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Calculating Car

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  • 1. COMMISSION BANCAIRE General Secretariat Office of International Affairs Paris, February 17 , 2006 METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS __ Update of January 1, 20061 1 For further information regarding this document, contact the Office of International Affairs by telephone at 01.42.92.60.34, 01.42.92.60.33, or 01.42.92.70.18, or by fax at 01.42.92.20.15. Methods for Calculating International Capital Adequacy Ratios can also be consulted on the Internet page of the Banque de France, www.banque-france.fr, under the heading Banking Regulation and Supervision / Banking and Financial Supervision / Supervision. It is also available, along with the text of all banking regulations issued since January 1, 1999, on the Internet site of the Commission Bancaire, www.commission-bancaire.org.
  • 2. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 Since January 1, 1998, internationally active French credit institutions2 have been required to measure the market risk to which they are exposed and to apply minimum capital adequacy requirements, as they were already required to do for their credit risk. The international requirements relating to market risk (laid out in Amendment to the Capital Accord to Incorporate Market Risks, published by the Basel Committee in January 1996) were incorporated in the November 1997 edition of this Notice. The provisions relating to the calculation of capital requirements for credit risk are updated in this Notice. 3 2 Internationally active credit institutions are defined as those institutions : − having subsidiaries or branches outside France and/or, − whose transactions in foreign currencies with residents and foreigners, combined with their transactions in euros with non-residents, amount to more than one third of their total consolidated balance sheet. Of course, any other credit institution may adopt the international capital adequacy framework voluntarily if it judges this to be conducive to the development of its activities. 3 Paragraphs that have been added or modified are underlined. 2
  • 3. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 INDEX 1. DEFINITIONS..................................................................................................................................... 7 1.1. MARKET RISK .................................................................................................................................. 7 1.2. THE TRADING BOOK......................................................................................................................... 7 1.3. METHODS FOR MEASURING MARKET RISK........................................................................................ 7 1.4. OVERALL MINIMUM CAPITAL REQUIREMENTS.................................................................................. 8 1.5. DEFINITION OF CAPITAL AND COVERAGE OF MARKET RISK .............................................................. 8 1.6. CALCULATING THE CAPITAL RATIO.................................................................................................. 8 2. THE CONSTITUENTS OF CAPITAL............................................................................................. 8 2.1. CORE CAPITAL (“ TIER 1 ”) .............................................................................................................. 9 2.2. SUPPLEMENTARY CAPITAL (quot;TIER 2quot;)............................................................................................ 10 2.2.1. Upper Tier 2 Capital ............................................................................................................ 10 2.2.2. Lower Tier 2 Capital ............................................................................................................ 11 2.3. DEDUCTION OF PARTICIPATIONS ................................................................................................... 12 2.4. TIER 3 CAPITAL ............................................................................................................................. 13 3. RISK WEIGHTING OF ASSETS AND OFF-BALANCE SHEET EXPOSURES..................... 13 3.1. ON-BALANCE SHEET EXPOSURES ................................................................................................... 13 3.1.1. Exposures risk weighted at 0%............................................................................................. 13 3.1.2. Exposures risk weighted at 20%........................................................................................... 14 3.1.3. Exposures risk weighted at 50%........................................................................................... 15 3.1.4. Exposures risk weighted at 100%......................................................................................... 16 3.1.5. On-balance sheet netting ...................................................................................................... 16 3.1.6. Additional details.................................................................................................................. 18 3.1.6.1. Amount of claims to be taken into account...................................................................................18 3.1.6.2. Amount of claims to be included in exposures .............................................................................18 3.1.6.3. Collateral.......................................................................................................................................18 3.1.6.4. Guarantees .................................................................................................................................... 16 3.1.6.5. Securitisations...............................................................................................................................19 3.1.6.6. Securities held as assets ................................................................................................................20 3.1.6.7. Shares in UCITs and ordinary shares in FCCs..............................................................................20 3.1.6.8. Repurchase agreements.................................................................................................................20 3.1.6.9. Securities lending and borrowing..................................................................................................21 3.1.6.10. Temporary sales of securities (repurchase agreements, securities lending and borrowing and securities received in repurchase agreements) .............................................................................21 3.1.6.11. Sales with repurchase options ......................................................................................................23 3.1.6.12. Guarantee deposits and contributions to Clearnet clearing fund................................................. 22 3.1.6.13. Option premiums .........................................................................................................................22 3.1.6.14. Special cases ................................................................................................................................23 3.2. OFF-BALANCE SHEET EXPOSURES ................................................................................................. 23 3.2.1. Off-balance sheet exposures, excluding derivative instruments ........................................... 24 3.2.1.1. Instruments for which the credit conversion factor is 100% ..........................................................24 3.2.1.2. Instruments for which the credit conversion factor is 50% ............................................................ 24 3.2.1.3. Instruments for which the credit conversion factor is 20% ............................................................ 25 3.2.1.4. Instruments for which the credit conversion factor is 0%..............................................................25 3.2.2. Off-balance sheet exposures in the form of derivative instruments. ..................................... 26 3.2.2.1. Measurement of gross exposure..................................................................................................... 26 3.2.2.2. Netting ........................................................................................................................................... 29 3.2.2.3. Assets collateralising derivative transactions.................................................................................31 3.2.2.4. Special cases ..................................................................................................................................32 4. CAPITAL REQUIREMENTS FOR MARKET RISK .................................................................. 32 4.1. THE STANDARDISED APPROACH .................................................................................................... 33 4.2. THE INTERNAL MODELS APPROACH ............................................................................................... 33 5. METHODS FOR CALCULATING AND APPLYING THE RATIO ......................................... 33 3
  • 4. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 5.1. MINIMUM STANDARDS RELATING TO THE RATIO AND CAPITAL ..................................................... 33 5.2. DENOMINATOR OF THE RATIO ....................................................................................................... 34 5.3. NUMERATOR OF THE RATIO ........................................................................................................... 34 5.4. RULES OF CALCULATION ............................................................................................................... 34 ANNEX 1 - CALCULATING NET POSITIONS............................................................................... 37 1. PRINCIPLES....................................................................................................................................... 37 2. INCLUSION OF FORWARD POSITIONS AND OPTIONS............................................................ 37 3. SPECIAL CASES ............................................................................................................................... 39 ANNEX 2 - INTEREST RATE RISK ................................................................................................. 40 1. SPECIFIC RISK.................................................................................................................................. 40 2. GENERAL RISK ................................................................................................................................ 41 2.1. FOR EACH CURRENCY, CALCULATE THE CAPITAL REQUIREMENT FOR THE NET POSITIONS DEFINED IN ANNEX 1.................................................................................................................................... 42 2.2. FOR EACH CURRENCY, CALCULATE THE ADDITIONAL CAPITAL REQUIREMENT FOR OPTION RISK USING THEMETHODS OF ANNEX 6 .................................................................................................. 42 2.2.1. Maturity method.................................................................................................................... 42 2.2.2. Duration method................................................................................................................... 45 2.2.3. Use of a sensitivity algorithm ............................................................................................... 47 ANNEX 3 - EQUITY-POSITION RISK ............................................................................................. 48 1 - GENERAL RISK............................................................................................................................... 48 2 - SPECIFIC RISK ................................................................................................................................ 48 3. ARBITRAGE BETWEEN SPOT AND FORWARD POSITIONS ................................................... 49 ANNEX 4 - FOREIGN EXCHANGE RISK ....................................................................................... 50 1. CALCULATING THE OVERALL NET POSITION ........................................................................ 50 1.1. STAGE 1......................................................................................................................................... 50 1.1.1. Items included....................................................................................................................... 50 1.1.2. Items excluded ...................................................................................................................... 51 1.1.3. Use of present value.............................................................................................................. 51 1.1.4. Gold position ........................................................................................................................ 51 1.2. STAGE 2......................................................................................................................................... 51 2. CALCULATING CAPITAL REQUIREMENTS ............................................................................... 51 ANNEX 5 - COMMODITIES RISK.................................................................................................... 52 1. CALCULATING POSITIONS ........................................................................................................... 52 1.1. GENERAL RULES............................................................................................................................ 52 1.2. SPECIAL RULES FOR DERIVATIVE PRODUCTS ................................................................................. 52 1.3. FINANCING POSITIONS ................................................................................................................... 53 1.4. MATURITY TABLE AND SPREAD RATES .......................................................................................... 53 2. CALCULATING CAPITAL REQUIREMENTS ............................................................................... 53 2.1. MATURITY TABLE METHOD ........................................................................................................... 53 2.2. SIMPLIFIED APPROACH .................................................................................................................. 54 ANNEX 6 - OPTION RISK .................................................................................................................. 55 4
  • 5. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 1. DELTA PLUS METHOD ................................................................................................................... 55 2. SCENARIO ANALYSIS .................................................................................................................... 56 3. SIMPLIFIED METHOD ..................................................................................................................... 57 ANNEX 7 - USE OF INTERNAL MODELS IN CALCULATING CAPITAL REQUIREMENTS ............................................................................................................. 59 1. PRINCIPLES....................................................................................................................................... 59 2. QUALITATIVE CRITERIA............................................................................................................... 59 3. SPECIFICATION OF MARKET RISK FACTORS........................................................................... 61 4. TREATMENT OF SPECIFIC RISK................................................................................................... 62 5. QUANTITATIVE CRITERIA............................................................................................................ 62 6. STRESS TESTING ............................................................................................................................. 63 7. COMBINED USE OF INTERNAL MODELS AND THE STANDARDISED APPROACH........... 64 8. BACK-TESTING ................................................................................................................................ 64 9. CALCULATING CAPITAL REQUIREMENTS ............................................................................... 64 ANNEX 8 - LIST OF OECD GROUP COUNTRIES ........................................................................ 67 ANNEX 9 - LIST OF PUBLIC-SECTOR GUARANTEE AGENCIES AND PUBLIC-SECTOR EXPORT-INSURANCE AGENCIES LOCATED IN OECD GROUP COUNTRIES ............................................................ 68 1. LIST OF FRENCH PUBLIC-SECTOR AGENCIES AUTHORISED TO GIVE GUARANTEES..................................................................................... 68 2. LIST OF PUBLIC-SECTOR EXPORT INSURANCE AGENCIES IN OECD GROUP COUNTRIES..................................................................................................... 69 ANNEX 10 - LIST OF FRENCH AGENCIES TREATED AS PART OF THE CENTRAL GOVERNMENT OR CENTRAL BANK....................................... 71 ANNEX 11 - REGIONAL AND LOCAL AUTHORITIES RISK-WEIGHTED AT 0% .............. 73 ANNEX 12 - LIST OF MISCELLANEOUS LOCAL FRENCH ADMINISTRATIVE BODIES RISK WEIGHTED AT 20% .................................... 75 ANNEX 13 - LIST OF MULTILATERAL DEVELOPMENT BANKS RISK WEIGHTED AT 20%.................................................................................................................................. 78 ANNEX 14 - LIST OF STOCKS CONSIDERED SUFFICIENTLY LIQUID AND INDEXES JUDGED BROADLY DIVERSIFIED ......................................................................... 79 ANNEX 15 - PRUDENTIAL TREATMENT OF CREDIT DERIVATIVES ................................. 81 1. CRITERIA FOR CLASSIFICATION OF CREDIT DERIVATIVES IN THE TRADING BOOK OR THE BANKING BOOK ................................................................................................... 81 1.1. CLASSIFICATION IN THE TRADING BOOK ........................................................................................ 81 1.2. CLASSIFICATION IN THE BANKING BOOK ........................................................................................ 82 5
  • 6. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 2. TREATMENT OF CREDIT DERIVATIVES IN THE BANKING BOOK ...................................... 83 2.1. TREATMENT OF RISK FOR THE SELLER OF PROTECTION ................................................................. 83 2.2. TREATMENT OF RISK FOR THE BUYER OF PROTECTION .................................................................. 83 2.2.1. Maturity mismatch ................................................................................................................ 84 2.2.2. Basis and currency mismatch ............................................................................................... 85 3. TREATMENT OF CREDIT DERIVATIVES IN THE TRADING BOOK....................................... 85 3.1. GENERAL AND SPECIFIC RISK ........................................................................................................ 85 3.2. COUNTERPARTY RISK .................................................................................................................... 86 3.2. LIQUIDITY AND MODELLING RISK .................................................................................................. 86 ANNEX 16 - LIST OF MASTER AGREEMENTS WHICH PERMIT PRUDENTIAL RECOGNITION OF NETTING ....................................................... 87 1. NATIONAL MASTER AGREEMENT ...................................................................................................... 87 2. INTERNATIONAL MASTER AGREEMENTS ........................................................................................... 87 ANNEX 17 - PRESS RELEASE ISSUED BY THE BASEL COMMITTEE ON OCTOBER 27, 1998 : INSTRUMENTS ELIGIBLE FOR INCLUSION IN TIER 1 CAPITAL.................................................................... 88 ANNEX 18 - PRUDENTIAL TREATMENT OF SECURITISATION TRANSACTIONS........... 91 1. PRINCIPLES ....................................................................................................................................... 92 2. METHODS OF APPLICATION ............................................................................................................... 93 6
  • 7. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 1. DEFINITIONS 1.1. Market risk Market risk, defined as the risk of loss on on-balance sheet or off-balance sheet positions arising from fluctuations in market prices, covers :  Risks pertaining to interest rate-related instruments and equity positions in the trading book ;  Foreign exchange risk and commodities risk arising from all on- and off-balance sheet activities 1.2. The trading book For the purposes of this Notice, the trading book consists of the elements listed in article 6 of regulation 95-02, as amended by regulation 99-01 of June, 1999. Temporary sales of securities and repurchase agreements in the trading book are included in the calculation of general market risk. They are excluded from the scope of specific market risk, but continue to be fall within the scope of the capital adequacy requirements for credit risk set by the 1988 Capital Accord. The Secrétariat Général de la Commission Bancaire will pay particular attention to the economic substance of transactions assigned to the trading book, and to the continuity in the methods used to decide which financial instruments belong in the trading book. There should be a accurate and exhaustive audit trail which makes it possible to verify that the criteria for apportionment between the portfolios have been respected. In this connection, the General Secretariat of the Commission Bancaire reminds credit institutions that, in order to be placed in the trading book, positions must have been taken either for trading purposes, or to hedge other positions in the institution’s trading book. In either case, the marketability of the instruments used must be well established. Furthermore, the institution must have the means and the experience for ensuring the active management of its trading positions, as well as adequate systems of internal control. The Secrétariat Général de la Commission Bancaire reserves the right to reclassify to the banking book any elements whose marketability becomes doubtful; for example if there is a shortage of liquidity or an absence of genuine trading in the instrument in question, a fortiori if the average holding period for the instruments is longer than is consistent with a short-term trading intent. 1.3. Methods for measuring market risk Capital requirements for market risk apply on a consolidated basis in the same way as for credit risk. Banks can choose between two broad categories of methods for measuring their market risks, subject to the approval of the Secrétariat Générale de la Commission Bancaire : 7
  • 8. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006  The first approach consists of standardised methods for measuring risks, using the mechanisms set forth in Section 4.1.  The other approach, referred to as “internal models” is set forth in Section 4.2. The use of this approach is subject to certain conditions and requires the explicit approval of the Secrétariat Général de la Commission Bancaire, It permits banks to rely on risk measures obtained from their own internal risk management models, provided the bank satisfies qualitative and quantitative conditions stated in Annex 7. 1.4. Overall minimum capital requirement The overall minimum capital requirement is composed of : a) the requirements for credit risk set forth in the 1988 Basel Accord, calculated excluding debt and equity securities held in the trading book and all positions in commodities, but including 4 counterparty risk on all over-the-counter derivative products in both the trading and banking books. ; plus the requirements for market risk : b) either the arithmetic sum of the capital requirements for market risk described in Section 4.1 ; c) or the capital requirements obtained from the modelling approach described in Section 4.2 ; d) or a combination of b) and c) summed arithmetically. 1.5. Definition of capital and coverage of market risk The principal forms of capital accepted for covering market risk are core capital and supplementary capital, as those terms are defined in the 1988 Accord, and in such amounts as remain available after the capital requirements for credit risk have been covered. A third form of capital, Tier 3 capital (defined in Section 2.4), consists of short-term subordinated debt and, may be used only to cover a portion of banks’ capital requirements for market risk. The conditions for its eligibility are set forth in Part 5 of this Notice. 1.6. Calculating the capital ratio The capital ratio represents the capital available to cover both credit risk and market risk. If a bank disposes of eligible Tier 3 capital which is not being used to cover market risk, it may report that excess as unused but eligible Tier 3 capital alongside its standard ratio. 2. THE CONSTITUENTS OF CAPITAL It is important to distinguish between core capital and supplementary capital, some deductions from capital being deducted entirely from core capital, and others from total capital.. 4 or, more precisely, quot;continuing to includequot;, these risks are already included in the calculation of credit risk and counterparty risk under the 1988 Accord. 8
