Regulators Eyeball Credit Derivatives
Until last fall, many participants in the credit derivatives markets
lived in mortal fear of what major regulatory agencies would say about credit
derivatives. Would the Fed or the OCC declare credit derivatives hopelessly
speculative? Would credit derivatives be ineligible for off-balance-sheet
hedging treatment? These were critical issues to be resolved, since most
dealers have aggressively marketed credit derivatives as a risk management
tool appropriate for mid-sized commercial banks as well as their more sophisticated
Although Generally Accepted Accounting Principles, which most banks use
for regulatory reporting, do not provide guidance for the treatment of credit
derivatives, the Fed, the OCC and the FDIC all issued letters last fall
that outline their positions to date. Most of the comments are "Yes,
but..." statements which offer suggestions, but clearly reserve judgment.
The United States' National Association of Insurance Commissioners, which
develops model regulations for potential adoption by state insurance regulators,
has also considered credit derivatives in its deliberations on investment-related
Although market players have taken these letters as a step in the right
direction, they note that the Bank for International Settlement (BIS) has
remained noticeably silent on the topic. Currently, the BIS's suggested
method for determining credit-based capital adequacy dates back to 1988.
How to modify the calculation of this charge to accommodate a more sophisticated
view of credit, which includes the benefits of diversification and more
precise analyses of credit quality, is the subject of a hot behind-the-scenes
Here's a summary of what the major regulators have to say about credit
The Office of the Comptroller of the Currency (OCC), which regulates
U.S. domestic banks, released a document last August to review some of the
regulatory issues associated with the use of credit derivatives for risk
management purposes by end-user banks. The OCC Bulletin (OCC 96-43) recognizes
credit derivatives as legitimate risk management tools: "Credit derivatives
permit the transfer of credit exposure between parties-i.e., the buyer and
seller of credit protection-in isolation from other forms of risk. These
derivatives represent a natural extension of the market for similar products
that unbundle risks, such as certain interest rate and foreign exchange
products." This concept of credit derivatives as risk management tools
applies to default swaps as well as to total return swaps. Like the Federal
Reserve Board, the OCC is likely to equate credit derivatives with their
underlying reference instruments. Also, the OCC emphasizes the need to consider
counterparty credit risk in the case that a bank is buying credit protection
from another institution.
The FDIC, which regulates U.S.-based depository institutions and insures
consumer deposits, came out with a brief letter on credit derivatives in
August 1996. The FDIC's position appears, in principle, almost identical
to the OCC's: credit derivatives are acceptable risk-diversifying tools,
and, from a reporting perspective, should be considered analogous to their
underlying reference credits. As with the OCC, the FDIC emphasizes that
banks which use credit derivatives should fully understand the structures
in question and have appropriate controls and risk management policies in
The Bank for International Settlements
The Bank for International Settlements (BIS), a notoriously slow-moving
entity, does not specifically recognize credit derivatives. Instead, banks
holding credit derivatives used for risk management purposes are required
to hold reserve capital for these transactions based on a set of criteria
developed in 1988. These criteria include the (broad) credit rating of the
obligor in a credit transaction, the type of exposure (drawn loans or potential
contingent commitments) and whether the maturity of the transaction is more
or less than one year. Because the BIS takes an additive approach to credit-based
capital requirements, meaning that the risk associated with each individual
transaction is added together, banks and other financial institutions that
use credit derivatives in order to enhance their portfolio-wide diversification
do not receive capital relief.
Currently, finding a way to reform the credit-risk-based capital requirement
is of major concern both to BIS regulators and to credit market participants.
Blythe Masters, one of the major architects of JP Morgan's CreditMetrics,
explains that the Credit-Metrics methodology provides a less arbitrary alternative
to the BIS approach, which considers the credit quality associated with
both obligors and reference assets and considers how portfolio concentration
can affect overall risk.
The Federal Reserve Board
According to Joanna Frodin of the Federal Reserve Bank of Philadelphia,
"Credit derivatives are following in the footsteps of other financial
instruments that looked like financial toys at first but proved to be versatile
tools of risk diversification, risk management and yield enhancement."
She adds, however, that because so much of the credit derivatives market
today is nonstandardized, regulators will be considering the regulatory
and supervisory treatment of credit derivatives on a case-by-case basis.
So far, the board of governors of the Federal Reserve has come out with
one document, Supervisory Letter SR96-17, as an interim set of guidelines
(the document was released in August 1996).
