees and Credit Derivatives)). NEW REQUIREMENTS The Standardised approach is similar to the old regime in a number of respects. The principal similarity is that a simple pre-determined risk weighting percentage is applied (and, in respect of off-balance sheet exposures, a credit conversion factor) to each exposure of the bank. Credit risk mitigation may then be recognised and serve to reduce the amount of the exposure see Regulatory Capital Briefing 5 (Funded Credit Risk Mitigation in the Banking Book) and Regulatory Capital Briefing 6 (Unfunded Credit Risk Mitigation in the Banking Book: Guarantees and Credit Derivatives). Unlike the old regime, however, risk weightings rely on the external credit rating of the exposure, where possible. Various eligibility requirements apply for rating agencies (referred to as eligible credit assessment institutions, or ECAIs) to be recognised (BIPRU 3.6 (Use of rating agencies' credit assessments for the determination of risk weights under the standardised approach to credit risk)). Export credit agency credit assessments may also be recognised for certain purposes. A simplified version of the Standardised approach is available for firms that do not have significant non-trading book assets see BIPRU 3.5. Classification of exposures, credit conversion factors and credit risk mitigation In the Standardised approach assets are divided into various different exposure classes. These are: claims or contingent claims on central governments or central banks; claims or contingent claims on regional governments or local authorities; claims or contingent claims on administrative bodies and non-commercial undertakings; claims or contingent claims on multilateral development banks; claims or contingent claims on international organisations; claims or contingent claims on institutions; claims or contingent claims on corporates; retail claims or contingent retail claims; claims or contingent claims secured on real estate property; past due items; Allen & Overy 2008 2 www.allenovery.com/regulatorycapital

items belonging to regulatory high-risk categories; claims in the form of covered bonds; short-term claims on institutions and corporates; claims in the form of collective investment undertakings; or exposures to securitisation vehicles (see Regulatory Capital Briefing 7 (Securitisation Framework)). Fundamentals: the risk weight calculation The risk weight is calculated by multiplying (i) the value of the asset by (ii) the risk weight of the asset (expressed as a percentage) by (iii) a credit conversion factor (if the asset is off-balance sheet). This is then multiplied by (iv) 8% to come up with the amount of capital required to be held against the exposures. Valuation Derivatives, stock-lending/repo and long settlement transactions are subject to specific valuation procedures under BIPRU 13 (The calculation of counterparty risk exposure values for financial derivatives, securities financing transactions and long settlement transactions). Other assets are to be valued at their balance sheet value, net of specific provisions. Risk weights Risk weights are determined by reference to the type of exposure and rating of the relevant counterparty see Annex 1. Certain intra-group exposures may be exempted from the risk weighting requirement where the relevant group entity satisfies certain conditions enabling it to fall within the UK integrated group of the firm (see BIPRU 3.2.25R-27R (Zero risk weighting for intra-group exposures)). Credit conversion factors In respect of off-balance sheet factors, a further credit conversion factor is applied to the exposure, reflecting the lower likelihood of an exposure existing at the time of a default by the counterparty. The credit conversion factors are set out in Annex 2. RELATED AREAS See Regulatory Capital Briefing 4 (Internal Ratings Based Approach to Credit Risk in the Banking Book); Regulatory Capital Briefing 5 (Funded Credit Risk Mitigation in the Banking Book); Regulatory Capital Briefing 6 (Unfunded Credit Risk Mitigation in the Banking Book: Guarantees and Credit Derivatives); Regulatory Capital Briefing 7 (Securitisation Framework); and Regulatory Capital Briefing 8 (Trading Book). Allen & Overy 2008 3 www.allenovery.com/regulatorycapital

CONTACT INFORMATION For further information please speak to: Bob Penn Partner 020 3088 2582 bob.penn@allenovery.com Damian Carolan Partner 020 3088 2495 damian.carolan@allenovery.com Paul Phillips Partner 020 3088 2510 paul.phillips@allenovery.com Irina Molostova Associate 020 3088 4913 irina.molostova@allenovery.com Charlotte Phipps Business Development Co-ordinator 020 3088 2136 charlotte.phipps@allenovery.com or your usual Allen & Overy contact. Allen & Overy 2008 4 www.allenovery.com/regulatorycapital