  • 9. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 2.1. Core Capital (“Tier 1”)5 2.1.1 For institutions non subject to IFRS For institutions not subject to IFRS, core capital (“Tier 1”) includes : – ordinary shares/common stock and certificates of investment, – non-cumulative preferred shares (Article L228-11 and following of the Code de Commerce) with the prior consent of the Secrétariat Général de la Commission Bancaire, – non-cumulative preferred shares (Article L228-35-1 of the Code de Commerce) and preferred certificates of investment, excluding preferred shares without voting rights (Article L228-35- 2), – deeply subordinated notes issued under the conditions set in the article L.228-97 of the Code de Commerce, revised by the Financial Security Law dated August 1, 2003, with the prior consent of the Secrétariat Général de la Commission Bancaire and provided that these notes meet the eligibility criteria for Tier 1 as defined in Annex 17, – consolidated reserves (including revaluation reserves), – retained earnings, – undistributed earnings (if not yet approved by the general shareholders’ meeting), – positive goodwill – differences arising from consolidation by the equity method, – minority interests except those on which there is a put, – positive foreign currency translation reserves, – Reserve for general banking risks (“fonds pour risques bancaires généraux”) as defined in the Governors’ agreement of November 6, 1991. The following elements are deducted from Core Capital : – holdings of own shares 6, – the unpaid portion of capital, – accumulated losses, – formation expenses, – intangible assets (excluding leaseholds), 5 In accordance with the 27 October 1998 press release issued by the Basel Committee on instruments eligible for Tier 1, reproduced in French in Annex 17, certain innovative products may be included in core capital subject to the prior approval of the Secrétariat Générale de la Commission Bancaire. 6 At their accounting value. 9
  • 10. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – negative goodwill – minority interests in loss-making units, – negative foreign currency translation reserves - provisions for pensions and similar advantages evaluated according to the recommendation of Conseil national de la comptabilité n°2003-R.01 of 1st April 2003 not booked as provisions for risks and charges - revaluation differences on tangible and financial fixed assets, net of tax deducted. These differences are included for 45% before tax in supplementary capital. Notwithstanding the provisions relating to fixed assets set forth above, institutions subject to the present regulation may include in supplementary capital, after tax and application of a discount where relevant, 100% of revaluation differences on such fixed assets under French accounting standards until 31 December 2004. In that case, the restatements shall apply to unrealised capital gains and revaluation differences that exceed the fraction included for 100% in supplementary capital. 2.1.2 For institutions subject to IFRS For institutions subject to IFRS, core capital includes items listed in 2.1.1 except reserves for general banking risks and except revaluation reserves, and shall be restated as follows. All shares issued by mutual institutions shall be included in core capital. The as yet non-amortised share of hybrid debt included in book capital under IFRS shall be deducted from core capital. The instrument may be included in capital if it complies with inclusion conditions in core capital or supplementary capital. The positive impact on capital of components of derivatives on own stock booked as shareholders’ equity shall be neutralised. However, it may be included in capital if it complies with inclusion conditions in core capital or supplementary capital. If the impact is negative, causing a decrease in capital, it shall not be restated. Net actuarial gains booked to earnings or reserves (in the latter case reflecting variations in previous years) in the framework of defined benefit pension schemes must be restated so that they are neutralised in core capital. The reserves shall include unrealised or deferred gains or losses, especially if they are attributable to IFRS. However, unrealised capital gains and losses on financial assets available for sale, booked directly as shareholders’ equity, shall be restated as follows : - for own equity instruments, net unrealised capital gains shall be deducted from core capital, currency by currency, net of tax deducted, and included for 45%, currency by currency and before tax, in supplementary capital. Net unrealised capital losses are not restated ; - unrealised capital gains or losses on other financial instruments, comprising debt instruments or loans and receivables, shall be neutralised ; - losses of value on any asset available for sale booked to the income statement are not restated ; 10
  • 11. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 - restatements of financial assets available for sale do not apply to elements deducted from capital pursuant to article 2.3. Unrealised capital gains or losses booked directly to shareholders’ equity as the result of a cashflow hedging transaction shall be neutralised. Revaluation differences on tangible fixed assets shall be deducted from core capital, item by item, net of tax deducted, and included for 45%, item by item and before tax, in supplementary capital. Unrealised capital gains on investment properties booked in application of the fair value model shall be deducted from core capital, item by item, net of tax deducted, and included for 45%, item by item and before tax, in supplementary capital. Unrealised capital losses are not restated. The positive impacts of revaluations made on first application of IFRS to tangible fixed assets or investment properties, whether or not they are subsequently valued at amortised cost under IFRS, shall be deducted from core capital, item by item, net of tax deducted, and included for 45%, item by item and before tax, in supplementary capital. Negative impacts are not restated. These restatements do not concern elements included in the difference of “mise en equivalence”. Notwithstanding the provisions relating to fixed assets set forth above, institutions subject to the present regulation may include in supplementary capital, after tax and application of a discount where relevant, 100% of revaluation differences on such fixed assets under French accounting standards until 31 December 2004. In that case, the restatements shall apply to unrealised capital gains and revaluation differences that exceed the fraction included for 100% in supplementary capital. The prudential restatements of IFRS set forth above shall not apply to items included in the difference of “mise en equivalence”. However, the Commission Bancaire keep the possibility of applying these prudential restatements to the difference of “mise en equivalence” if the inclusion of all or part of these items seems inappropriate or can mislead of the point of view of prudential supervision objectives. The Commission Bancaire may decide other prudential restatements in order to maintain the definition and required qualities of regulated capital, especially if the fair value option is used. 2.2. Supplementary Capital (“Tier 2”) Supplementary capital may be included only up to the limit of 100% of core capital. A distinction is drawn between upper Tier 2 capital and lower Tier 2 capital. The following elements may be included in supplementary capital : 2.2.1. UPPER TIER 2 CAPITAL – items included in supplementary capital according to the restatements presented in article 2.1.1 for institutions not subject to IFRS and 2.1.2 for institutions subject to IFRS ; – deeply subordinated notes issued but not included in Tier 1 because they are in excess of the 15% limitation as defined Annex 17 ; – unrealised gains on holdings of marketable securities. A discount of 55% is applied, line by line, to the difference between the market price of the securities and their price of acquisition, 11
  • 12. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 in order to take into account the potential volatility of share prices and the notional tax charge on gains ; – general provisions 7 not held against materialised and measurable losses may be included in supplementary capital as well as, for institutions subject to IFRS, provisions constituted for depreciation of portfolio according to IAS 39 (collective provisions) if they constitute general provisions from the prudential point of view; both up to a limit of 1,25% of risk-weighted assets ; – guarantee funds, under the conditions set in Regulation n° 90-02 of the Comité de la Réglementation Bancaire ; – hybrid capital instruments 8 (including subordinated bonds which are convertible or redeemable only in shares) that meet the following four conditions : they are subordinated 9 in capital and interest and are fully paid up, they are perpetual and cannot be redeemed except at the initiative of the issuer and with the prior consent of the Secrétariat Général de la Commission Bancaire 10. Under no circumstances should a request for redemption be made before a period of five years has elapsed, unless the redeemed borrowings are replaced with capital of equal or better quality. they include a clause giving the borrower the right to defer the payment of interest in the event that the profitability of the banks renders their payment inadvisable 11, they are available to cover losses without the bank being obliged to cease operations. Methodological details for hybrid capital instruments All perpetual subordinated debt issued prior to December 31, 1998 is included in upper Tier 2 capital, subject to the ceiling mentioned above. For new issuances, the debt contracts should be submitted for approval by the Secrétariat Général de la Commission Bancaire. When a hybrid instrument or an instrument of higher quality is part of a financing whose structure makes it impossible to determine with certainty if the instrument is perpetual, the instrument is classified as term subordinated debt. This policy, adopted by the Basel Committee on May 26, 1989, does not apply to instruments issued prior to that date. 7 Provisions on the liability side of the balance sheet and which are taken against probable losses or charges are deducted from the corresponding exposures. For country risk provisions, the 1991 Governors’ Accord, also referred to as the “Accord on cleaning provisions,” has applied since 31 December 1993. 8 Institutions should include a list of these instruments in an annex to the table of capital ratio calculations. 9 The requirement that instruments be subordinated precludes them in particular from having quot;negative pledgequot; clauses, as noted in Bulletin n° 13 of the Commission Bancaire. 10 The Secrétariat Général de la Commission Bancaire will grant approval if the redemption is at the initiative of the issuer, the redemption will not affect the solvency of the institution, and new instruments of lower quality are not issued at the same time as the redemption. 11 If the payment of interest is deferred, the payment of interest not paid on its normal due date cannot take place before the next date on which interest is due. 12
  • 13. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 When a perpetual subordinated debt instrument incorporates a clause providing for progressive escalation in the interest rate (TSIP or perpetual subordinated debt with interest step-up), the recognition of the perpetual character of the instrument depends on limits placed on the step-ups. The following cumulative limits apply, subject to approval by the Secrétariat Général de la Commission Bancaire on a case-by-case basis : – The interest rate cannot increase by more than 75 basis points at a time ; – The increase cannot exceed 75 basis points in a five-year period ; however the combination of two five-year periods is acceptable, yielding a maximum increase of 150 basis points in the tenth year of the borrowing. – The interest rate cannot be more than 250 basis points above the yield on a government bond. These limits are computed in terms of the market conditions prevailing at the time of issuance. If the reference rate changes, the size of the step-up is measured by combining the spread over the variable rate to which it is indexed (PIBOR, LIBOR, or similar reference rate) with the swap rate quoted at the time of issuance between that reference rate and the initial reference rate. 2.2.2. LOWER TIER 2 CAPITAL This category includes term subordinated debt instruments 12 whose initial maturity is greater than or equal to five years, with the application of a annual amortisation once the residual life of the instrument falls below five years. Early redemption of these instruments is permitted, with the approval of the Secrétariat Général de la Commission Bancaire. However, under no circumstances should a request for redemption be made before a period of five years has elapsed, unless the redeemed borrowings are replaced with capital of equal or better quality. Furthermore, redemption must not occasion payment of compensatory indemnification by the borrower. Subordinated debt that is convertible to or redeemable in shares or cash is treated as equivalent to shares or cash. For the rate of amortisation in the last five years of a subordinated debt instrument, two cases are possible. For instruments that are redeemed in full at maturity, the amortisation is set at 20% per year. For instruments that are redeemed on a predetermined annual schedule, the security or subordinated loan is broken down into as many pieces as there are redemption dates and a linear discount of 20% per year is applied to each piece. To illustrate the latter case, take the example of a subordinated loan in the amount of 1 MEUR with an initial maturity of 10 years and redemption of half the principal after 7 years. The amount included in capital is indicated in the diagram. In this example, at the end of six years the amount of the loan included in capital is 20% of 500,000 plus 80% of 500,000 = 0,5 MEUR. In other words, the discount is 50% in the seventh year. 12 See note at the bottom of the following page. 13
  • 14. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 The preceding limits on step-ups, which apply to perpetual hybrid capital instruments, are reduced in the case of term subordinated debt to 50 basis points per adjustment and per period of five years, without any option of combining two five-year periods. When the step-up is greater than 50 basis points, the date of the step-up is considered as the final maturity of the loan for purposes of calculating the discount. In addition, the yield must not be more than 250 basis points higher than the reference rate used. Capitalised interest on subordinated debt is eligible for inclusion in lower Tier 2 capital, provided that it has the same degree of subordination as principal on the debt and that the residual period of capitalisation is at least five years. Capitalised interest is subject to a prudential discount of 20% per year in the last four years of the period of capitalisation. All of the instruments in this category of subordinated debt may be included in capital only up to the limit of 50% of the amount of core capital. 2.3. Deduction of participations After applying the respective ceilings, the following investments in the capital (or its equivalent) of credit institutions or investment firms 13 must be deducted from total core capital and total supplementary capital : Loans made, and participating notes and subordinated debt issued by credit institutions 14 15, – or investment firms. – Shares, preference shares, and “parts sociales” issued by credit institutions or investment firms. – Deeply subordinated notes issued by credit institutions or investment firms. – Guarantees provided in securitisation transactions as defined in Regulation n°93-06 of the Comité de la Réglementation Bancaire (see Section 3.1.6.5). 2.4. Tier 3 capital Tier 3 capital consists of subordinated loans whose initial maturity is greater than two years, which do not carry guarantees, and which satisfy the following conditions : – the loan must be fully paid out, and the loan contract must provide that the loan cannot be redeemed before the agreed maturity without the approval of the Secrétariat Général de la Commission Bancaire ; – neither interest nor principal on these subordinated loans may be paid if it would result in the institution no longer satisfying its minimum capital requirement. 13 The deduction applies to all securities constituting capital (or equivalent) of credit institutions or investment firms, even when they carry a guarantee provided by a third party. (See Bulletin de la Commission Bancaire n° 9). 14 The amount of term subordinated debt to be deducted is calculated after applying the cumulative annual discount when the remaining maturity falls below five years. The amount corresponding to the discount must be recorded as exposures risk-weighted at 100% and included in the denominator of the ratio. 15 Including participating notes and subordinated debt issued and then repurchased by the institution. 14
  • 15. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 Upper Tier 2 capital that is above the ceiling applied in calculating capital requirements for credit risk is eligible without restriction for inclusion in Tier 3 capital. Lower Tier 2 capital that is above the ceiling applied in calculating capital requirements for credit risk is eligible only if it strictly satisfies the conditions stated above. Furthermore, the amortised portion of lower Tier 2 capital discounted its the last five years may not be included in Tier 3 capital. Tier 3 capital may be used to cover market risk within certain limits, as set forth in Part 5 of this Notice. 3. RISK WEIGHTING OF ASSETS AND OFF-BALANCE SHEET EXPOSURES The framework for measuring credit risk set forth in this section does not apply to debt and equity securities held in the trading book. It does apply to over-the-counter derivative instruments, temporary sales of securities and inter-bank transactions, even when they fall within the trading book for the calculation of market risk. 3.1. On-balance sheet exposures 3.1.1. EXPOSURES RISK-WEIGHTED AT 0% – Cash. – Claims 16 on central governments 17 and central banks of OECD Group countries 18, on the European Communities (ECSC, EC, EURATOM) and on the institutions by prescribed treaty (European Commission, ECJ). – Claims 17 on (or guaranteed directly by) central governments and central banks of countries that do not belong to the OECD Group, if denominated in their national currency and financed in the same currency. – Claims 17 guaranteed directly by (or collateralised by securities issued by) central governments or central banks of OECD Group countries or by the European communities, or guaranteed by public sector agencies authorised to give their guarantee 19. – Claims on Public Sector Entities (PSEs) which are not part of the central government but which are assigned a preferential risk weight of 0% by the supervisory authority of the country in which they are located, provided that the country belongs to the OECD Group 20. 16 Taking the form of loans or securities. For a given counterparty, the risk-weighting of off-balance sheet exposures is identical. 17 See Annex 10 for a list of French agencies treated as part of the central government or central bank. 18 See Annex 8 for the composition of the OECD Group. 19 See Annex 9 for a list of these agencies. 20 To preserve competitive equality and in accordance with the decision published by the Basel Committee on September 21, 2001, claims on these entities may henceforth be risk-weighted at 0% (or 10% in certain cases) if the entities are assigned 15
  • 16. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – Claims 17 collateralised by cash or certificates of deposit issued by and deposited at the lending bank. 3.1.2. EXPOSURES RISK-WEIGHTED AT 20% – Claims 17 on regional and local authorities of OECD Group countries 21, claims on institutions not of an industrial or commercial nature over which public authorities exercise control, either through capital holdings or through the nomination of managers, and claims on miscellaneous administrative bodies listed in Annex 12. – Claims 17 guaranteed directly by, or collateralised with securities issued by regional or local authorities of OECD Group countries 16. – Claims 17 on the multilateral development banks listed in Annex 13, and claims guaranteed directly by them or collateralised with securities issued by them. – Claims 17 on credit institutions 22 and investment firms 23 whose headquarters are located in an OECD Group country and on financial companies as that term is defined in Council Directive 92/30/CEE, including claims guaranteed directly by them but excluding claims collateralised by notes or zero-coupon bonds issued by them. – Claims 17 with a residual maturity of one year or less on credit institutions whose headquarters are located outside the OECD Group of countries, and claims guaranteed by such credit institutions. – Claims on 17 banking “economic interest groups” (groupes d’intérêts économiques - GIE) – or on structures considered by the Secrétariat Général de la Commission Bancaire to be that risk weight by the OECD authorities responsible their supervision. This rule extends the decision taken in July 2001 for the Province of Quebec to all member countries of the OECD. 21 Claims on or guaranteed by regional and local authorities of a member State of the European Economic Area (EEA) may be assigned a risk weight of 0% if that member State has authorised its credit institutions to apply a 0% risk weight to those claims. See Annex 11 for a list of regional and local authorities in EU countries that are risk-weighted at 0%. Note, however, that when the guarantee takes the form of collateralisation with securities issued by such authorities, the risk weight may not be lower than 20%. 22 For institutions having their headquarters outside France, “credit institution” means any institution whose usual business is carrying out banking transactions and which is subject to supervision by a bank regulatory agency. A list of credit institutions authorised in the European Union is published in the Official Journal of the European Communities (OJEC of December 20, 1999) 23 Claims on investment firms authorised by the competent authorities in a Member State of the European Union or in another State that is party to the Agreement on the European Economic Area are automatically risk-weighted at 20%. Claims on investment firms authorised by competent authorities in other States must satisfy certain conditions in order to qualify for a 20% risk weight. These conditions are as follows : – the legal status of the entity : the entity cannot be a holding company at the top of a group. This type of entity is risk-weighted at 100%, as are any of its subsidiaries that do not have the legal status of bank or broker-dealer, even when they can carry out activities resembling those of investment service providers ; – the activity of the entity : it must correspond to an activity of an investment service provider as defined in Directive 93/22/CEE dated May 10, 1993 (the Investment Services Directive) ; – the entity’s administrative authority : this authority, which can be either a bank supervisory agency or a market regulatory agency, gives an indication of the entity’s field of activity. 16
  • 17. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 equivalent – all of whose members are credit institutions, but excluding any GIE the object of which is to structure or grant loans 24. _ Securities issued by a land bank (société de crédit foncier) as that term is defined in Law n° 99-532 of June 25, 1999 on saving and financial security, and which qualify for the privilege defined in Article 98 of that law (securities referred to as obligations foncières); and securities issued by a credit institution having its headquarters in the European Economic Area and whose legal status is intended to protect the holders of securities equivalent to those referred to above (such as Pfandbriefe and Cedulas hipotecarias) – Assets in the course of collection 25. 3.1.3. EXPOSURES RISK-WEIGHTED AT 50% – Mortgage loans fully secured by residential real estate which is or will be occupied by the borrower or which is intended for rental, as well as mortgage loans that finance alterations or improvements to such properties. – Securities representing claims mentioned in the preceding paragraph, with the exception of portions that are guaranteed, which are assigned the risk weight of the guarantor, and “specific shares” in Fonds Communs de Créances, which are deducted from capital within the limits specified in Regulation n° 93-07. – Real estate leasing transactions. – Accrued interest and prepaid expenses where the counterparty cannot be identified. 3.1.4. EXPOSURES RISK-WEIGHTED AT 100% – Claims 17 on central governments and central banks of countries which do not belong to the OECD Group and which are not denominated and financed in the local currency. 17 – Claims on regional and local authorities of countries which do not belong to the OECD Group. – Claims 17 on credit institutions whose headquarters are located outside the OECD Group of countries with a residual maturity of more than one year. – Claims 17 on investment firms whose headquarters are located outside the OECD Group of countries. – Claims 17 on customers, including claims on insurance companies, firms not authorised as credit institutions but affiliated with credit institutions (or parents of credit institutions), and state-owned enterprises which are not assigned a more favourable risk weight in the preceding paragraphs. – The portion of holdings in capital (participating or subordinated loans and securities) of other credit institutions that is not deducted from capital. 24 In this case, the risk weight is 100%. 25 The net amount after deduction of corresponding liabilities. 17
  • 18. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – Fixed assets. – Real estate investments. – All other assets. 3.1.5. ON-BALANCE SHEET NETTING In accordance with the guiding principles established by the Basel Committee in April 1998, the Sevrétariat Gé,érale de la Commission Bancaire has decided to authorise the netting of certain balance sheet elements, subject to the following conditions : a. Institutions are authorised to net transactions covered by a novation agreement, under which all of the institution’s obligations to a counterparty in a given currency and on a given delivery date are integrated in a single net amount which substitutes contractually for the previous gross obligations. ; b. Institutions may also net transactions covered by legally valid bilateral netting agreements ; c. In both case a) and case b), the bank must demonstrate to its national supervisor that it possesses : – a netting contract or agreement with the counterparty covering all transactions, and giving the institution the right to receive or the obligation to pay only the overall net amount of the positive or negative market values of all the transactions covered in the event the counterparty defaults on payments for one of the following reasons : default or cessation of payments, initiation of legal reorganisation or liquidation procedures, or similar circumstances ; – well-founded written legal opinions indicating that, in case of legal challenge, the legal and administrative authorities involved will rule that the institution’s exposure is limited to the net amount under : the laws in force in the country where the counterparty is established, and, if a foreign branch of the counterparty is involved, the laws in the country where that branch is located ; the law governing the various transactions ; the law governing the netting contract or agreement ; – procedures to ensure that the legal framework governing the netting procedures will be reviewed for consistency with any changes in the applicable laws. Two points should be noted regarding the recognition of master agreements : – First, netting contracts that contain “walkaway clauses” are not recognised for prudential purposes ; – Second, in the absence of a common understanding from the Basel Committee on the application of the Accord to multi-branch netting agreements, it will be required : either that netting agreements be concluded only with countries that recognise the legal validity of netting, so that it is possible to report a net amount for all of the transactions covered by the agreement ; 18
