Post global financial crisis (2008-09), multiple financial institutions and broad range of stakeholders raised a concern and discomfort with the institutions calculated and reported risk-weighted assets (RWA) and capital ratios. This results in analysis performed by multiple committees and agencies which indicated the material variability in the calculations of RWA and capital ratios across different institutions.
The Basel Committee on Banking Supervision (BCBS) outlined the new standardised approach to counterparty credit risk (SA-CCR) to replace the existing approaches (eg current exposure method (CEM), standard method (SM)) in the Basel capital framework. In December 2018, the Board of Governors of the Federal Reserve System (FRS), the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) published their proposed version of SA-CCR for the US.
As proposed in the US, SA-CCR will be mandatory for financial institutions that are regulated by the US banking agencies and have assets totaling more than $250bn or foreign exposure totaling more than $10bn. It will be optional for other banks.
SA-CCR is an exhaustive, standardised (non-modelled) approach for calculating RWA of counterparty credit risk associated with OTC derivatives, exchange-traded derivatives, and long settlement transactions. It is intended to be more risk-sensitive without introducing undue complexity, reduce excessive variability of RWA calculations and to narrow the gap between banks on the standardised approaches vs advanced approaches. In particular, regulators wanted a methodology that would address the deficiencies of the existing approaches (eg CEM) by establishing the below changes:
- Differentiating between margined and non-margined trades.
- More meaningful representation of netting and hedging benefits.
- Recognition of over collateralisation.
- Calibrated to reflect the level of volatilities observed over the recent stress period.
SA-CCR brings heavy changes in the calculation methodology of EAD for derivatives portfolio which demands various new input parameters (eg option delta, new hedging sets concept, duration, commodity type, margin info) and requirement for granular data across business lines. The more complex a derivative product, the possibility of availability of necessary information require for SA-CCR is remote in existing approaches and regulations.
The following figure lists some of the key changes under SA-CCR.
Figure 1: Revisions to the approaches for counterparty credit risk
SA-CCR is a huge development that will have multiple implications for the US capital framework. Below are the key impacts of SA-CCR.
Impact on other regulations:
SA-CCR will also be used and impact other areas of capital framework. Regulations in which it will play a role include:
- Single counterparty credit limits (SCCL)
- The supplementary leverage ratio (SLR)
- The credit valuation adjustment (CVA) capital charge
- The global systemically important banks (G-SIB) buffer
- The comprehensive capital analysis and review (CCAR)
- Banking Organisation Systemic Risk Report (FR Y-15)
Figure 2: Regulations that are affected by SA-CCR requirements
Impact on capital:
The impact of SA-CCR on capital requirements will vary materially across financial institutions and largely depend on an institution’s derivatives portfolios and netting sets. Detailed assessment will be required to evaluate SA-CCR methodology impact on capital requirements.
Overall, the impact of SA-CCR methodology on financial institutions capital cannot be generalised. It may lead to increase in capital as compare to CEM (and other existing methods), where derivative portfolios are mostly non-diversified, non-margined and non-cleared transactions such as those undertaken with corporate hedgers. However, it may lead to decrease in capital in case of diversified and perfectly offsetting trades portfolio of derivatives.
Risk and finance dilemma:
SA-CCR is a complex regulation that require additional data requirements and understanding, rule interpretations, system ownership and additional supervisory burden as compare to existing approaches (eg CEM). This led to number of dilemmas for financial institutions. One of such dilemmas is the function (risk or finance) within the financial institutions to manage the SA-CCR. Some of the views suggest that the SA-CCR requires complex data which risk function is equipped to analyse and explain the risk sensitivities, others feel finance is best placed to manage the reporting process especially for financial institutions where regulatory reporting to be taken care by finance. However, all stakeholders would agree that risk and finance are the key players and close collaboration between them along with others (legal, operations, compliance, data and technology) would be required for successful implementation of SA-CCR.
SA-CCR is not an isolated regulation. It has interdependency and impacts to multiple other areas of capital framework. Although the intention to design this approach is to reduce the complexity but the reality might be different on the ground. This new approach requires complex data attributes and calculations are more complicated than the existing approaches (eg CEM). As a result, financial institutions should not underestimate the new calculation methodology and capital impact they need to address to comply with the SA-CCR.