In March 2013 the Basel Committee on Banking Supervision (the “Basel Committee”) released for public comment a Consultative Document addressing recognition of the cost of credit protection purchased. In some circumstances, the risk based capital rules permit banking organizations to recognize the mitigating effect of credit protection for purposes of determining the amount of risk weighted assets of a particular on-or off-balance sheet exposure. The risk based capital rules applicable to most banking organizations in the United States, and which are based upon Basel I, permit banking organizations to recognize a guarantee provided by the central government of an OECD-based country, a U.S. government agency or government sponsored entity, a state or local government of an OECD-based country, a U.S. depository institution, or a foreign bank in an OECD-based country by substituting the risk weight applicable to the guarantor for the risk weight that would otherwise be assigned to the exposure to the extent of the guarantee. Similarly, large banking organizations that use the Basel II advanced approaches rule for calculating risk based assets may recognize the mitigating effect of credit protection obtained by an eligible credit protection provider or through an eligible credit derivative for purposes of determining the amount of risk weighted assets generated by a particular wholesale or securitization exposure in certain circumstances.
In the Consultative Document, the Basel Committee expressed concern that the current Basel II rules may create an opportunity for capital arbitrage where there is a delay in recognizing the cost of the protection in earnings (i.e., where there is no upfront credit protection payment or the cost of credit protection is payable over time) and the banking organization receives an immediate benefit in the form of a lower risk weight on the exposure. The Basel Committee noted that arbitrage may be particularly likely to occur in the context of securitization transactions where the difference in risk weight before and after buying protection can be quite large.
To address this concern, the Consultative Document sets forth a proposal under which banking organizations would be required to recognize the present value of material credit protection costs in an appropriately conservative manner if such costs have not already been recognized in earnings or otherwise reflected in the amount of common Tier 1 equity. The present value of such costs would be treated as an exposure with a 1250% risk weight. Credit protection costs would be considered material when the risk-weight on the exposure would be greater than 150% in the absence of credit protection, though the proposal outlined in the Consultative Document would reserve the right for national supervisors to require recognition of credit protection costs even when an exposure would attract a lower risk-weight. The Consultative Paper raises several issues for national supervisors to consider, including the appropriate discount rate that should be applied to determine present value and whether and how spread income should be taken into account when determining present value.
The Basel Committee is requesting comments on the proposal outlined in the Consultative Document by June 21, 2013. Even if adopted by the Basel Committee, the proposal would still need to be adopted and implemented by national supervisors before it would have any effect. As a result, it is not clear whether or how the proposal outlined in the Consultative Document would be implemented in the United States and, if implemented, whether it would affect only advanced approaches banks or would apply more generally. Banking organizations that use credit default swaps or that engage in synthetic securitization may wish to evaluate the potential implications of this proposal on their reports to bank regulators concerning capital adequacy.