  • 19. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 or, if the agreement covers a larger set of countries, either the institution must provide legal opinions which establish that the failure to execute the agreement in some countries will not jeopardise the netting of obligations for which prudential recognition of the net balance is required, or the agreement must contain a “severability clause” which permits the isolation of the transactions carried out in countries where the legal validity of netting is established (in which case the institutions must possess legal opinions guaranteeing that the existence of the severability clause does not jeopardise the validity of the netting agreement under the relevant laws). If these conditions are satisfied, institutions may report net balances with branches located in countries recognising the legal validity of netting and gross amounts with branches located in other countries ; d. the maturity of the liability must be equal to or greater than the maturity of the asset with which it is netted ; e. the positions must be denominated in the same currency ; f. the institution must have control systems permitting it to manage its risk exposure on a net basis. In particular, an institution wishing to net on-balance sheet items must be able to demonstrate that it manages its risk exposure on a net basis in a prudent manner and on an ongoing basis ; g. The institution must be able at any time to determine the gross amount its claims on and debts to each of the counterparties with which it has concluded a netting agreement ; h. the scope of on-balance sheet netting is limited to bilateral elements (loans and deposits). 3.1.6. ADDITIONAL DETAILS 3.1.6.1. Amount of claims to be taken into account The amount of claims to be taken into account is the principal plus interest accrued but not yet due, whether the claims take the form of inter-bank loans, loans to customers, or securities (balance adjusted for any premium or discount). 3.1.6.2. Amount of claims to be included in exposures The amount of claims to be included in exposures is the balance net of provisions. 3.1.6.3. Collateral The collateral must be legally valid and binding on third parties. In particular, the pledging of financial instruments provided for in the law on modernisation of financial activities of July 2, 1996 is recognised as collateral, it being understood that the substitution of risk weights is accepted only for claims collateralised by securities which are perfectly separable and which are accepted in reduction of the risk-weightings of the commitments which they cover (see preceding paragraphs). Collateral and equivalent guarantees are not recognised unless their maturity is at least equal to that of the assets which they cover when the latter have a residual maturity less than or equal to one year. If the residual maturity of the assets covered is greater than one year, and if the maturity of the collateral or equivalent guarantees is greater than one year but less than that of the assets covered, the beneficiary may transfer the risk to the guarantor : i.e. the risk-weighted exposure on the covered assets is calculated using the risk weight of the collateral or of the guarantor. In order to capture the future exposure that results from the disappearance of the collateral before the maturity of the covered items, the beneficiary must record an additional exposure equal to 50% of the risk-weighted exposure to the covered items. 19
  • 20. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 3.1.6.4. Guarantees In general, when a claim is guaranteed, the risk weight that applies to the guarantor, if more favourable, substitutes for that of the counterparty. To qualify for this treatment, the guarantee must be direct, unconditional, and legally certain. If the guarantee is partial, only the portion of the claim which is covered by the guarantee receives the reduced risk weight. When a guarantee takes the form of collateralisation with a zero-coupon security (excluding zero-coupons issued by credit institutions or customers), a fraction of the guaranteed claim corresponding to the market price of the security, or in the absence of a market price, its capitalised value, is risk-weighted at the rate corresponding to the issuer of the security. Guarantees are not recognised unless they cover a period at least equal to the maturity of the assets which they cover when the latter have a residual maturity less than or equal to one year. If the residual maturity of the assets covered is greater than one year, and if the term of the guarantee is greater than one year but less than that of the assets covered, the beneficiary may transfer the risk to the guarantor : i.e. the risk- weighted exposure on the covered assets is calculated using the risk weight of the guarantor. In order to capture the future exposure that results from the disappearance of the guarantee before the maturity of the covered items, the beneficiary must record an additional exposure equal to 50% of the risk- weighted exposure to the covered items. Claims which are guaranteed and for which the repayment risk on principal and interest are not the same 26 must be broken into a set of flows each of which presents a homogenous credit risk. Each set of homogenous flows is then valued at its financial contribution to the total amount of the claim – i.e. in proportion to its share of the net present value of the claim – and then risk-weighted according to the risk attached to it. The Secrétariat Général de la Commission Bancaire will set the conditions for application of these provisions as the need arises. 3.1.6.5. Securitisations The treatment of securitisation transactions is specified in Annex 18, which reproduces the provisions published in Bulletin n° 27 of the Commission Bancaire 27. It applies without prejudice of the accounting treatment required for these operations. Recourse clauses that engage the selling institution to take back claims before or after they reach their maturity (aside from cases of liquidation of a fund or a vehicle), whatever their nature – recourse obligations or rights, rights of pre-emption – are considered a form of credit enhancement. They oblige the selling institution to apply the prudential treatment defined in Annex 18, and also : - to record in its off-balance sheet positions any recourse “commitments,” including implicit recourse commitments (recourse rights or rights of pre-emption) ; - to publish, in an annex to its annual financial accounts, detailed information on the securitisation transaction, in accordance with the provisions of Regulation n° 93-06 of the Comité de la Réglementation Bancaire et Financière ; - to pass provisions, as needed and in accordance with Article 3 of Regulation n° 93-06, in the amount of the risk of default on the claims sold as valued at the end of each accounting period. 26 This is the case for transactions in which interest or coupons, but not principal, are indexed to a reference portfolio, or for securities for which only the payment of principal on the contractually agreed date is guaranteed (claims of a “composite” nature). 27 Bulletin n° 27 of the Commission Bancaire, November 2002 – New prudential provisions relating to securitisation transactions. 20
  • 21. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 In the expectation of the results of works led internationally on the prudential notion of “significant risk transfer”, the treatment of transactions specified in Annex 18 applies for all the positions held by a credit institution or an investment firm. Nevertheless, if the sum of these positions is higher than 8 % of the risk-weighted exposure on securitised exposures, the Secrétariat Général de la Commission Bancaire could require, for the purposes of the calculation of capital requirements, an appropriate prudential treatment in the case where the application of the 8 % cap could be misleading from the point of view of the objectives of prudential surveillance. Finally, a 0% credit conversion factor applies to liquidity facilities extended in the framework of securitisation transactions when the following conditions are satisfied : - the liquidity facility is protected from credit risk by a credit enhancement mechanism, and - the contractual maturity of the liquidity facility is less than or equal to one year, or the institution providing the liquidity facility can cancel it unconditionally, at any time and without notice. On the one hand, liquidity facilities which can be drawn in order to cover a credit risk, notably in the case of default of the selling institution, cannot receive a 0% credit conversion factor. In that veine, it should be noted that the « commingling » risk, defined as the risk, notably in the case of default of the selling institution, that cash flow payments could be freezed, must be viewed as a credit risk. Consequently, a 0% credit conversion factor cannot apply to liquidity facilities which are not protected from such a risk by a specific mechanism. On the other hand, the contractual maturity of a liquidity facility covered by a commitment for renewal for a fixed period is calculated from the date on which the commitment is signed. Liquidity facilities which provide credit enhancement must be treated in accordance with the provisions of Annex 18. Liquidity facilities which do not provide credit enhancement and which do not satisfy the conditions cited above receive a credit conversion factor of 50%. This prudential treatment shall be applied without prejudice of the accounting treatment applied to these liquidity facilities, including when the special purpose vehicles that are the beneficiaries of these liquidity facilities are consolidated according to accounting rules, by the credit institutions or the investment firms that have granted them to the SPVs. 3.1.6.6. Securities held as assets Securities held as assets are risk weighted according to their issuer. The risk weight is applied to the balance net of deliverables if the securities are the object of a forward sale on the monthly settlement market (this netting must be carried out security by security). Such netting does not extend to options covering spot positions in securities (in particular; securities covered by the sale of call options). 3.1.6.7. Shares in UCITs and ordinary shares in FCCs Shares in UCITs and ordinary shares in Fonds Communs de Créances (FCCs) may be assigned the risk weights corresponding to the nature of each asset held by such organisations, provided that the credit institution is able to establish the composition of the assets. However, the pledging of such shares as collateral does not reduce the risk weight of the assets covered by the collateral. 21
  • 22. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 3.1.6.8. Repurchase agreements : – securities received in repurchase agreements in the framework of a master agreement established under the auspices of the Banque de France are treated as guarantees. They valued at their market value and risk-weighted at the lower of the risk weight of the counterparty and the risk weight of the issuer of the securities. When the securities are not delivered, the risk weight of the counterparty applies ; – securities delivered in a repurchase agreement continue to be treated as exposures of the seller (and the applicable risk weight remains that of the issuer of the securities) ; – margin calls paid in the framework of the master agreement can take the form of supplementary remittance of cash, bills or securities. When these supplementary remittances are made in cash, they are recorded as miscellaneous receivables and risk weighted according to the nature of the counterparty. When the remittances are made in the form of bills or securities, they are recorded off-balance sheet as other values transferred in guarantee and are not counted as such in the calculation of risk-weighted exposures. However, the corresponding bills or securities continue to be risk-weighted according to the nature of the issuer of the securities. 3.1.6.9. Securities lending and borrowing : – Unsecured (“sec”) lending and borrowing of securities and “irregular” deposits of securities 28: for the lender, securities lent are risk-weighted by the higher of the rate that applies to the borrower and the rate for the issuer of the securities ; securities borrowed are not counted as exposures of the borrower. – Lending and borrowing of securities secured by cash : these transactions are treated in all respects like repurchase agreements (see above). – Lending and borrowing of securities secured by securities : for the lending institution, the securities 29 are risk weighted at the higher of : the risk weight of the issuer of the securities lent, • the lower of the risk weight of the borrower and the risk weight of the issuer of the • securities received in collateral, for the borrowing institution, the securities borrowed are not counted as exposures. The securities given in guarantee in the transaction continue to be risk-weighted according to the nature of the issuer of the securities, whether or not they are delivered, in accordance with the general provisions governing values given in guarantee. The Secrétariat Général de la Commission Bancaire will set the conditions for application of these provisions as the need arises. 28 Securities on deposit may be used by the borrowing institution, as long as the lender has not failed ; for example they may be sold or used to guarantee refinancing operations. 29 Whether the securities lent are held on the lender’s its own account or have previously been borrowed. 22
  • 23. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 3.1.6.10. Temporary sales of securities (repurchase agreements, securities lending and borrowing and securities received in repurchase agreements) : In place of the provisions set forth in Points 3.1.6.8 and 3.1.6.9, institutions may apply the regime set forth in Regulation n° 95-02, subject to the modifications given below : - For each temporary sale of assets, Regulation n° 95-02 defines the risk basis as the value of the items sold minus the value of the items received, multiplied by the risk weight that applies to the counterparty involved. - Accrued interest is included in the calculation of the market value of the amounts lent or borrowed and of the guarantee. Netting of these transactions is recognised subject to the conditions set forth in Point 3.1.5. - Institutions must adhere to the following rules : No credit is given for securities received if either of the following conditions applies : • the issuer of the securities is related to the counterparty, in the meaning of Article 3 of Regulation n° 93-05 ; • the securities are not delivered or the transaction does not receive an equivalent guarantee. In order to take account of the volatility of the net exposure to the counterparty, a flat- rate deduction of 5% is applied to the market value of the assets received, whatever their form (cash, government securities, or securities issued by other entities). This discount is applied to the position net of repurchase and reverse repurchase agreements for the same security. When an institution uses this method, it must also apply it to unsecured securities lending and to “irregular” deposits of securities. - By reference to the provisions of Article 3 of Regulation n° 89-07 and to Article 1 of Instruction n° 94-06, securities transferred with a guarantee against the risk of failure of the issuer 30 must be recorded as “shares received in repurchase agreements” and treated as temporary sales of securities. 3.1.6.11. Sales with repurchase option : – for the transferee, securities received in a sale with repurchase option referred to in Article 4-II of Regulation n° 89-07 are considered guarantees by the transferor. They are risk-weighted at the lower of the risk weight of the transferor and the risk weight of the issuer of the securities ; – for the transferor, the securities sold are recorded as off-balance sheet instruments with a credit conversion factor of 100% (see below). 30 The guarantee can take the form of a credit derivative instrument or an equity swap. 23
  • 24. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 3.1.6.12. Guarantee deposits and contributions to Clearnet’s clearing fund and to Euroclear France Guarantee deposits placed with clearing houses are risk-weighted at 20% if the clearing body is a credit institution, 0% if the commitments of the body are guaranteed by an entity which is itself risk-weighted at 0%, and 100% in all other cases. Contributions paid into the clearing fund of Clearnet and into the mutual fund to secure the system RVG2 Filière Révocable from Euroclear are risk-weighted at 20%. 3.1.6.13. Option premiums For option premiums purchased by the institution, two cases are distinguished : – for transactions which are not carried out on an organised exchange with daily margin adjustment, the underlying is included in the calculations for off-balance sheet financial instruments, and the premiums therefore are not counted as exposures ; – for instruments which are traded on an organised exchange, and whose underlying are not counted as off-balance sheet forward financial instruments, the purchased premiums are counted as exposures in the amount of the asset and risk-weighted according to the type of clearing house (see above) 3.1.6.14. Special cases The following risk weight applies to “carry-back” tax claims of businesses on the Public Treasury which are sold to a credit institution in a “Dailly” transaction : - 20% for commitments covered by a “Dailly” sale of the receivable from the Public Treasury, provided the Public Treasury has acknowledged receipt of the notification of the sale, and both the existence of the claim and the absence of potential adverse claims on the situation of the seller have been verified. The 20% risk weight is composed of a credit-risk equivalent of 20%, risk-weighted at 100%, on the seller ; plus a credit-risk equivalent of 80%, risk- weighted at 0%, on the State, - 0% for irrevocable off-balance sheet commitments of less than one year to purchase “carry- back” tax claims. If the credit is approved in advance, i.e. before the conditions mentioned above have been completely satisfied, a risk weight of 100% applies until the conditions have been fulfilled. 3.2. Off-balance sheet exposures Off-balance sheet exposures are converted into credit-risk equivalents ; the resulting amounts are then risk-weighted in the same way as on-balance sheet transactions, according to the type of counterparty or, in the case of certain transactions in securities, the type of issuer. The credit conversion factors applied to the nominal amounts of commitments are intended to reflect both the probability that a commitment will result in an on-balance sheet exposure and the estimated magnitude of the risk. Two fixed credit conversion factor values have been assigned to commitments that take the form of a line of credit or a revolving credit : 0% for commitments with an original maturity of less than one year or for commitments of any maturity which can be unconditionally cancelled at any time 24
  • 25. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 (or cancelled upon the expiration of a notice period that conforms strictly to legislation or banking practice relating to consumer protection) ; and 50% for all other commitments 31. The initial maturity – which determines the choice of credit conversion factor – should be evaluated in terms of the economic substance of the commitment and may therefore differ from the contractual maturity. In practice, this means that the factor of 50% should be applied in cases where the bank is committed to the beneficiary for a period of more than one year following the date that the facility is granted. A maximum risk weight of 50% applies to commitments which take the form of derivative instruments and which are made to counterparties who would normally be risk-weighted at 100%. 3.2.1. OFF-BALANCE SHEET EXPOSURES, EXCLUDING DERIVATIVE INSTRUMENTS 3.2.1.1. INSTRUMENTS FOR WHICH THE CREDIT CONVERSION FACTOR IS 100% – Financial guarantees (“financial standby letter of credit”). In particular, this category includes guarantees of payment or repayment. _ Counter-guarantees provided to credit institutions covering exposures to other credit institutions. – Guarantees of repayment to credit institutions by other credit institutions. – Acceptances and commitments to pay. – Uncancellable lines of credit which are certain to be drawn, and surety bonds serving as credit substitutes. – Substitution for a counterparty “decredere” (“ducroires”). – Securities due to the institution 32 33. – Temporary asset sales 27 in which the bank retains the credit risk (i.e. there is a strong probability that the selling bank will repurchase the asset 34). – Forward asset purchases and 27.28, and unpaid purchases of shares and other securities. 31 All “Note Issuance Facilitiesquot; and quot;Revolving Underwriting Facilitiesquot; are assigned a credit conversion factor of 50%. 32 These instruments must be risk-weighted according to the type of asset and not the nature of the counterparty i the transaction. 33 This includes in particular commitment, net of Cette rubrique comprend notamment les engagements, nets des rétrocessions, relatifs à des interventions à l'émission, garanties de prise ferme ou autres garanties de placement, ainsi que les achats sur les marchés à terme de valeurs mobilières jusqu'à la date de règlement des titres. 34 In particular, sales with repurchase rights referred to in Article 4-II of Regulation ° 89-07 (sales with repurchase option). 25
  • 26. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 3.2.1.2. INSTRUMENTS FOR WHICH THE CREDIT CONVERSION FACTOR IS 50% – First demand guarantees of a technical nature (“performance standby letter of credit”) including performance guarantees and guarantees of contract execution or completion, repayment of deposit, bids, or contract holdbacks. – Refinancing agreements and confirmed lines of credit with an initial maturity greater than one year. – Surety bonds, endorsements and other guarantees (other than first-demand guarantees and repayment guarantees), i.e. instruments that do not constitute direct credit substitutes), including in particular guarantees of repayment of deposits or financing of subcontractors. – Note Issuance Facilities and Revolving Underwriting Facilities. – Project finance commitments. – Lines of credit that can be drawn in several segments, if any of the segments is longer than one year; however, the segments may be considered separately if there is no possibility of transfer between them and if they serve distinct and independent purposes.. – Commitments of more than one year in an amount that varies seasonally (the credit conversion factor applies to the maximum amount of the commitment). – Commitments of indefinite maturity, or renewable commitments that the bank can cancel unconditionally at any time after a notice period (“evergreen” commitments). – Documentary lines of credit issued or confirmed by a credit institution, where the underlying goods do not serve as collateral. – Backup lines for commercial paper. – Guarantees provided by the presenting institution for the payment of cash compensation payable by the initiator in a purchase of securities as part of a takeover bid (“offre publique d’achat”) or exchange offer (“offre publique d’échange”). 3.2.1.3. INSTRUMENTS FOR WHICH THE CREDIT CONVERSION FACTOR IS 20% – Guarantees (other than on first demand) covering good execution of contracts, bids or contract holdbacks, taking the form of surety bonds. – Issued or confirmed documentary credits where the underlying merchandise serves as collateral. – Guarantees of administrative or tax obligations. – EC Surety bonds (“cautions communautaires”). – Commitments provided to UCITs to guarantee their capital or yield 35. 35 In accordance with Note n° 92-09 of the Secrétariat Général de la Commission Bancaire, these commitments are treated for accounting purposes as commitments to customers, in the amount specified in the contract, or the contract does not specifiy an amount, for the nominal value of the shares which are covered by the guarantee. In calculating the capital 26
