5.Majority-owned or controlled banking entities, securities entities (where subject to broadly similar regulation or where securities activities are deemed banking activities) and other financial entities should generally be fully consolidated. Notwithstanding the banks decision on exercising control over an entity and the subsequent consolidation of that entity, the Central Bank reserves the right to determine whether the bank exercises control over an entity and hence may require banks to consolidate/deconsolidate entities.

6.In instances where it is not feasible to consolidate certain majority-owned banking, securities or other regulated financial entities¹, banks may, subject to prior Central Bank approval, opt for non-consolidation of such entities for regulatory capital purposes.

7.For group level reporting, if any majority-owned financial subsidiaries are not consolidated for capital purposes, all assets, liabilities and third-party capital investments in the subsidiaries will be removed from the bank’s balance sheet. All equity and other investments in regulatory capital instruments in those entities attributable to the bank / banking group will be deducted.

8.Banks are required to deduct from CET1 the full amount of any capital shortfalls of subsidiaries excluded from regulatory consolidation, that are regulated entities and are subject to capital requirements. The amount of the capital requirement and capital shortfall for this deduction is to be based on the regulations issued by the subsidiary’s regulator (i.e. based on the host regulator’s local capital adequacy requirements).

¹ Examples of the types of activities that financial entities might be involved in include financial leasing, issuing credit cards, portfolio management, investment advisory, custodial and safekeeping services and other similar activities that are ancillary to the business of banking.

Banking, securities, financial and insurance entities – (ownership in entity does not exceed 10%)

9.A bank’s equity interests in banking, securities, insurance and other financial entities are defined as investments in the capital of banking, securities, insurance and other financial entities if the bank owns up to 10% of the investee’s common share capital.

For detailed treatment of investments in such entities, refer to Section 3.9 - Regulatory Adjustments.

Banking, securities, financial and insurance entities – Significant investments (ownership in entity exceeds 10%)

10.Significant investments in banking, securities and other financial entities are defined as investments in the capital of banking, securities and other financial entities (that are outside the scope of regulatory consolidation) wherein the bank owns more than 10% of the investee’s common share capital. Such investments will be subject to the treatment outlined in Section 3.10 - Regulatory Adjustments.

11.Significant investments in commercial entities are subject to the treatment outlined in section 5. Subsidiaries that are commercial entities are not to be consolidated for regulatory capital purposes. In cases where a subsidiary that is a commercial entity has been consolidated for accounting purposes, the entity is to be deconsolidated for regulatory purposes (i.e. all assets, liabilities and equity will be removed from the bank’s balance sheet) and the book value of the investment will be subject to the treatment.

For detailed treatment of investments in such entities, refer to Section 5.

12.Total regulatory capital will consist of the sum of the following items:

1. i.Tier 1 capital, composed of
   1. a.Common Equity Tier 1 (“CET1”)
   2. b.Additional Tier 1 (“AT1”)
2. ii.Tier 2 capital.

These regulatory capital components are net of regulatory adjustments.

13.Article (2.2) of Capital Adequacy Regulation requires banks to apply the following minimum requirement, at all times:

1. i.CET1 capital must be at least 7.0% of risk-weighted assets (RWA).
2. ii.Tier 1 capital must be at least 8.5% of RWA.
3. iii.Total capital, calculated as sum of Tier 1 capital and Tier 2 capital, must be at least 10.5% of RWA.

14.Article (5.1) of Capital Adequacy Regulation requires banks to maintain a capital conservation buffer (CCB) of 2.5% of total risk weighted assets, in the form of CET1 capital.

15.Article (6) of Capital Adequacy Regulation requires banks to implement a countercyclical buffer (CCyB). Banks must meet the CCyB requirements by using CET1 capital exclusively. Banks will be subject to a countercyclical buffer that varies between zero and 2.5% of total risk weighted assets. The buffer that will apply to each bank will reflect the geographic composition of its portfolio of credit exposures. The CCyB buffer extends the capital conservation buffer (CCB).

16.Domestic Systemically Important Banks (D-SIBs) are required to comply with article (7) of the Capital Adequacy Regulation. The additional requirements for identified D-SIBs will be communicated individually by the Central Bank to each relevant bank. Banks must meet the D-SIB buffer requirements by using CET1 capital. The D-SIB buffer extends the capital conservation buffer (CCB).

17.Based on the outcome of the Supervisory Review and Evaluation Process (SREP) conducted by the Central Bank, a bank may be subject to an additional capital add-on, also referred to as individual Supervisory Capital Guidance requirement (SCG). Banks notified must apply the individual SCG requirement, as set by the Central Bank. The Individual SCG increases the minimum capital requirement.

18.The aggregation of all the capital buffers (CCB, CCyB and D-SIB) form an effective capital conservation buffer. Any breach of the capital conservation buffers will lead to the following additional supervisory requirements and constraints on distributions:

1. i.The relevant bank must immediately inform the Central Bank of the breach.
2. ii.The relevant bank shall submit an approved plan to restore its regulatory capital to meet the buffer level requirement.
3. iii.The relevant bank will be subjected to more intense supervision.
4. iv.Capital conservation restrictions will immediately become effective in the form of restriction of dividends as prescribed by the Central Bank.

19.As per Article 3.1 of the Capital Adequacy Regulation, CET1 capital consists of the sum of the following elements:

1. i.Common shares issued by a bank which are eligible for inclusion in CET1 (or the equivalent for non-joint stock companies);
2. ii.Share premium resulting from the issue of instruments included in CET1;
3. iii.Retained earnings;
4. iv.Legal reserves;
5. v.Statutory reserves;
6. vi.Accumulated other comprehensive income and other disclosed reserves;
7. vii.Common shares issued by consolidated subsidiaries of a bank and held by third parties, also referred to as minority interest, which are eligible for inclusion in CET1;
8. viii.Regulatory adjustments applied in the calculation of CET1.

20.Retained earnings and other comprehensive income include audited/reviewed interim profit or loss. Expected dividend payments are excluded from CET1.

Common shares issued by the bank

21.For an instrument to be included in CET1 capital, it must meet all of the following criteria stated below. In cases where banks issue non-voting common shares, they must be identical to voting common shares of the issuing bank in all respects except the absence of voting rights for inclusion in CET1.

1. i.Represents the most subordinated claim in liquidation of the bank.
2. ii.The investor is entitled to a claim on the residual assets that is proportional to its share of issued capital, after all senior claims have been paid in liquidation (i.e. has an unlimited and variable claim, not a fixed or capped claim).
3. iii.The principal is perpetual and never repaid outside of liquidation (setting aside discretionary repurchases or other means of effectively reducing capital in a discretionary manner that is allowable under relevant law and subject to the prior approval of the Central Bank).
4. iv.The bank does nothing to create an expectation at issuance that the instrument will be bought back, redeemed or cancelled, nor do the statutory or contractual terms provide any feature that might give rise to such an expectation.
5. v.Distributions are paid out of distributable items, including retained earnings. The level of distributions is not in any way tied or linked to the amount paid in at issuance and is not subject to a contractual cap (except to the extent that a bank is unable to pay distributions that exceed the level of distributable items).
6. vi.There are no circumstances under which the distributions are obligatory. Non-payment is, therefore, not an event of default.
7. vii.Distributions are paid only after all legal and contractual obligations have been met and payments on more senior capital instruments have been made. This means that there are no preferential distributions, including in respect of other elements classified as the highest quality issued capital.
8. viii.The issued capital takes the first and proportionately greatest share of any losses as they occur. Within the highest quality capital, each instrument absorbs losses on a going concern basis proportionately and pari passu with all the others.
9. ix.The paid-in amount is recognized as equity capital (i.e. not recognized as a liability) for determining balance sheet insolvency.
10. x.The paid-in amount is classified as equity under the relevant accounting standards.
11. xi.It is directly issued and paid-in and the bank cannot directly or indirectly have funded the purchase of the instrument.
12. xii.The paid-in amount is neither secured nor covered by a guarantee of the issuer or related entity or subject to any other arrangement that legally or economically enhances the seniority of the claim.
13. xiii.It is either only issued with the approval of the owners of the issuing bank, given directly by the owners or, if permitted by applicable law, given by the Board of Directors or by other persons duly authorized by the owners.
14. xiv.It is clearly and separately disclosed on the bank’s balance sheet.

22.Articles 3.2 of the Capital Adequacy Regulation, AT1 capital consists of the sum of the following elements:

1. i.Instruments issued by a bank which are eligible for inclusion in AT1 and are not included in CET1 (e.g. perpetual equity instruments, not included in CET1);
2. ii.Stock surplus, or share premium, resulting from the issue of instruments included in AT1;
3. iii.Instruments issued by consolidated subsidiaries of the bank and held by third parties which are eligible for inclusion in AT1 and are not included in CET1;
4. iv.Regulatory adjustments applied in the calculation of AT1.

23.The treatment of instruments issued out of consolidated subsidiaries of the bank and the regulatory deductions applied in the calculation of AT1 capital are addressed in the Tier Capital Instruments Standard.

Instruments issued by the bank that meet the Additional Tier 1 criteria

24.The following is the minimum set of criteria for an instrument issued by the bank to meet or exceed in order for it to be included in Additional Tier 1 capital:

1. i.Issued and paid-in
2. ii.Subordinated to depositors, general creditors and subordinated debt of the bank
3. iii.Is neither 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
4. iv.Is perpetual, i.e. there is no maturity date and there are no step-ups or other incentives to redeem
5. v.May be callable at the initiative of the issuer only after a minimum of five years:
   1. a.To exercise a call option a bank must receive prior Central Bank approval; and
   2. b.A bank must not do anything which creates an expectation that the call will be exercised; and
   3. c.Banks must not exercise a call unless:
      1. 1)They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank; or
      2. 2)The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.
6. vi.Any repayment of principal (e.g. through repurchase or redemption) must be with prior Central Bank’s approval and banks should not assume or create market expectations that Central Bank’s approval will be given.
7. vii.Dividend/coupon discretion:
   1. a.the Central Bank and the bank must have full discretion at all times to cancel distributions/payments
   2. b.cancellation of discretionary payments must not be an event of default
   3. c.banks must have full access to cancelled payments to meet obligations as they fall due
   4. d.Cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders.
8. viii.Dividends/coupons must be paid out of distributable items
9. ix.The instrument cannot have a credit-sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organization’s credit standing.
10. x.The instrument cannot contribute to liabilities exceeding assets in the required balance sheet test to determine insolvency.
11. xi.Instruments classified as liabilities for accounting purposes must have principal loss absorption through a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point. The loss absorption trigger must be set at a level of 7.625% of CET1. The write-down will have the following effects:
    1. 1.Reduce the claim of the instrument in liquidation;
    2. 2.Reduce the amount re-paid when a call is exercised; and
    3. 3.Partially or fully reduce coupon/dividend payments on the instrument.
12. xii.Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument or otherwise come into possession of the instrument, such as through receipt of collateral or a reverse repurchase agreement, nor can the bank directly or indirectly have funded the purchase of the instrument.
13. xiii.The instrument cannot have any features that hinder recapitalization, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame.
14. xiv.[Applicable for Islamic banks only] If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g. a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in AT1 capital (Refer to the Capital Instruments Standards).
15. xv.In addition to the criteria outlined above, the instrument must meet criteria for minimum requirements to ensure loss absorbency at the point of non-viability. Please refer to the Capital Instruments Standards.

Share premium resulting from the issue of instruments included in Additional Tier 1 capital;

25.Share premium that is not eligible for inclusion in CET1, will only be permitted to be included in AT1 capital if the shares giving rise to the stock surplus are permitted to be included in AT1 capital.

26.Articles 3.3 of the Capital Adequacy Regulation, Tier 2 capital consists of the sum of the following elements:

1. i.Banks using the standardized approach for credit risk: general provisions or general loan loss reserves, up to maximum of 1.25% of credit RWA;
2. ii.Instruments issued by the bank that meet the criteria for inclusion in Tier 2 capital, and are not included in Tier 1 capital;
3. iii.Share premium resulting from the issue of instruments included in Tier 2 capital;
4. iv.Instruments which are eligible for inclusion of Tier 2 (refer to paragraph 27)
5. v.Instruments issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in Tier 2 capital, and are not included in Tier 1 capital;
6. vi.Regulatory adjustments applied in the calculation of Tier 2.

27.The treatment of instruments issued out of consolidated subsidiaries of the bank and the regulatory deductions applied in the calculation of Tier 2 capital are addressed in the Tier Capital Instrument Standard.

Instruments issued by the bank that meet the Tier 2 criteria

28.The objective of Tier 2 capital is to provide loss absorption on a gone-concern basis. Based on this objective, the minimum set of criteria for an instrument to meet or exceed in order for it to be included in Tier 2 capital are set out below.

Criteria for inclusion in Tier 2 Capital

1. i.Issued and paid-in.
2. ii.Subordinated to depositors and general creditors of the bank.
3. iii.Is neither 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 depositors and general bank creditors
4. iv.Maturity:
   1. a.minimum original maturity of at least five years
   2. b.recognition in regulatory capital in the remaining five years before maturity will be amortized on an annualized straight line basis (i.e. 20% incremental reduction in recognition every successive year in the last five years)
   3. c.there are no step-ups or other incentives to redeem
5. v.May be callable at the initiative of the issuer only after a minimum of five years:
   1. a.To exercise a call option a bank must receive prior Central Bank’s approval;
   2. b.A bank must not do anything that creates an expectation that the call will be exercised; and
   3. c.Banks must not exercise a call unless:
      1. 1.They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank; or
      2. 2.The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.
6. vi.The investor must have no rights to accelerate the repayment of future scheduled payments (coupon or principal), except in bankruptcy and liquidation.
7. vii.The instrument cannot have a credit-sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organization’s credit standing.
8. viii.Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument or otherwise come into possession of the instrument, such as through receipt of collateral or a reverse repurchase agreement, nor can the bank directly or indirectly have funded the purchase of the instrument.
9. ix.[Applicable for Islamic banks only] If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g. a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Tier 2 Capital (Refer to the Capital Instruments Standards).

29.In addition to the criteria outlined above, the instrument must meet the minimum requirements to ensure loss absorbency at the point of non-viability. Please refer to the Capital Instruments Standards.

Share premium resulting from the issue of instruments included in Tier 2 capital

30.Share premium that is not eligible for inclusion in Tier 1, will only be permitted to be included in Tier 2 capital if the shares giving rise to the stock surplus are permitted to be included in Tier 2 capital.
 

General provisions/General loan-loss reserves:

31.Provisions or loan-loss reserves held against future, presently unidentified losses are freely available to meet losses which subsequently materialize and therefore qualify for inclusion within Tier 2. Provisions ascribed to identified deterioration of particular assets or known liabilities, whether individual or grouped, should be excluded. Furthermore, general provisions or general reserves for loan losses will be limited to a maximum of 1.25% of credit risk weighted risk assets calculated under the standardised approach.
 

Capital component of Capital Adequacy Regulation

32.If a bank has complied with the minimum CET1 and Tier 1 capital ratios, the excess AT1 capital can be counted to meet the total capital ratio, also referred to as Capital Adequacy Ratio (CAR).
 

33.Profit-sharing investment accounts must not be classified as part of an Islamic bank’s regulatory capital as referred to in Article 2 of Capital Adequacy Regulation.

34.Investment risk reserves and a portion of the Profit Equalization Reserve (PER), if any, belong to the equity of investment account holders, and thus must not be used in the calculation of an Islamic bank’s regulatory capital. As the purpose of a PER is to smooth the profit pay-outs and not to cover losses, any portion of a PER that is part of the Islamic bank’s reserves must not be treated as regulatory capital as referred to in Article 2 of Capital Adequacy Regulations.

35. In order for an instrument issued by a bank to be included in AT1 or Tier 2 capital, it must also meet or exceed the minimum requirements defined in Capital Instruments Standards. These requirements are in addition to the criteria for AT1 and Tier 2 instruments stated above.