ANNEX 1 RISK WEIGHTS OF EXPOSURE CLASSES Exposure class Risk weighting Central governments and central banks 1 S&P rating 2 AAA to AA- A+ to A- B B B+ to B- CCC+ and Risk weight 0% 20% 50% 150% Regional governments, local authorities 3 and public sector entities 4 Rating of government Risk weight AAA to AA- 20% A+ to A- 50% B B B+ to B- CCC+ and 150% Administrative bodies and non-commercial undertakings 5 International organisations European Community/ECB Internal Monetary Fund Bank for International Settlements Unpaid capital subscribed to the EIF 0% 0% 0% 20% Institutions 6 and multilateral development banks 7 Exposures to institutions with an original effective maturity of more than three months Rating AAA to AA- A+ to A- B B B+ to B- CCC+ and Risk weight 20% 50% 50% 150% 50% 1 2 3 4 5 6 7 Regional governments and local authorities may be treated as central governments in some circumstances see BIPRU 3.4.17. Exposures to EEA governments and central banks denominated in domestic currency are 0% risk weighted. S&P ratings are used in this table (and in these briefings) for convenience: other ratings are also eligible see BIPRU 3.3. By exception short-term exposures (under three months) to regional governments and local authorities are 20% risk weighted. Under certain circumstances exposures to public sector entities may be treated as exposures to central governments or institutions see BIPRU 3.4.24-26. Exposures to public sector entities must be assigned a risk weight. A firm may treat an exposure to a public sector entity as an exposure to a regional government or local authority. In exceptional circumstances, a firm may treat an exposure to a public sector entity established in the UK as an exposure to the central government of the UK if there is no difference in risk between exposures to that body and exposures to the central government of the UK because of the existence of an appropriate guarantee by the central government. "Institution" includes banks and investment firms. Exposures to an unrated institution must not be assigned a risk weight lower than that applied to exposures to its central government. Investments in equity or regulatory capital instruments issued by institutions must be risk weighted at unless deducted from capital resources. The preferential treatment for short-term exposures must not be applied. Allen & Overy 2008 5 www.allenovery.com/regulatorycapital

Exposures to institutions with an original effective maturity of three months or less 8 Shortterm rating AAA to AA- A+ to A- B B B+ to B- CCC+ and Risk weight 20% 20% 20% 50% 50% 150% 20% Corporates 9 Rating AAA to AA- A+ to A- B B B+ to B- CCC+ and Risk weight 20% 50% 150% 150% Retail claims 10 75% Real estate property Exposures fully secured by commercial real estate property Exposures secured by mortgages on residential property 11 12 35% Past due items If value adjustments are less than 20% If value adjustments are no less than 20% (exposures secured by residential property or commercial property) 150% (other) 50% (exposures secured by residential property) (other) High-risk categories (venture capital and hedge fund exposures) 150% Covered bonds Rating of issuer AAA to AA- A+ to B B- CCC+ and Covered bond risk weight 10% 20% 50% 50% 8 This treatment depends on there not being a short-term rating for the relevant institution's short-term exposures. If there is a short-term rating it (i) must be used for weighting the rated exposure only, if more favourable than the application of rates above: or (ii) must be used for all short-term exposures if less favourable see BIPRU 3.4.40-43. In addition, short-term sterling exposures to a UK institution or short-term exposures to certain EEA institutions denominated in their domestic currency attract a weighting, regardless of the rating of the institution, of one rating that of the state's government (ie 20%) see BIPRU 3.4.45. 9 exposures must be assigned a risk weight or the risk weight of its central government, whichever is the higher. 10 To be eligible for the retail exposure class, an exposure must meet the following conditions: (a) the exposure must be either to an individual person or persons, or to a small or medium sized entity; (b) the exposure must be one of a significant number of exposures with similar characteristics such that the risks associated with such lending are substantially reduced; and (c) the total amount owed to the firm, its parent undertakings and its subsidiary undertakings, including any past due exposure, by the obligor client or group of connected clients, but excluding claims or contingent claims secured on residential real estate collateral, must not, to the knowledge of the firm, exceed EURO 1 million. Securities are not eligible for the retail exposure class. 11 A number of conditions apply to risk weight residential mortgages at the 35% risk weight see BIPRU 3.4.60-80. The secured (and hence 35% weighted) portion of a loan secured by a residential mortgage is limited to 80% or less of the value of the mortgaged property. The remainder will generally be treated as a retail exposure. Separate conditions (and potentially different risk weights) apply to loans to other jurisdictions see BIPRU 3.4.83-85. 12 The figure applies to UK and non-eea mortgages. Lending secured by commercial mortgages in other EEA member states may benefit from a lower risk weight depending on local rules. Allen & Overy 2008 6 www.allenovery.com/regulatorycapital