  • 27. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – Surety bonds prescribed by laws governing financial guarantees required to practice certain professions, including in particular surety bonds covering the restoration of mine sites. – Guarantees covering financing of a takeover bid (“offre publique d’achat”). 3.2.1.4. INSTRUMENTS FOR WHICH THE CREDIT CONVERSION FACTOR IS 0% – Refinancing agreements and confirmed lines of credit with an initial maturity of one year or less. Commitments which can be cancelled unconditionally at any time and without notice 36. – – Commitments which can be renegotiated at the end of a period of at most one year, if the renegotiation procedure involves a complete new review of the financial structure of the beneficiary and if the bank has complete discretion not to renew the commitment. – Simple OPE tenders, provided that the commitment is included in the bank’s off-balance accounts and the bank can confirm the magnitude of its commitment Multi-optional financing facilities (MOFF) and other forms of composite financing must be split into their constituent components (lines of credit, NIF,...) and each component assigned a corresponding credit conversion factor. If the total value of the components exceeds the value of the facility, the components with the smallest credit conversion factors are ignored until the excess is eliminated. In the case of commitments to commit where the credit conversion factor of the second commitment depends on the maturity (for example, a commitment to extend a future credit line), the initial maturity is measured from the date that the first commitment is granted. If the first commitment is cancellable at any time, the credit conversion factor is 0%. In the case of commitments to commit where the credit conversion factor of the second commitment does not depend on the maturity (for example, a commitment to extend a future surety bond), the credit conversion factor is 0% if the maturity of the first commitment is less than or equal to one year or if the first commitment is cancellable at any time. Otherwise it is equal to the credit conversion factor of the second commitment. Lines of credit where the credit is for more than one year and the line must be drawn within one year at most are considered to have a maturity of one year at most, provided that at the end of that time the undrawn portion of the credit line is automatically cancelled. 3.2.2. OFF-BALANCE SHEET EXPOSURES IN THE FORM OF DERIVATIVE INSTRUMENTS. 3.2.2.1. MEASUREMENT OF GROSS EXPOSURE – The credit-risk equivalent of derivative instruments is calculated using the method of “mark to market.” ratio, a credit conversion factor of 20% is applied. Institutions may apply the principle of transparance to these transactions, i.e. they may apply the risk weights associated with the assets held by the UCIT. 36 This does not include lending that falls within the scope of application of Article L. 313-12 of the Code Monétaire et Financier. 27
  • 28. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – The calculation covers only over-the-counter derivative transactions; commitments involving exchange-traded derivatives are excluded. 37. Five broad categories of instruments are defined : interest rate, currency and gold, equity, precious metals (excluding gold), and commodities. Contracts which do not fall clearly into one of these categories are treated as commodities instruments. 3.2.2.1.1. TYPES OF TRANSACTIONS Interest-rate instruments means : • interest-rate swaps in the same currency ; • forward rate agreements (FRA) ; • interest-rate forwards ; • interest rate options (purchased contracts only) ; • other contracts of the same nature (caps, floors, collars,...). Currency and gold instruments means : • interest-rate and foreign-currency swaps ; • foreign exchange forwards ; • currency forwards ; • currency options (purchased contracts only) ; • other contracts of the same nature 38. Currency contracts with an initial maturity of 14 calendar days or less are exempted. This exemption does not apply, however, to gold contracts, which are subject to credit risk capital requirements whatever their initial maturity. Equity instruments means all forward and swap contracts, purchased options and similar derivative instruments based on shares or share indexes. Precious metal instruments means all forward and swap contracts, purchased options and similar derivative instruments based on metals other than gold, such as silver, platinum, palladium... Finally, commodities instruments means all forward and swap contracts, purchased options and similar derivative instruments whose underlying are contracts for energy products, agricultural products, non-ferrous metals (such as aluminium, copper and zinc), or other non-precious metals. 37 However, transactions carried out on markets treated as organised exchanges in accounting valuation (within the meaning of Regulation n° 88-02 of the CRB) are included. 38 Foreign exchange warrants are treated as foreign exchange options. Only purchased warrants are included, unless the transaction involves a bank repurchasing a warrant issued by the same bank. 28
  • 29. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 Credit derivative instruments, which are designed to buy or sell the credit risk of a reference asset, is accorded a conservative treatment. The institution selling protection records a credit risk on the reference asset; the exposure is treated as a direct credit substitute attracting a credit conversion factor of 100%, and risk-weighted according to the nature of the issuer of the reference asset. The buyer of protection also records a risk on the reference asset, but it is permitted to substitute the risk weight of the protection seller for the risk weight of the issuer. This treatment is subject to prudential conditions set forth in Annex 15. (The treatment of credit-linked notes is slightly different : see Annex 15.) 3.2.2.1.2. METHOD FOR MEASURING THE CREDIT-RISK EQUIVALENT (CURRENT EXPOSURE AND POTENTIAL FUTURE EXPOSURE) The credit-risk equivalent of derivative instruments is determined by taking the sum of : – the total replacement cost (valued at the market price 39) of all contracts that are in-the-money, – an add-on for the potential future exposure, calculated on the basis of the nominal amount recorded on the institution’s books 40 and multiplied by the following add-ons factors 41 42 which depend on the residual maturity and the type of contract. Precious metal Commodities Interest-rate Currency and Equity Residual maturity 43 contracts contracts contracts gold contracts contracts (excluding gold) Up to one year................. 0,0% 1,0% 6,0% 7,0% 10% More than one year and less than or equal to five 0,5% 5,0% 8,0% 7,0% 12,0% years More than five years ....... 1,5% 7,5% 10,0% 8,0% 15,0% For contracts that are not covered by a novation agreement or a netting agreement satisfying the conditions set forth in Point 3.2.2.2.1, the replacement cost is equal to the market value of the contract, if greater than zero. If the market value is less than zero, the replacement value is zero. However, the replacement cost of any exchange rate contracts whose initial maturity does not exceed 14 calendar days is zero. 39 For interest-rate and currency swaps, the market price is calculating using one of the methods referred to in Regulation n° 90-15 as amended by Regulation n° 92-04 (before adjusting the market value for counterparty risk.). 40 The add-on is calculated on the notional amount of all contracts, whatever their market value, i.e. whether they are in or out of the money. 41 Except for variable rate swaps in the same currency, for which credit risk is calculated exclusively on the basis of replacement cost without an add-on for potential future risk. 42 For contracts involving multiple exchanges of principal, the add-on factors are multiplied by the number of payments remaining to be made. 43 For contracts whose value is automatically reset to zero after a payment, the residual maturity is the interval between two such resettings to zero (with a minimum add-on of 0,5% for interest-rate contracts which have a residual maturity of more than one year). 29
  • 30. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 For contracts that are covered by the same novation agreement or netting agreement, which satisfies the conditions set forth in Point 3.2.2.2.1, the replacement cost is equal to the net of the market value of the individual contracts, if greater than zero. If the net of the market values is less than zero, the replacement value is zero. Purchased options and exchange rate contracts whose initial maturity does not exceed 14 calendar days are included in the netting calculation. 3.2.2.2. NETTING Under the terms of an Amendment to the 1988 Accord adopted by the Basel Committee in December 1994, netting of positions with the same counterparty, which previously was allowed only in the framework of a novation agreement, is extended to cover contracts negotiated within a master agreement that satisfies the conditions set forth in Article 33 of Law n°85-98 of January 25, 1985 as amended and Chapter III of Banking Law n°96-597 of July 2, 1996. Another amendment to the 1988 Accord, adopted by the Basel Committee in April 1995, permits the recognition of netting in the definition of add-on factors. 3.2.2.2.1. CONDITIONS FOR RECOGNITION OF NETTING a. Institutions are authorised to net transactions subject to novation, under which all of the institution’s obligations to a counterparty in a given currency and on a given delivery date are integrated in a single net amount which substitutes contractually for the previous gross obligations. ; b. Institutions may also net transactions covered by legally valid bilateral netting agreements ; c. In both case a) and case b), the bank must demonstrate to its national supervisor that it possesses : – a netting contract or agreement with the counterparty covering all transactions, and giving the institution the right to receive or the obligation to pay only the overall net amount of the positive or negative market values of all the transactions covered in the event the counterparty defaults on payments for one of the following reasons : default or cessation of payments, initiation of legal reorganisation or liquidation procedures, or similar circumstances ; – well-founded written legal opinions indicating that, in case of legal challenge, the legal and administrative authorities involved will rule that the institution’s exposure is limited to the net amount under : the laws in force in the country where the counterparty is established, and, if a foreign branch of the counterparty is involved, the legislation in the country where the branch is located ; the law governing the various transactions ; the law governing the netting contract or agreement ; – procedures to ensure that the legal framework governing the netting procedures will be reviewed for consistency with any changes in the governing laws. Two points should be noted regarding the recognition of master agreements : – First, netting contracts that contain “walkaway clauses” are not recognised ; 30
  • 31. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – Second, in the absence of a common understanding from the Basel Committee on the application of the Accord to multi-branch netting agreements, it will be required : either that netting agreements be concluded only with countries that recognise the legal validity of netting, so that it is possible to report a net amount for all of the transactions covered by the agreement ; or, if the agreement covers a larger set of countries, either the institutions must provide legal opinions which establish that the failure to execute the agreement in some countries will not jeopardise the netting of obligations for which prudential recognition of the net balance is required, or the agreement must contain a “severability clause” which permits the isolation of the transactions carried out in countries where the legal validity of netting is established (in which case the institutions must possess legal opinions guaranteeing that the existence of the severability clause does not jeopardise the validity of the netting agreement under the relevant laws). If these conditions are satisfied, institutions may report net balances with branches located in countries recognising the legal validity of netting and gross amounts with branches located in other countries ; 3.2.2.2.2. TREATMENT OF TRANSACTIONS COVERED BY A NETTING AGREEMENT. The following method can be used to calculate the potential future exposure of contracts which are covered by the same novation or netting agreement, providing the agreement satisfies the conditions set in Point 3.2.2.2.1 : – the first step is to calculate RNG, the ratio of the net replacement cost to the gross replacement cost : the numerator of this ratio is the net replacement cost of the contracts after netting or novation, calculated using the methods described above ; the denominator of the ratio is the gross replacement cost of the contracts before netting or novation, calculated using the methods described above. When the denominator is equal to zero, the ratio is set equal to zero. – the second step is to calculate PFR, the potential future risk of the contracts covered by the novation agreement or netting agreement. PFR is calculated by applying the following formula : PFR = (0,4 + 0,6 × RNG) × (sum of the risk-weighted nominal amounts as specified in Point 3.2.2.1.2) Alternatively, an institution may calculate a single RNG for all of the contracts covered by legally valid novation or netting agreements. In this case, the ratio is calculated as follows : – the numerator is the sum of the net replacement costs (as defined in this section) for each of the novation and netting agreements ; – the denominator is the sum of the gross replacement costs for all of the contracts. Institutions must notify the Secrétariat Général de la Commission Bancaire as to which method they use to calculate the RNG ratio ; this choice should be permanent. 31
  • 32. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 c. The sum of the replacement cost and the potential future exposure is risk-weighted according to the nature of the counterparties involved. The risk weight is capped at 50%. 3.2.2.3. ASSETS COLLATERALISING DERIVATIVE TRANSACTIONS a. Collateral taken in the form of cash, securities or deposits may be taken into account in calculating capital requirements for derivatives transactions, under the following conditions – the collateral must take one of the forms eligible for recognition as collateral for on-balance sheet exposures. These include : cash and term deposits (0%) but not demand deposits ; certificates of deposit or “bons de caisse” issued by the institution receiving the collateral (0%) ; securities issued by central governments and central banks of OECD Group countries or the European Communities (0%) ; securities issued by multilateral development banks or by regional or local authorities of OECD Group countries OCDE (20%) ; it should be recalled that shares in UCITs are not included in eligible collateral ; – the pledge of collateral must be legally valid and binding on third parties ; – in calculating the ratio, the market value of the assets pledged as collateral determines the portion of the credit-risk equivalent amount that benefits from the risk weight of the collateral. The rest of the credit-risk equivalent amount, which is not covered by the collateral, continues to receive the risk-weight of the counterparty. b. The posting of collateral at regular intervals in the context of a master netting agreement is recognised for prudential purposes under the following circumstances : – the collateral must be posted in cash ; – when the posting of collateral is not subject to a threshold, it may be treated as a resetting to market value of the derivative instruments covered by the collateral. The add-ons for potential future risk are calculated on basis of a reduced maturity (the period of time between two postings of margin) ; – when the posting of collateral is required only when a threshold exposure is exceeded, the exposure on a given counterparty is calculated using the following formula : Min (Max ((Threshold, Net liquidation value of the derivative instruments) + Potential future risk for the reduced maturity) ; (Net liquidation value of the derivative instruments + Potential future risk for the reduced maturity)) – the use of add-ons with reduced maturities is permitted only for derivatives based on currencies and gold, equity positions, precious metals and commodities. Interest-rate derivatives, for which the variability in value depends significantly on initial maturity, the add-on cannot be lower than 0.5% when the residual maturity is greater than one year. 32
  • 33. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 3.2.2.4. SPECIAL CASES : a. Swaps with a delayed start must be recorded and included in capital computations from the date the transaction is entered into. b. “Amortising swaps” and swaps whose notional amount varies over the course of the contract can be assigned add-on factors that correspond to either the maximum or the average notional amount over the period to maturity. c. “Multiplier swaps”, in which one of the interest streams is multiplied by a constant, is treated by applying the add-on factor to the notional amount multiplied by the constant. d. Synthetic interest-rate and exchange-rate instruments (“synthetic agreements for forward exchanges” or “SAFEs”) are treated as follows. Synthetic interest-rate instruments (“Exchange rate agreements” or “ERAs”) are treated like interest-rate contracts. Synthetic exchange-rate instruments (“Forward Exchange Agreements or “FXAs”) are also treated like interest-rate contracts unless their value at maturity differs by more than 10% from the value at the date the contract was signed. In that case, the smaller of the two values is treated in the same way as the notional amount in an interest-rate contract, and add-on factor for foreign exchange contracts is applied to the difference between the two values. 4. CAPITAL REQUIREMENTS FOR MARKET RISK Market risk is defined as the risk of loss on balance sheet and off-balance sheet positions arising from changes in market prices. Capital requirements for market risk apply on a consolidated basis in the same way as for credit risk. Banks can choose between two broad approaches for measuring their market risks, the standardised approach and the “internal models” approach. The choice of algorithms used in the first approach, or the choice of models used in the second approach, must be approved in advance by the Secrétariat Général de la Commission Bancaire. Institutions that are currently implementing or improving the models which they use for internal risk management models may, on an temporary basis, use a combination of the standardised method and their internal models to determine their market risk exposure. Similarly, institutions using the standardised approach may use different methods for the same risk category, particularly when the institution’s whose risk appears limited. However, the Secrétariat Général de la Commission Bancaire will pay particular attention to the continuity in the methods used, as well as to the institution’s progress towards more sophisticated approaches. Banks which use models for a single risk category are expected, with the passage of time, to encompass all of their transactions and to move towards a global model (i.e. one which covers all market risk categories). 33
  • 34. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 4.1. The standardised approach This approach consists of measuring risk in a standardised fashion, using the methods of calculation set forth in the annexes listed in the following table. The capital requirements calculated for each of the different risk categories are then summed arithmetically. RISK CATEGORY SCOPE OF APPLICATION RELEVANT ANNEXES INTEREST RATE RISK Trading book ANNEX 1, net positions general risk and specific risk ANNEX 2, interest rate risk EQUITY-POSITION RISK Trading book ANNEX 1, net positions general risk and specific risk ANNEX 3, equity-position risk FOREIGN EXCHANGE All transactions, whether in ANNEX 4 RISK the trading book or not COMMODITIES RISK All transactions, whether in ANNEX 5 the trading book or not OPTION RISK Options associated with each ANNEX 6 of the preceding risk categories 4.2. The internal models approach The “internal models” approach is presented in Annex 7. It permits banks to rely on measures of risk obtained from their own internal risk management models, provided they satisfy the qualitative and quantitative conditions set forth in this Annex. The use of the internal models approach is conditioned on satisfying certain conditions and is subject to the explicit approval of the Secrétariat Général de la Commission Bancaire; The capital requirement is equal to the higher of : i) the value-at-risk on the previous day, calculated using the parameters given in Annex 7, and ii) the average of the value-at-risk over the previous 60 working days, multiplied by a scaling factor. 5. METHODS FOR CALCULATING AND APPLYING THE RATIO 5.1. Minimum standards relating to the ratio and to capital The ratio is calculated on a consolidated basis. The consolidation of capital and of exposures is carried out according to the provisions of Regulation n° 85-12 of the Comité de la Réglementation Bancaire et Financière as amended by Regulations n° 90-06, n° 91-02, 94-03 and 96-06, and in conformance with Instruction n° 86-05 of the Commission Bancaire as amended by Instruction n° 91-06. The minimum standard is 8% of a risk base defined on the same scale as that of the preceding Basel ratio (risk-weighted credit-risk-equivalent). In order to calculate a composite ratio and provide consistency in the calculation of capital requirements for credit and market risks, an explicit arithmetic link is created by multiplying the measure of market risk by 12,5 (i.e. the inverse of the minimum capital ratio of 8%). 34
  • 35. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 Core capital must be at least equal to the sum of 50% of the total capital required for credit risk (the balance must be covered by supplementary capital) plus 2/7 (28,6%) of the risk base for market risk. 5.2. Denominator of the ratio The denominator of the ratio is the sum of the risk-weighted credit-risk equivalents as calculated in Section 3, and the market-risk equivalent, i.e. the capital requirement for market risk as calculated in sections 4.1 or 4.2 multiplied by 12.5. 5.3. Numerator of the ratio The capital ratio represents the cushion of capital available to cover an increase in risks, whether credit risk or market risk. The excess portion, if any, of eligible Tier 3 capital which is not allocated to covering market risk is expressed in terms of an excess Tier 3 capital ratio. The numerator of the instrument consists of core capital, eligible supplementary capital, and (if the institution has any Tier 3 capital at its disposal) any eligible Tier 3 capital allocated, along with supplementary capital, to cover market risk. Banks may use Tier 3 capital within the following limits : – Tier 3 capital (T3) covers only market risk as defined in Section 4. This means that all capital requirements for credit risk, including credit risk on derivative instruments in the trading and banking books, must be met with capital as defined in the 1988 Accord (i.e. core capital – T1 – and supplementary capital – T2 – ) ; – eligible Tier 3 capital (T3) is limited to 250% of residual core capital (T1r), i.e. core capital remaining available after coverage of credit risk. This means that at least 2/7 (or approximately 28.6%) of market risk must be covered by core capital which is not used to cover credit risk ; – Residual supplementary capital (T2r) can be substituted for Tier 3 capital (T3) within the same limit of 250%, to the extent that the overall limits established in the 1988 Accord are not exceeded : the amount of supplementary capital (T2) may not exceed the total amount of core capital (T1) and the amount of long-term subordinated debt may not exceed 50% of core capital (T1). 5.4. Rules of calculation Because the amount in excess of the capital ratio represents the cushion available to cover both credit and market risk, the amount of eligible Tier 3 capital which can be allocated to cover market risk is subject to the following constraints : – the total amount of core capital must be greater than or equal to the total amount of supplementary capital eligible for the capital ratio ; – the amount of eligible supplementary capital remaining available after allocation for credit market risk may not be greater than the amount of core capital that remains available after allocation for the same risks. The maximum amount of T3 which may be allocated to market risk is determined by optimisation, using the following steps : 35
  • 36. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – the allocation of core and supplementary capital (T1cr and T2cr) capital base for credit risk (CR 44) is carried out according to the following rules : T1cr ≥ 50% CR and T2cr = CR - T1cr ; – the allocation of core and supplementary capital (T1mr and T2mr) to market risk (MR) is carried out according to the following rules: T1mr ≥ 2/7 × MR and T2mr + eligible T3 allocated = MR - T1mr ; – the amount of eligible T3 allocated is capped so that at the end of the process the allocation of the amounts of T1 and T2 remaining available, T1d (= T1 - T1cr -T1mr) and T2d (=eligible T2 - T2cr - T2mr), obeys the rule : T1d ≥ T2d. 44 CR = 8% of the credit risk equivalent. 36
  • 37. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 The two ratios which credit institutions are required to calculate are determined in the following manner : – Basel capital ratio = Mis en forme : Anglais unallocated eligible T3 (Royaume-Uni) credit risk equivalent + market risk equivalent 45 – ratio of excess Tier 3 capital = Mis en forme : Anglais eligible T1 + T2 +allocated eligible T3 (Royaume-Uni) credit risk equivalent + market risk equivalent 45 Equivalent market risk EMR = 12,5 × market risk MR 37
  • 38. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 1 CALCULATING NET POSITIONS 1. PRINCIPLES46 The net position is the long balance (or net long position) or short balance (or net short position) of the transactions recorded by the institution in each of the securities in its trading book. In calculating its net positions, an institution may fully offset its long and short positions in: – equities from the same issuer, – loans to and debts from the same debtor with the same maturity and which are directly fungible under the terms of the documentation, – debt securities from the same issuer with the same maturity and which are directly fungible under the terms of the bond indenture, Net positions are converted daily into the reporting currency used for the returns, at the spot exchange rate. 2. INCLUSION OF FORWARD POSITIONS AND OPTIONS Forward positions and options evaluated using the methods described in Annex 6 may be converted into equivalent positions in the underlying instrument or into equivalent foreign exchange positions, subject to compliance with the provisions set forth below. 2.1. Interest-rate futures, forward rate agreements and forward commitments47 to buy or sell debt securities are treated as combinations of long and short positions: – a long position in interest-rate or foreign-exchange futures is treated as a combination of a loan maturing on the delivery date of the future contract and a long position in the instrument underlying the contract. – a forward interest-rate or foreign-exchange-rate contract is treated as a long position whose maturity is equal to the settlement date of the contract plus the period of the contract, 46 Net positions are calculated according to provisions similar to those prescribed in Annex I, paragraphs 1 through 6, of Regulation 95-02. However, there are differences in the computational methods used, in particular relating to the treatment of options and interest-rate swaps. 47 In particular, underwriting transactions. 38