Common shares issued by consolidated subsidiaries (that is within the scope of regulatory consolidation)

36.Minority interest arising from the issue of common shares by a fully consolidated subsidiary of the bank may receive recognition in CET1 only if:

1. i.The instrument giving rise to the minority interest would, if issued by the bank, meet all of the criteria for classification as common shares for regulatory capital purposes; and
2. ii.The subsidiary that issued the instrument is itself a bank. (It is noted that minority interest in a subsidiary that is a bank is strictly excluded from the parent bank’s common equity if the parent bank or affiliate has entered into any arrangements to fund directly or indirectly minority investment in the subsidiary whether through an SPV or through another vehicle or arrangement. The treatment outlined here, thus, is strictly available where all minority investments in the bank subsidiary solely represent genuine third party common equity contributions to the subsidiary.)

37.The amount of capital meeting the above criteria that will be recognized in consolidated CET1 is calculated as follows

Total minority interest meeting the two criteria above minus the amount of the surplus CET1 of the subsidiary attributable to the minority shareholders.

1. i.Surplus CET1 of the subsidiary is calculated as the CET1 (after the application of regulatory deductions) of the subsidiary minus the lower of:
   1. a.the minimum CET1 requirement of the subsidiary plus the capital conservation buffer (i.e. 9.5% of risk weighted assets) and
   2. b.the portion of the parent’s consolidated minimum CET1 requirement plus the capital conservation buffer (i.e. 9.5% of consolidated risk weighted assets) that relates to the subsidiary.
2. ii.The amount of the surplus CET1 that is attributable to the minority shareholders is calculated by multiplying the surplus CET1 by the percentage of CET1 that is held by minority shareholders.

Tier 1 qualifying capital issued by consolidated subsidiaries (that is within the scope of regulatory consolidation)

38.Tier 1 capital instruments issued by a fully consolidated subsidiary of the bank to third party investors (including amounts under paragraph 37) may receive recognition in Tier 1 capital only if the instruments would, if issued by the bank meet all of the criteria for classification as Tier 1 capital.
 

39.The amount of this capital that will be recognized in Tier 1 will be calculated as follows:

Total Tier 1 of the subsidiary issued to third parties minus the amount of the surplus Tier 1 of the subsidiary attributable to the third party investors.

1. i.Surplus Tier 1 of the subsidiary is calculated as the Tier 1 of the subsidiary (after the application of regulatory deductions) minus the lower of:
   1. a.the minimum Tier 1 requirement of the subsidiary plus the capital conservation buffer (i.e. 11% of risk weighted assets) and
   2. b.the portion of the parent’s consolidated minimum Tier 1 requirement plus the capital conservation buffer (i.e. 11% of consolidated risk weighted assets) that relates to the subsidiary.
2. ii.The amount of the surplus Tier 1 that is attributable to the third party investors is calculated by multiplying the surplus Tier 1 by the percentage of Tier 1 that is held by third party investors.

The amount of this Tier 1 capital that will be recognized in Additional Tier 1 will exclude amounts recognized in CET1 under paragraph 37.

Tier 1 and Tier 2 qualifying capital issued by consolidated subsidiaries (that is within the scope of regulatory consolidation)

40.Total capital instruments (i.e. Tier 1 and Tier 2 capital instruments) issued by a fully consolidated subsidiary of the bank to third party investors (including amounts under paragraph 37 and 39) may receive recognition in Total Capital only if the instruments would, if issued by the bank, meet all of the criteria for classification as Tier 1 or Tier 2 capital
 

41.The amount of this capital that will be recognized in consolidated Total Capital will be calculated as follows:

Total capital instruments of the subsidiary issued to third parties minus the amount of the surplus Total Capital of the subsidiary attributable to the third party investors.

1. i.Surplus Total Capital of the subsidiary is calculated as the Total Capital of the subsidiary (after the application of regulatory deductions) minus the lower of:
   1. a.the minimum Total Capital requirement of the subsidiary plus the capital conservation buffer (i.e. 13% of risk weighted assets) and
   2. b.the portion of the parent’s consolidated minimum Total Capital requirement plus the capital conservation buffer (i.e.13% of consolidated risk weighted assets) that relates to the subsidiary.
2. ii.The amount of the surplus Total Capital that is attributable to the third party investors is calculated by multiplying the surplus Total Capital by the percentage of Total Capital that is held by third party investors.

The amount of this Total Capital that will be recognized in Tier 2 will exclude amounts recognized in CET1 under paragraph 37 and amounts recognized in AT1 under paragraph 39 above.

42.An illustrative example for calculation of minority interest and other capital issued out of consolidated subsidiaries that is held by the third parties is furnished as Appendix 4 in Guidance for Capital Adequacy of Banks in the UAE.

Other Instructions relating to the calculation of the amount of minority interest

43.All calculations must be undertaken in respect of the subsidiary on a sub-consolidated basis (i.e. the subsidiary must consolidate all of its subsidiaries that are also included in the wider consolidated group). However, the bank may elect to give no recognition (in consolidated capital of the group) to the capital issued by the subsidiary to third parties.

44.Where capital has been issued to third parties out of an SPV, none of this capital can be included in CET1. However, such capital can be included in consolidated AT1 or Tier 2 capital and treated as if the bank itself had issued the capital directly to the third-parties only if:

1. i.it meets all the relevant entry criteria; and
2. ii.the only asset of the SPV is its investment in the capital of the bank in a form that meets or exceeds all the relevant entry criteria (as required by criterion xiv for Additional Tier 1 and criterion ix for Tier 2 capital)

In cases where the capital has been issued to third parties through an SPV via a fully consolidated subsidiary of the bank, such capital may, subject to the requirements of this paragraph, be treated as if the subsidiary itself had issued it directly to the third parties and may be included in the bank’s consolidated AT1 or Tier 2 in accordance with the treatment outlined in paragraphs 39 and 41.

46.Goodwill and all other intangibles must be deducted in the calculation of CET1 (this deduction includes mortgage servicing rights), including any goodwill included in the valuation of significant investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation. The full amount is to be deducted net of any associated deferred tax liability, which would be extinguished if the intangible assets become impaired or derecognized under the relevant accounting standards.

47.Banks are required to use the IFRS definition of intangible assets to determine which assets are classified as intangible and required to be deducted.

48.Deferred tax assets (DTAs) that rely on future profitability of the bank to be realized are to be deducted in the calculation of CET1. Deferred tax assets may be netted with associated deferred tax liabilities (DTLs) only if the DTAs and DTLs relate to taxes levied by the same taxation authority and the relevant taxation authority permits offsetting.

49.The treatment for DTA are classified as:

1. i.Where these DTAs relate to temporary differences (e.g. allowance for credit losses) the amount to be deducted is set out in the “threshold deductions”.
2. ii.All other DTAs, e.g. those relating to operating losses, such as the carry forward of unused tax losses, or unused tax credits, are to be deducted in full net of DTL as described above.

50.The DTLs permitted to be netted against DTAs must exclude amounts that have been netted against the deduction of goodwill, intangibles and defined benefit pension assets, and must be allocated on a pro rata basis between DTAs subject to the threshold deduction treatment and DTAs that are to be deducted in full.

51.An over-instalment of tax or, in some jurisdictions, current year tax losses carried back to prior years may give rise to a claim or receivable from the government or local tax authority. Such amounts are typically classified as current tax assets for accounting purposes. The recovery of such a claim or receivable would not rely on the future profitability of the bank and would be assigned the relevant sovereign risk weighting.

52.The amount of the cash flow hedge reserve that relates to the hedging of items that are not fair valued on the balance sheet (including projected cash flows) should be derecognized in the calculation of CET1. This means that positive amounts should be deducted and negative amounts should be added back.

53.This treatment specifically identifies the element of the cash flow hedge reserve that is to be derecognized for prudential purposes. It removes the element that gives rise to artificial volatility in common equity, as in this case the reserve only reflects one half of the picture (the fair value of the derivative, but not the changes in fair value of the hedged future cash flow).

54.Derecognize in the calculation of CET1 any increase in equity capital resulting from a securitization transaction, such as that associated with expected Future Margin Income (FMI) resulting in a gain-on-sale.

55.Derecognize in the calculation of CET1, all unrealized gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank’s own credit risk.

56.Defined benefit pension fund liabilities, as included on the balance sheet, must be fully recognized in the calculation of CET1 (i.e. CET1 cannot be increased through derecognizing these liabilities).

57.For each defined benefit pension fund that is an asset on the balance sheet, the asset should be deducted in the calculation of CET1 net of any associated deferred tax liability, which would be extinguished if the asset should become impaired or derecognized under the relevant accounting standards.

58.Assets in the fund to which the bank has unrestricted and unfettered access can, with Central Bank’s approval, offset the deduction. Such offsetting assets should be given the risk weight they would receive if they were owned directly by the bank.

59.This treatment addresses the concern that assets arising from pension funds may not be capable of being withdrawn and used for the protection of depositors and other creditors of a bank. The concern is that their only value stems from a reduction in future payments into the fund. The treatment allows banks to reduce the deduction of the asset if they can address these concerns and show that the assets can be easily and promptly withdrawn from the fund.

60.All of a bank’s investments in its own common shares, whether held directly or indirectly, will be deducted in the calculation of CET1 (unless already derecognized under the relevant accounting standards).

61.In addition, any own stock, which the bank could be contractually obliged to purchase, should be deducted in the calculation of CET1. The treatment described will apply irrespective of the location of the exposure in the banking book or the trading book. In addition:

1. i.Gross long positions may be deducted net of short positions in the same underlying exposure only if the short positions involve no counterparty risk.
2. ii.Banks should look through holdings of index securities to deduct exposures to own shares. However, gross long positions in own shares resulting from holdings of index securities may be netted against short position in own shares resulting from short positions in the same underlying index. In such cases, the short positions may involve counterparty risk (which will be subject to the relevant counterparty credit risk charge).

62.Following the same approach outlined above, banks must deduct investments in their own AT1 in the calculation of their AT1 capital and must deduct investments in their own Tier 2 in the calculation of their Tier 2 capital.

63.Reciprocal cross holdings of capital that are designed to artificially inflate the capital position of banks will be deducted in full from CET1.
 

64.The regulatory adjustment described in this Standard applies to investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation and where the bank does not own more than 10% of the issued common share capital of the entity. In addition,

1. i.Investments include direct, indirect and synthetic holdings of capital instruments. For example, banks should look through holdings of index securities to determine their underlying holdings of capital.
   
   If banks find it operationally burdensome to look through and monitor their exact exposure to the capital of other financial institutions as a result of their holdings of index securities, Central Bank may permit banks, subject to prior supervisory approval, to use a conservative estimate. The methodology for the estimate should demonstrate that in no case will the actual exposure be higher than the estimated exposure. If a look-through or an acceptable estimate are not possible, the full amount of the investment should be accounted for.
    
2. ii.Holdings in both the banking book and trading book are to be included. Capital includes common stock and all other types of cash and synthetic capital instruments (e.g. subordinated debt). It is the net long position that is to be included (i.e. the gross long position net of short positions in the same underlying exposure where the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least one year).
3. iii.Underwriting positions held for five working days or less can be excluded. Underwriting positions held for longer than five working days must be included.
4. iv.If the capital instrument of the entity in which the bank has invested does not meet the criteria for CET1, AT1, or Tier 2 capital of the bank, the capital is to be considered common shares for the purposes of this regulatory adjustment.
5. v.Banks may, with prior Central Bank’s approval, exclude temporarily certain investments where these have been made in the context of resolving or providing financial assistance to reorganize a distressed institution.

65.If the total of all holdings listed above in aggregate exceed 10% of the bank’s common equity (after applying all other regulatory deductions in full, apart from the deductions outlined in this Standard (paragraph 63 to 71)) then the amount above 10% is required to be deducted from CET1.

66.Amounts below the threshold that are not deducted are to be risk weighted as follows:

1. i.Amounts below the threshold that are in the banking book are to be risk weighted as per the credit risk (i.e. investments that are not listed and not marked to market will be risk weighted at 150% and investments that are listed will be risk weighted at 100%).
2. ii.Amounts below the threshold that are in the trading book are to be risk weighted as per the market risk rules.

67.The regulatory adjustment described in this Standard applies to investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation where the bank owns more than 10% of the issued common share capital of the issuing entity or where the entity is an affiliate of the bank. An affiliate of a bank is defined as a company that controls, or is controlled by, or is under common control with, the bank. Control of a company is defined as (1) ownership, control, or holding with power to vote 20% or more of a class of voting securities of the company; or (2) consolidation of the company for financial reporting purposes. In addition,

1. i.Investments include direct, indirect and synthetic holdings of capital instruments. For example, banks should look through holdings of index securities to determine their underlying holdings of capital.
2. ii. Holdings in both the banking book and trading book are to be included. Capital includes common stock and all other types of cash and synthetic capital instruments (e.g. subordinated debt). It is the net long position that is to be included (i.e. the gross long position net of short positions in the same underlying exposure where the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least one year)
3. iii.Underwriting positions held for five working days or less can be excluded. Underwriting positions held for longer than five working days must be included.
4. iv.If the capital instrument of the entity in which the bank has invested does not meet the criteria for CET1, AT1, or Tier 2 capital of the bank, the capital is to be considered common shares for the purposes of this regulatory adjustment. If the investment is issued out of a regulated financial entity and not included in regulatory capital in the relevant sector of the financial entity, it is not required to be deducted.
5. v.Banks may, with prior Central Bank’s approval, exclude temporarily certain investments where these have been made in the context of resolving or providing financial assistance to reorganize a distressed institution.

68.All investments included above that are not common shares must be fully deducted from CET1.

69.Investments included above that are common shares will be subject to the “Threshold deductions” treatment described in the section 4 below.

6.Exposure to the Federal Government and Emirates Government receives 0% risk weight, if such exposures are denominated and funded in AED or USD for a transition period of 7 years from the date of implementation of this Standard. After the transition period, 0% risk weights are only applied to exposures that are denominated and funded in AED.

7.A 0% risk weight may also be applied to exposures to other GCC sovereigns and their central banks only if these exposures are denominated and funded in the domestic currency of that sovereign and the Supervisory authority of that sovereign has adopted such preferential treatment for exposures to its own sovereign and central bank.

8.Exposure to the Federal Government and Emirates Government in currencies other than AED or USD and claims on other sovereigns and central banks that do not meet the criteria set out in paragraph 6, are risk weighted as follows:

9.Exposure to the Bank for International Settlements, the International Monetary Fund, the European Central Bank, the European Union, the European Stability Mechanism (ESM) and the European Financial Stability Facility (EFSF) receive a 0% risk weight.

10.PSEs include the following categories:

1. (i)Non-Commercial PSEs; and
2. (ii)Other PSEs including commercial PSEs (Government Related Entity (GRE) i.e. commercial PSEs that are fully owned or more than 50% in ownership by the UAE government).

11.Non-Commercial PSEs that are acknowledged by the Central Bank may be treated in the same as Claims on Bank. However, the preferential treatment for short-term claims under Claims on Bank must not be applied to non-commercial PSE. The Central Bank issues a GRE list to banks on a regular basis that the Central Bank considers Non-Commercial PSEs that qualify for this treatment. The Central Bank may allow certain domestic Non-Commercial PSEs to be treated same manner as claims on UAE sovereign if these entities have specific revenue raising powers and have specific institutional arrangements the effect of which is to reduce their risks of default.

12.Exposure to all other PSEs that are not included on the Central Bank’s list must be treated like exposures to corporates as per section III.F below.

13.With the exception of the MDBs that meet the criteria specified at paragraph 14 below, the risk weights applied to exposures to MDBs must be based on external credit assessments as set out in the table below.

14.A 0% risk weight will be applied to exposures to highly rated MDBs that meet the Basel Committee on Banking Supervision (BCBS) eligibility criteria for MDBs risk weighted at 0%.

1. (i)The BCBS will continue to evaluate eligibility on a case-by-case basis so it is not possible to provide a definitive list of the MDBs that satisfy the BCBS's eligibility criteria. The up-to-date list of MDBs that meet the BCBS's eligibility criteria can be found on the BCBS's website www.bis.org.
2. (ii)As a national discretion, exposures to the Arab Monetary Fund (AMF) receive 0% risk weight.

15.Claims on banks must be risk weighted based on the external credit assessment of the bank itself as set out in the table below. For the purposes of calculating capital requirements, a bank exposure is defined as a claim on any financial institution that is licensed to take deposits from the public and is subject to appropriate prudential standards and level of supervision.

16.Claims on unrated banks shall be risk-weighted at 50%. No claim on an unrated bank may receive a risk weight lower than that applied to claims on its sovereign of incorporation.

