Participants in the Australian over-the-counter (OTC) derivatives market only have one month to make comments on the Australian Prudential Regulation Authority's (APRA) Discussion Paper on its proposed implementation of the recently announced Basel III capital rules relating to derivatives.
Concurrently with the Discussion Paper, APRA released for public consultation draft revised prudential and reporting standards that will implement its proposals.
Background to the Basel III capital rules relating to derivatives
The Basel III reforms include adjustments to the existing rules for capitalising bank exposures to counterparty credit risk in respect of OTC derivatives, repo and securities financing transactions, and the introduction of a new capital charge for potential mark-to-market losses associated with a deterioration in counterparty creditworthiness.
This new charge, known as the credit value adjustment risk capital charge (CVA charge), was introduced in response to lessons learned from the financial crisis where it was found that over two-thirds of counterparty risk losses were due to a deterioration in counterparties' credit quality that fell short of actual counterparty defaults.
To supplement these reforms, in July 2012, the Basel Committee released interim rules specifying the capital requirements for bank OTC derivatives trade exposures to central clearing counterparties (CCPs). These interim rules are designed to incentivise banks to clear all standardised OTC derivatives trades through CCPs, while at the same time ensuring that their credit exposures to CCPs are sufficiently capitalised.
APRA's approach in the Discussion Paper
APRA proposes to adopt the new Basel III OTC derivatives capital requirements in their entirety, except in certain areas where there are strong pragmatic reasons to either allow for a simplified approach or continue APRA’s existing approach. This is in line with APRA's policy to ensure that the prudential capital framework for authorised deposit-taking institutions (ADIs) in Australia is as consistent as possible with global standards.
In line with the Basel III framework, the Draft Revised Standards are designed to incentivise trading via CCPs, with the more favourable capital treatment applying in the case of derivatives cleared through "qualifying" CCPs. For the purposes of the Draft Revised Standards, a qualifying CCP is a licensed CCP subject to domestic supervision consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures.
Non-cleared OTC derivatives
In line with the Basel III reforms, an ADI's capital requirements for non-cleared OTC derivatives will consist of a capital charge for counterparty default risk and the new CVA charge.
The CVA charge for non-cleared derivatives must be calculated in accordance with the formulae set out in draft Prudential Standard APS 112. Non-internationally active ADIs (which APRA has indicated is likely to exclude the top 40 ADIs in Australia) may elect to adopt a simpler calculation, which allows ADIs to calculate the CVA charge as an additional amount equal to the counterparty default risk charge.
The formulae approach in APS 112 departs from the Basel III rules, which provide for the calculation of counterparty default risk via an internal model method (IMM). Although APRA does not propose to introduce the IMM into the Australian prudential framework at this stage, it remains open to adopting an IMM calculation in the future, and will continue to review its approach to ADI counterparty credit risk management and measurement during 2013.
Cleared OTC derivatives
The capital requirements for cleared OTC derivative trade exposures will depend on whether the trades are cleared through a qualifying CCP (QCCP) or a non-QCCP.
OTC derivatives cleared through QCCPs
Where derivatives are cleared through a QCCP, APRA proposes to require ADIs to set aside additional capital against the following potential exposures:
ADI clearing member trade exposures to a QCCP;
ADI exposures to a clearing member, or to a QCCP through the agency of a clearing member (where an ADI is a client of a clearing member);
ADI clearing member exposures to a clearing client; and
ADI clearing member default fund exposures to a QCCP.
APRA will also implement the Basel III rules requiring ADIs to set capital aside against assets posted to a QCCP as collateral. This article focuses on APRA's capital requirements in relation to the four exposures referred to above.
Capital requirements for clearing member trade exposures to QCCPs
Where an ADI acts as a clearing member, its OTC derivatives trade exposures to a QCCP will be exempt from the CVA charge and subject to a counterparty default risk charge based on a risk-weight of 2%. The 2% risk-weight will also apply to a clearing ADI's exposure to a QCCP as a result of the ADI guaranteeing client trades cleared through the QCCP.
Capital requirements for client trade exposures to QCCPs
Where an ADI enters into cleared derivatives as the client of a clearing member, its trade exposure may be either to the clearing member (where the clearing member completes an offsetting transaction with the QCCP) or to the QCCP itself (where the clearing member acts as the client's agent in transacting with the QCCP).
Under the proposed rules, the ADI's trade exposure under either of these clearing arrangements will receive the same capital treatment as if they were the clearing member's exposure to the QCCP (including the lower risk-weighted counterparty default risk charge of 2% on such exposure) provided the ADI's clearing arrangements prevent loss to the ADI arising from:
the default or insolvency of the clearing member;
the default or insolvency of another client of the clearing member; or
the joint default or insolvency of the clearing member and any of its clients.
If the clearing arrangements meet all but the last of these criteria, a higher risk weight of 4% will apply to the ADI's trade exposures under those clearing arrangements.
In all other cases, the ADI will be required to capitalise its exposures under those clearing arrangements as though they were non-cleared derivatives transacted with the clearing member.
Capital requirements for QCCP clearing member trade exposures to clients
Even though a trade may be cleared through a QCCP, the clearing member ADI is required to capitalise its trade exposures to its clients as non-cleared derivatives, irrespective of whether the clearing member is directly interposed between the client and the QCCP, or merely guarantees performance of the client to the QCCP.
However, in recognition of the shorter close-out period for cleared transactions, APRA will implement the Basel Committee's interim rule that allows a QCCP clearing member to multiply its actual exposure to clients under QCCP cleared trades by a discount factor of 0.71.
Capital requirements for exposure to the default fund of a QCCP
A clearing member ADI will be required to set capital aside against its exposure to its default fund contributions to a QCCP. This capital will be in addition to any capital that the ADI is required to set aside against its trade exposures to the QCCP.
Although the Basel III reforms allow banks to choose between two methods for calculating the capital charge for QCCP default fund contributions, APRA proposes to adopt the simpler of these under which default fund exposures will be subject to a 1,250% risk-weight (effectively treating the exposure as a deduction from capital), subject to an overall cap based on 20% of the ADI's trade exposure to the QCCP.
OTC derivatives cleared through non-QCCPs
Non-QCCP trade exposures will be assigned a risk-weight in accordance with the Basel III rules for bilateral counterparty credit risk. As a result, non-QCCP exposures are likely to attract higher capital charges because they will not be exempt from the CVA charge and neither will they have the benefit of the flat 2% risk-weight applicable to QCCP exposures.
Although non-QCCP default fund exposures will be capitalised in the same way as QCCP default fund exposures (ie. subject to a 1,250% risk-weight) the calculations will not be subject to the cap applicable to QCCP exposures. Moreover, consistent with the Basel III rules, APRA proposes to retain a discretion to require an ADI to apply the 1,250% risk-weight to a portion of its unfunded contributions to non-QCCP default funds.
The less favourable capital treatment of exposures under trades cleared through non-QCCPs will act as an incentive for ADIs to clear through a QCCP.
APRA intends to issue final prudential standards and reporting requirements in late 2012, with the new counterparty credit risk rules effective from 1 January 2013.
Submissions in response to APRA's counterparty credit risk proposals in relation to OTC derivatives are due by 28 September. APRA has specifically requested feedback to help it assess the compliance costs of the proposed changes.