In broad terms, the Federal Reserve is considering most credit derivatives
as being analogous to letters of credit and other off-balance-sheet guarantees.
That's because the bank providing credit protection through a credit derivative
can become exposed to the reference asset in a credit derivative just as
it would if the reference asset were on its own balance sheet.
Consider, for example, a typical credit swap in which Bank A is contractually
obligated to make a lump-sum payment to Bank B in the event of a credit
event at Company C. Through the credit derivative, Bank A takes on considerable
exposure to Company C. In these cases, the Federal Reserve requires dealers
providing this sort of credit protection to hold capital reserves against
credit risk associated with the reference asset.
However, in the case of a total return swap, which may include provisions
for the depreciation or appreciation of the reference asset, the bank providing
risk protection can deduct any amount paid to its counterparty from the
notional amount of exposure to the reference asset when calculating its
For end-users of credit derivatives, the question becomes whether or
not your credit derivative provides sufficient protection to be considered
a guarantee for regulatory capital purposes. Typically, guaranteed assets
are associated with reduced capital requirements. However, whether or not
a credit derivative truly qualifies as a guarantee depends on whether the
maturity of the credit derivative matches the maturity of the asset it is
protecting; how default or other credit events are described in the transaction's
documentation; and the size of the payout in the event of a default or other
In addition to exposures to reference assets, the Fed's supervisory letter,
as with the OCC letter, also considers good old-fashioned counterparty risk.
If you purchase a credit derivative to, say, receive a guaranteed payment
in the event of a credit event, you may have mitigated your exposure to
the reference asset, but you have gained exposure to your counterparty.
For purposes of calculating standard capital requirements, credit derivatives
are, for now, to be treated as off-balance-sheet direct credit substitutes.
This means that, for institutions on the sell side of a credit derivative,
100 percent of the notional amount of credit derivative must be included
in calculations of risk-based capital requirements. On the buy side, this
means that the notional amount of the transaction is assigned a risk weight
according to the credit quality of the guarantor. For example, if the guarantor
is an OECD bank, then the percentage of the notional amount will drop to
20 percent. This buy-side risk-weighting approach to calculating capital
requirements for credit derivatives also applies to sell side institutions
that have written a credit derivative and, in turn, hedged their exposure
through another credit derivative.
However, banks that choose to use the optional, market-risk-based capital
requirements that the Fed now allows may be able to reduce capital charges
if a considerable portion of their credit exposures are guaranteed by high
quality non-OECD institutions. In this case, banks would mark their net
exposures to market and take the additional capital charges for counterparty-specific
exposures. According to Bankers Trust's Phil Borg, calculating market-based
capital requirements could provide limited relief from capital charges to
financial institutions with sizable credit portfolios. He cautions, however,
that this method is only appropriate for institutions that have extremely
sophisticated risk analytics and systems in place that allow them to calculate
portfolio-wide market risk within a Value-at-Risk or similar portfolio-wide
The National Association of Insurance Commissioners
Insurance regulation in the United States is conducted on a piecemeal
basis; each state designs its own rules and regulations. The National Association
of Insurance Commissioners (NAIC) was formed in order to foster consistency
among state insurance regulations. Basically, the NAIC designs model regulations
and then distributes them to state insurance commissions, which can choose
how and to what extent they should be implemented locally. According to
Larry Gorsky, chairman of the NAIC's investment committee, the organization
released a document last year that generally discussed the use of derivatives-including
credit derivatives-for hedging and limited yield-enhancement purposes. Gorsky
explains that the investment committee is now looking closely at how derivatives
can be used to replicate various cash instruments. Credit derivatives, for
example, could be used to replicate certain bonds, loans or high-yield instruments.
From a reporting perspective, the NAIC is leaning toward considering credit
derivatives used for replication as equivalent to the derivative's underlying
reference asset. "We will be doing a lot of work on credit derivatives
over the coming months," notes Gorsky.
The Bank of England
Recently, the Bank of England released a draft document explaining its
position on credit derivatives and calculating associated capital requirements.
Unlike the Fed or the OCC, the bank recognizes distinctions between credit
derivatives that function mostly as "guarantees" and credit derivatives
that act as "trading assets." In practice, this means that credit
swaps-which most closely resemble letters of credit and other traditional
guarantees-receive more lenient treatment than total return swaps, despite
the fact that users may purchase both types of instruments for risk management
purposes. Most dealers who have commented on this draft call this distinction
"artificial" and unwarranted.