17.A preferential risk weight that is one category more favourable shall be applied to claims with an original maturity of three months or less, subject to a floor of 20%. This treatment shall be available to both rated and unrated banks, but not to banks risk weighted at 150%. Short-term claims in the table below are defined as having an original maturity of three months or less. However, claims with (contractual) original maturity under three months which are rolled over (i.e., where the effective maturity is longer than three months) shall not qualify as short-term claims and shall not enjoy the preferential risk weighting treatment.

18.Claims on securities firms shall be treated as claims on banks provided the securities firms are authorized by a competent authority and subject to supervisory and regulatory arrangements that are the same or equivalent to those under this standards, including, in particular, risk-based capital requirements. Otherwise, such claims must follow the rules for claims on corporates as per section III F below.

19.The table provided below in the next paragraph illustrates the risk weighting of rated corporate claims, including claims on insurance companies.

20.The standard risk weight for unrated claims on corporates shall be 100%. No claim on an unrated corporate may be given a risk weight that is lower than that assigned to its sovereign of incorporation. For unrated exposures to Small- and Medium-sized Entities (SME) that do not meet the criteria in paragraph 21, an 85% risk weight will be applied. The Central Bank may, at its sole discretion, require a higher risk weighting for some unrated corporates as advised to banks directly where appropriate.

21.A 75% risk weighting may apply for exposures classified as “Retail” except as provided below for past due loans as per section III J below. For an exposure to be classified as “Retail” the Central Bank will need to be satisfied that the four criteria listed below are met:

1. (i)Orientation criterion – Exposure to a natural person or persons, or Small- and Medium-sized Entities (SME);
2. (ii)Product criterion – Eligible products included are credit cards, revolving credit, personal lending and small business credit facilities. Residential mortgage products are excluded as these are treated separately as “Claims Secured by Residential Property” as per section H below;
3. (iii)Granularity criterion – No exposure to any one counterparty can exceed 0.20% of the total regulatory retail portfolio being evaluated (exposure is gross before any credit risk mitigation; and one counterparty includes connected persons);
4. (iv)Value criterion –
   1. (i)Maximum aggregated exposure to one counterparty must not exceed the value of AED 4,000,000 for exposures to SME,
   2. (ii)For all other exposures, the maximum aggregated exposure to one counterparty must not exceed the value of AED 2,000,000.

22.The Central Bank reserves the right to increase the 75% risk weight if this risk weight value is deemed to be too low based on the default experience for these types of exposures in the UAE. Exposures to SMEs that do not meet all of the above criteria set out in paragraph 21 are treated as under the corporate asset class and must follow the rules for claims on corporates as per Section III F above.

23.A 35% risk weighting shall apply to exposures fully secured by eligible immovable residential property that is occupied by the owner or that is rented, and where the purpose of the facility is to fund the purchase of the property. This risk weight value shall be applied only where there exists a substantial margin of additional security over the amount of the loan.

24.Residential property shall be considered eligible immovable property if the following criteria are met:

1. (i)A mortgage is enforceable in all jurisdictions which are relevant at the time of the conclusion of the credit agreement and shall be appropriately filed within a reasonable time;
2. (ii)All legal requirements for establishing the mortgage have been fulfilled;
3. (iii)The protection agreement and the legal process underpinning it enable the bank to realise the value of the property within a reasonable timeframe;
4. (iv)Location of the property must be in the UAE; and
5. (v)Banks shall have in place procedures to monitor that the property taken as credit protection is adequately insured against the risk of damage.

25.Banks shall be responsible to monitor on an ongoing basis that the criteria listed in paragraph 24 above are met. In case of failure to conduct such internal monitoring or if the results of such internal monitoring indicate that the criteria are not met, the residential property cannot be considered eligible immovable property for the application of the 35% risk weight.

26.Banks shall clearly document the types of residential immovable property they accept and their lending policies in this regard.

27.Exposures secured by eligible residential real estate, as specified by the eligibility criteria set out in paragraph 24 above, and for which the 35% risk weight applies must not exceed any of the two items below:

1. (i)85% of the market value of the property (i.e., the LTV ratio must be less than or equal to 85%); and
2. (ii)AED 10 million;

28.If the two criteria listed above in paragraph 27 cannot be definitively established or met, then the 35% risk weight cannot be applied. If the exposure meets the criteria for regulatory retail claims as set out at paragraph 21 then a 75% risk weight applies, otherwise a 100% risk weighting must be used.

29.The Central Bank may increase the 35% risk weight if this risk weight is deemed to be too low based on the default experience for these types of exposures in the UAE.

30.A 100% risk weighting shall apply to exposures secured by commercial real estate. For the purposes of this paragraph, a commercial real estate exposure is an exposure secured by immovable property that is not residential real estate as per section III H above.

31.The unsecured portion of any loan (other than a residential mortgage loan as per section H above) that is past due for more than 90 days, net of specific provisions (including partial write-offs), must be risk-weighted as follows:

1. (i)150% risk weight when specific provisions are less than 20% of the outstanding amount of the loan;
2. (ii)100% risk weight when specific provisions are 20% and above of the outstanding amount of the loan.

32.In the case of residential mortgage loans as per section H above, when such loans are past due for more than 90 days they shall be risk weighted at 100%, net of any specific provisions.

33.For the purpose of defining the secured portion of the past due loan, eligible collateral and guarantees shall be the same as for Credit Risk Mitigation set out below at section IV.

34.Past due retail loans are to be excluded from the overall regulatory retail portfolio when assessing the granularity criterion specified in Paragraph 21, for risk-weighting purposes.

35.The following claims shall be risk weighted at 150% or higher:

1. (i)Claims on sovereigns, PSEs, banks, and securities firms rated below B-;
2. (ii)Claims on corporates rated below BB-;
3. (iii)Past due loans as set out in section J above; and
4. (iv)Real estate acquired in settlement of debt and not liquidated within the statutory period (Article 93 of Federal Law).

36.The Central Bank may apply a 150% or higher risk weight reflecting the higher risks associated with the assets.

37.The risk weights applicable to securitisation and re-securitisation exposures are set out in the Standards on Capital for Securitisation Exposures.

38.Gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities shall be treated as cash and therefore risk-weighted at 0%.

39.Cash items in the process of collection are risk-weighted at 20%.

40.Investments in commercial entities shall be treated as per the Capital Supply standard.

41.Exposure to investments in the capital of banking, securities, financial and insurance entities, must be treated as per the Capital Supply standard.

42.The treatment of securitisation exposures is presented separately in line with Securitisation Standard below in these standards.

43.The standard risk weight for exposure to all other assets not specifically mentioned shall be 100%.

44.Off-balance sheet items must be converted into credit exposure equivalents through the use of CCF.

Credit Conversion Factor of 100%

45.The following items must be converted into credit exposure equivalents through the use of CCF of 100%:

1. (i)All direct credit substitutes, including general guarantees of indebtedness (such as standby letters of credit serving as financial guarantees for loans and securities) and acceptances (such as endorsements with the character of acceptances);
2. (ii)Sale and repurchase agreements and asset sales with recourse, where the credit risk remains with the bank;
3. (iii)Forward asset purchases, forward deposits and commitments for the unpaid portion of partly-paid shares and securities which represent commitments with certain draw-downs, and which shall be risk-weighted according to the type of asset and not according to the type of counterparty with whom the transaction has been entered into;
4. (iv)The lending of banks’ securities or the posting of securities as collateral by banks, including instances where these arise out of repo-style transactions (i.e., repurchase/reverse repurchase and securities lending/securities borrowing transactions). Section IV on credit risk mitigation sets out the requirements for the calculation of risk-weighted assets where the credit converted exposure is secured by eligible collateral;
5. (v)Off-balance sheet items that are credit substitutes not explicitly included in any other category (including credit derivatives such as credit default swaps).

Credit Conversion Factor of 50%

46.The following items must be converted into credit exposure equivalents through the use of CCF of 50%:

1. (i)Transaction-related contingent items (e.g., performance bonds, bid bonds warranties, and standby letters of credit related to particular transactions);
2. (ii)Underwriting commitments under note issuance and revolving underwriting facilities regardless of maturity of the underlying facility;
3. (iii)Other commitments that are not unconditionally cancellable with an original maturity exceeding one year.

Credit Conversion Factor of 20%

47.The following items must be converted into credit exposure equivalents through the use of CCF of 20%:

1. (i)Other commitments not unconditionally cancellable with an original maturity of one year or less; and
2. (ii)Short-term self-liquidating trade letters of credit arising from the movement of goods (e.g., documentary credits collateralised by the underlying shipment), for both issuing and confirming banks.

Credit Conversion Factor of 0%

48.Any commitments that are unconditionally cancellable at any time by the bank without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower’s creditworthiness must be converted into credit exposure equivalents using CCF of 0%.

Other Principles

49.Where there is an undertaking to provide a commitment on an off-balance sheet item (i.e., commitment for a commitment), banks shall apply the lower of the two applicable CCFs.

50.The credit equivalent amount of OTC derivatives that expose a bank to counterparty credit risk shall be calculated under the rules set forth below in the Counterparty Credit Risk Standard below.

Failed Trades and Non-DvP Transactions

51.Banks shall closely monitor securities, commodities, and foreign exchange transactions that have failed or not been timely settled.

Principles for Failed Trades and Non-DvP Transactions

52.DvP also refers to PvP transactions for the purpose of this Standard. Transactions settled through a DvP system, providing simultaneous exchanges of securities for cash, expose firms to a risk of loss on the difference between the transaction valued at the agreed settlement price and the transaction valued at current market price (i.e., positive current exposure). Transactions where cash is paid without receipt of the corresponding receivable (securities, foreign currencies, gold, or commodities) or, conversely, deliverables were delivered without receipt of the corresponding cash payment (i.e., non-DvP, or free-delivery transactions) expose firms to a risk of loss on the full amount of cash paid or deliverables delivered. Specific capital charges address these two kinds of exposures.

53.The following capital treatment is applicable to all transactions on securities, foreign exchange instruments, and commodities that give rise to a risk of delayed settlement or delivery. This includes transactions through recognised clearing houses that are subject to daily mark-to-market and payment of daily variation margins and that involve a mismatched trade. Repurchase and reverse-repurchase agreements as well as securities lending and borrowing that have failed to settle are excluded from this capital treatment. (All repurchase and reverse-repurchase agreements as well as securities lending and borrowing, including those that have failed to settle, shall be treated in accordance with the sections on CRM below).

54.In cases of a system wide failure of a settlement or clearing system, the Central Bank may use its discretion to waive capital charges until the situation is rectified.

55.Failure of a counterparty to settle a trade in itself shall not be deemed a default for purposes of credit risk.

Capital Requirements for Failed Trades and Non-DvP Transactions

56.The capital requirement for failed trades and Non-DvP transactions shall be calculated as follows:

1. (i)For DvP transactions, if the payments have not yet taken place five business days after the settlement date, firms must calculate a capital charge by multiplying the positive current exposure of the transaction by the appropriate factor, according to the table below.
    

   Number of working days after the agreed settlement date	Corresponding risk multiplier
   From 5 to 15	8%
   From 16 to 30	50%
   From 31 to 45	75%
   46 or more	100%

2.  
3. (ii)For Non-DvP transactions (i.e., free deliveries), after the first contractual payment/delivery leg, the bank that has made the payment shall treat its exposure as a loan if the second leg has not been received by the end of the business day. This means that a bank shall use the risk weights set forth in the exposure classes set out in this Standard. However, when exposures are not material, banks may choose to apply a uniform 100% risk-weight to these exposures, in order to avoid the burden of a full credit assessment.
4. (iii)If five business days after the second contractual payment/delivery date the second leg has not yet effectively taken place, the bank that has made the first payment leg shall deduct from capital the full amount of the value transferred plus replacement cost, if any. This treatment shall apply until the second payment/delivery leg is effectively made.

Introduction

57.Banks may use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralised by first priority claims, in whole or in part with cash or securities, a loan exposure may be guaranteed by a third party, or a bank may buy a credit derivative to offset various forms of credit risk. Additionally, banks may agree to net loans owed to them against deposits from the same counterparty.

58.In this Standard, “counterparty” is used to denote a party to whom a bank has an on or off-balance sheet credit exposure. That exposure may, for example, take the form of a loan of cash or securities (where the counterparty would traditionally be called the borrower), of securities posted as collateral, of a commitment or of exposure under an OTC derivatives contract

General Requirements for legal certainty

59.The Central Bank recognizes certain credit risk mitigation techniques for regulatory capital purposes, provided that all documentation used in collateralised transactions and for documenting on-balance sheet netting, guarantees and credit derivatives are binding on all parties and legally enforceable in all relevant jurisdictions, and that banks have conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability.

60.Where a bank has a single exposure covered either by more than one type of credit risk mitigation, or by differing maturities of protection provided by the same credit protection provider, the bank shall:

1. (i)Subdivide the exposure into parts covered by each type or maturity of credit risk mitigation tool; and
2. (ii)Calculate the risk-weighted assets for each part obtained in point (i) above separately in accordance with the risk weights applicable to each exposure category as described in the relevant section.

61.The comprehensive approach for the treatment of collateral (described further below from paragraph 85) shall also be applied to calculate the counterparty risk charges for OTC derivatives and repo-style transactions booked in the trading book.

62.No transaction in which CRM techniques are used shall receive a higher capital requirement than an otherwise identical transaction where such techniques are not used.

63.The effects of CRM shall not be double counted. Therefore, no additional supervisory recognition of CRM for regulatory capital purposes shall be granted on claims for which an issue-specific rating is used that already reflects that CRM. Principal-only ratings shall also not be allowed within the framework of CRM to claims for which an external credit assessment can be conducted.

64.Considering that, while the use of CRM techniques reduces or transfers credit risk, it simultaneously may increase other risks (residual risks), and that residual risks include legal, operational, liquidity and market risks, banks shall employ robust procedures and processes to control these risks, including strategy, consideration of the underlying credit, valuation, policies and procedures, systems, control of roll-off risks, and management of concentration risk arising from the bank’s use of CRM techniques and its interaction with the bank’s overall credit risk profile. Where these risks are not adequately controlled, the Central Bank may impose additional capital charges or take other supervisory actions under Pillar 2.

65.The banks shall also observe the Central Bank’s Pillar 3 requirements to obtain capital relief in respect of any CRM techniques.

66.A collateralised transaction is one in which:

1. (i)Banks have a credit exposure or potential credit exposure; and
2. (ii)Credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty.

67.Where banks take eligible financial collateral (e.g., cash or securities, more specifically as per section IV C (a)), they are allowed to reduce their credit exposure to a counterparty when calculating their capital requirements to take account of the risk mitigating effect of the collateral.

Overall framework

68.Banks may opt for either the simple approach (described further in Section IV C(c)), which substitutes the risk weighting of the collateral for the risk weighting of the counterparty for the collateralised portion of the exposure (generally subject to a 20% floor), or for the Comprehensive Approach (described further in Section IV C(b)), which allows fuller offset of collateral against exposures, by effectively reducing the exposure amount by the value ascribed to the collateral.

69.Partial collateralisation is recognised in both approaches.

70.Mismatches in the maturity of the underlying exposure and the collateral shall only be allowed under the comprehensive approach.

71.Banks shall operate under either the simple approach or comprehensive approach, but not both approaches, in the banking book, but only under the comprehensive approach in the trading book.

72.Banks that intend to apply the comprehensive approach require prior approval from the Central Bank.

Minimum Conditions

73.The minimum conditions set out below must be met before capital relief will be granted in respect of any form of collateral under either the simple approach or comprehensive approach.

74.In addition to the general requirements for legal certainty set out above at paragraph 59 to 65, the legal mechanism by which collateral is pledged or transferred shall ensure that the bank has the right to liquidate or take legal possession of it, in a timely manner, in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Furthermore, banks shall take all steps necessary to fulfil those requirements under the law applicable to the bank’s interest in the collateral for obtaining and maintaining an enforceable security interest, e.g., by registering it with a registrar, or for exercising a right to net or set off in relation to title transfer collateral.

75.In order for collateral to provide protection, the credit quality of the counterparty and the value of the collateral must not have a material positive correlation (for example, securities issued by the counterparty - or by any related group entity - would provide little protection and so would be ineligible).

