Today, the Basel Committee proposed a non-internal model method (NIMM) for assessing the counterparty credit risk associated with derivative transactions. The proposal would, when finalized, replace the Basel capital framework’s existing methods for determining the credit exposure amount for derivatives, i.e., the Current Exposure Method (CEM) and the Standardized Approach.
According to the Basel Committee, NIMM improves the risk sensitivity of the CEM by differentiating between margined and unmargined trades. NIMM also revises certain supervisory factors to reflect the level of volatilities observed over the recent stress period and provides a more meaningful recognition of the benefits of legally enforceable netting agreements.
The Basel Committee noted that the CEM, which would be replaced by the NIMM, has been criticized for the following limitations:
- It does not differentiate between margined and unmargined transactions;
- The supervisory add-on factors do not sufficiently capture the level of volatilities as observed over the recent stress periods; and
- The recognition of hedging and netting benefits through the net-to-gross ratio (NGR) is too simplistic and does not reflect economically meaningful relationships between the derivative positions.
The Basel Committee also observed that the Standardized Approach has been criticized for significant weaknesses:
- Like the CEM, it does not differentiate between margined and unmargined transactions and the supervisory credit conversion factors do not sufficiently capture the level of volatilities as observed over stress periods within the last five years;
- Its definition of “hedging set” leads to operational complexity, which could result in firms not being able to implement the Standardized Approach or implementing the Standardized Approach in an inconsistent way;
- The relationship between current exposure and potential future exposure (PFE) is misrepresented in the Standardized Approach because only current exposure or PFE is capitalized; and
- The Standardized Approach does not provide banks that do not have internal model capabilities with an alternative for calculating exposure at default (EAD) because the Standardized Approach uses internal methods for the computation of delta-equivalent for non-linear trades.
The Basel Committee will conduct a quantitative impact study in order to inform the final formulation of NIMM and to assess the difference in exposure and overall capital requirements under this proposal as compared to other measures of counterparty credit risk under the existing Basel framework.
Leverage Ratio and Large Exposures: In addition to replacing the CEM and the Standardized Method in the Basel Committee’s risk-based capital framework, NIMM may also be used with respect to the Basel III leverage ratio, large exposures framework and methods for calculating exposures to central counterparties (CCPs).
Comments on the proposal are due on Friday, September 27, 2013.
Basel Committee, The non-internal model method for capitalising counterparty credit risk exposures – consultative document (Jun. 2013) available here: http://www.bis.org/publ/bcbs254.pdf