Credit Risk Mitigation – Basel III

Credit Risk Mitigation – Basel III

In the realm of credit risk mitigation, when a financial institution (AIFI) invests in a security with a specific rating from an approved agency, the risk weight of that investment reflects the rating. If the AIFI’s claim isn’t directly linked to that rated security but the borrower has a rated issue, then the rating can apply to the AIFI’s claim only under certain conditions. These include the claim being of equal or higher priority and having a maturity not exceeding that of the rated issue. Ratings must be public and explicitly linked to the specific obligations they cover.

For credit risk mitigation techniques, AIFIs use various methods like collateralization with cash, securities, or third-party guarantees. These techniques are applied primarily to banking book exposures but also affect counterparty risk charges for over-the-counter derivatives and repo-style transactions in the trading book. The key principle is that transactions using credit risk mitigation shouldn’t carry higher capital requirements than those without such techniques.

Legal Certainty

Legal certainty is crucial. All documentation for collateralized transactions and guarantees must be enforceable in all relevant jurisdictions. AIFIs should ensure they have the right to quickly liquidate or take possession of collateral in case of default. Collateral quality and the counterparty’s credit quality shouldn’t be positively correlated.

For collateralized transactions, AIFIs can either use a simple approach, substituting the risk weight of the collateral for the counterparty’s, or a comprehensive approach. The comprehensive approach considers the potential fluctuations in the value of the exposure and the collateral, applying ‘haircuts’ to adjust their values. Eligible financial collaterals include cash, gold, government securities, and certain debt securities.

Credit Risk Mitigation Techniques

When there’s a mismatch in the maturity of collateral and exposure, CRM is recognized only when the original maturity is at least one year. In case of mismatches, a specific formula adjusts the value of the credit protection. Multiple CRM techniques for a single exposure need to be treated separately.

Lastly, guarantees and counter-guarantees can be factored in, provided they are direct, explicit, irrevocable, and unconditional. The range of eligible guarantors includes sovereigns, banks, and certain entities with strong credit ratings. The covered portion of the exposure gets the risk weight of the guarantor, while the uncovered part retains the risk weight of the original counterparty. For maturity mismatches in guarantees, there’s an adjustment formula to calculate the effective value of the guarantee.