76.Banks shall have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly.

77.Where the collateral is held by a custodian, banks shall take reasonable steps to ensure that the custodian segregates the collateral from its own assets.

78.A capital requirement shall be applied to a bank on either side of the collateralised transaction (for example, both repos and reverse repos shall be subject to capital requirements). Likewise, both sides of a securities lending and borrowing transaction shall be subject to explicit capital charges, as shall the posting of securities in connection with a derivative exposure or other borrowing.

79.Where a bank, acting as an agent, arranges a repo-style transaction (i.e., repurchase/reverse repurchase and securities lending/borrowing transactions) between a customer and a third party and provides a guarantee to the customer that the third party will perform on its obligations, then the risk to the bank shall be the same as if the bank had entered into the transaction as a principal. In such circumstances, a bank shall be required to calculate capital requirements as if it were itself the principal.

The simple approach

80.In the simple approach the risk weighting of the collateral instrument collateralising or partially collateralising the exposure shall be substituted for the risk weighting of the counterparty. Details of this framework are provided further below at section IV C (c).

The comprehensive approach

81.In the comprehensive approach, when taking collateral, banks shall calculate their adjusted exposure amount to a counterparty for capital adequacy purposes in order to take account of the effects of that collateral. Using haircuts, banks shall adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either, occasioned by market movements (exposure amounts may vary, for example where securities are being lent.) This will produce volatility-adjusted amounts for both exposure and collateral. Unless either side of the transaction is cash, the volatility-adjusted amount for the exposure shall be higher than the exposure and for the collateral, it shall be lower.

82.Where the exposure and collateral are held in different currencies an additional downwards adjustment shall be made to the volatility adjusted collateral amount to take account of possible future fluctuations in exchange rates.

83.Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral amount (including any further adjustment for foreign exchange risk), banks shall calculate their risk-weighted assets as the difference between the two multiplied by the risk weight of the counterparty. The framework for performing these calculations is set out further below in paragraph 97 to 100.

84.Banks shall use the standard supervisory haircuts and the parameters therein as set by the Central Bank. The use of own-estimate haircuts that rely on banks own internal estimates of market price volatility is prohibited.

85.The size of the individual haircuts shall depend on the type of instrument, type of transaction and the frequency of marking-to-market and re-margining (for example, repo style transactions subject to daily marking-to-market and to daily re-margining will receive a haircut based on a 5-business day holding period and secured lending transactions with daily mark-to-market and no re-margining clauses will receive a haircut based on a 20-business day holding period. These haircut numbers will be scaled up using the square root of time formula depending on the frequency of re-margining or marking-to-market).

86.For certain types of repo-style transactions (broadly speaking government bond repos) banks are permitted in certain cases not to apply the standard supervisory haircuts in calculating the exposure amount after risk mitigation. Paragraph 108 lists cases where such treatment is allowed.

87.The effect of master netting agreements covering repo-style transactions can be recognised for the calculation of capital requirements subject to the conditions specified in Paragraph 110.

On-balance sheet netting

88.Where banks have legally enforceable netting arrangements for loans and deposits they may calculate capital requirements on the basis of net credit exposures subject to the conditions in paragraphs 120.

Guarantees and credit derivatives

89.Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and the Central Bank is satisfied that banks fulfil certain minimum operational conditions relating to risk management processes, banks are allowed to take account of such credit protection in calculating capital requirements.

90.A range of guarantors and protection providers are recognized by the Central Bank. A substitution approach shall be applied. Thus only guarantees issued by or protection provided by entities with a lower risk weight than the counterparty will lead to reduced capital charges since the protected portion of the counterparty exposure is assigned the risk weight of the guarantor or protection provider, whereas the uncovered portion retains the risk weight of the underlying counterparty. Detailed operational requirements for the recognition of guarantees and credit derivatives are given below in paragraphs 122 to 128.

Maturity mismatch

91.Where the residual maturity of the CRM is less than that of the underlying credit exposure a maturity mismatch occurs.

92.Where there is a maturity mismatch and the CRM has an original maturity of less than one year, the CRM shall not be recognised for capital purposes. In other cases where there is a maturity mismatch, partial recognition shall be given to the CRM for regulatory capital purposes as detailed below in paragraphs 137 to 140.

93.Under the simple approach, such partial recognition is not allowed for collateral maturity mismatches.

Miscellaneous

94.The treatments for pools of credit risk mitigants and first- and second-to-default credit derivatives are given in paragraphs 141 to 145.

a) Eligible financial collateral

95.The following collateral instruments are eligible for recognition in the simple approach:

1. (i)Cash (as well as certificates of deposit or comparable instruments issued by the lending bank) on deposit with the bank which is incurring the counterparty exposure.
   
   Note 1: Cash funded credit linked notes issued by the bank against exposures in the banking book which fulfil the criteria for credit derivatives will be treated as cash collateralised transactions.
   
   Note 2: When cash on deposit, certificates of deposit or comparable instruments issued by the lending bank are held as collateral at a third-party bank in a noncustodial arrangement, if they are openly pledged/assigned to the lending bank and if the pledge/assignment is unconditional and irrevocable, the exposure amount covered by the collateral (after any necessary haircuts for currency risk) will receive the risk weight of the third-party bank);
    
2. (ii)Gold;
3. (iii)Debt securities rated by a recognised external credit assessment institution where these are either:
   • ○Rated at least BB- when issued by sovereigns or PSEs that are treated as sovereigns by the Central Bank; or
   • ○At least BBB- when issued by other entities (including banks and securities firms); or
   • ○At least A-3/P-3 for short-term debt instruments.
4. (iv)Debt securities not rated by a recognised external credit assessment institution where these are:
   • ○Issued by a bank; and
   • ○Listed on a recognised exchange; and
   • ○Classified as senior debt; and
   • ○All rated issues of the same seniority by the issuing bank must be rated at least BBB- or A-3/P-3 by a recognised external credit assessment institution; and
   • ○The bank holding the securities as collateral has no information to suggest that the issue justifies a rating below BBB- or A-3/P-3 (as applicable); and
   • ○The Central Bank is sufficiently confident about the market liquidity of the security.
5. (v)Equities (including convertible bonds) that are included in a main index (a widely accepted index that ensures adequate liquidity, depth of market, and size of bid-ask spread).
6. (vi)UCITS and mutual funds where:
   • ○A price for the units is publicly quoted daily; and
   • ○The UCITS/mutual fund is limited to investing in the instruments listed in this paragraph. However, the use or potential use by a UCITS/mutual fund of derivative instruments solely to hedge investments listed in this paragraph and the next paragraph shall not prevent units in that UCITS/mutual fund from being eligible financial collateral.

96.The following collateral instruments are eligible for recognition in the comprehensive approach:

1. (i)All of the collateral instruments that are eligible for recognition in the Simple Approach, as outlined in the above at paragraph 95;
2. (ii)Equities (including convertible bonds) which are not included in a main index but which are listed on a recognised exchange;
3. (iii)UCITS/mutual funds which include such equities.

b) The Comprehensive Approach

Calculation of Adjusted exposure

97.For a collateralised transaction, the exposure amount after risk mitigation is calculated as follows:

98.The exposure amount after risk mitigation shall be multiplied by the risk weight of the counterparty to obtain the risk-weighted asset amount for the collateralised transaction.

99.The treatment for transactions where there is a mismatch between the maturity of the counterparty exposure and the collateral is given in paragraphs 137 to 140.

100.Where the collateral is a basket of assets, the haircut on the basket will be

Standard supervisory haircuts

101.The following table sets the standard supervisory haircuts (assuming daily mark-to-market, daily re-margining and a 10-business day holding period), expressed as percentages:

102.The standard supervisory haircut for currency risk where exposure and collateral are denominated in different currencies is 8% (also based on a 10-business day holding period and daily mark-to-market).

103.For transactions in which the bank lends non-eligible instruments (e.g., noninvestment grade corporate debt securities), the haircut to be applied on the exposure must be the same as the one for equity traded on a recognised exchange.

Adjustment for different holding periods and non-daily mark-to-market or re-margining

104.For some transactions, depending on the nature and frequency of the revaluation and re-margining provisions, different holding periods are appropriate. The framework for collateral haircuts distinguishes between repo-style transactions (i.e., repo/reverse repos and securities lending/borrowing), “other capital-market-driven transactions” (i.e., OTC derivatives transactions and margin lending) and secured lending. In capital-market-driven transactions and repo-style transactions, the documentation contains re-margining clauses; in secured lending transactions, it generally does not.

105.The minimum holding period for various products or transactions is summarised in the table below:

106.When the frequency of re-margining or revaluation is longer than the minimum, the minimum haircut numbers shall be scaled up depending on the actual number of business days between re-margining or revaluation using the square root of time formula below:

107.When a bank calculates the volatility on a T_N day holding period which is different from the specified minimum holding period T_M, the H_M will be calculated using the square root of time formula:

Conditions for zero Haircut on repo-style transactions with a core market participant

108.For repo-style transactions where the following conditions are satisfied, and the counterparty is a Core Market Participant (see definition in the next paragraph), banks may choose not to apply the haircuts specified in the Comprehensive Approach and may instead apply a haircut of zero. However, counterparties specified in 109 (iii), (iv), (v) and (vi) require prior approval from the Central Bank.

1. (i)Both the exposure and the collateral are cash or a sovereign security or PSE security qualifying for a 0% risk weight in the standardised approach;
2. (ii)Both the exposure and the collateral are denominated in the same currency;
3. (iii)Either the transaction is overnight or both the exposure and the collateral are marked-to-market daily and are subject to daily re-margining;
4. (iv)Following a counterparty’s failure to re-margin, the time that is required between the last mark-to-market before the failure to re-margin and the liquidation of the collateral is considered to be no more than four (4) business days. It is noted this does not require the bank to always liquidate the collateral but rather to have the capability to do so within the given time frame;
5. (v)The transaction is settled across a settlement system proven for that type of transaction;
6. (vi)The documentation covering the agreement is standard market documentation for repo-style transactions in the securities concerned;
7. (vii)The transaction is governed by documentation specifying that if the counterparty fails to satisfy an obligation to deliver cash or securities or to deliver margin or otherwise defaults, then the transaction is immediately terminable; and
8. (viii)Upon any default event, regardless of whether the counterparty is insolvent or bankrupt, the bank has the unfettered, legally enforceable right to immediately seize and liquidate the collateral for its benefit.

109.Core Market Participants are the following entities:

1. (i)Sovereigns, central banks and Non-commercial PSEs;
2. (ii)Banks and securities firms;
3. (iii)Other financial companies (including insurance companies) eligible for a 20% risk weight in the standardised approach;
4. (iv)Regulated mutual funds that are subject to capital or leverage requirements;
5. (v)Regulated pension funds; and
6. (vi)Recognised clearing organisations.

Treatment of repo-style transactions covered under master netting agreements

110.The effects of bilateral netting agreements covering repo-style transactions will be recognised on a counterparty-by-counterparty basis if the agreements are legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of whether the counterparty is insolvent or bankrupt. In addition, netting agreements must:

1. (i)Provide the non-defaulting party the right to terminate and close-out in a timely manner all transactions under the agreement upon an event of default, including in the event of insolvency or bankruptcy of the counterparty; and
2. (ii)Provide for the netting of gains and losses on transactions (including the value of any collateral) terminated and closed out under it so that a single net amount is owed by one party to the other; and
3. (iii)Allow for the prompt liquidation or setoff of collateral upon the event of default; and
4. (iv)Be, together with the rights arising from the provisions required in (i) to (iii) above, legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of the counterparty's insolvency or bankruptcy.

111.Netting across positions in the banking and trading book will only be recognized when the netted transactions fulfil both of the following two conditions:

1. (i)All transactions are marked to market daily. It is noted that the holding period for the haircuts will depend as in other repo-style transactions on the frequency of margining; and
2. (ii)The collateral instruments used in the transactions are recognised as eligible financial collateral in the banking book.

112.The formula in paragraphs 97 will be adapted to calculate the capital requirements for transactions with netting agreements.

113.For banks using the standard supervisory haircuts, the framework below will apply to take into account the impact of master netting agreements.

114.The intention here is to obtain a net exposure amount after netting of the exposures and collateral and have an add-on amount reflecting possible price changes for the securities involved in the transactions and for foreign exchange risk if any. The net long or short position of each security included in the netting agreement will be multiplied by the appropriate haircut. All other rules regarding the calculation of haircuts stated in paragraphs under the comprehensive approach equivalently apply for banks using bilateral netting agreements for repo-style transactions.

c) The Simple Approach

Minimum conditions

115.For collateral to be recognised in the simple approach the collateral must be pledged for at least the life of the exposure and it must be marked to market and revalued with a minimum frequency of six months. Those portions of claims collateralised by the market value of recognised collateral receive the risk weight applicable to the collateral instrument. The risk weight on the collateralised portion will be subject to a floor of 20% except under the conditions specified in paragraphs 116 to 118. The remainder of the claim must be assigned to the risk weight appropriate to the counterparty. A capital requirement will be applied to banks on either side of the collateralised transaction: for example, both repos and reverse repos will be subject to capital requirements.

Exceptions to the risk weight floor

116.Transactions that fulfil the criteria outlined in paragraph 108 and are with a core market participant, as defined in paragraph 109; receive a risk weight of 0%. If the counterparty to the transactions is not a core market participant, the transaction must receive a risk weight of 10%.

117.OTC derivative transactions subject to daily mark-to-market, collateralised by cash and where there is no currency mismatch must receive a 0% risk weight. Such transactions collateralised by sovereign can receive a 10% risk weight.

118.The 20% floor for the risk weight on a collateralised transaction will not be applied and a 0% risk weight can be applied where the exposure and the collateral are denominated in the same currency, and either:

1. (i)The collateral is cash on deposit as defined in item (i), namely Cash, in paragraph 95; or
2. (ii)The collateral is in the form of sovereign and its market value has been discounted by 20%.

d) Collateralised OTC derivatives transactions

119.Under the SA-CCR Standard, the calculation of risk weighted assets for counterparty credit risk depends on replacement cost and an add-on for potential future exposure, and takes into account collateral in the manner specified in that Standard. The haircut for currency risk (H_fx) must be applied when there is a mismatch between the collateral currency and the settlement currency. Even in the case where there are more than two currencies involved in the exposure, collateral and settlement currency, a single haircut assuming a 10- business day holding period scaled up as necessary depending on the frequency of mark- to-market will be applied.

120.A bank may use the net exposure of loans and deposits as the basis for its capital adequacy calculation in accordance with the formula in Paragraph 97, where the bank:

1. (i)Has a well-founded legal basis for concluding that the netting or offsetting agreement is enforceable in each relevant jurisdiction regardless of whether the counterparty is insolvent or bankrupt;
2. (ii)Is able at any time to determine those assets and liabilities with the same counterparty that are subject to the netting agreement;
3. (iii)Monitors and controls its roll-off risks; and
4. (iv)Monitors and controls the relevant exposures on a net basis.

121.Assets (loans) are treated as exposure and liabilities (deposits) as collateral. The haircuts will be zero except when a currency mismatch exists. A 10-business day holding period will apply when daily mark-to-market is conducted and all the requirements stipulated under paragraphs 101, 107, and 137 to 140 will apply.

a) Operational requirements

Operational requirements common to guarantees and credit derivatives

122.A guarantee (counter-guarantee) or credit derivative must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible. Other than non-payment by a protection purchaser of money due in respect of the credit protection contract it must be irrevocable; there must be no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure (Note that the irrevocability condition does not require that the credit protection and the exposure be maturity matched; rather that the maturity agreed ex ante may not be reduced ex post by the protection provider. Paragraph 138 sets forth the treatment of call options in determining remaining maturity for credit protection). It must also be unconditional; there must be no clause in the protection contract outside the direct control of the bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due.

Additional operational requirements for guarantees

123.In addition to the legal certainty requirements described in paragraph 59, in order for a guarantee to be recognised, the following conditions must be satisfied:

1. (i)On the qualifying default/non-payment of the counterparty, the bank may pursue the guarantor for any monies outstanding under the documentation governing the transaction within a reasonable time period. The guarantor may make one lump sum payment of all monies under such documentation to the bank, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The bank must have the right to receive any such payments from the guarantor without first having to take legal actions in order to pursue the counterparty for payment;
2. (ii)The guarantee is an explicitly documented obligation assumed by the guarantor; and
3. (iii)Except as noted in the following sentence, the guarantee covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments etc. Where a guarantee covers payment of principal only, interests and other uncovered payments must be treated as an unsecured amount in accordance with paragraph 136.

