Basel III Counterparty Credit Risk: Basel Committee Publishes Consultative Document Proposing New Non-Internal Model Method to Replace the Current Exposure Method for Calculating Capital for Counterparty Credit Risk Exposures for Derivative Transactions

Sullivan & Cromwell LLP - July 22, 2013

The Basel Committee on Banking Supervision (the Basel Committee”) recently published for comment a consultative document (the “Proposal”) that describes a new non-internal model method (“NIMM”) for measuring exposure at default (“EAD”) used in measuring counterparty credit risk (“CCR”) for derivative transactions in capital adequacy calculations. The NIMM would replace the current exposure method (“CEM”) and the standardized method (“SM”) in the CCR framework.

A replacement of CEM may have broad implications. The Basel Committee indicates it may adopt the NIMM in other areas, including in the Basel capital framework’s leverage ratio and calculations of exposures to central counterparties frameworks and in the Basel Committee’s proposed limits on large bank exposures. The NIMM also could be used in other contexts within the U.S. bank regulatory regime. In particular, under Dodd-Frank, banking organizations must include derivatives exposures when calculating exposure to a counterparty under the single counterparty credit limit under Section 165 of Dodd-Frank (analogous to the Basel Committee’s proposed large bank exposure limits), to an affiliate under Section 23A of the Federal Reserve Act, to an insider or related interest under Section 22(h) of the Federal Reserve Act, and to a borrower under the national bank lending limit. The proposals to implement these requirements are in various stages of development and could incorporate the NIMM to measure derivative exposures.

Although the NIMM is similar to the CEM in general structure—the calculation of EAD under NIMM includes the sum of (i) replacement cost (“RC”), which reflects the net current exposure of all contracts with a counterparty subject to a legally enforceable netting agreement (a “netting set”), and (ii) an estimate of potential future exposure (“PFE”) of the netting set—the calculation methodologies differ significantly. In general, EAD under the NIMM would be determined based on the particular characteristics of the trades within the netting set. In particular, under the NIMM, the size of the EAD amount would be driven by the following factors: 

  • Collateral may be taken into account in determining RC and PFE. In addition, overcollateralization may further reduce the EAD amount.
  • Offsetting between long and short positions within sets of narrowly defined trades (e.g., foreign exchange trades referencing the same currency pairs) is permitted. As a result, greater hedging (as recognized in the Proposal) ultimately results in a lower EAD.
  • Anticipated volatility in the underlying asset class is taken into account.
  • A net out-of-the-money position for a netting set reduces EAD. There is no reduction if the bank is in-the-money to any degree.
  • The sum of RC and PFE, as calculated under the NIMM, will be increased by 40% through the application of the same multiplier used within the internal model method (“IMM”) to scale expected positive exposure.

The annex to this memorandum compares the CEM and NIMM calculations and describes in detail the key steps of the calculation under the NIMM.

Although the NIMM responds to criticisms that the CEM is a crude methodology that lacks risk sensitivity, the calculation of PFE remains conservative. For example, the ability to offset transactions fully is generally limited to within narrowly defined hedging sets. As a result, the value of the exposures calculated under the NIMM are likely to continue to overstate risk associated with derivative transactions with a counterparty.

The Basel Committee indicates that it will conduct a quantitative impact study to understand and compare the exposure and overall capital requirements under the NIMM and CEM as well as inform the final formulation of the NIMM. Comments on the Proposal are due by September 27, 2013.