  • 39. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 combined with a long position whose maturity is the same as the settlement date of the contract.. – a forward commitment to purchase a security is treated as the combination of a loan maturing on the delivery date of the contract and a long position in the security. 2.2. Temporary sales of securities associated with securities lending and borrowing and with repurchase agreements. These transactions do not affect the institution’s net position in the underlying securities. They may generate interest-rate risk when they are made for cash. In such cases they are considered as purchases coupled with sales at different value dates, and are treated according to the provisions of point 2.1. 2.3. For calculation of interest-rate risk as it is defined in Annex 2, swaps are treated on the same basis as instruments carried on the balance sheet. An interest-rate swap in which an institution receives a floating rate and pays a fixed rate is treated as a combination of a long position in a floating- rate instrument whose maturity is equivalent to the time until the next interest-rate fixing, and a short position in a fixed-rate instrument with the same maturity as the swap itself. When the floating rate causes more complex behaviour, the institution must break down the overall position into as many elementary positions as necessary or use a sensitivity algorithm. 2.4. Options and warrants on interest rates, debt securities, equities, financial futures, swaps and foreign currencies are treated as positions whose value is equal to the amount of the security underlying the option, multiplied by the delta. The positions so calculated may be netted against any offsetting positions in identical securities or derivatives, subject to the conditions specified in Annexes 2 and 3. The delta used is that of the exchange involved or, where that is not available or for options traded over-the-counter, the delta calculated by the institution itself, provided the institution uses a standard Cox, Ross, Rubinstein or Black and Scholes model or another comparable and equivalent model which is based on sufficiently conservative assumptions. In the latter case, the model must be communicated in advance to the Secrétariat Général de la Commission Bancaire, which can prohibit its use. Options are included in net positions up to the delta-equivalent of the underlying position, using the method for evaluating options chosen by the institution (see annex 6). 2.5. Stock-index futures and option on stock market indexes are treated as positions of equal value in the underlying portfolio, multiplied by the delta for the options. 2.6. Institutions may treat as fully offsetting any positions in interest-rate derivatives (forward rate agreements, (FRA, swaps, caps, floors, swaptions) which, at a minimum, satisfy the following conditions : – the positions have the same nominal value and are denominated in the same currency and relate to the same underlying ; – the reference rates for floating or adjustable rate positions are identical and the differential between coupons for fixed-rate positions is no greater than 15 basis points ; – the next interest-rate fixing date or, for fixed-coupon positions, the residual maturity satisfies the following conditions : less than one month : same day ; between one month and one year : within seven days ; over one year : within thirty days. 39
  • 40. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 3. SPECIAL CASES 3.1. Positions in certificates of securities on deposit (in particular, positions in American Depository Receipts - ADR) may be netted (without any capital requirement) against positions in the corresponding equities or against identical equities trading on different exchanges. 3.2. Hybrid instruments: when these instruments consist of several components, they are split into an interest-rate component and an equity component using appropriate methods. A convertible bond may be treated as a bond when the probability of conversion is very low, and as an equity when conversion is likely and would not involve any loss to the institution. 3.3. Positions in warrants are treated as equity call options. However, if the option can be exercised at any time during the subscription period, the exposure may be limited to the difference between the quoted price of the underlying action and the subscription price, taking into account the par value and, if applicable, the value of the coupon. For purchases, the exposure is limited in any event to the book value of the warrant. 3.4. Shares in collective investment undertakings can be treated in either of the following ways, at the option of the institution : a) by applying the principle of transparency : dividing the assets of the collective investment undertaking into as many individual positions as there are instruments held in the portfolio, and then adding each individual position to the institution’s net position in the corresponding instrument ; b) by treating the aggregate positions in units of undertakings for collective investment in transferable securities as if they were positions in equity or debt securities according to their investor information classification as defined by the Commission des Opérations de Bourse for purposes of informing investors. 3.5. Shares in UCITS that invest in assets other than stocks, bonds or other debt securities referred to in point 3.1 above are subject to capital charges for credit risk calculated using the methods of the 1988 Basel Accord (see section III). The same is true for shares in other undertakings for collective investment when the principle of transparency cannot be applied. 40
  • 41. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 2 INTEREST-RATE RISK 1. SPECIFIC RISK The capital requirement for specific interest-rate risk is intended to protect the institution against unfavourable movements in the price of a security stemming from deterioration in the credit quality of the issuer. The institution calculates its net position in each security or instrument in its trading book using the methods described in Annex 1, and assigns the following risk weights according to the nature of the securities held or underlying and their residual maturity : a) Zone A central governments and central bank securities and similar securities Securities assigned a 0% risk weight for purposes of point 3.1.1. of this Notice are assigned a 0% risk weight for purposes of specific risk. b) Eligible securities Eligible securities comprise : – Securities assigned a 20% risk weighting in Point 3.1.2. of this Notice ; – Securities that satisfy both of the following conditions: They are judged to be sufficiently liquid. They are debt instruments judged to be of good quality, either because they present a risk of default no greater than that of bank debt accepted for refinancing by the Banque de France, or because their debt category has recently been given a minimum rating by a recognised rating organisation 48. The following coefficients are assigned to these securities, according to their residual maturity : Mis en forme : Non souligné 48 Institutions should refer to points 1 and 2 of Annex VIII of Regulation n° 95-02. When the security is “composite” in nature, institutions should ensure that the rating reflects an assessment of the overall performance of the security and not just the credit quality of the issuer. If that is not possible, the security should be broken down into a set of cash flows as described in point 3.1.6.4. 41
  • 42. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – less than or equal to 6 months 0,25% – from 6 to 24 months 1,00% – over 24 months 1,60% c) Interest-rate UCITS Subject to application of the principle of transparency, institutions apply a requirement of 8% to positions in interest-rate UCITS. However, if 0% risk-weighted securities constitute more than 90% of the UCITS’s portfolio, the position receives a zero risk-weight. d) Other securities Other securities are risk-weighted at 100% e) Items for which there are no capital requirements related to specific risk There are no capital requirements relating to specific risk for the following items : – items deducted from capital ; – positions resulting from the breaking down of derivatives as described in point 2 of Annex I, provided that they are not covered by points a) through d) of this Annex ; – the following items : temporary sales of securities and forward exchange-rate transactions, when they are carried out with the objective of benefiting from favourable movements in interest rates, or when they hedge another item in the trading book. ; other funding transactions, when they hedge another item in the trading book. The capital requirement is equal to the sum of the risk-weighted position. 2. GENERAL RISK The capital requirement for general interest-rate risk is intended to protect the institution against the risk of loss resulting from unfavourable movements in market interest rates. Institutions may choose between two methods for calculating general risk : – Maturity method based on residual maturity – Duration method using a sensitivity algorithm The steps for each method are as follows : 42
  • 43. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 2.1. For each currency, calculate the capital requirement for the net positions defined in Annex 1 – calculation of the net position (long or short) in each instrument and each issuer, – slotting net positions into time bands according to their residual maturity (maturity method) or modified duration (duration method), – calculation of aggregate net long positions and aggregate net short positions in each time band, – weighting the net position in each time band by a factor designed to reflect its sensitivity to overall changes in interest rates, – calculation of total matched and total unmatched positions in each time band, – offsetting within zones, – offsetting between zones, – calculation of capital requirements. 2.2. For each currency, calculate the additional capital requirement for option risk using the methods of Annex 6 2.2.1. MATURITY METHOD 2.2.1.1. FIRST STEP : CALCULATION OF WEIGHTED NET POSITIONS – The institution slots its net position in each security or instrument, calculated using the methods of Annex 1, into the appropriate maturity band in the following table : 43
  • 44. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ZONE MATURITY BANDS WEIGHTING ASSUMED INTEREST RATE (%) CHANGE (%) Coupon of 3% or Coupon of less more than 3% (1) (2) (3) (4) (5) 0 ≤ 1 month 0 ≤ 1 month 0,00 1,00 >1 ≤ 3 months >1 ≤ 3 months One 0,20 1,00 >3 ≤ 6 months >3 ≤ 6 months 0,40 1,00 >6 ≤ 12 months >6 ≤ 12 months 0,70 1,00 >1 ≤ 2 years >1 ≤ 1,9 years 1,25 0,90 >2 ≤ 3 years >1,9 ≤ 2,8 years Two 1,75 0,80 >3 ≤ 4 years >2,8 ≤ 3,6 years 2,25 0,75 >4 ≤ 5 years >3,6 ≤ 4,3 years 2,75 0,75 >5 ≤ 7 years >4,3 ≤ 5,7 years 3,25 0,70 >7 ≤ 10 years >5,7 ≤ 7,3 years 3,75 0,65 >10 ≤ 15 years >7,3 ≤ 9,3 years Three 4,50 0,60 >15 ≤ 20 years >9,3 ≤ 10,6 years 5,25 0,60 >10,6 ≤ 12 years > 20 years 6,00 0,60 >12 ≤ 20 years 8,00 0,60 > 20 years 12,50 0,60 Fixed-rate securities are slotted into maturity bands on the basis of their residual maturity; other instruments are slotted on the basis of the time remaining until their next interest-rate fixing. A distinction is also drawn between instruments with a coupon of 3% or more and instruments with a coupon of less than 3% (see table above). – Each position is then multiplied by the weight indicated in column (4) for the corresponding maturity band. 44
  • 45. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 2.2.1.2. SECOND STEP : ALLOWANCE FOR OFFSETTING OF POSITIONS – Within maturity bands : weighted short positions and weighted long positions are offset to determine the matched weighted position. The short or long balance represents the unmatched weighted position for that band.. – Within zones : The institution calculates the sum of the unmatched weighted long positions in the time bands in each zone to obtain the unmatched weighted long position for that zone. Similarly, the unmatched weighted short positions of the time bands in each zone are summed to obtain the unmatched weighted short position for that zone. The portion of the unmatched weighted long position in a given zone which can be offset against the unmatched weighted short position in the same zone is the matched weighted position for that zone. The portion of the unmatched weighted long or short position that cannot be offset in this fashion (the long or short balance) is the unmatched weighted position for that zone. – Between zones : The institution calculates the amount of the unmatched weighted long (or short) position for zone 1 which can be offset against the unmatched weighted short (or long) position for zone 2. This yields the matched weighted position between zones 1 and 2. A similar calculation is carried out on the residual unmatched weighted position in zone 2 and the unmatched weighted position in zone 3, to yield the matched weighted position between zones 2 and 3. The order of offsetting between zones may be reversed, in which case the matched weighted position between zones 2 and 3 is calculated first and the matched weighted position between the residual matched weighted position in zone 2 and the unmatched weighted position in zone 1 is calculated second. The residual unmatched weighted position in zone 1 is then offset against the residual unmatched weighted position in zone 3 to yield the matched weighted position between zones 1 and 3. This process of offsetting between zones yields the final residual unmatched weighted positions (final positions). 2.2.1.3. THIRD STEP : CALCULATION OF THE CAPITAL REQUIREMENT The institution’s capital requirement is equal to the sum of the following items : – 10% of the sum of the matched weighted positions in all of the maturity bands ; – 40% of the matched weighted position in zone one ; – 30% of the matched weighted position in zone two ; – 30% of the matched weighted position in zone three ; 45
  • 46. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – 40% of the matched weighted position between zones one and two, and between zones two and three ; – 100% of the matched weighted position between zones one and three ; and – 100% of the final positions. 2.2.2. DURATION METHOD Institutions wishing to use this method must give prior notification of their intention to the Secrétariat Général de la Commission Bancaire, which may prohibit its use. Only institutions having the means to use it continuously may use this method. This method consists in calculating the modified duration of each debt security, then slotting the positions (weighted by their duration and by an assumed interest-rate change) into time bands, and finally offsetting weighted positions within time bands, within zones, and between different zones. The capital requirement is then calculated. 2.2.2.1. CALCULATION OF MODIFIED DURATION The institution takes the market value of each fixed-rate debt security and calculates its yield to maturity, which is the implicit discount rate for that security. In the case of variable-rate instruments, the institution takes the market value and calculates its yield on the assumption that the principle is due at the next interest-rate fixing. The institution then calculates the modified duration of each debt security using the following formula: 1 ∂P Modified duration = − P ∂r where r is the yield and P is the price of the debt security. 46
  • 47. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 2.2.2.2. CALCULATION OF WEIGHTED POSITIONS Each debt security is slotted into one of the time bands in the following table on the basis of its modified duration : Assumed interest-rate Zone Modified duration change (in months or years) (in percent) * (1) (2) (3) <= 1 month 1,0 >1 ≤ 3 months 1,0 One >3 ≤ 6 months 1,0 >6 ≤ 12 months 1,0 >1 ≤ 1,9 an 0,85 >1,9 ≤ 2,8 years Two 0,85 >2,8 ≤ 3,6 years 0,85 >3,6 ≤ 4,3 years 0,70 >4,3 ≤ 5,7 years 0,70 >5,7 ≤ 7,3 years 0,70 >7,3 ≤ 9,3 years 0,70 Three >9,3 ≤ 10,6 years 0,70 >10,6 ≤ 12 years 0,70 >12 ≤ 20 years 0,70 > 20 years 0,70 The weighted position in each time band is calculated by multiplying the market value of each instrument by its modified duration and by the assumed interest-rate change 49. 49 Offsetting between positions in derivative instruments that satisfy the conditions set forth in paragraph 2.6 of Annex 1 is permitted before calculating net positions 47
  • 48. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 2.2.2.3. ALLOWANCE FOR OFFSETTING OF POSITIONS The same method outlined for the maturity method is applied to the preceding table to obtain the matched and unmatched positions in each time band, in each zone, and between zones. 2.2.2.4. CALCULATION OF THE CAPITAL REQUIREMENT The institution’s capital requirement is equal to the sum of the following items : – 5% of the sum of the matched duration-weighted positions in all of the time bands ; – 40% of the matched duration-weighted position in zone one ; – 30% of the matched duration-weighted position in zone two ; – 30% of the matched duration-weighted position in zone three ; – 40% of the matched duration-weighted position between zones one and two and between zones two and three ; – 100% of the matched duration-weighted position between zones one and three ; – 100% of the residual unmatched duration-weighted positions. 2.2.3. USE OF A SENSITIVITY ALGORITHM Institutions may use discounted cash-flow valuation techniques to calculate directly, by maturity band, the sensitivity of interest-rate and interest-rate hedging instruments. The algorithm used by the institution must be disclosed in advance to the Secrétariat Général de la Commission Bancaire, which can prohibit its use. Sensitivity must be assessed relative to independent fluctuations in a range of rates across the yield curve, and must include at least one sensitivity point for each of the time bands in the table in paragraph 2.2.2.2. Institutions using this method compute a sensitivity factor for each category of instruments in each time band. This sensitivity factor is weighted by the corresponding assumed interest-rate change. Previously matched weighted sensitivities may be entered directly within the same time band if they are derived from instruments valued using the same yield curve; for this purpose, any bond is considered to be valued on its own unique yield curve. Offsetting is carried out using the same methods as those used in the duration method. 48
  • 49. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 3 EQUITY-POSITION RISK The capital requirement for equity-position risk is the sum of a requirement for general risk associated with the variability in the price of an equity due to overall market trends, and a requirement for specific risk attributable to factors that are specific to the security or issuer concerned. 1 – GENERAL RISK To determine the risk base, the institution calculates the sum of its net long positions and the sum of its net short positions in each equity security (in accordance with the methods described in Annex 1). The difference between these two amounts represents the overall net position. The overall net position is calculated for each national market in which the bank holds equities. The capital requirement for general risk is the sum of the overall net positions (by national market) multiplied by 8%. 2 - SPECIFIC RISK The capital requirement for specific risk is calculated by applying a coefficient to each net position. The value of the coefficient depends on the liquidity and diversification of the position. For positions in equity securities, the coefficient is 8%. However, institutions may apply a reduced coefficient of 4% if the position is part of a diversified portfolio and the two following conditions are satisfied : – no individual position represents more than 5% of the value of the institution's overall equity portfolio. This limit may be raised to 10% if the total of the positions involved does not exceed 50% of the total equity portfolio ; – the equity is judged very liquid by the competent authorities of the principal market in which it is traded. A list of the stocks satisfying this condition is published by the Secrétariat Général of the Commission Bancaire and is reproduced in Annex 14. A coefficient of 2% is applied to positions on broadly diversified stock market indexes which are traded on a regulated or recognised market. (A list of the market indexes considered broadly diversified is provided in Annex 14.) Positions on sectoral indexes or on insufficiently diversified indexes are assigned a coefficient of 4%. When the institution takes opposite positions on the same index for different dates or on different exchanges, the 2% requirement applies only to one position, the opposing position being exempted. The capital requirement for specific risk is equal to the sum of the positions weighted by their coefficients. 49
  • 50. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 3. ARBITRAGE BETWEEN SPOT AND FORWARD POSITIONS In the context of a deliberate strategy of arbitrage between spot and forward positions, or when a forward instrument on a broadly diversified stock market index hedges a basket of stocks, the institution may remove the entire set of positions from the standardised approach if : – the transaction is undertaken specifically for the purpose of arbitrage and is managed separately ; – the composition of the basket represents at least 90% of the index, when broken down into its notional components. In this case the capital requirement is 4% (i.e. 2% of the gross value of each leg). This rule applies even when the basket of stocks perfectly matches the index in composition and proportions. Any excess in the value of the basket of stocks relative to the value of the forward instrument, or vice versa, must be treated as an open long or short position and treated according to the general rules. 50
  • 51. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 4 FOREIGN EXCHANGE RISK 1. CALCULATING THE OVERALL NET POSITION The overall net position in foreign currencies is calculated in two stages. 1.1. Stage one The institution calculates its net open position in each currency, including the euro. The position is the algebraic sum of the positive and negative items listed below. 1.1.1. ITEMS INCLUDED – the net spot position, i.e. total assets minus total liabilities, including accrued interest not yet due denominated in the currency in question. Currency purchases or sales where the parties do not defer settlement or defer it only by a customary delivery period are considered to be spot foreign-exchange transactions ; – the net interest payable or receivable not yet accrued but already fully hedged ; – at the discretion of the institution and with the prior approval of the Secrétariat Général de la Commission Bancaire, other net future income and expenses fully hedged by forward foreign- exchange transactions ; – the net forward position, i.e. all amounts to be received less all amounts to be paid in forward foreign-exchange transactions. Currency purchases and sales where the parties defer settlement for reasons other than a customary delivery period are considered to be forward foreign-exchange transactions ; – the net delta (or delta-based) equivalent of the total currency-option book. Such positions may be netted against opposite positions in identical currencies. If the delta used is not calculated by a market authority, the calculation method chosen must be communicated in advance to the Secrétariat Général de la Commission Bancaire, which may prohibit its use. Provisions that are allocated to the coverage of assets or off-balance sheet items and that are constituted in currencies other than those of the assets or off-balance sheet items covered must be : – included in the calculation of the position in the currency in which the claim is denominated ; – and excluded from the position in the currency in which the provision is constituted. The net position in a currency is described as a net long position when the assets exceed the liabilities and as a net short position when the liabilities exceed the assets. 51
  • 52. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 1.1.2 – ITEMS EXCLUDED – transactions whose foreign-exchange risk is borne by the central government ; – the Secrétariat Général de la Commission Bancaire may grant an institution's request to exclude long-term structural assets (equity participations in affiliates and subsidiaries, tangible and intangible fixed assets, etc.) 50, which are financed in a currency other than the currency in which they are denominated. Any change in the terms of exclusion of these categories of transactions requires the prior approval of the General Secretariat of the Commission Bancaire. 1.1.3 – USE OF PRESENT VALUE Present value may be used to calculate the net open position in each currency, provided that the method used is deemed satisfactory by the General Secretariat of the Commission Bancaire, in particular regarding the interest rates used in the discounting calculations. 1.1.4 GOLD POSITION The gold position is calculated separately. 1.2. Stage 2 The overall net foreign exchange position is calculated for each institution included in the consolidation and, for each institution, balanced in the relevant currency such that the sum of long positions equals the sum of short positions. The consolidated overall net position is obtained by consolidating the individual positions calculated in this way. 2. CALCULATING CAPITAL REQUIREMENTS Each position is converted to the bank’s reporting currency using the spot exchange rate. The equivalent value of the foreign exchange position (the sum of the equivalent values of the long and short positions, excluding gold) gives rise to a capital requirement equal to 8% of the amount of the position. The position in gold also gives rise to a capital requirement equal to 8% of its amount. 50 Of course, equity securities cannot be included in the structural position; they must be included in the calculation of the foreign exchange position. The same holds for “TIAPs”. 52