Additional operational requirements for credit derivatives

124.In order for a credit derivative contract to be recognised, the following conditions must be satisfied:

1. (i)The credit events specified by the contracting parties must at a minimum cover:
   • ○Failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation);
   • ○Bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and
   • ○Restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e., charge-off, specific provision or other similar debit to the profit and loss account). When restructuring is not specified as a credit event, refer to the next paragraph;
2. (ii)If the credit derivative covers obligations that do not include the underlying obligation, item (vii) below governs whether the asset mismatch is permissible;
3. (iii)The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay, subject to the provisions of paragraph 137;
4. (iv)Credit derivatives allowing for cash settlement are recognised for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There must be a clearly specified period for obtaining post-credit event valuations of the underlying obligation. If the reference obligation specified in the credit derivative for purposes of cash settlement is different than the underlying obligation, item (vii) below governs whether the asset mismatch is permissible;
5. (v)If the protection purchaser’s right/ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation must provide that any required consent to such transfer may not be unreasonably withheld;
6. (vi)The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event;
7. (vii)A mismatch between the underlying obligation and the reference obligation under the credit derivative (i.e. the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if (i) the reference obligation ranks pari passu with or is junior to the underlying obligation, and (ii) the underlying obligation and reference obligation share the same obligor (i.e., the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place; and
8. (viii)A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if (i) the latter obligation ranks pari passu with or is junior to the underlying obligation, and (ii) the underlying obligation and reference obligation share the same obligor (i.e., the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.

125.When the restructuring of the underlying obligation is not covered by the credit derivative, but the other requirements in the previous paragraph are met, partial recognition of the credit derivative will be allowed. If the amount of the credit derivative is less than or equal to the amount of the underlying obligation, 60% of the amount of the hedge can be recognized as covered. If the amount of the credit derivative is larger than that of the underlying obligation, then the amount of eligible hedge is capped at 60% of the amount of the underlying obligation.

126.Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees will be eligible for recognition. The exception stated in paragraph 127 below applies.

127.Where a bank buys credit protection through a total return swap and records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by an addition to reserves), the credit protection will not be recognised. The treatment of first-to-default and second-to-default products is covered separately in paragraphs 142 to 145.

128.Other types of credit derivatives will not be eligible for recognition at this time. Note that cash funded credit linked notes issued by the bank against exposures in the banking book which fulfil the criteria for credit derivatives will be treated as cash collateralised transactions.

b) Range of eligible guarantors (counter-guarantors)/protection providers

129.Credit protection given by the following entities will be recognised:

1. (i)Sovereign entities (including the Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community, as well as those MDBs eligible for 0% risk weight listed in paragraph 14), PSEs, banks (including other MDBs) and Securities Firms with a lower risk weight than the counterparty;
2. (ii)Other entities rated A- or better by an eligible credit assessment institution. This would include credit protection provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor.

c) Risk weights

130.The protected portion is assigned the risk weight of the protection provider. The uncovered portion of the exposure is assigned the risk weight of the underlying counterparty.

131.Materiality thresholds on payments below which no payment is made in the event of loss are equivalent to retained first loss positions and must be deducted in full from the capital of the bank purchasing the credit protection.

Proportional cover

132.Where the amount guaranteed, or against which credit protection is held, is less than the amount of the exposure, and the secured and unsecured portions are of equal seniority, i.e., the bank and the guarantor share losses on a pro-rata basis capital relief will be afforded on a proportional basis: i.e., the protected portion of the exposure will receive the treatment applicable to eligible guarantees/credit derivatives, with the remainder treated as unsecured.

Tranched cover

133.Where the bank transfers a portion of the risk of an exposure in one or more tranches to a protection seller or sellers and retains some level of risk of the loan and the risk transferred and the risk retained are of different seniority, banks may obtain credit protection for either the senior tranches (e.g., second loss portion) or the junior tranche (e.g., first loss portion). In this case, the rules as set out in the Securitisation chapter below will apply.

d) Currency mismatches

134.Where the credit protection is denominated in a currency different from that in which the exposure is denominated — i.e., there is a currency mismatch — the amount of the exposure deemed to be protected will be reduced by the application of a haircut H_FX, i.e.

135.The appropriate haircut based on a 10-business day holding period (assuming daily marking-to-market) will be applied. Banks using the supervisory haircuts shall apply 8%. The haircut value of 8% must be scaled up using the square root of time formula, depending on the frequency of revaluation of the credit protection as described in paragraphs 106.

e) Sovereign guarantees and counter-guarantees

136.Portions of claims guaranteed by the UAE sovereign, where the guarantee is denominated in AED and the exposure is funded in AED are risk weighted at 0%. A claim may be covered by a guarantee that is indirectly counter-guaranteed by a sovereign. Such a claim may be treated as covered by a sovereign guarantee provided that:

1. (i)The sovereign counter-guarantee covers all credit risk elements of the claim;
2. (ii)Both the original guarantee and the counter-guarantee meet all operational requirements for guarantees, except that the counter-guarantee need not be direct and explicit to the original claim; and
3. (iii)The Central Bank is satisfied that the cover is robust and that no historical evidence suggests that the coverage of the counter-guarantee is less than effectively equivalent to that of a direct sovereign guarantee.

137.For the purposes of calculating risk-weighted assets, a maturity mismatch occurs when the residual maturity of a hedge is less than that of the underlying exposure.

a) Definition of maturity

138.The maturity of the underlying exposure and the maturity of the hedge must both be defined conservatively. The effective maturity of the underlying must be gauged as the longest possible remaining time before the counterparty is scheduled to fulfil its obligation, taking into account any applicable grace period. For the hedge, embedded options which may reduce the term of the hedge must be taken into account so that the shortest possible effective maturity is used. Where a call is at the discretion of the protection seller, the maturity will always be at the first call date. If the call is at the discretion of the protection buying bank but the terms of the arrangement at origination of the hedge contain a positive incentive for the bank to call the transaction before contractual maturity, the remaining time to the first call date will be deemed to be the effective maturity (For example, where there is a step-up in cost in conjunction with a call feature or where the effective cost of cover increases over time even if credit quality remains the same or increases, the effective maturity will be the remaining time to the first call).

b) Risk weights for maturity mismatches

139.As outlined in paragraph 95, hedges with maturity mismatches are only recognized when their original maturities are greater than or equal to one year. As a result, the maturity of hedges for exposures with original maturities of less than one year must be matched to be recognised. In all cases, hedges with maturity mismatches will no longer be recognised when they have a residual maturity of three months or less.

140.When there is a maturity mismatch with recognised credit risk mitigants (collateral, on-balance sheet netting, guarantees and credit derivatives) the following adjustment will be applied.

a) Treatment of pools of CRM techniques

141.In the case where a bank has multiple CRM techniques covering a single exposure (e.g. a bank has both collateral and guarantee partially covering an exposure), the bank will be required to subdivide the exposure into portions covered by each type of CRM technique (e.g. portion covered by collateral, portion covered by guarantee) and the risk-weighted assets of each portion must be calculated separately. When credit protection provided by a single protection provider has differing maturities, they must be subdivided into separate protection as well.

b) First-to-default credit derivatives

142.There are cases where a bank obtains credit protection for a basket of reference names and where the first default among the reference names triggers the credit protection and the credit event also terminates the contract. In this case, the bank may recognize regulatory capital relief for the asset within the basket with the lowest risk-weighted amount, but only if the notional amount is less than or equal to the notional amount of the credit derivative.

143.With regard to the bank providing credit protection through such an instrument, if the product has an external credit assessment from an eligible credit assessment institution, the risk weight applied to securitisation tranches will be specified in the Securitisation Standard. If the product is not rated by an eligible external credit assessment institution, the risk weights of the assets included in the basket will be aggregated up to a maximum of 1250% and multiplied by the nominal amount of the protection provided by the credit derivative to obtain the risk-weighted asset amount.

c) Second-to-default credit derivatives

144.In the case where the second default among the assets within the basket triggers the credit protection, the bank obtaining credit protection through such a product will only be able to recognise any capital relief if first-default-protection has also been obtained or when one of the assets within the basket has already defaulted.

145.For banks providing credit protection through such a product, the capital treatment is the same as in paragraph 143, with one exception. The exception is that, in aggregating the risk weights, the asset with the lowest risk weighted amount can be excluded from the calculation.

5.Banks must calculate RWA for CCR at the level of nettings sets for derivatives. Accordingly, a bank must group all exposures for each counterparty into one or more netting sets. In every such case where netting is applied, a bank must satisfy the Central Bank that it has:

• •A contract with the counterparty or other agreement that creates a single legal obligation, covering all included transactions, such that the bank would have either a claim to receive or obligation to pay only the net sum of the positive and negative mark-to-market values of included individual transactions in the event a counterparty fails to perform due to default, bankruptcy, liquidation, or similar circumstances.
• •Written and reasoned legal reviews that in the event of a legal challenge, the relevant courts and administrative authorities would find the bank’s exposure to be such a net amount under:
  • •The law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of the jurisdiction in which the branch is located;
  • •The law that governs the individual transactions; and
  • •The law that governs any contract or agreement necessary to affect the netting.
• •Procedures in place to ensure that the legal characteristics of netting arrangements are kept under review in light of the possible changes in relevant law.

6.The Central Bank, after consultation when necessary with other relevant supervisors, must be satisfied that the netting is enforceable under the laws of each of the relevant jurisdictions.

7.A bank must calculate RWA for CCR by (i) calculating the Exposure At Default (EAD) for each netting set associated with a counterparty, (ii) summing EAD across netting sets for that counterparty, (iii) calculating risk-weighted EAD by multiplying the total EAD for a counterparty by the risk-weight corresponding to the exposure class to which that counterparty belongs under general risk-based capital requirements, (iv) summing the resulting risk-weighted EAD across all counterparties within a given exposure class and (v) summing across exposure classes.

8.Banks must calculate EAD separately for each netting set, as the sum of the Replacement Cost (RC) of the netting set plus the calculated Potential Future Exposure (PFE) for the netting set, with the sum of the two multiplied by a factor of 1.4:

$$\mathrm{E}\mathrm{A}\mathrm{D}=(\mathrm{R}\mathrm{C}+\mathrm{P}\mathrm{F}\mathrm{E})\times 1.4$$
 

9.Margined and un-margined netting sets require different calculation methods for RC and PFE. The EAD for a margined netting set is capped at the EAD of the same netting set calculated on an un-margined basis. That is, for a netting set covered by a margin agreement, the bank may calculate EAD as if the netting set is un-margined, and may use that value as the EAD if it is lower than the EAD calculation considering margin.

10.The time-period for the haircut applicable to non-cash collateral for the RC calculation should be one year for un-margined trades, and the relevant margin period of risk for margined trades.

11.Banks must calculate replacement cost at the netting set level. Calculations for margined and un-margined transactions differ.

12.Banks first must calculate the total current market value of the derivative contracts in the netting set. Banks may net transactions within a netting set that are subject to any legally valid form of bilateral netting, including netting by novation. Banks must then subtract from that total current market value the net value of collateral (after application of collateral haircuts) held by the bank for the netting set. The result is the Net Current Value (NCV) of the transactions in the netting set.

13.For un-margined transactions, RC for a netting set is equal to the NCV, provided the NCV is greater than zero. If that value is not greater than zero, RC equals zero.

14.For margined transactions, RC depends on the greatest exposure that would not trigger a call for variation margin, taking into account the mechanics of collateral exchanges in the margining agreements. That critical exposure level is equal to the threshold level of variation that would require a transfer of collateral, plus the minimum transfer amount of the collateral. The bank should subtract from that exposure amount the NICA, if any, to calculate the RC for margined transactions. However, the resulting RC may be no less than the RC if the netting set were un-margined. That is, for a margined netting set the RC is equal to the larger of the amount calculated according to this paragraph, or the RC for the same netting set if un-margined.

15.Bilateral transactions with a one-way margining agreement in favor of the bank’s counterparty (that is, where the bank posts margin but the counterparty does not) must be treated as un-margined transactions.

16.If multiple margin agreements apply to a single netting set, the bank must divide the netting set into sub-netting sets that align with each respective margin agreement, and calculate RC for each sub-netting set separately.

17.Calculation of PFE relies on computation of various “add-on” amounts, which are intermediate measures of exposure that are combined in various ways to compute PFE. The bank must calculate PFE for each netting set as a simple summation of the add-ons computed for each of the various asset classes within that netting set, multiplied by a multiplier that allows for recognition of excess collateral or negative mark-to-market value for the transactions. Requirements for calculation of the multiplier and the add-ons for each asset class are described below in this Standard.

18.The bank must allocate all derivatives transactions to one or more of the following asset classes based on the primary risk driver of the transaction:

• •Interest Rate Derivatives
• •Foreign Exchange Derivatives
• •Credit Derivatives
• •Equity Derivatives
• •Commodity Derivatives

19.As described in more detail below in this Standard, trades within each of these asset classes are further divided into hedging sets, and an aggregation method is applied to aggregate trade-level inputs at the hedging set level and finally at the asset class level. For derivative transactions within the credit, equity, and commodity asset classes, this aggregation involves a supervisory correlation parameter to capture important aspects of basis risk and diversification.
 

20.For trades that may have more than one risk driver (e.g. multi-asset or hybrid derivatives), banks must apply an analysis based on risk-driver sensitivities and volatility of the underlying reference price or rate to determine the existence of a dominant risk driver, and make the asset class allocation accordingly. When a derivative is materially exposed to risk drivers spanning more than one asset class, a bank must assign the position to each relevant asset class rather than to a single asset class, with appropriate delta adjustment. The Central Bank may direct banks to assign complex derivatives to multiple asset classes, regardless of analysis that the bank may or may not have conducted.

21.As is the case with Replacement Cost, if multiple margin agreements apply to a single netting set, the bank must divide the netting set into sub-netting sets that align with each respective margin agreement, and calculate the PFE for each sub-netting set separately.

22.Banks must calculate adjusted notional amounts from trade-level notional amounts for each transaction as described in this Standard.

23.For foreign exchange derivatives, the adjusted notional is defined as the notional of the foreign currency leg of the contract, converted to the domestic currency. If both legs of a foreign exchange derivative are denominated in currencies other than the domestic currency, the notional amount of each leg should be converted to the domestic currency, and the adjusted notional amount is equal to the value of the leg with the larger domestic currency value.

24.For equity and commodity derivatives, the adjusted notional is equal to the product of the current price of one unit of the stock or commodity and the number of units referenced by the trade. For equity and commodity volatility transactions, adjusted notional is equal to the product of the underlying volatility and the notional value of the transaction.

25.For interest rate derivatives and credit derivatives, the trade-level adjusted notional in units of domestic currency must be multiplied by a supervisory duration (SD) measure as follows:

1. a)First, the bank must determine the start date of the time period referenced by the interest rate or credit contract, and time that remains until that start date, measured in years; this is “S.” If the derivative references the value of another interest rate or credit instrument (as with a swaption or bond option), the time period is that of the underlying instrument. If the time-period referenced by the derivative has already started, the bank must set S to zero.
2. b)Next, the bank must determine the end date of the time period referenced by the interest rate or credit contract, and the time remaining until that end date, measured in years; this is “E.” If the derivative references the value of another interest rate or credit instrument (as with a swaption or bond option), the time period is that of the underlying instrument.
3. c)The bank then must compute SD for the transaction using the following formula, with the identified values of S and E based on the terms of the contract (where “exp” denotes the exponential function):

   $$\frac{\mathrm{<img\; alt="1"\; data-entity-type="file"\; data-entity-uuid="c6a4d0fd-a755-4522-8106-39045a41616c"\; height="36"\; src="/sites/default/files/inline-images/4\_5.png"\; width="221">}}{}$$
    

4. d)Finally, the bank calculates the adjusted notional amount for the transaction by multiplying the trade notional amount by the supervisory duration SD.