Securitisation positions 13 Short-term claims on institutions and corporates See Regulatory Capital Briefing 7 (Securitisation Framework) Rating AAA to AA- A+ to A- B B B+ to B- CCC+ and Risk weight 20% 50% 150% 150% 150% Collective S&P rating AAA to A+ to A- B B+ to B- CCC+ and investment AA- B undertakings (CIUs) 14 Risk weight 20% 50% 150% 150% Tangible assets Prepayments and accrued income Cash 20% Holdings of equity Gold bullion 0% Asset sale and repurchase agreement Asset specific Any other item Any item weighted at 150% in respect of which a value adjustment has been made If value adjustment is less than 20% If value adjustment is more than 20% 50% 13 For an originator or sponsor, the risk weighted exposure amounts calculated in respect of its positions in a securitisation may be limited to the risk weighted exposure amounts which would be calculated for the securitised exposures had they not been securitised subject to the presumed application of a 150% risk weight to all past due items and items belonging to regulatory high risk categories amongst the securitised exposures. 14 Where a firm considers that a position in a CIU is associated with particularly high risks it must assign that position a risk weight of 150%. Allen & Overy 2008 7 www.allenovery.com/regulatorycapital

ANNEX 2 CREDIT CONVERSION FACTORS FOR OFF-BALANCE SHEET ITEMS (BIPRU 3.7R) Full risk at Medium risk at 50% Medium/Low risk at 20% Low risk at 0% Guarantees having the character of credit substitutes Credit derivatives Acceptances Endorsements on bills not bearing the name of another credit institution Transactions with recourse Irrevocable standby letters of credit having the character of credit substitutes Assets purchased under outright forward purchase agreements Forward deposits The unpaid portion of partly-paid shares and securities Asset sale and repurchase agreements Other items also carrying full risk Documentary credits issued and confirmed Warranties and indemnities (including tender, performance, customs and tax bonds) and guarantees not having the character of credit substitutes Irrevocable standby letters of credit not having the character of credit substitutes Undrawn credit facilities (agreements to lend, purchase securities, provide guarantees or acceptance facilities) with an original maturity of more than one year Note issuance facilities (NIFs) and revolving underwriting facilities (RUFs) Documentary credits in which underlying shipment acts as collateral, and other self-liquidating transactions Undrawn credit facilities (agreements to lend, purchase securities, provide guarantees or acceptance facilities) with an original maturity of up to and including one year which may not be cancelled unconditionally at any time without notice or that do not effectively provide for automatic cancellation due to deterioration in a borrower's creditworthiness Undrawn credit facilities (agreements to lend, purchase securities, provide guarantees or acceptance facilities) which may be cancelled unconditionally at any time without notice, or that do effectively provide for automatic cancellation due to deterioration in a borrower's creditworthiness. Retail credit lines may be considered as unconditionally cancellable if the terms permit the credit institution to cancel them to the full extent allowable under consumer protection and related legislation Allen & Overy 2008 8 www.allenovery.com/regulatorycapital