Credit Derivatives

Under current interpretations of the Basel Accord, a bank may substitute the risk
weight of the protection-selling counterparty for the weight of its underlying exposure.
To illustrate this treatment, consider a $50 million, one year bullet loan to XYZ, a
high-quality borrower. The loan is subject to a 100% risk-weight, and the bank must
allocate regulatory capital for this commitment of $4 million ($50 millionî100%
î8%). If the bank earns a spread over its funding costs of 25 basis points, it will net
$125 000 on the transaction ($50 millionî0.0025). The bank earns a 3.125% return
on regulatory capital (125 000/4 000 000).
Because of regulatory capital constraints, the bank may decide to purchase protection
on the exposure, via a default swap costing 15 basis points, from an OECD
bank. The bank now earns a net spread of 10 basis points, or $50 000 per year.
However, it can substitute the risk weight of its counterparty, which is 20%, for that
of XYZ, which is 100%. The regulatory capital for the transaction becomes $800 000
($50 millionî20%î8%), and the return on regulatory capital doubles to 6.25%
(50 000/800 000).9
The transaction clearly improves the return on regulatory capital. Because of the
credit strength of the borrower, however, the bank in all likelihood does not attribute
much economic capital to the exposure. The default swap premium may reduce the
return on the loan by more than the economic capital declines by virtue of the
enhanced credit position. Therefore, as noted earlier, a transaction that increases
the return on regulatory capital may simultaneously reduce the return on economic
capital.
As discussed previously, many credit derivative transactions do not cover the full
maturity of the underlying exposure. The international supervisory community has
concerns about mismatches because of the forward capital call that results if banks
reduced the risk weight during the protection period. Consequently, some countries
do not permit banks to substitute the risk weight of the protection provider for that
of the underlying exposure when a mismatch exists. Recognizing that a failure to
provide capital relief can create disincentives to hedge credit risk, the mismatch
issue remains an area of active deliberation within the Basel Committee.