26.Banks also must apply the following rules when determining trade notional amounts, for transaction covered by the cases noted below:

1. a)For transactions with payoffs that are state contingent such as digital options or target redemption forwards, a bank must calculate the trade notional amount for each state, and use the largest resulting calculation.
2. b)If the notional is based on a formula that depends on market values, the bank must enter the current market values to determine the trade notional amount to be used in computing adjusted notional amount.
3. c)For variable notional swaps such as amortizing and accreting swaps, banks must use the average notional over the remaining life of the swap as the trade notional amount.
4. d)For leveraged swaps in which rates are multiplied by a factor, the bank must multiply the stated notional by the same factor to determine the trade notional amount.
5. e)For a derivative contract with multiple exchanges of principle, the bank must multiply the notional by the number of exchanges of principle in the derivative contract to determine the trade notional amount.

27.Banks must determine a supervisory delta adjustment for each transaction for use in calculations of effective notional amounts. Banks must apply supervisory delta adjustments at the trade level that reflect the direction of the transaction - that is, whether the position is long or short in the primary risk driver - and on whether the transaction is an option, CDO tranche, or neither. Supervisory delta adjustments are provided in Table 1.

Table 1: Supervisory Delta Adjustments

Definitions for Table 1

For options:
 

In this expression, P is the current forward value of the underlying price or rate, K is the exercise or strike price of the option, T is the time to the latest contractual exercise date of the option, a is the appropriate supervisory volatility from Table 2, and 0 is the standard normal cumulative density function. A supervisory volatility of 50% should be used on swaptions for all currencies.

For CDO tranches:

In this expression, A is the attachment point of the CDO tranche and D is the detachment point of the CDO tranche.

28.Banks must determine a maturity factor (MF) for each transaction for use in calculations of effective notional amounts, with the specific calculation method for MF depending on whether the derivative transaction is margined or un-margined.

29.For un-margined transactions, the maturity factor must be set equal to 1.0, unless the remaining maturity of the derivative transaction is less than one year. If the remaining maturity is less than one year, the maturity factor for an un-margined transaction is computed as the square root of the remaining maturity expressed in years, on a business-day-count basis, as follows:

30.If an un-margined transaction has a remaining maturity of 10 business days or less, the bank must set the maturity factor equal to the square root of (10/250).

31.For margined transactions, the maturity factor MF must be based on the margin period of risk (MPOR) appropriate for the margining agreement containing the transaction, measured in days, and computed as follows:

32.The bank must determine MPOR based on the terms of the margined transaction, subject to the following minimums:

1. a)At least ten business days for non-centrally-cleared derivative transactions subject to daily margin agreements.
2. b)At least five business days for centrally cleared derivative transactions subject to daily margin agreements that clearing members have with their clients.
3. c)At least twenty business days for netting sets consisting of 5000 or more transactions that are not centrally cleared.

33.The bank must double the MPOR for netting sets that have experienced more than two margin call disputes over the previous two calendar quarters if those disputes were not resolved within a period corresponding to the MPOR that would otherwise be applicable.

Allocation of Transactions to Hedging Sets

34.Banks must allocate every transaction within each netting set to a hedging set according to the following rules for each asset class:

1. a)Interest Rate Derivatives: A hedging set must be created for each set of interest rate derivatives that reference interest rates of the same currency. Interest rate derivative hedging sets are further subdivided into maturity categories, as described below. In interest rate hedging sets, full offset is recognized between long and short positions within one maturity category, and partial offset across maturity categories. Note that the number of interest rate hedging sets may differ between different netting sets, depending on the number of distinct currencies.
2. b)Foreign Exchange Derivatives: A hedging set consists of derivatives that reference the same currency pair. Full offset is recognized between long and short positions in any currency pair. Note that the number of foreign exchange hedging sets may vary between different netting sets.
3. c)Credit Derivatives: All credit derivatives should be allocated to a single hedging set. Full offset is recognized between long and short positions referencing the same entity (name or index) within the hedging set.
4. d)Equity Derivatives: All equity derivatives should be allocated to a single hedging set. Full offset is recognized between long and short positions referencing the same entity (name or index) within the hedging set.
5. e)Commodity Derivatives: In the commodity asset class, separate hedging sets are used for energy, metals, agriculture, and other commodities. Full offset of long and short positions is recognized between derivatives referencing the same commodity type, while PFE add-on calculations provide partial offset between different commodity types within the same commodity hedging set.

35.Basis transactions and volatility transactions must form separate hedging sets within their respective asset classes.

1. a)All basis transactions in a netting set that belong to the same asset class and reference the same pair of risk factors form a single hedging set, and follow the hedging set aggregation rules for the relevant asset class. The bank must treat each pair of risk factors as a separate hedging set.
2. b)The bank must place all volatility transactions in a netting set into a distinct hedging set within the corresponding asset class, according to the rules of that asset class. For example, all equity volatility transactions within a netting set form a single volatility hedging set within that netting set.

Add-on for Interest Rate Derivatives

36.For interest rate derivatives, banks must assign each contract to one of three maturity categories based on the remaining life of the contract:
 

37.The bank must then calculate the effective notional amount for each interest rate derivative hedging set (that is, for the set of interest rate derivatives in any single currency) by summing across transactions within a maturity category the product of the adjusted notional amount of the transaction, the maturity factor for the transaction, and the supervisory delta adjustment. That is, for each individual interest rate derivative within a maturity category in a single hedging set, the bank must calculate:

$$\text{Adjusted Notional Amount}\times \text{Supervisory Delta Adjustment}\times \text{MF}$$
 

and then sum that product across all interest rate derivatives in one maturity category in that hedging set to get the effective notional amount.

38.For each interest rate hedging set, the result will be three effective notional amounts, one for each maturity category: D1 for Category 1, D2 for Category 2, and D3 for Category 3. The bank may then combine these effective notional amounts from each maturity category using the following formula:

39.As an alternative, the bank may choose to combine the effective notional values as the simple sum of the absolute values for each of the three maturity categories within a hedging set, which has the effect of ignoring potential offsets. That is, as an alternative to the calculation above, the bank may calculate:

$$|D1|+|D2|+|D3|$$
 

40.Regardless of the approach used to combine the effective notional amounts, the bank must multiply the result of the calculation by the supervisory factor for the interest rate asset class from Table 2, and sum across all interest rate hedging sets to calculate the aggregate add-on for the interest rate asset class.

Add-on for Foreign Exchange Derivatives

41.For foreign exchange derivatives, banks must calculate the effective notional amount for each hedging set (that is, for the set of foreign exchange derivatives referencing a single currency pair) by summing across transactions within a hedging set the product of the adjusted notional amount of the transaction, the maturity factor for the transaction, and the supervisory delta adjustment. That is, for each individual foreign exchange derivative in a single hedging set (that is, referencing a single currency pair), the bank must calculate:

$$\text{Adjusted Notional Amount}\times \text{Supervisory Delta Adjustment}\times \mathrm{MF}$$
 

and then sum that product across all foreign exchange derivatives in that hedging set to get the effective notional amount for the hedging set.

42.The bank must multiply the absolute value of the resulting effective notional amount for each hedging set (each currency pair) by the supervisory factor for the foreign exchange asset class from Table 2, and sum across all foreign exchange hedging sets to calculate the aggregate add-on for the foreign exchange asset class.

Add-on for Credit Derivatives

43.For credit derivatives, banks must calculate the effective notional amount for each entity (that is, for each set of credit derivatives referencing a single name or credit index) by summing, across all credit derivative transactions that reference that entity, the product of the adjusted notional amount of the transaction, the maturity factor for the transaction, and the supervisory delta adjustment. That is, for each individual credit derivative referencing any single entity, the bank must calculate:

$$\text{Adjusted Notional Amount}\times \text{Supervisory Delta Adjustment}\times \mathrm{MF}$$
 

for each transaction and then sum that product across all credit derivatives that reference that entity to get the effective notional amount for the entity.

44.The bank must calculate the entity-level add-on by multiplying the result of this calculation by the appropriate supervisory factor from Table 2, depending on the rating of the entity (for single-name derivatives) or depending on whether the index is investment grade or speculative grade (for index derivatives).

45.For credit derivatives that reference unrated single-name entities, the bank should use the Supervisory Factor corresponding to BBB rated entities. However, where the entity has an elevated risk of default, banks should use the Supervisory Factor corresponding to BB rated entities. For credit index entities, the classification into investment grade or speculative grade should be determined based on the credit quality of the majority of the individual components of the index.

46.The bank must use the entity-level add-ons to calculate the add-on for the credit derivative hedging set. This is done through a calculation based on the use of supervisory correlation factors from Table 2. Specifically, the bank must calculate the add-on for the credit derivative hedging set by calculating:

47.Note that credit derivatives that are basis or volatility transactions must be treated in separate hedging sets within the credit derivatives asset class, with adjustments to supervisory factors as required under this Standard. In that case, the add-on for the credit derivatives asset class is the sum of the hedging set add-on calculated above, plus add-ons for any basis or volatility hedging sets.

Add-on for Equity Derivatives

48.For equity derivatives, banks must calculate the effective notional amount for each entity (that is, for each set of equity derivatives referencing a single name or equity index) by summing, across all equity derivatives transactions that reference that entity, the product of the adjusted notional amount of the transaction, the maturity factor for the transaction, and the supervisory delta adjustment. That is, for each individual equity derivative referencing any single entity, the bank must calculate:

$$\text{Adjusted Notional Amount}\times \text{Supervisory Delta Adjustment}\times \mathrm{MF}$$
 

for each transaction and then sum that product across all equity derivatives that reference that entity to get the effective notional amount for the entity.

49.The bank must calculate the entity-level add-on by multiplying the result of this calculation by the appropriate supervisory factor from Table 2.

50.The bank must use the entity-level add-ons to calculate the add-on for the equity derivative hedging set. This is done through a calculation based on the use of supervisory correlation factors from Table 2 for single-name equities and equity indexes. Specifically, the bank must calculate the add-on for the equity derivative hedging set by calculating:

51.Note that equity derivatives that are basis or volatility transactions must be treated in separate hedging sets within the equity derivatives asset class, with adjustments to supervisory factors as required under this Standard. In that case, the add-on for the equity derivatives asset class is the sum of the hedging set add-on calculated above, plus add-ons for any basis or volatility hedging sets.

Add-on for Commodity Derivatives

52.For the commodity asset class, a bank must assign each commodity derivative to one of the four hedging sets: energy, metals, agriculture, or other. The bank should also define one or more commodity types within each hedging set, and assign each derivative transaction to one of those commodity types. Long and short trades within a single commodity type can be fully offset.

53.The bank must establish appropriate governance processes for the creation and maintenance of the list of defined commodity types that are used for CCR calculations. These types should have clear definitions stated in written policies, and independent internal review or validation processes should ensure that the commodity types are applied properly. Internal review and validation processes also should determine that commodities grouped as a single type are in fact reasonably similar. Only commodity types established through adequately controlled internal processes may be used.

54.Banks must calculate the effective notional amount for each commodity type (that is, for each set of commodity derivatives that reference commodities of the same type) by summing, across all transactions that reference that commodity type, the product of the adjusted notional amount of the transaction, the maturity factor for the transaction, and the supervisory delta adjustment. That is, for each individual commodity derivative referencing any single commodity type, the bank must calculate:

$$\text{Adjusted Notional Amount}\times \text{Supervisory Delta Adjustment}\times \mathrm{MF}$$
 

for each transaction and then sum that product across all commodity derivatives that reference that commodity type to get the effective notional amount for the commodity type.

55.The bank must calculate the add-on for each commodity type by multiplying the result of this calculation by the appropriate supervisory factor from Table 2.

56.The bank must use the add-ons for each commodity type to calculate the add-on for each hedging set (energy, metals, agriculture, and other). This is done through a calculation using the supervisory correlation factor for commodity derivatives. Specifically, the bank must calculate the add-on for each of the four commodity derivative hedging sets by calculating:

57.Note that commodity derivatives that are basis or volatility transactions must be treated in separate hedging sets within the commodity derivatives asset class, with adjustments to supervisory factors as required under this Standard.

58.The add-on for the commodity derivatives asset class is the sum of the four hedging set add-ons as calculated above (some of which may be zero if the bank has no derivatives within one of the four hedging sets), plus corresponding add-ons for any basis or volatility hedging sets.

59.Commodity hedging sets have been defined in this Standard without regard to other potentially important characteristics of commodities, such as location and quality. For example, the energy hedging set contains commodity types such as crude oil, electricity, natural gas, and coal. The Central Bank may require a bank to use more refined definitions of commodity types if the Central Bank determines that the bank is significantly exposed to the basis risk of different products within any bank-defined commodity type.

60.Table 2 provides the values of Supervisory Factors, correlations, and supervisory option volatilities for use with each asset class and subclass.

61.For any basis transaction hedging set, the Supervisory Factor applicable to its relevant asset class or sub-class must be multiplied by 0.5.

62.For any volatility transaction hedging set, the Supervisory Factor applicable to its relevant asset class or sub-class must be multiplied by 5.0.

Table 2: Supervisory Factors, Correlations, and Volatilities

63.For each netting set, the bank must compute a PFE multiplier and multiply the sum of the asset class add-ons for the netting set by that multiplier. The bank must calculate the PFE multiplier using the NCV and the aggregate add-on for the netting set (AddOn_agg) according to the following formula (where “exp” denotes the exponential function):

64.Consistent with international regulatory standards, the Floor for this calculation is established at the level of 0.05 (5%) under this Standard.

65.If the PFE multiplier for a netting set is greater than 1.0 when calculated according to the formula above (which generally occurs when NCV>0), the bank should set the PFE multiplier equal to 1.0 when calculating PFE. Note that NCV is the same as the calculation of RC for un-margined transactions, but without the limitation of a lower bound of zero (that is, NCV can be negative).

66.If a single margin agreement applies to several netting sets, so that collateral is exchanged based on mark-to-market values that are netted across all transactions covered under the margin agreement irrespective of netting sets, calculations of both RC and PFE are affected as described in this Standard. Special treatment is necessary because it is problematic to allocate the common collateral to individual netting sets.

67.A bank must compute a single combined RC for all netting sets covered by the margin agreement. Combined RC is the sum of two elements, each of which must be no less than zero. The first element is equal to the un-margined current exposure the bank has to the counterparty, aggregated across all netting sets covered by the margin agreement, less the cash equivalent value of any collateral available to the bank at the time (including both VM and _NICA) if the bank is a net holder of collateral. The second term is added only when the bank is a net provider of collateral, and is equal to the current net value of the posted collateral, reduced by the un-margined current exposure of the counterparty to the bank aggregated across all netting sets covered by the margin agreement.

68.The bank must calculate PFE for transactions subject to a single margin agreement covering multiple netting sets as if those transactions were un-margined, with the resulting calculations of PFE for each netting set then aggregated through summation. Both the multiplier and the PFE add-on should be calculated as if the transactions were un-margined.

69.The Financial Stability Board has determined that central clearing of over-the-counter derivatives reduces global systemic risk. Accordingly, the Central Bank assigns lower risk weights to bank exposures to central counterparties (CCPs) that meet certain standards for qualification, as described below for Qualifying Central Counterparties (QCCPs).

70.Banks must treat exposures to non-qualifying CCPs as they would treat exposures to any other non-qualifying counterparty. If a CCP being treated as a QCCP ceases to qualify as a QCCP, exposures to that former QCCP may continue to be treated as though they were QCCP exposures for a period of three months, unless the Central Bank requires otherwise. After the three-month period, the bank’s exposures to such a CCP must be treated as bilateral counterparty credit exposures.

71.For a counterparty entity to be considered a QCCP for purposes of this Standard, the entity must meet the following conditions:

• •Be licensed to operate as a CCP and permitted to operate as such by the appropriate regulator or overseer with respect to the products that are centrally cleared.
• •Provide UAE banks with the information required to calculate RWA for any default fund exposures to the CCP according to the requirements stated in this Standard.
• •Be based and prudentially supervised in a jurisdiction where the relevant regulator or overseer has established and publicly indicated that domestic rules and regulations consistent with the CPMI-IOSCO Principles for Financial Market Infrastructures apply to the CCP on an ongoing basis. For CCPs in jurisdictions that do not have a CCP regulator applying the Principles to the CCP, the Central Bank may make a determination regarding whether the CCP meets the requirements for treatment as a QCCP.