  • 53. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 5 COMMODITIES RISK 1. CALCULATING POSITIONS 1.1. General Rules Positions in commodities are calculated as follows : – positions in the same commodity are netted. Positions in different commodities may not be offset against each other. However, with the prior approval of the Secrétariat Générale de la Commission Bancaire, positions in sub-categories 51 of the same commodity may be offset if they are substitutable for each other and if the institution can clearly demonstrate a 0.9 correlation in their prices over a period of one year ; – spot and forward positions are expressed in standard units of measurement (barrels, kilograms, etc.) and converted at the spot price for the product, then into the national currency using the spot exchange rate. These positions are entered in a maturity table, a model of which is given below ; – all derivative instruments and other positions whose value is affected by changes in the price of commodities must be included in the measurement system ; – options may be excluded from the commodities position along with the underlying hedges, and subjected to a special treatment (scenario analysis or simplified approach : see Annex 6). 1.2. Special rules for derivative products – financial futures and commodities futures must be included in the measurement system as notional amounts expressed in standard units and must be assigned a maturity corresponding to the expiry date. For markets with daily delivery dates, positions in contracts maturing with an interval of less than 10 days may be netted before being entered in the table ; – commodity swaps where one leg is at a fixed price and the other is at the current market price must be included as a set of positions equal to the notional amount, with one position for each payment in the corresponding band of the table. Positions will be long if the institution pays a fixed price and receives a floating price and short in the opposite case ; 51 Commodities may be classified in categories, groups, subgroups, or as individual products. One can have, for example, the category of energy products, of which one group would be hydrocarbons, oil being a subgroup, consisting of individual products such as West Texas Intermediate, Arabian Light and Brent. 53
  • 54. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – commodity swaps whose legs involve different products must be entered in each of the corresponding tables ; – options are entered as delta equivalents. 1.3. Financing positions Positions that relate purely to inventory financing (where a physical inventory is sold forward and the financing cost is frozen until the sale) may be excluded from the table. They give rise to a capital requirement for interest-rate risk calculated in accordance with the methods described in Annex II. 1.4. Maturity table and spread rates Maturity band Spread rate 0-1 month 1,5% 1-3 months 1,5% 3-6 months 1,5% 6-12 months 1,5% 1-2 years 1,5% 2-3 years 1,5% > 3 years 1,5% 2. CALCULATING CAPITAL REQUIREMENTS 2.1. Maturity table method Positions in individual commodities are entered in a maturity table, with spot positions entered in the first band. A specific table is used for each commodity, and capital requirements are calculated product by product, as follows : The institution nets long and short positions within each band, and a capital charge is calculated equal to the overall net position (short or long) multiplied by the spread rate associated with that band. 52. In the following step, the residual net position is successively carried over to the next higher band and offset, where applicable, against opposite positions by applying the spread rate coefficient. Each time a position is carried over to the next higher maturity band, a capital surcharge equal to 0.6% of the amount carried over is applied. 52 Interest-rate curvature/spread risk. 54
  • 55. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 These successive carryovers determine the net position, which is subject to a capital requirement equal to 15% o its amount. 53 2.2. Simplified method Institutions may opt for the simplified method of calculating the capital requirement. It is equal to 15% of the net position in each commodity plus 3% of the gross position (sum of long and short positions). 53 Directional risk. 55
  • 56. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 6 OPTION RISK Institutions may choose between three different methods to calculate capital requirements for their options portfolios : – the delta-plus method, – scenario analysis, – the simplified method (available only in certain cases). 1. DELTA PLUS METHOD Institutions convert their options into equivalent positions in the underlying and include them in the net positions as described in Point 2.4 of Annex 1. Capital requirements for general risk and, where relevant, specific risk are calculated on these net positions in accordance with Annexes 2 through 5 (interest rate risk, equity risk, foreign exchange risk, and commodities risk) The delta plus method imposes additional capital requirements to cover the risk associated with the non-linear behaviour of options (quot;gamma riskquot;) and the sensitivity of options to the volatility of the underlying (quot;vega riskquot;). Gamma and vega factors are calculated for each individual option and aggregated by underlying. The following should be treated as separate individual underlyings : – for equity securities and stock-market indexes, each national market, – for interest-rate instruments, each maturity band as defined in Annex 2, – for currencies and gold, each pair of currencies and gold, – for commodities, the position in each individual product. a. Gamma is defined as the second derivative of the value of the option in relation to the underlying. Gamma risk is calculated using the following formula : Gamma risk = 1/2 x gamma x (variation in the underlying)2 The variation in the underlying is determined in the same way as in calculating general risk, namely : – for options on equity securities and stock-market indexes, it is equal to 8% of the market value of the underlying ; 56
  • 57. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – for options on interest-rate instruments, institutions may calculate the gamma either directly in relation to the underlying interest rate or in relation to the market value of the underlying. In the first case, the variation of the underlying is the assumed interest-rate change as defined in Annex 2. In the second case, the variation of the underlying is calculated as follows : value of the position x modified duration x interest rate change (see Annex 2) ; – for foreign exchange and gold options, the variation of the underlying is equal to 8% of the exchange rate for the currency pair concerned, or of the price of gold ; – for commodities, the variation of the underlying is equal to 15% of the market value of the commodity concerned. Each option on the same underlying will have either a positive or a negative impact on gamma. These individual impacts are summed, yielding a net impact on gamma for each underlying which may be positive or a negative. Only negative net impacts on gamma are included in the calculation of capital requirements. b. Vega is the derivative of the option price in relation to the implied volatility of the underlying. Vega risk is given by the formula : Vega risk = vega x (relative change in volatility) For all categories of risk, the change in relative value is equal to 25% of the implied volatility of the options. c. The overall additional capital requirement for option risk (general risk) is the sum of the absolute values for : – Vega risk, – and negative net gamma risks. 2. SCENARIO ANALYSIS a. Specific risk is calculated on net positions as defined in Annex 1 (including the delta equivalent of options). b. In calculating general market risk, institutions may apply quot;scenario-matrixquot; algorithms to their options portfolios and associated hedges. In this case the options and their hedges are dissociated from the net positions calculated in Annexes 1, 4 and 5. The choice of algorithm must be communicated in advance to the Secrétariat Générale de la Commission Bancaire, which may prohibit its use. Algorithms must be based on the following principles : A different matrix must be constructed for each category of instrument, namely : – a separate matrix for each national market, for risk on equity securities and stock-market indexes ; – a matrix for each currency pair and one for gold, for foreign-exchange risk ; 57
  • 58. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – a matrix for each currency and for each group of maturity bands (at least six groups), for interest-rate risk. A group of bands consists of at most three consecutive bands as defined in Annex 2 ; – a matrix for each commodity, for commodity risk. The rows of the matrices represent variations in the value of the underlying (solely with respect to general risk) and must satisfy the following conditions : – the range of variation is ± 8% for equity securities and stock-market indexes ; – the range of variation is ± 8% for currency pairs and gold ; – the range of variation in interest rates for a group of maturity bands is equal to the largest assumed interest-rate change within the group in question ; – the range of variation in price is ± 15% for commodities ; – for all categories of risk, each band is divided into at least seven observations at identical intervals, including the current observation (for example, for commodities : - 15%, - 10%, - 5%, 0%, + 5%, + 10%, + 15%). The columns of the matrix represent the relative variations in the volatility of the rate or price of the underlying. A minimum variation of ± 25% is required. In each cell of the matrix, the portfolio is revalued in response to changes in the underlying and its volatility. Each cell contains the net gain or loss in the value of the options and any associated hedges; the cell containing the largest loss determines the portfolio capital requirement for the underlying associated with that matrix. 3. SIMPLIFIED METHOD Banks that handle a limited range of purchased options only may use the simplified approach described below for specific combinations. If the portfolio consists of a long position on a call or put option, the capital requirement is the smaller of the following two amounts : – the sum of the general risk and the specific risk (if any) calculated on the underlying ; – the value of the option; for items that are not marked to market (such as certain foreign- exchange options), the book value may be used. If the portfolio consists of : – a long spot position coupled with a long put position in one-to-one proportions, – or a short spot position coupled with a long call position in one-to-one proportions, the capital requirement is equal to the sum of the capital requirements for general risk and specific risk (if any) calculated on the spot position, less the amount the intrinsic value of the option (if any), with a minimum of zero. The intrinsic value is the difference : – for a call, between the market value of the underlying and the strike price, 58
  • 59. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – for a put, between the strike price and the market value of the underlying. 59
  • 60. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 7 USE OF INTERNAL MODELS IN CALCULATING CAPITAL REQUIREMENTS 1. PRINCIPLES The use of internal models to calculate own funds requirements is subject to the prior approval of the Commission Bancaire, which will be subject to compliance with the following minimum conditions : a) The institution's risk management system must be based on sound principles and must be implemented with integrity ; b) The institution must have a sufficient number of qualified staff to apply the models not only to trading but also to risk monitoring, internal control and post-marketing ; c) The institution's models must have been be demonstrated to measure risk with a reasonable degree of accuracy ; d) The institution must regularly carry out stress testing as set forth below. In addition to these general standards, institutions using their own internal models to calculate capital requirements are subject to the requirements described in this Annex. 2. QUALITATIVE CRITERIA Institutions using models must have market risk management systems that are based on sound principles and implemented with integrity, put into practice in compliance with the qualitative criteria set forth below. 2.1. The extent of compliance with these criteria may determine the level of the scaling factor used in calculating capital requirements as set forth at Point 9.2 of this Annex. 2.2. At a minimum, the qualitative criteria should include the following elements : a) The institution should have an independent risk control unit that is responsible for the design and implementation of the institution’s risk management system. The unit should produce and analyse daily reports on the output of the models, including an evaluation of the use of trading limits. This unit must be independent from trading units and should report directly to the institution's executive body as defined in Article 4 of Regulation 97-02 of February 21, 1997. 60
  • 61. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 b) The decision-making body as defined in Article 4 of Regulation 97-02 of February 21, 1997 and the executive body should be actively involved in the risk control process and must regard risk control as an essential aspect of the institution's activity. c) The daily reports prepared by the independent risk control unit must be reviewed by members of the executive body having sufficient seniority and authority to order, if necessary, a reduction of positions taken by individual traders or a reduction of the institution's overall risk exposure. d) The institution's internal risk measurement models must be closely integrated into the day-to- day risk management process and its output should be an integral part of the process of planning, monitoring and controlling the institution’s market risk profile. e) The risk measurement system should be used in conjunction with operational limits which are consistent with risk modelling and which are well understood by both traders and senior management f) A routine and rigorous programme of stress testing should be in place to supplement the risk analysis based on day-to-day output of the institution’s risk measurement model. The results of stress testing should be reviewed by the executive body and should be reflected in the risk policies and limits provided for in Title V of Regulation n° 97-02 of February 21, 1997. When stress tests reveal particular vulnerability to a given set of circumstances, prompt steps should be taken to reduce those risks. g) Institutions should have a routine in place for ensuring compliance with internal rules and procedures concerning the operation of the risk measurement system. The system must be well documented, with the documentation describing the basic principles of the risk management system and the empirical techniques used to measure market risk. h) An independent review of the risk measurement system should be carried out regularly within the framework of the institution’s own internal auditing system. This review should include both the activities of the business trading units and of the independent risk control unit. A review of the overall risk management process should take place at regular intervals (at least once a year) and should address, at a minimum : – the adequacy of the documentation of the risk management system and process ; – the organisation of the risk control unit ; – the integration of market risk measures into daily risk management ; – the approval process for risk pricing models and valuation systems ; – the validation of any significant change in the risk measurement process ; – the scope of market risks captured by the risk measurement model ; – the integrity of the management information system and the reports provided to senior management ; – the accuracy and completeness of position data ; – the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources ; 61
  • 62. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – the accuracy and appropriateness of volatility and correlation assumptions ; – the accuracy of position valuations and risk sensitivity calculations ; – the verification of the model’s accuracy through a system of back-testing that satisfies the conditions set forth in Point 8 of this Annex. i) the adequacy and degree of sophistication of the modelling technique for each market, taking into account the type and level of the institution’s involvement in that market. 3. SPECIFICATION OF MARKET RISK FACTORS Risk factors, i.e. the principal market parameters changes in which are deemed by the institution to be most likely to affect the value of its trading positions, should be chosen in a manner that reflects its level of activity in the various markets. Institutions must meet the following minimum conditions: a) for interest-rates, there must be a set of risk factors corresponding to interest rates in each currency in which the institution has interest-rate-sensitive on- or off-balance sheet positions : – the risk assessment system should model the yield curve using one of a number of generally accepted approaches. The yield curve should be divided into various maturity bands in order to capture variation in the volatility of rates across the entire range of maturities; there will typically be one risk factor for each band. For material exposures to interest rate movements in the major currencies and markets, banks must model the yield curve using a minimum of six risk factors, – the risk assessment system must incorporate separate factors to capture spread risk (i.e. the risk associated with rate differentials between types of instrument and/or categories of issuer) ; b) for exchange rates (including gold), the risk measurement system should incorporate risk factors corresponding to the individual foreign currencies in which the institution's positions are denominated ; c) for equity prices, there should be risk factors corresponding to each of the equity markets in which the institution holds significant positions. At a minimum, there should be a risk factor that is designed to capture market-wide movements in equity prices (i.e. a market index). A more detailed approach is to have risk factors corresponding to various sectors of the overall equity market. The most comprehensive approach is be to have risk factors corresponding to the volatility of individual equity issues. d) for commodity prices, there should be risk factors corresponding to each of the commodity markets in which the institution holds significant positions : – In cases where the aggregate positions are quite small, it might be acceptable to use a single risk factor for a relatively broad sub-category of commodities (for instance, a single risk factor for all types of oil) , – for more active trading, the model must also take account of differences in quality for the same commodity and differences in maturities. In addition, account should be taken of the difference the holding yield between positions in derivatives, especially futures and swaps, and spot positions ; and of market characteristics, especially delivery dates and the possibilities available to traders for unwinding their positions. ; 62
  • 63. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 e) for options, the measurement system must include a set of risk factors that takes account of the volatility of the rate or price of the underlying. Institutions that hold large portfolios and/or complex options must use volatilities differentiated by maturity and, where relevant, by strike price 4. TREATMENT OF SPECIFIC RISK The Commission Bancaire may authorise an institution to use an internal model to measure specific risk if the model meets the following conditions : a) it can explain, ex ante, historical variation in the value of the portfolio ; b) it has demonstrated its sensitivity to the risk of concentration in the composition of the portfolio ; c) it remains operationally reliable in an adverse environment ; d) the quality of its performance is borne out by back-testing. 5. QUANTITATIVE CRITERIA The following principles must be respected : a) “value-at-risk” is computed on a daily basis ; b) a 99th percentile, one-tailed confidence interval is used ; c) an instantaneous price shock equivalent to 10-day movement in prices is used, corresponding to a ten-working-day holding period. Institutions may use value-at-risk numbers calculated on the basis of a shorter period and scaled up by the square root of the ratio of durations in order to obtain a figure for ten working days ; d) the observation period (historical sample) for calculating value-at-risk is at least one year ; e) institutions must update their data sets at least quarterly, and more frequently if there is a notable increase in observed price volatility ; f) institutions may recognise empirical correlations between all risk factors provided that the system for assessing them is reliable and is applied with integrity and that the estimates are of satisfactory quality ; g) the institution’s models must accurately capture the unique risks associated with the non-linear nature of the price of options or similar positions. 6. STRESS TESTING 6.1. Institutions that use internal models to satisfy market risk capital requirements must have in place a rigorous and comprehensive programme of stress testing. Stress testing, which permits the identification of events that could have a considerable impact, must be adapted to institutions' level of activity and risk. 63
  • 64. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 6.2. At institutions that have a significant amount of market activity, stress tests must respect the following principles: a) they must cover the entire range of factors that can generate extraordinary losses or gains, or make the control of risk in those portfolios very difficult. These factors include low- probability events in all major categories of risk, including the various components of market and credit risk. Stress scenarios need to shed light on the impact of such events on positions having both linear and non-linear price characteristics (i.e. options and instruments that have option-like characteristics) ; b) stress tests must be both quantitative and qualitative, incorporating both market risk and liquidity aspects of market disturbances. They must identify plausible situations liable to generate large potential losses. In addition, institutions must draw up a list of measures to be taken in order to reduce their exposure and preserve their capital ; c) one type of scenario involves testing the current portfolio against past situations of significant disturbance, incorporating both the large price movements and the sharp reduction in liquidity associated with these events. A second type of scenario evaluates the sensitivity of the institution’s market risk exposure to changes in the assumptions about volatilities and correlations. Applying this test requires an evaluation of the historical range of variation for volatilities and correlations and evaluation of the institution’s current positions against the extreme values of the historical range ; d) scenarios must include situations that institutions identify as being the most unfavourable on the basis of the characteristics of their portfolio. They are required to provide the Commission Bancaire with a description of the methodology used to identify the scenarios and measure their impact. 6.3. Apart from the simulations carried out by institutions themselves, the Commission Bancaire may ask institutions to assess the impact of scenarios that it has defined and to report all findings. 7. COMBINED USE OF INTERNAL MODELS AND THE STANDARDISED APPROACH In calculating their capital requirements, institutions may be authorised to use their internal model in place of the method set forth in Annexes II, III, V, V-1 and V-2 to this Regulation, or in combination with it. 7.1. Unless its exposure to a particular risk factor is insignificant, an institution having a significant amount of market activity must have an integrated risk measurement system that captures all of the broad risk factor categories (i.e. interest rates, exchange rates, equity and commodity prices, with related options volatilities being included in each risk factor category). 7.2. However, the Commission Bancaire may authorise the use of models for just one or several categories of risk factor subject, subject to the following conditions : a) the partial model satisfies all of the criteria set forth in this Annex ; b) the institution may not return risks covered by the partial model to the standardised approach, unless the Commission Bancaire withdraws its authorisation to use internal models. 64
  • 65. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 8. BACK-TESTING Institutions must carry out back-testing designed to ensure that the observed extent of coverage corresponds to the 99% one-tailed confidence level. Back-testing should be carried out on the basis of both real or hypothetical results. Where possible, these two methods, which provide complementary information, should be implemented jointly : a) Real results compare the value-at-risk calculated by the model over a one-day holding period on the basis of end-of-day positions each working day, with the actual change over one day in the value of the portfolio, ascertained at the end of the following working day ; b) Hypothetical results compare the value-at-risk with the difference between the end-of-day value of the portfolio and the value of the same portfolio, with positions unchanged, at the end of the following day. Back-testing should be carried out and exceptions (days when the observed loss exceeds the value at risk calculated by the model) analysed at least quarterly. Institutions must use data for the previous 250 working days for this purpose. 9. CALCULATING CAPITAL REQUIREMENTS 9.1. If an internal model is used in combination with the standardised approach, the institution obtains its overall capital requirement by simple addition of the capital requirements calculated using each approach. 9.2. For the risks covered by the internal model, the institution is subject to a capital requirement equal to the greater of the following two amounts : a) the total value-at-risk for the previous day, calculated according to this Annex ; b) the average of daily measurements of the total value-at-risk over the previous sixty working days, multiplied by a scaling factor. The scaling factor is assigned to each institution by the Commission Bancaire according to the quality of its risk management system. The minimum value is 3; an additional factor between 0 and 1 is added according to the number of exceptions generated by back-testing, as set forth in the following table : Number of exceptions Increase in scaling factor less than 5 0 5 0,4 6 0,5 7 0,65 65
  • 66. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 8 0,75 9 0,85 10 or more 1 If the number of exceptions indicates that the model is not sufficiently accurate, the Commission Bancaire may withdraw its authorisation to use the model for calculating capital requirements or require the institution to take appropriate measures to ensure that the model is promptly improved. In order that the Commission Bancaire may constantly ensure that the assigned scaling factors are appropriate, institutions must inform the Secrétariat Général de la Commission Bancaire promptly, and in all cases within five working days, of exceptions revealed by their back-testing programme which, according to the table above, would imply an increase in the scaling factor. 9.3. If an institution is authorised by the Commission Bancaire to use an internal model in calculating its capital requirement for specific risk, the institution must increase its capital requirement, in accordance the provisions of Point 9.2 above, – either by the amount of the fraction of the total value-at-risk of the institution's overall trading book corresponding to specific risk, – or by the total value-at-risk of the sub-portfolios of debt and equity securities that contain specific risk. In this case, the sub-portfolios must be clearly identified from the outset and the Commission Bancaire must give its approval to any significant subsequent changes. Back-testing to verify that specific risk is properly taken into account may be carried out on only those sub-portfolios that contain specific risk. Exceptions must be analysed regularly so that corrective measures can be taken promptly when the number of exceptions leads to the statistical conclusion that the model's measurement of specific risk is not sufficiently accurate. Failing that, the institution should calculate the capital requirement for specific risk using the standardised approach, in the same way as if the model did not cover that risk. The Commission Bancaire may exempt an institution from the increase in the scaling factor described above if the institution can show that its model also takes proper account of circumstantial risk and issuer default risk in its debt security and equity trading books. If an institution does not use an internal model for specific risk, or if its model is not recognised by the Commission Bancaire, it must use the standardised approach to calculate its capital requirement for specific risk. 66
  • 67. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 8 LIST OF OECD GROUP COUNTRIES By virtue of the December 1984 decision of the Basel Committee, countries which are members of the OECD, or which have concluded special lending arrangements with the IMF associated with the Fund’s General Arrangements to Borrow, benefit from preferential risk weights, provided that they have not restructured their external sovereign debt within the past five years. The list of countries qualifying is the following : 1. OECD countries • Australia • Luxembourg • Austria • Mexico • Belgium • Netherlands • Canada • New Zealand • Czech Republic • Norway • Denmark • Poland • Finland • Portugal • France • Slovak Republic • Germany • Spain • Greece • South Korea • Hungary • Sweden • Iceland • Switzerland • Ireland • Turkey • Italy • United Kingdom • Japan • United States 2. Countries other than OECD members that have concluded special lending arrangements with the IMF associated with the Fund’s General Arrangements to Borrow : • Saudi Arabia 67
  • 68. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 9 LIST OF PUBLIC-SECTOR GUARANTEE AGENCIES AND PUBLIC-SECTOR EXPORT- INSURANCE AGENCIES LOCATED IN OECD GROUP COUNTRIES Claims guaranteed by French public-sector guarantee agencies are risk-weighted at 0% when they act on behalf of the central government. Similarly, claims guaranteed by public-sector export insurance agencies located in countries in the Group of Ten benefit from a risk weight of 0% if they are operating and under the supervision and with the guarantee of the central government. In the case of some agencies, the guarantee of the central government may cover only certain contracts (for example, only long-term contracts) or certain risks (for example, only political risk). In such cases, only the portion of the contract that is covered by the guarantee receives the 0% risk weight. 1. LIST OF FRENCH PUBLIC-SECTOR AGENCIES AUTHORISED TO GIVE GUARANTEES – Compagnie Française d'Assurance pour le Commerce Extérieur (COFACE) – Office National Interprofessionnel des Céréales (ONIC) – Fonds d'Intervention et de Régularisation du Marché du Sucre (FIRS) – Office National Interprofessionnel des Vins (ONIVINS) – Office National Interprofessionnel des Plantes à Parfum, Aromatiques et Médicinales (ONIPPAM) – Office National Interprofessionnel des Fruits, des Légumes et de l'Horticulture (ONIFLHOR) – Office National Interprofessionnel du Lait et des Produits Laitiers (ONILAIT) – Office National Interprofessionnel des Viandes, de l'Elevage et de l'Aviculture (ONIVAL) – Société “ Interlait ” – Société Interprofessionnelle des Oléagineux (SIDO) – Office National Interprofessionnel des produits de la Mer et de l’aquacultutre (ONIMER) 68
  • 69. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 9 2. LIST OF PUBLIC-SECTOR EXPORT INSURANCE AGENCIES IN OECD GROUP COUNTRIES – Australia : Export Insurance and Finance Corporation (EFIC) – Austria : Österreichische Kontrolbank Aktiengesellschaft (OKB) – Belgium : Office national ducroire – Canada : Export Development Corporation – Czech Republique: Exportni Garantni Pojistovaci Spolecnost AS (EGAP) – Denmark : Eksportkreditfonden (EKF) – Finland : Vlationtakuukeskus (FGB) – France : COFACE – Germany : Hermes Kredit Versicherungs AG – Greece : ECIO – Hungary : Magyar Exporthitel Biztosito Rt. (MEHIB) – Ireland : Export Credit Division – Italy : Sace – Japan : Eximbank Central Government Insurance Local Government Insurance – Luxembourg : Office ducroire du Luxembourg – Netherlands : Nederlandische Credietverzekering Maatschappij - NCM – Norway : Garanti-Instituttet for Eksportkredit (GIEK) – Poland : Korporajca Ubezpieczén Kredytow (KUKE SA) – Portugal : COSEC – Spain : Compania Espanola de Seguros de Credito a la Exportacion (CESCE) – Sweden : EKN – Switzerland : Export Riko Garantie - ERG – United Kingdom : Export Credits Guarantee Department - EGCD 69
  • 70. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – United States : Eximbank Foreign Credit Insurance Association (FCIA) 70
  • 71. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 10 LIST OF FRENCH AGENCIES TREATED AS PART OF THE CENTRAL GOVERNMENT OR CENTRAL BANK THE FOLLOWING ARE TREATED AS PART OF THE CENTRAL GOVERNMENT OR CENTRAL BANK : – Caisse des Dépôts et Consignations – Caisse Nationale d'Epargne – Caisse Nationale de l'Industrie – Caisse Nationale des Banques – Caisse Nationale des Télécommunications – IEDOM – TPGs – CCPs – CNRS (Centre National de la Recherche Scientifique) – CNRA (Centre National de la Recherche Agronomique) – CEA (Commissariat à l'Energie Atomique) – CNOUSS and CROUSS (Centre National / Régional des Œuvres Universitaires et Scolaires) – DRASS and DDASS (Directions Régionales / Départementales des Affaires Sanitaires et Sociales) – FSGT (Fonds Spécial de Grands Travaux) – FIS (Fonds d'Intervention Sidérurgique) – EPFR (Etablissement Public de Financement et de Restructuration) – Assistance Publique de Paris and hospitals belonging to it 71
  • 72. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – Assistance Publique de Marseille – Hospices Civils de Lyon – Public health establishments (hospital centres, including regional hospital centres) – Private non-profit establishments eligible to participate in the administration of public hospital services, including the Centres de Lutte Contre le Cancer – Caisse Centrale de la Mutualité Sociale Agricole (excluding the Caisses Départementales, which are risk-weighted at 20%) – CDR (Consortium de Réalisation) – Guarantee agencies covered by Annex III of Commission Bancaire Instruction n° 91-02 (COFACE, ONIC, FIRS, ONIVINS, ONIPPAM, ONIFLHOR, ONILAIT, ONIVAL, Société Interlait, SIDO, FIOM) - GNIS (groupement national interprofessionnel des semences, graines et plants) – the French Antarctic Territories – GIE MDII – INED – ONF (Office National des Forêts) as well as the set of public bodies of an industrial or commercial nature which do not have direct or indirect ownership interests in commercial firms. – Higher education institutions (Grandes Écoles) incorporated in the form of an institution of public administration, including : Ecole Polytechnique, Ecole Centrale, Ecole Nationale d'Administration, Ecole Nationale Supérieure des Mines de Paris. – Public institutions of a scientific, cultural, or professional nature listed in decree n° 2000- 250 dated March 15, 2000. – Fondation nationale des sciences politiques – Institut Catholique de Lille – Public institutions of an administrative nature figuring on the list of Organismes Divers d’Administration Centrale in the government accounting. – Claims on Social Security organisms (ACOSS, UNEDIC, URSSAF, CNRACL, including CADES and ASSEDIC) are also risk-weighted at 0%, with the exception of claims on regional (CRAM), departmental (CPAM, CAF) and municipal depending on social insurance, which are risk-weighted at 20%. - Agence France Trésor (French treasury agency) - AFPA (Association nationale pour la Formation Professionnelle des Adultes) - la Caisse de garantie du logement locatif social 72
  • 73. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 A list of miscellaneous central government agencies is published by INSEE. In addition, institutions may request risk weights for agencies not listed in this Notice from the Secrétariat Général de la Commission Bancaire, which will respond on a case-by-case basis. 73
  • 74. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 11 REGIONAL AND LOCAL AUTHORITIES RISK- WEIGHTED AT 0% 1. Countries of the European Union Claims on or guaranteed by regional or local authorities of Member States of the European Economic Area which have authorised their credit institutions to apply a risk weight of 0% may be assigned a risk weight of 0%. However, when the guarantee takes the form of collateralisation with securities issued by such authorities, the risk weighting may not be lower than 20%. For purposes of calculating international capital ratios, the 0% risk weight may be applied to claims listed below on regional or local authorities of Member States of the European Union, in accordance with decisions issued by those Member States : Austria : −claims on Länder and Gemeinden (municipalities) Belgique : −claims on Regions (Région de Bruxelles-Capitale, Région flamande and Région wallonne) and Communities (Communauté flamande, Communauté française and Communauté germanophone) Danemark : − claims on all regional and local authorities Germany : −claims on Länder (States), Gemeinden (communes) and Gemeindeverbände (local authorities) Finland : − claims on Gemeinden (municipalities), Kommunen (communes) et the Province of Aland (“ Provinz Aland ”) Luxembourg : − claims on communes 74
  • 75. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 Netherlands : − claims on all regional and local authorities Spain : − debt securities issued by the Comunidades autonomas (Communautés autonomes) with the authorisation of the State as well as those issued by Spanish communes. Sweden : − claims on Sveriges kommuner (communes), Kommunalförbund (unions of communes), sveriges Landsting (large communes) et instituts (institutes) 2. Non-EU countries : - claims on canadian provinces and territories 75
  • 76. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 12 LIST OF MISCELLANEOUS LOCAL FRENCH ADMINISTRATIVE BODIES RISK WEIGHTED AT 20% – Services départementaux de secours et de protection contre l'incendie (departmental rescue services and fire departments) – Caisses des écoles (school funds) – Centre de formation des personnels communaux (training centre for community staff) – Enseignement secondaire du deuxième cycle – lycées (upper secondary schools) – Enseignement secondaire du premier cycle – collèges (lower secondary schools) – Bureaux d'aides sociale (social service bureaus) – ODAL “Action sociale” (social action agencies) – ODAL “Crèches” (child-care centres) – Agence foncière et technique de la région parisienne (Paris regional and technical development agency) – Etablissement public foncier de la métropole lorraine (Lorraine urban development board) – Etablissement public foncier du Nord-Pas de Calais (North Pas de Calais development board) – Etablissement public foncier de l’Ouest Rhône-Alpes (West Rhone Alps development board) – Etablissements publics d'aménagement des villes nouvelles (development boards of new towns) – Institut d'aménagement et d'urbanisme de la région Ile-de-France (Ile de France regional urban development board) – Office de transports de la région Corse (Corse regional transport office) – Etablissement public d'aménagement de la Défense (Défense development board) – Etablissement public d'aménagement de Seine Arche de Nanterre (Seine-Arch of Nanterre development board) 76
  • 77. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – Syndicat des transports d’Ile-de-France (Ile-de-France transport union) – Agence d'urbanisme (urban development agency) – Agences des espaces verts de la région Ile-de-France (Ile de France park authority) – Agences financières de bassin (financial bureaus of the basin) – Etablissement de la Basse-Seine (Basse-Seine institution) – Centres régionaux de propriété forestière (regional forestry centres) – Sociétés d'aménagement foncier et d'établissements rural (SAFER) (rural development associations) – Chambres d'agriculture (agricultural associations) – Chambres de commerce et d'industrie (chambers of commerce and industry) – Chambres des métiers (trade associations) – CNFFPT (Centre National de Formation de la Fonction Publique Territoriale) (national public service training center) – OPHLM (Office Public des Habitations à Loyer Modéré) (low-income housing agency) – Régie des Transports de Marseille (Marseilles transport corporation) OTHER FRENCH AGENCIES RISK WEIGHTED AT 20% – Caisse Nationale des Autoroutes (national highway fund) – Caisse Nationale de l'Energie (national eneragy fund) – Ports autonomes (autonomous ports) – Réseau Ferré de France (French railroad system) – AFCI (Assemblée des Chambres Françaises de Commerce et d’Industrie) (assembly of French chambres of commerce and industry) – AMUES (Agence pour la Modernisation des Universités et des Etablissements de l’Enseignement Supérieur) (Agency for the modernisation of universities and higher education establishments) 77
  • 78. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – ARTE (Association Relative à la Télévision Européenne) (European Television Association) 78
  • 79. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 13 LIST OF MULTILATERAL DEVELOPMENT BANKS RISK WEIGHTED AT 20% – European Investment Bank (EIB) – International Bank for Reconstruction and Development (IBRD, “World Bank”) – International Finance Corporation – Inter-American Development Bank – Inter-American Investment Corporation – African Development Bank – Asian Development Bank – Council of Europe Development Bank (formerly the Council of Europe Social Development Bank, and before that, the Council of Europe Resettlement Fund) – Nordic Investment Bank – Caribbean Development Bank – European Bank for Reconstruction and Development (EBRD) – European Investment Fund (EIF) - Multilateral Investment Guarantee Agency (MIGA) 79
  • 80. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 14 LIST OF STOCKS CONSIDERED SUFFICIENTLY LIQUID The stocks making up the following indexes are considered sufficiently liquid : CAC 40 SBF 120 (top 80) AEX 25 (Netherlands) ASX 100 (top 20) (Australia) BEL 20 (Belgium) DAX (Germany) FTSE 100 (Great Britain) Nikkei 225 (top 100) (Japan) SP 100 (United States) TSE 35 (Canada) 80
  • 81. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 14 (continued) LIST OF INDEXES JUDGED BROADLY DIVERSIFIED CAC 40 SBF 120 SBF 250 MIDCAC Second Marché AEX 25 (Netherlands) ASX 100 (Australia) ATX (Austria) BEL 20 (Belgium) DAX (Germany) FTSE 100 (Great Britain) FTSE mid 250 (Great Britain) IBEX 35 (Spain) Nikkei 225 (Japan) OMX (Sweden) SP 100 (United States) SP 500 (United States) SMI (Switzerland) TSE 35 (Canada) 81
  • 82. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 15 PRUDENTIAL TREATMENT OF CREDIT DERIVATIVES For the purpose of this Annex, credit derivatives are : - instruments (swaps or options) that serve to buy or sell the credit risk inherent in debt securities or other assets (“reference assets”) in return for interest payments or a premium. These instruments generally provide for payment, by means of physical settlement or cash settlement, in the event of occurrence of a “credit event” defined in the contract ; - debt securities indexed to a reference asset (“credit-linked notes”) : debt securities for which the reimbursement of principal and interest is a function of whether the reference asset experiences a credit event defined in the contract. This Annex treats three topics : - the criteria for classification in the trading book or the banking book ; - the treatment in the banking book ; - the treatment in the trading book. 1. CRITERIA FOR CLASSIFICATION OF CREDIT DERIVATIVES IN THE TRADING BOOK OR THE BANKING BOOK Regardless of whether an instrument is booked in the trading book or the banking book, the guarantee represented by the instrument is not recognised unless the seller of protection is not linked directly or indirectly to the underlying reference asset. 1.1. Classification in the trading book In order to be booked in the trading book, credit derivative instruments must have been negotiated either for trading purposes or for the purpose of hedging other items in the trading book. They must be freely marketable without any restrictive clauses, or be hedgeable. In addition, the Secrétariat Général de la Commission Bancaire can prohibit the booking of credit derivatives in the trading book if the institution does not possess the means and the experience necessary to manage them actively, or does not have adequate internal systems and controls. 82
  • 83. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 In order to be eligible for the trading book, all of the following conditions must satisfied : - the institution must have a clearly documented trading strategy for credit derivatives which has been approved by senior management ; - there must be clearly defined procedures including, in particular, a system of limits and daily tracking of their observance ; - a daily, conservative valuation must be carried out, either at market prices or with reference to a model that has been validated by the internal risk monitoring division and that has not been objected to by the institution’s internal or external auditors ; - an active monitoring of positions must be carried out, including in particular an evaluation of the quality and availability of market data used in the valuation process, the volume of transactions, and the size of the positions traded ; - the institution must have in place a system of reporting to senior management as part of its global monitoring of the management of risks arising from the institution’s trading activities ; - the valuations at market prices or with reference to a model must take into account liquidity risk and modelling risk, using a methodology that has been approved by senior management and that is consistent with point 3.3 of this Annex. Marketability implies, in addition to the absence of restrictive clauses : - daily valuation at market prices or market value – selling price / buying price – obtained from independent sources on the basis of a significant volume of transactions in terms of the total volume of outstanding balances; - a security issued by the reference issuer has been rated recently by a recognised, independent rating. The marketability of the reference asset creates a presumption in favour of the marketability of the credit derivative. Hedging intent is evidenced by the taking of a position in credit derivatives which totally or partially offsets the risk factors of another position in the trading book. 1.2 Classification in the banking book Credit derivative instruments which do not satisfy all of the conditions set in 1.1 of this Annex must be classified in the banking book. 2. TREATMENT OF CREDIT DERIVATIVES IN THE BANKING BOOK 2.1. Treatment of risk for the seller of protection The guarantor records the credit risk as a direct risk (credit substitute) on the reference instrument in the transaction. 83
  • 84. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 The treatment of ‘first loss’ derivatives on a basket of assets, and, more generally, of CDO- type structures, is analogous to the treatment of sellers in derivative transactions (deduction from capital). The treatment of ‘second loss’ derivatives is determined on a case-by-case basis. The treatment of ‘first to default’ derivatives on a basket of assets is based on the principle of summing the risk-weighted exposures for each of the assets making up the basket. However, these instruments can be risk weighted at 200% of the notional amount when the number of assets making up the basket, the maturity of the products, and the ratings assigned to the underlying assets, are such as to limit the risk within acceptable bounds. 54 In the case of CLNs (credit-linked notes), the seller of protection assumes credit risk on both the issuer of the note and the reference entity. The treatment of CLNs for the seller of protection is therefore based on summing the risk-weighted exposure on the reference asset and the risk-weighted exposure on the security issued. If the reference asset is a subordinated banking credit, its amount is deducted from the capital of the subscriber. Guarantees that apply ‘prorata temporis’ are initially valued on the basis of their present value. 2.2. Treatment of risk for the buyer of protection The treatment of the buyer of protection permits a reduction in capital charges for assets that are covered by protection, under the following conditions : In all cases, recognition is limited to guarantees provided by : – French credit institutions and foreign credit institutions which are regulated in an identical manner to banks ; – Investment firms which are licensed in France and which are authorised to do so under conditions defined by the Comité de la Réglementation Bancaire et Financière ; – Investment firms having their headquarters in another member State of the European Economic Area, under terms governing their activities in France. and for which : – the unconditionality of the guarantee is ensured by the terms of the contract or the master agreement governing the transaction. The guarantee must be the subject of a separate contract or a separate clause within a standard master agreement ; – the legal validity is assured, in particular regarding legal challenge by third parties ; 54 Specifically, the maximum number of assets making up the basket must be calibrated such that the equivalent rating for the protection instrument (determined in accordance with tables of historical cumulative default rates published by recognised rating agencies) is no lower than BBB-. In making that determination, the cumulative default rate of the protection instrument is calculated by summing the cumulative default rates of each of the assets in the basket. The calibration must satisfy the following conditions : the time horizon used to measure default rates must be no shorter than the maturity of the protection instrument, the ratings of the underlying assets must all be issued by the same rating agency, and the cumulative historical default rates used must include a safety margin to take into account statistical errors on the part of the rating agencies and the volatility of default rates. 84