72.A bank must have robust internal procedures to identify specific CCPs that qualify for treatment as QCCPs under this Standard. The internal identification process should reflect the conditions stated above in this Standard, and produce evidence the bank then provides to the Central Bank to demonstrate that a specific CCP meets the conditions for qualification. A bank may not treat any CCP as a QCCP for capital purposes unless and until the Central Bank reviews the bank’s determination and indicates no objection.

73.A bank must calculate RWA for exposures to QCCPs to reflect credit risk due to trade exposures (either as a clearing member of the QCCP or as a client of a clearing member), posted collateral, and default fund contributions. If a bank’s combined RWA for trade exposures to a QCCP and default fund contribution for that QCCP is higher than would apply for those same exposures if the QCCP were a non-qualifying CCP, the bank may treat the exposures as if the QCCP was non-qualifying.

Trade exposures to the QCCP

74.A risk weight of 2% applies to a bank’s trade exposure to the QCCP where the bank as a clearing member of the QCCP trades for its own account. The risk weight of 2% also applies to trade exposures to the QCCP arising from clearing services the bank provides to clients where the bank is obligated to reimburse those clients for losses in the event that the QCCP defaults.

75.In general, a bank must calculate exposure amounts for trade exposures to QCCPs as for other derivatives exposure under this Standard. Banks must use a minimum MPOR of 10 days for the calculation of trade exposures to QCCPs on over-the-counter derivatives. Where QCCPs retain variation margin against certain trades and the member collateral is not protected against the insolvency of the QCCP, the minimum horizon applied to the bank’s QCCP trade exposures must be the lesser of one year and the remaining maturity of the transaction, with a floor of 10 business days.

Treatment of posted collateral

76.Any assets or collateral posted to the QCCP by the bank must receive the banking book or trading book treatment it would receive under the capital adequacy framework, regardless of the fact that such assets have been posted as collateral. Where the entity holding such assets or collateral is the QCCP, a risk-weight of 2% applies to collateral included in the definition of trade exposures. The relevant risk-weight of the QCCP will apply to assets or collateral posted for other purposes.

77.A risk weight of zero applies to all collateral (including cash, securities, other pledged assets, and excess initial or variation margin) posted by the clearing member that is held by a custodian and is bankruptcy remote from the QCCP. Collateral posted by a client that is held by a custodian and is bankruptcy remote from the QCCP, the bank, and other clients of the bank is not subject to a CCR capital requirement.

78.Where a bank posts assets or collateral (either as a clearing member or on behalf of a client) with a QCCP or a clearing member, and the assets or collateral is not held in a bankruptcy remote manner, the bank must recognize credit risk based upon the creditworthiness of the entity holding such assets or collateral. Posted collateral not held in a bankruptcy remote manner must be accounted for in the NICA term for CCR calculations.

Default fund exposures

79.A bank’s default fund contributions as a clearing member of a QCCP must be included in the bank’s calculation of risk-weighted assets. Certain inputs required for the RWA calculation must be provided to the bank by the QCCP, its supervisor, or some other body with access to the required data, as described below. Provision of the necessary inputs is a condition for CCP qualification.

80.Risk-weighted assets for the bank’s default fund contributions should be calculated as:

where

• •RW is a risk weight of 20% unless the Central Bank determines that banks must apply a higher risk weight, for example to reflect a QCCP membership composed of relatively high-risk members;
• •DF_M is the bank’s total pre-funded contributions to the QCCP’s default fund;
• •DF is the total value of the QCCP’s default fund, including its own funds and the prefunded contributions from members; and
• •EAD is the sum of the QCCP’s exposure to all clearing members accounts, including clearing members’ own transactions, client transactions guaranteed by clearing members, and the value of all collateral held by the QCCP against those transactions (including clearing members’ prefunded default fund contributions) prior to exchange of margin in the final margin call on the date of the calculation. This exposure should include the exposure arising from client sub-accounts to the clearing member’s proprietary business where clearing members provide client-clearing services and the client transactions and collateral are held in separate (individual or omnibus) subaccounts.

81.However, if the RWA from the calculation above is less than 2% of the amount of the bank’s pre-funded contributions to the default fund, then the bank must set RWA equal to 2% of its pre-funded contributions to the default fund, which is 2%×DFM.

82.Exposure to each clearing member for the QCCP’s EAD calculation is the bilateral CCR trade exposure the QCCP has to the clearing member as calculated under this Standard, using MPOR of 10 days. All collateral held by a QCCP to which that QCCP has a legal claim in the event of the default of the member or client, including default fund contributions of that member, is used to offset the QCCP’s exposure to that member or client for the PFE multiplier. If the default fund contributions of the member are not split with regard to client and sub-accounts, they must be allocated to sub-accounts according to the initial margin of that sub-account as a fraction of the total initial margin posted by or for the account of the clearing member.

83.If clearing member default fund contributions are segregated by product types and only accessible for specific product types, the RWA calculation must be performed for each specific product giving rise to counterparty credit risk. Any contributions by the bank to prepaid default funds covering settlement-risk-only products should be risk-weighted at 0%. If the QCCP’s own prefunded resources cover multiple product types, the QCCP must allocate those funds to each of the calculations, in proportion to the respective product-specific EAD.

84.However, where a default fund is shared between products or types of business with settlement risk only (such as equities and bonds) and products or types of business which give rise to counterparty credit risk, all of the default fund contributions receive the risk weight determined above, without apportioning to different classes or types of business or products.

85.Banks must apply a risk weight of 1250% to default fund contributions to a non-qualifying CCP. For the purposes of this paragraph, the default fund contributions of such banks will include both the funded contributions and any unfunded contributions for which the bank could be liable upon demand by the CCP.

86.As a requirement for QCCP qualification, the CCP, its supervisor, or another body with access to the required data must calculate and provide values for EAD, D_FM, and DF in such a way to permit the supervisor of the CCP to oversee those calculations, and must share sufficient information about the calculation results to permit banks to calculate capital requirements for their exposures to the default fund, as well as to permit the Central Bank to review and confirm such calculations. The information must be provided at least quarterly, although the Central Bank may require more frequent calculations in the event of material changes, such as material changes to the number or size of cleared transactions, material changes to the financial resources of the QCCP, or initiation by the QCCP of clearing of a new product.

Clearing member exposures to clients

87.A bank as a clearing member of a QCCP must treat its exposure to clients as bilateral trades, irrespective of whether the bank as clearing member guarantees the trade or acts as an intermediary between the client and the QCCP.

88.If a bank as a clearing member of a QCCP collects collateral from a client and passes this collateral on to the QCCP, the bank may recognize this collateral for both the exposure to the QCCP and the exposure to the client.

89.If a bank as a clearing member conducts an exchange-traded derivatives transaction on a bilateral basis with a client, it is treated as a bilateral counterparty credit risk exposure rather than a QCCP exposure. In this case, the bank can compute the exposure to the client using a margin period of risk, subject to a minimum MPOR of at least five days.

90.These requirements also apply to transactions between lower-level clients and higher-level clients in a multi-level client structure. (A multi-level client structure is one in which banks can centrally clear as an indirect client of a clearing member; that is, when clearing services are provided to the bank by an institution that is not a direct clearing member, but is itself a client of a clearing member or another clearing client.)

Bank exposures as a client of clearing members

91.Where a bank is a client of a clearing member, and enters into a transaction with a clearing member who completes an offsetting transaction with the QCCP, of if a clearing member guarantees QCCP performance to the bank as a client, the bank’s exposures to the clearing member may be treated as trade exposures to the QCCP with a risk weight of 2% if the conditions below are met. (This also applies to exposures of lower-level clients to higher- level clients in a multi-level client structure, provided that for all intermediate client levels the two conditions below are met.)

• •Condition 1: Relevant laws, regulation, rules, contractual, or administrative arrangements make it highly likely that, in the event that the clearing member defaults or becomes insolvent, the offsetting transactions with the defaulted or insolvent clearing member would continue to be indirectly transacted through or by the QCCP, and that client positions and collateral with the QCCP would be transferred or closed out at market value.
• •Condition 2: Offsetting transactions are identified by the QCCP as client transactions, and collateral to support them is held by the QCCP and/or the clearing member under arrangements that prevent any losses to the client due to the default or insolvency of either the clearing member or other clients of the clearing member, or of a joint default or insolvency of the clearing member and any of its other clients.

92.Where a bank is a client of the clearing member and the two conditions above are not met, the bank must treat its exposures to the clearing member as an ordinary bilateral exposure under this Standard, not a QCCP exposure. If the two conditions above are met with the exception of the requirement regarding joint default or insolvency of the clearing member and any of its other clients, a 4% risk weight must be applied instead of 2%.

93.A bank must have conducted sufficient legal review (and undertake such further review as necessary to ensure continuing enforceability) and have a well-founded basis to conclude that, in the event of legal challenge, the relevant courts and administrative authorities would find that such arrangements mentioned above would be legal, valid, binding and enforceable under the relevant laws of the relevant jurisdictions. Upon the insolvency of the clearing member, there should be no legal impediment (other than the need to obtain an appropriate court order) to the transfer of the bank’s collateral to one or more surviving clearing members or to the bank or the bank’s nominee.

94.The treatment described here also applies to exposures resulting from posting of collateral by the bank as a client of a clearing member that is held by the QCCP on the bank’s behalf but not on a bankruptcy remote basis.

95.If a bank conducts an exchange-traded derivatives transaction on a bilateral basis with a clearing member as a client of that clearing member, the transaction is treated as a bilateral counterparty credit risk exposure, not a QCCP exposure. The same applies to transactions between lower-level clients and higher-level clients in a multi-level client structure.

96.The fact that a CCP qualifies as a QCCP does not relieve a bank of the responsibility to ensure that it maintains adequate capital to cover the risk of its exposures. Where the bank is acting as a clearing member, the bank should assess whether the level of capital held against exposures to a QCCP adequately addresses the inherent risks of those transactions through appropriate scenario analysis and stress testing.

97.A bank must monitor and report to its senior management and Board, or an appropriate committee of the Board, on a regular basis all of its exposures to QCCPs, including exposures arising from trading through a QCCP and exposures arising from QCCP membership obligations such as default fund contributions.

98.Bank calculations for Counterparty Credit Risk under this Standard and associated bank processes must be subject to appropriate levels of independent review and challenge. Reviews must cover material aspects of the calculations under this Standard, including but not limited to the determination of netting sets, the assignment of individual transactions to asset classes and hedging sets, the application of supervisory parameters, the definition of commodity types, the treatment of complex derivatives transactions, and the identification of QCCPs.

99.Banks offering Islamic financial services that use Shari’ah Compliant alternatives to derivatives approved by their internal Shari’ah control committees should calculate the risk weighted asset (RWA) to recognize the exposure amounts for counterparty credit risk (CCR) as a result of obligations arising from terms and conditions of contracts and documents of those Shari’ah compliant alternatives in accordance with provisions set out in this standard/guidance and in the manner acceptable by Shari’ah. This is applicable until relevant standards and/or guidance in respect of these transactions are issued specifically for banks offering Islamic financial services.

Banks are required to calculate RWA for CVA as a multiple of capital for CVA risk calculated as specified in these Standards. The calculation relies on regulatory measures of counterparty credit risk exposure, and recognizes the impact of differences in maturity, as well as adjustments to reflect certain common hedging activities that banks use to manage CVA risk. The relevant requirements are described in this Standard.

19.Bank calculations for CVA risk under these Standard and associated bank processes must be subject to appropriate levels of independent review and challenge. Reviews must cover material aspects of the calculations under these Standards, including but not limited to determination of eligible hedges, determination of maturities and amounts, mapping of counterparties to risk weights based on credit rating, and the CVA capital calculation.

20.Banks offering Islamic financial services that use Shari’ah Compliant alternatives to derivatives and Securities financing transactions (SFTs) approved by their internal Shari’ah control committees should calculate the risk weighted asset (RWA) for Credit Valuation Adjustment (CVA) of these Shari’ah compliant alternatives in accordance with provisions set out in this standard/guidance and in the manner acceptable by Shari’ah. This is applicable until relevant standards and/or guidance in respect of these transactions are issued specifically for banks offering Islamic financial services

5.Banks must treat in-scope equity positions in a manner consistent with one or more of the following three approaches: the “look-through approach”, the “mandate-based approach” and the “fall-back approach”.

1.Look-through approach (LTA)

6.The look-through approach (LTA) requires a bank to risk weight the underlying exposures of a fund as if the bank held the exposures directly. LTA must be used by a bank when:

1. (iii)there is sufficient and frequent information provided to the bank regarding the underlying exposures of the fund to determine the applicable risk weights and exposure amounts; and
2. (iv)such information is subject to verification by an independent third party.

7.To satisfy condition (i) above, the frequency of financial reporting of the fund must be the same as, or more frequent than, the financial reporting obligation of the bank, and the granularity of the financial information must be sufficient to calculate the corresponding risk weights and exposure amounts without requiring an external audit. To satisfy condition (ii) above, there must be verification of the underlying exposures by an independent third party, such as a depository or custodian bank or, where applicable, a fund management company.

8.Under the LTA, a bank must risk weight all underlying exposures of a fund as if the bank held those exposures directly. This includes, for example, any underlying exposure arising from the fund’s derivatives activities and the counterparty credit risk (CCR) exposure associated with those derivatives. However, instead of determining the applicable credit valuation adjustment (CVA) capital associated with the fund’s derivatives exposures, a bank should instead increase the CCR exposure by 50 percent (that is, multiply the CCR exposure by a factor of 1.5) before applying the risk weight associated with the counterparty. Banks are not required to apply the 1.5 factor to transactions for which the CVA capital charge would not otherwise be applicable, such as those conducted directly with central counterparties.

9.Banks may rely on third-party calculations to determine the risk weights associated with equity investments in funds (that is, the underlying risk weights of the exposures of the fund) if they cannot obtain adequate data or information themselves to perform the calculations. In such cases, however, the bank must increase the resulting risk weight by 20 percent (that is, multiplied by a factor of 1.2) relative to the risk weight that would be applicable if the bank held the exposure directly.

10.Banks should use the risk weights from the LTA to compute RWA for the fund. After calculating the RWA for a fund according to the LTA, banks must calculate the average risk weight for that fund (Avg RW_fund) by dividing the total RWA of the fund by the total (unweighted) assets of the fund.

2.Mandate-based approach (MBA)

11.Banks should use the second approach, the mandate-based approach (MBA), only when the conditions for applying the LTA are not met. Banks should use the information contained in a fund’s mandate or in the relevant regulations governing such investment funds to perform a conservative calculation of the applicable risk weights for the assets of the fund.

12.Under the MBA, on-balance-sheet exposures (that is, the fund’s assets) are risk weighted assuming that the underlying portfolios are invested to the maximum extent allowed under the fund’s mandate in assets that would attract the highest risk weights, and then progressively in other assets that attract lower risk weights. If more than one risk weight could be applied to a given exposure, the bank should use the highest applicable risk weight.

13.The notional amount of derivative exposures and off-balance-sheet items should be risk-weighted according to the requirements of the risk-based capital standards.

14.Banks should calculate the CCR exposure associated with a fund’s derivative positions in accordance with the Central Bank’s Standard for Counterparty Credit Risk Capital. If replacement cost cannot be determined, the bank should use the notional amount of the derivative as the replacement cost. If the Potential Future Exposure (PFE) cannot be determined, the bank should use an amount equal to 15 percent of the notional value as the PFE.

15.As with the LTA, banks should account for CVA Risk on derivatives by increasing the CCR exposure by 50 percent (that is, multiply the CCR exposure by a factor of 1.5) before applying the risk weight associated with the counterparty. Banks are not required to apply the 1.5 factor for transactions to which the CVA capital charge would not otherwise be applicable, such as those conducted directly with central counterparties.

16.As with the LTA, after calculating the RWA for a fund according to the MBA, banks must calculate the average risk weight for that fund (Avg RW_fund) by dividing the RWA of the fund by the total (unweighted) assets of the fund.

3.Fall-back approach (FBA)

17.When the conditions for applying either the LTA or the MBA are not met, banks are required to apply the FBA, under which Avg RW_fund for a bank’s investment in the fund is set equal to 1250 percent.