  • 85. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – the guarantee must cover at least the following three credit events: bankruptcy, failure to pay, and restructuring 55 ; and which cover amounts in excess of absolute or relative materiality thresholds. If these conditions are satisfied, the buyer of protection records a counterparty credit risk on the seller of protection. If the seller is risk-weighted at 0% or if the protection takes the form of a CLN involving initial payment by the subscriber, the buyer of protection is not required to record a capital charge (for CLNs, the initial payment serves as cash collateral). When the protection is settled by a cash payment, the amount of the payment must be set by a party other than the seller of protection. Furthermore, the coverage provided by credit derivative instruments is very often imperfect, involving a mismatch in maturity, asset basis, or currency. 2.2.1. MATURITY MISMATCH If the expiration date of the instrument covered and the instrument of coverage (the credit derivative) do not match 56, the following treatment is applied, both in calculating capital ratios and in the treatment of large exposures. If the residual maturity of the asset or off-balance sheet item is less than or equal to one year, the benefit of the guarantee is not recognised unless its coverage has a duration at least equal to that of the instrument covered. If the maturity of the instrument covered is greater than one year and the maturity of the coverage is at least one year but less than the maturity of the instrument covered, the buyer of protection may transfer the risk to the guarantor by risk-weighting the instrument covered at the risk- weight associated with the guarantor. Furthermore, in order to take account of the future exposure that results from the disappearance of the protection prior to the maturity of the instrument covered, the buyer of protection should record a supplementary exposure equal to 50% of the risk-weighted amount of the instrument covered. The overall risk weight of an asset risk-weighted at 100% and guaranteed by an entity risk- weighted at 20% is thus 70%. For credit derivatives including a ‘call’ with step-up at the option of the buyer of protection, the preceding treatment applies, subject to the condition that the step-ups are reasonable, i.e. that they do not provide a strong incentive to exercise the call. Application of this treatment will be require prior approval by the Secrétariat Générale de la Commission Bancaire on a case-by-case basis. 2.2.2. BASIS AND CURRENCY MISMATCH If the “guarantee” is referenced on an instrument other than the instrument covered, but both have the same issuer, recognition is subject to two conditions. First, the reference instrument must have a degree of subordination sufficient to ensure the indemnification of the buyer of protection. And 55 The contract must include at least the three following criteria for restructurings, from among those defined by ISDA (1999 Credit Derivatives Definitions) : - a reduction in the interest rate, the amount of interest to be paid, or the amount of accrued interest - a reduction in the amount of principal or of the premium to be paid at maturity or on reimbursement dates - modification in the seniority of debt resulting in their subordination 56 Maturity matching must take into account any options for early termination of protection and must be based on the economic substance of the transaction. 85
  • 86. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 second, the reference instrument and the underlying instrument must have cross-acceleration clauses. If these two conditions are satisfied, the benefit of protection can be recognised, subject to a haircut of 10% 57 of the amount of the guarantee if the covered instrument and the reference instrument are denominated in the same currency, and 20% if they are denominated in different currencies. The haircuts are intended to take account of the differences in the payment streams of the covered and reference instruments. If the instrument referenced by the guarantee and the instrument covered by it are the same, but the guarantee and the instrument covered are denominated in different currencies, a haircut of 10% is applied. For derivatives on baskets of assets, the treatment of the buyer of protection consists in recognising protection for the asset that represents the smallest portion of the basket in terms of its risk-weighted amount, provided that the transaction terminates when the first asset in the basket defaults. Finally, when the buyer of protection has the right to add assets to the basket or to substitute new assets for those originally included in the basket, it must not use that right to raise the average quality of the portfolio as it existed at the origin of the transaction and as it would normally evolve through changes in the external or internal ratings of the risks transferred. 3. TREATMENT OF CREDIT DERIVATIVES IN THE TRADING BOOK 3.1. General and specific risk Positions in credit derivatives are broken down into basic positions in the reference securities, which are then subject to capital charges for general risk and specific risk. It should be noted that positions in the reference asset arising from credit derivative instruments are treated in terms of their own specific risk if the maturity of the derivative instrument is not the same as that of the reference asset. 57 15% for synthetic securitisations. 86
  • 87. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 The case of the buyer of protection raises sensitive questions relating to the possibility of netting between positions in opposite directions which have different levels of specific risk (e.g. the credit derivative instrument and the reference instrument have different maturities, or the reference asset and the underlying asset are not the same). Not only are the international rules on this question very restrictive, but the logic of the trading book treatment, which is meant to capture the risk of price variation, dictates caution in the recognition of netting, or even partial netting. These are the reasons why, in contrast with the banking book treatment, current rules do not allow any netting in the trading book, except in the case of perfectly matched positions (strict identity between the covered asset and the reference asset and between the maturity of the credit derivative and that of the covered asset. Discussions continue at the international level on the possibility of allowing partial netting. As an interim measure, the capital requirement for specific risk associated with a position (asset or liability) that is hedged by an position with a different maturity will be limited to the specific risk requirement for the longer of the two positions. 3.2. Counterparty risk The treatment is based on the difference in volatility of the products, as a function of the characteristics (rating) of the reference asset. : Buyer of protection Seller of protection TROR - eligible reference asset Interest rate add-on Interest rate add-on - ineligible reference asset Equity add-on Equity add-on Other credit derivatives - eligible reference asset e Interest rate add-on - - ineligible reference asset Equity add-on - Eligibility is defined according to Annex 2. 3.3. Liquidity and modelling risk For credit derivative instruments which are classified in the trading book and which are valued at market price or with reference to a model – and for non-standard instruments in particular – the institution must make adjustments to income received or pass provisions in order to take into account the liquidity and modelling risk which they present. If the Secrétariat Général de la Commission Bancaire considers that these adjustments or provisions are insufficient relative to the demonstrated liquidity of the instruments and/or the adequacy of the valuation methods used, it may : - recommend to the institution that it increase the level of its adjustments or provisions ; or - require that the instruments be reclassified in the banking book. 87
  • 88. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 16 LIST OF MASTER AGREEMENTS WHICH PERMIT PRUDENTIALRECOGNITION OF NETTING 1. National master agreement Master agreement of the French Banking Association governing forward market transactions 2. International master agreements – Master agreement of the International Swaps and Derivatives Association (ISDA). – International Foreign Exchange Master Agreement (IFEMA), version approved in 1995 and 1997 version. – International Currency Options Market (ICOM) Master Agreement. – Foreign Exchange Netting and Close-Out Agreement (FXNET). – (International Foreign Exchange and Options Master Agreement (FEOMA). – Master Agreement for Financial Derivative Transactions (Rahmenvertrag für Finanztermingeschäfte), 1993 version. – Swiss Master Agreement for Over-The-Counter Derivative Instruments. – International Bullion Master Agreement (IBMA), June 1994 version. – Master Energy Price Swap Agreement (ERMA). – Master Agreement for Options on Emerging Market Instruments (EMTA), July 1994 version. – Euromaster Agreement, October 1999 version, for debts and debt instruments relating to repurchase agreements governed by this master agreement. – Global Master Repurchase Agreement (PSA/ISMA, modified), 2000 version . 88
  • 89. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 17 PRESS RELEASE ISSUED BY THE BASEL COMMITTEE ON OCTOBER 27, 1998 INSTRUMENTS ELIGIBLE FOR INCLUSION IN TIER 1 CAPITAL 1. The Basle Committee on Banking Supervision has taken note that over the past years some banks have issued a range of innovative capital instruments, such as instruments with step-ups, with the aim of generating Tier 1 regulatory capital that is both cost-efficient and can be denominated, if necessary, in non-local currency. The Committee has carefully observed these developments and at its meeting on October 21, 1998 decided to limit acceptance of these instruments for inclusion in Tier 1 capital. Such instruments will be subject to stringent conditions and limited to a maximum of 15% of Tier 1 capital. 2. As its starting point, the Committee reaffirms that common shareholders' funds, i.e. common stock and disclosed reserves or retained earnings, are the key element of capital. Common shareholders' funds allow a bank to absorb losses on an ongoing basis and are permanently available for this purpose. Further, this element of capital best allows banks to conserve resources when they are under stress because it provides a bank with full discretion as to the amount and timing of distributions. Consequently, common shareholders' funds are the basis on which most market judgements of capital adequacy are made. The voting rights attached to common stock also provide an important source of market discipline over a bank's management. For these reasons, voting common shareholders' equity and the disclosed reserves or retained earnings that accrue to the shareholders' benefit should be the predominant form of a bank's Tier 1 capital. 3. To provide supervisors and market participants with sufficient information to ensure that the integrity of capital is maintained, the Committee agrees that, as set forth in its recent report quot;Enhancing Bank Transparencyquot;, banks should periodically publicly disclose each component of Tier 1 capital and its main features. 4. In order to protect the integrity of Tier 1 capital, the Committee has determined that minority interests in equity accounts of consolidated subsidiaries that take the form of SPVs should only be included in Tier 1 capital if the underlying instrument meets the following requirements which must, at a minimum, be fulfilled by all instruments included in Tier 1: – issued and fully paid; – non-cumulative; – able to absorb losses within the bank on a going-concern basis; – junior to depositors, general creditors, and subordinated debt of the bank; – permanent; 89
  • 90. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 – neither be secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors; and – callable at the initiative of the issuer only after a minimum of five years with supervisory approval and under the condition that it will be replaced with capital of same or better quality unless the supervisor determines that the bank has capital that is more than adequate to its risks. 5. In addition, the following conditions have also to be fulfilled: – the main features of such instruments must be easily understood and publicly disclosed; – proceeds must be immediately available without limitation to the issuing bank, or if proceeds are immediately and fully available only to the issuing SPV, they must be made available to the bank (e.g. through conversion into a direct issuance of the bank that is of higher quality or of the same quality at the same terms) at a predetermined trigger point, well before serious deterioration in the bank's financial position; – the bank must have discretion over the amount and timing of distributions, subject only to prior waiver of distributions on the bank's common stock and banks must have full access to waived payments; and – distributions can only be paid out of distributable items; where distributions are pre-set they may not be reset based on the credit standing of the issuer. 6. Moderate step-ups in instruments issued through SPVs, as well as in directly issued Tier 1 instruments meeting the requirements set forth in paragraphs 4 and 5, are permitted, in conjunction with a call option, only if the moderate step-up occurs at a minimum of ten years after the issue date and if it results in an increase over the initial rate that is no greater than, at national supervisory discretion, either; – 100 basis points, less the swap spread between the initial index basis and the stepped-up index basis; or – 50% of the initial credit spread, less the swap spread between the initial index basis and the stepped-up index basis. 7. The terms of the instrument should provide for no more than one rate step-up over the life of the instrument. The swap spread should be fixed as of the pricing date and reflect the differential in pricing on that date between the initial reference security or rate and the stepped-up reference security or rate. 8. National supervisors expect banks to meet the Basle minimum capital ratios without undue reliance on innovative instruments, including instruments that have a step-up. Accordingly, the aggregate of issuances of non-common equity Tier 1 instruments with any explicit feature - other than a pure call option - which might lead to the instrument being redeemed is limited - at issuance - to 15% of the consolidated bank's Tier 1 capital. 9. Any instruments authorised or issued under existing national rules of Tier 1 which no longer qualify under the above interpretation will be grandfathered; the same will apply to any issues of such instruments in excess of the 15% limitation. 90
  • 91. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 10. This interpretation will be subject to further review as part of a broader effort already underway to reassess the present framework for evaluating banks' capital adequacy. In this respect, the Committee retains its flexibility to make any changes to this interpretation. 91
  • 92. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 ANNEX 18 PRUDENTIAL TREATMENT OF SECURITISATION TRANSACTIONS These new provisions relating to securitisation in France are designed to adapt the prudential treatment of securitisation transactions to changes in the way that securitised exposures are redistributed in the market. This change relates only to the capital charges for subordinated positions (whatever their form), which will henceforth be calibrated in terms of the risk assumed, and no longer in terms of the nature of the entity assuming the risk. It eliminates the distinction in the treatment of investors and originators, since maintaining this distinction until 2006 would serve no economic or prudential purpose. In order to understand the scope of this change, it is necessary to recall the principal structures. − The new provisions apply only to the calculation of the Basel capital ratio. The methods for calculating the European capital ratio fall under community provisions set forth in E.U. Directives. − This change involves only positions in the banking book, and does not apply to transactions in the trading book : the capital charge for trading book positions is unchanged. Positions in the trading book which are reclassified in the banking book will be subject to the banking book regime, according to the date that the exposure was initially assumed. It should be recalled that, in order to be classed in the trading book, an institution’s positions must satisfy the criteria set forth in Point 1.2 of this Notice. − Previously, originators were required to deduct positions rated below A- from capital. This threshold will henceforth be lowered to BBB- and will apply to both originators and third- party investors in all types of securitisations. Only holders of unrated or non-investment- grade subordinated positions will henceforth be subject to deduction. It should be noted that such holders will not necessarily be affected, if their position lies above the ceiling on deduction of 8% of the risk-weighted exposures. − The total amount of the above-mentioned positions “at risk” to be deducted is capped at 8% of the outstanding risk-weighted securitised assets to which they are attached 92
  • 93. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 1. PRINCIPLES Date of application December 31, 2002. Any exposure acquired on or after this date will be subject to the new treatment, even if the securitisation transaction was carried out before December 31, 2002. Grandfather clause Any exposure that predates December 31, 2002, regardless of subsequent changes in its rating, will remain subject to the prior treatment. This grandfather clause applies until the effective date of the New Capital Accord being developed by the Basel Committee. Effect Capped deduction from capital of subordinated positions, whatever their form (tranche, reserve account, letter of credit…) and whatever the role in the transaction of the holder of the positions (originators/sponsors/third-party investors). Scope of application − Basel capital ratio. − Positions taken by credit institutions or investment firms participating in the securitisation of assets, whether those assets come from bank balance sheets or not (including the securitisation of assets coming from the balance sheet of a commercial firm), and whether the positions are entered directly with the originator or through a special-purpose entity (FCC, SPV, conduit…). − Traditional securitisations involving the sale of assets or balance sheet items, as well as synthetic securitisations employing credit derivative instruments. − Only positions in the banking book are covered. Institutions are reminded of the need to ensure that the criteria for classifying transactions in the trading book are respected. Positions deducted from capital All subordinated positions that are unrated or are rated below BBB- are deducted from capital. Ceiling on deductions All subordinated positions qualifying for deduction are deducted, in the order of subordination – i.e. beginning with first-loss mechanisms – until the overall ceiling of 8% is reached. The ceiling of 8% is calculated on the basis of the assets or off-balance sheet items securitised, to which the subordinated positions are directly attached. This ceiling applies to sellers and investors in the same manner. 93
  • 94. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 In the case of structures involving more than one special-purpose vehicle, the ceiling is applied legal entity by legal entity, since credit enhancements and/or guarantees legally benefit only investors in the securities issued by a given vehicle. Principle of caution The Secrétariat Général de la Commission Bancaire reserves the right, as it does for all capital requirements, to modify this prudential treatment if the characteristics of a securitisation transaction indicate that the standard treatment is inappropriate or could lead to error from the point of view of the objectives of prudential supervision. 2. METHODS OF APPLICATION 2.1. Date of application : December 31, 2002 – Grandfather clause applies until the effective date of the future New Capital Accord (scheduled for December 31, 2006) Any exposure in the banking book that is acquired on or after December 31, 2002 will be subject to the new treatment for the calculation of the Basel capital ratio. In other words, the new system will apply to all securitisation transactions executed on December 31, 2002 or later. As for transactions executed before December 31, 2002 : − if the exposure is acquired prior to December 31, 2002, the grandfather clause will apply until the effective date of the New Capital Accord. The grandfather clause will also apply to trading book positions acquired before December 31, 2002 and subsequently reclassified in the banking book, whatever the date of the reclassification. ; − if the exposure is acquired after December 31, 2002, the new treatment applies immediately. In particular, if a refinancing letter (whatever its form) provided to a securitisation conduit supports, directly or indirectly, the credit risks in a new pool administered by the conduit, the portion of the letter relating to the new pool will be treated as a new exposure. However, any portion of the refinancing letter covering risks housed in a portfolio or a pool that existed before December 31, 2002 will be covered by the grandfather clause, even if the portfolio or pool can be replenished. 2.2. Determination of the applicable treatment The first step is to divide up positions on the basis of : − the scope of deductible positions, i.e. the set of subordinated positions that are unrated or are rated below BBB-, and − the overall ceiling of 8% of risk-weighted securitised assets. Only positions satisfying these two criteria must be deducted. All positions falling outside the scope of deduction, or within the scope of deduction but above the 8% ceiling, receive the “default” treatment – i.e. a risk weight of 100% – unless a preferential risk weight applies (the transparency approach, for example). 94
  • 95. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 Thus, a tranche rated BBB and falling below the 8% overall ceiling is not deducted. A tranche rated BB+ and falling above the 8% overall ceiling is also not deducted. In order to determine if unrated letters of credit (or their equivalent) provided to conduits fall within the scope of deduction, it is necessary to distinguish between the following two cases. − If the letter of credit (or equivalent) benefits directly from a substantial mechanism of first-loss coverage, it can be associated with the credit quality of the securitised portfolio to which it applies. This association can be made : • Either directly by the bank providing the letter of credit (or equivalent), subject to the condition that the bank does not bear the first losses. The credit quality associated with the letter of credit is the average risk-weighted rating of the underlying securitised portfolio. The institution must retain the information used in making that association (rating and size of each element of the underlying portfolio) throughout the lifetime of the letter of credit. This calculation is not required if each element of the securitised portfolio covered by the letter of credit is rated investment grade : in that case the letter of credit is considered to fall outside the scope of deduction, subject to any future deterioration in the ratings of the underlying elements. Or indirectly by a recognised external rating agency 58. The credit quality of the • underlying portfolio is treated as equivalent to the rating for the portfolio, as determined (and updated) by a recognised rating agency. If it is not possible to determine the credit quality of the underlying portfolio by one of these two methods, the letter of credit (or equivalent) will be considered as falling within the scope of deduction. − If the letter of credit (or equivalent) is not protected by a mechanism providing coverage of first losses in the portfolio purchased by the conduit to which the letter of credit is granted, or if the protection of first losses has been exhausted, the letter of credit is included in the scope of deduction for purposes of calculating prudential capital requirements. The 8% is a global ceiling : it applies not to investors (originator/third party) but to securitisation transactions, legal entity by legal entity in the case of structures using more than one vehicle (see Principle 6). Thus, for a given credit risk, the 8% ceiling applies to the risk-weighted assets and/or off-balance sheet elements which are directly exposed to that risk. The ceiling is applied beginning with first loss positions and proceeding towards mezzanine positions, which ensures full deduction of the most subordinated, and therefore most risky positions. 2.3. Methods for computing deductions The amount to be deducted remains capped at 8% of securitised assets. − the ceiling is calculated before provisioning : thus, the making of provisions ex post does not alter the level of the ceiling, but only the amount to actually deducted ; 58 The rating agencies recognised in the area of securitisation are included in the list in Point 2 of Annex VIII of CRBF Regulation CRBF n° 95-02. 95
  • 96. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 − the 8% quotient remains fixed throughout the lifetime of a securitisation transaction. It represents an amount equal to the capital charge on the portfolio of assets as it was before it was securitised and as it evolves as the securitised portfolio is amortised (8% of the total risk- weighted securitised assets). If a tranche straddles the 8% ceiling, the deduction applies to the part of the tranche that falls below the 8% ceiling, the rest being risk-weighted at 100%. For example, 25% of a tranche might be deducted and the remaining 75% risk-weighted at 100%. If this tranche is held be several investors, since they necessarily rank pari passu they deduct the same percentage of their exposure (25%) and they risk-weight the same percentage (75%) at 100%. When early amortisation of a securitisation structure is triggered, the scope of application of the 8% ceiling is reduced, and the amount of the deductions declines. There are two cases : − if the amortisation of the positions is tied to that of the securitised portfolio. In this case, the division of the positions around the 8% ceiling does not change (in the case of a tranche straddling the ceiling, the amount deduced is reduced progressively but the percentages applied — 25% and 75% — remain the same) ; − if the positions are amortised sequentially – i.e. if the positions do not all amortise at the same rate and the rate is largely independent of that of the underlying portfolio. In this case, which is the most common, not only do the amounts to be deducted decline as the underlying portfolio is amortised, but the division of the tranches around the 8% ceiling may change. 96
  • 97. METHODS FOR CALCULATING INTERNATIONAL CAPITAL ADEQUACY RATIOS, 01/01/2006 Example : the case of sequential amortisation, where the most subordinated tranches amortise less rapidly than other tranches and less rapidly than the underlying portfolio. In a portfolio of 100 in receivables of business firms, parts of two tranches are deducted at the launch of the securitisation, for an overall deduction of 8 (grey area). Three years later, only one of the tranches is affected, in an amount corresponding to 8 percent of the securitised receivables not yet amortised, or 4,8 (grey area). Year 1 Securitised portfolio / Tranches issued (AAA) 85 100 8%*100%*100 (BB+) 10 (NR) 5 Year 3 Securitised portfolio / Tranches issued (AAA) 47 60 (BB+) 8 8%*100%*60 (NR) 5 ( 97

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