18.A bank may use a combination of the three approaches when determining the capital requirements for an equity investment in an individual fund, with one approach applied to a portion of the fund’s exposures and one or more other approaches applied to the fund’s other exposures. The requirements for each approach as articulated under this Standard must be met for any portions of the fund to which the LTA or MBA are applied. RWA calculations from each applied approach should be added together with the sum then divided by the total fund assets to compute Avg RW_fund.

19.When a bank has an investment in one fund (e.g., Fund A) that itself has an investment in another fund (e.g., Fund B), the risk weight applied to the investment holding of the first fund (that is, Fund A’s investment in Fund B) should be determined by using the same three approaches set out above (LTA, MBA, and FBA). If fund investments are further layered (for example, if Fund B has investments in a Fund C), the risk weights applied to the additional layers of investment (that is, Fund B’s investment in Fund C) can be determined using the LTA, but only if the LTA was also used for determining the risk weight for the investment in the fund at the previous layer (Fund A’s investment in Fund B). Otherwise, the bank must apply the FBA to the additional investment layers.

20.Equity holdings in entities whose debt obligations qualify for a zero risk weight can be excluded from the LTA, MBA and FBA approaches (including government sponsored entities where a zero risk weight can be applied), at the discretion of the UAE Central Bank. If the UAE Central Bank makes such exclusion, this will be available to all banks.

21.The UAE Central Bank may, in its absolute discretion, change the risk weighting of debt obligations from time to time as it finds necessary.

22.When determining the risk weight for a bank’s equity investment in a fund, a bank must apply a leverage adjustment to the average risk weight of the fund as calculated above.

23.Leverage for a fund is calculated as the ratio of total fund assets (not risk weighted) to total fund equity. Under the LTA, this ratio should be calculated from the information obtained on the fund’s asset holdings and financing. Under the MBA, banks should assume the maximum financial leverage permitted in the fund’s mandate, or the maximum permitted under the regulations governing the fund.

24.Banks must calculate the risk weight to be applied to their equity investments in any fund as the product of the fund’s average risk weight and the fund’s leverage:

25.The risk weight for a bank’s equity investment in any fund is subject to a cap of 1250 percent. If the calculation described in the paragraph above produces a result in excess of 1250 percent, the bank should use the maximum risk weight of 1250 percent instead.

26.Banks should compute the RWA for their investments in funds by multiplying the amount of the equity investment in a given fund by the risk weight calculated as described in this Standard, based on Avg RW_fund and the leverage of the fund determined according to this Standard.

6.An originating bank may exclude underlying exposures from the calculation of risk-weighted assets only if all of the following conditions for risk transference have been met.

1. a.Significant credit risk associated with the underlying exposures has been transferred to third parties.
2. b.Banks should obtain legal opinion that confirms true sale, that the transferor does not maintain effective or indirect control over the transferred exposures; that is, that the exposures are legally isolated from the transferor in such a way (e.g., through the sale of assets or through sub-participation) that the exposures are put beyond the reach of the transferor and its creditors, even in bankruptcy or receivership.
3. c.The transferor is not able to repurchase from the transferee the previously transferred exposures in order to realize their benefits and is not obligated to retain the risk of the transferred exposures.
4. d.The securities issued are not obligations of the transferor. Thus, investors who purchase the securities only have a claim on the underlying exposures.
5. e.The transferee is an SPE and the holders of the beneficial interests in that entity have the right to pledge or exchange them without restriction.
6. f.Clean-up calls satisfy the conditions set out in Section D below.
7. g.The securitisation does not contain clauses that (i) require the originating bank to alter the underlying exposures such that the pool’s credit quality is improved unless this is achieved by selling exposures to independent and unaffiliated third parties at market prices; (ii) allow for increases in a retained first-loss position or credit enhancement provided by the originating bank after the transaction’s inception; or (iii) increase the yield payable to parties other than the originating bank, such as investors and third-party providers of credit enhancements, in response to a deterioration in the credit quality of the underlying pool.
8. h.There are no termination options or triggers except eligible clean-up calls meeting the requirements of Section D below, termination for specific changes in tax and regulation, or early amortization provisions that result in the securitisation transaction failing the operational requirements set out in Section D below.
9. i.Such other conditions as the Central Bank shall provide after notification to banks pursuant to a circular or otherwise.

Banks meeting these above conditions must still hold regulatory capital against any exposure they retain under the securitisation.

7.The transferor’s retention of servicing rights to the exposures does not in itself constitute indirect control of the exposures.

8.For synthetic securitisations, the use of credit risk mitigation (CRM) techniques (i.e., collateral, guarantees and credit derivatives) for hedging the underlying exposure may be recognized for risk-based capital purposes only if the conditions outlined below are satisfied:

1. a.Credit risk mitigants comply with the requirements set out for CRM in the Central Bank’s Standard for Credit Risk.
2. b.Eligible collateral is limited to that specified as eligible under in the Central Bank’s Standards for Credit Risk (eligible collateral pledged by SPEs may be recognized).
3. c.Eligible guarantors are as defined in the Central Bank’s Standard for Credit Risk (SPEs are not considered to be eligible guarantors).
4. d.Significant credit risk associated with the underlying exposures is transferred by the bank to third parties.
5. e.Instruments used to transfer credit risk do not contain terms or conditions that limit the amount of credit risk transferred.
6. f.The bank obtains a legal opinion that confirms the enforceability of the contract.
7. g.Such other conditions as the Central Bank shall provide after notification to banks pursuant to a circular or otherwise.

9.Clean-up calls for synthetic securitisations also must satisfy the conditions set out in Section D below. If a synthetic securitisation incorporates a call (other than a clean-up call) that effectively terminates the transaction and the purchased credit protection on a specific date, the bank should treat this as required under the Central Bank’s Standard for Credit Risk for CRM maturity mismatch. This requirement does not apply to synthetic securitisations that are assigned a risk weight of 1250%.

10.A transaction is deemed to fail the operational requirements for traditional or synthetic securitisations stated above in this Standard if the bank originates or sponsors a securitisation transaction that includes one or more revolving credit facilities, and the securitisation transaction incorporates an early amortization or similar provision that, if triggered, would:

1. i.Subordinate the bank’s senior or pari passu interest in the underlying revolving credit facilities to the interest of other investors;
2. ii.Subordinate the bank’s subordinated interest to an even greater degree relative to the interests of other parties;
3. iii.In other ways increases the bank’s exposure to losses associated with the underlying revolving credit facilities; or
4. iv.Not satisfy any conditions as set by the Central Bank after notification to banks pursuant to a circular or otherwise.

11.If a transaction contains one of the following examples of an early amortization provision but otherwise meets the operational requirements for traditional or synthetic securitisations stated above in this Standard, the originating bank may exclude the underlying exposures associated with such a transaction from the calculation of risk-weighted assets, but must still hold regulatory capital against any securitisation exposures they retain in connection with the transaction:

1. a.Replenishment structures where the underlying exposures do not revolve and early amortization terminates the ability of the bank to add new exposures;
2. b.Transactions with revolving credit facilities containing early amortization features that mimic term structures (i.e., where the risk on the underlying revolving credit facilities does not return to the originating bank) and where the early amortization provision does not effectively result in subordination of the originator’s interest;
3. c.Structures where a bank securitizes one or more revolving credit facilities and where investors remain fully exposed to future drawdowns by borrowers even after an early amortization event has occurred; or
4. d.The early amortization provision is triggered solely by events not related to the performance of the underlying assets or the selling bank, such as material changes in tax laws or regulations.

12.For securitisation transactions that include a clean-up call, no capital shall be required due to the presence of a clean-up call if the following conditions are met:

1. a.The exercise of the clean-up call is not mandatory, in form or in substance, but rather is at the discretion of the originating bank;
2. b.The clean-up call is not structured to avoid allocating losses to credit enhancements or positions held by investors or otherwise structured to provide credit enhancement; and
3. c.The clean-up call is exercisable only when 10% or less of the original underlying portfolio or securities issued remains, or, for synthetic securitisations, when 10% or less of the original reference portfolio value remains.
4. d.Such other conditions as the Central Bank shall provide after notification to banks pursuant to a circular or otherwise.

13.Securitisation transactions that include a clean-up call that does not meet all of the criteria stated in the immediately preceding paragraph result in a capital requirement for the originating bank. For a traditional securitisation, the bank must treat the underlying exposures as if they were not securitized. Additionally, banks must not recognize in regulatory capital any gain on sale. For synthetic securitisations, the bank purchasing protection must hold capital against the entire amount of the securitized exposures as if they did not benefit from any credit protection.

14.If a clean-up call, when exercised, is found to serve as a credit enhancement, the exercise of the clean-up call must be considered a form of implicit support provided by the bank, and must be treated as such in accordance with the requirements related to implicit support stated below in this Standard.

15.The following types of securitisations, if the originating bank is UAE based, will only be permitted in specific instances and require the Central Bank’s approval:

1. a.securitisation of revolving credit facilities
2. b.synthetic securitisation
3. c.resecuritisation exposure

20.For regulatory capital purposes, the exposure amount of a securitisation exposure shall be calculated as the sum of the on-balance sheet amount of the exposure, or carrying value – taking into account purchase discounts and write-downs or specific provisions the bank took on this securitisation exposure – and any off-balance sheet exposure amount as applicable, in accordance with the requirements in the following paragraphs.

21.For credit risk mitigants sold or purchased by the bank, the exposure amount should be determined using the treatment of credit risk mitigation set out below in the section on treatment of credit risk mitigation in this Standard. For all off-balance-sheet facilities that are not credit risk mitigants, the bank should apply a credit conversion factor (CCF) of 100%.

22.For securitisation-related derivatives other than credit risk derivatives (such as interest rate or currency swaps sold or purchased as part of the securitisation), the Central Bank’s Standard on Counterparty Credit Risk should be used to calculate the exposure amount.

23.Banks shall compute the risk-weighted asset amount for a securitisation exposure by multiplying the exposure amount as defined in this section by the appropriate risk weight determined under one of the approaches discussed below in this Standard. Risk weight caps may apply, as described in the this Standard on risk-weight caps for securitisation.

24.Banks may adjust risk weights for overlapping exposures. An exposure A overlaps another exposure B if in all circumstances the bank can avoid any loss on exposure B by fulfilling its obligations with respect to exposure A. A bank may also recognize overlap between relevant capital charges for exposures in the trading book and securitisation exposures in the banking book, provided that the bank is able to calculate and compare the capital charges for the relevant exposures.

25.Banks must deduct from Common Equity Tier 1 any increase in equity capital resulting from a securitisation transaction, such as a gain on a sale associated with expected future margin income.

26.Securitisation exposures are risk-weighted under one of two available approaches for securitisation, the Securitisation External Ratings-Based Approach (SEC-ERBA) or the Standardized Approach (SEC-SA). A bank must use SEC-ERBA if the exposure has an external credit assessment that meets the operational requirements for an external credit assessment, or an inferred rating that meets the operational requirements for inferred ratings. If a bank cannot use the SEC-ERBA, the bank must use the SEC-SA. Banks that are unable to apply either approach a securitisation exposure must assign such an exposure a risk weight of 1250%.

1.Calculation of Attachment and Detachment Points
 

27.Both the SEC-ERBA and the SEC-SA rely on the identification of attachment and detachment points for each securitisation tranche, which are decimal values between zero and one that capture the pool-loss conditions under which a securitisation exposure would experience losses due to the credit performance of the underlying pool of exposures.

28.The attachment point (A) represents the threshold (as a fraction of the pool’s total exposure) at which losses within the underlying pool would first be allocated to the securitisation exposure. The attachment point is calculated as:

29.The detachment point (D) represents the threshold at which losses within the underlying pool result in a total loss of principal for the tranche in which a securitisation exposure resides. The detachment point is calculated as:

30.Both A and D must be no less than zero.

31.For the calculation of A and D: (i) overcollateralization and funded reserve accounts must be recognized as tranches; and (ii) the assets forming these reserve accounts must be recognized as underlying assets. A bank can recognize only the loss-absorbing part of the funded reserve accounts that provide credit enhancement for this purpose. Unfunded reserve accounts, such as those to be funded from future receipts from the underlying exposures (e.g. unrealized excess spread) and assets that do not provide credit enhancement like pure liquidity support, currency or interest-rate swaps, or cash collateral accounts related to these instruments must not be included in the above calculation of A and D. Banks should take into consideration the economic substance of the transaction and apply these definitions conservatively.

2.External Ratings-Based Approach (SEC-ERBA)
 

32.For securitisation exposures that are externally rated, or for which a rating can be inferred as described below, risk-weighted assets under the SEC-ERBA will be determined by multiplying securitisation exposure amounts by the appropriate risk weights determined from Tables 1 and 2, provided that the following operational criteria for the use of external ratings are met:

1. a.The external credit assessments must take into account and reflect the entire amount of credit risk exposure the bank has with regard to all payments owed to it.
2. b.The external credit assessments must be from an eligible external credit assessment institution (ECAI) which is also approved by the Central Bank.
3. c.The rating must be published in an accessible form, such as on a public website or in a periodically distributed paper publication. Loss and cash flow analysis as well as sensitivity of ratings to changes in the underlying rating assumptions should be publicly available.
4. d.Eligible ECAIs must have a demonstrated expertise in assessing securitisations, which may be evidenced by strong market acceptance.

33.A bank may infer a rating for an unrated position from an externally rated “reference exposure” for purposes of the SEC-ERBA provided that the following operational requirements are satisfied:

1. a.The reference securitisation exposure must rank pari passu or be subordinate in all respects to the unrated securitisation exposure. Credit enhancements, if any, must be taken into account when assessing the relative subordination of the unrated exposure and the reference securitisation exposure.
2. b.The maturity of the reference securitisation exposure must be equal to or longer than that of the unrated exposure.
3. c.The inferred rating must be updated on an ongoing basis to reflect any subordination of the unrated position or changes in the external rating of the reference securitisation exposure.
4. d.The external rating of the reference securitisation exposure must satisfy the general requirements for recognition of external ratings as defined in this Standard.

34.Where CRM is provided to specific underlying exposures or to the entire pool by an eligible guarantor and the CRM is reflected in the external credit assessment of a securitisation exposure, banks should use the risk weight associated with that external credit assessment. In order to avoid any double-counting, no additional capital recognition is permitted. If the CRM provider is not recognized as an eligible guarantor, banks should treat the covered securitisation exposures as unrated.

35.In the situation where a credit risk mitigant solely protects a specific securitisation exposure within a given structure (e.g., an asset-backed security tranche) and this protection is reflected in the external credit assessment, the bank must treat the exposure as if it is unrated and then apply the CRM treatment specified in the Central Bank’s Standard for Credit Risk.

36.A bank is not permitted to use any external credit assessment for risk-weighting purposes where the assessment is based at least partly on unfunded support provided by the bank (such as a letter of credit provided by the bank that enhance the credit quality of the securitisation). If a bank buys ABCP where it provides an unfunded securitisation exposure extended to the ABCP program (e.g., liquidity facility or credit enhancement), and that exposure plays a role in determining the credit assessment on the ABCP, the bank must treat the ABCP as if it were not rated. The bank must continue to hold capital against the other securitisation exposures it provides (e.g., against the liquidity facility and/or credit enhancement).

37.For exposures with short-term ratings, or when an inferred rating based on a short-term rating is available, the risk weights in Table 1 apply unless otherwise notified by the Central Bank.

Table 1: SEC-ERBA risk weights for short-term ratings²

38.For exposures with long-term ratings, or with an inferred rating based on a long-term rating, risk weights are determined according to Table 2, after adjustment for tranche maturity as specified below and, for non-senior tranches, tranche thickness as specified below (unless otherwise notified by the Central Bank).

Table 2: SEC-ERBA risk weights for long-term ratings

(Subject to adjustment for tranche maturity and tranche thickness)

39.To account for tranche maturity, banks shall use tranche maturity (M_T) calculated as described below to derive the risk weight through linear interpolation between the risk weights for one year and five years from the table.

40.To account for tranche thickness, for non-senior tranches banks must multiply the risk weight derived from the table by a factor of 1-(D-A). However, the resulting risk weight must be no less than half the risk weight derived directly from the table based on maturity.

41.The risk weight is subject to a floor of 15%. In addition, the resulting risk weight should never be lower than the risk weight corresponding to a senior tranche of the same securitisation with the same rating and maturity.

Tranche maturity (M_T)

42.Tranche maturity is a tranche’s remaining effective maturity in years, calculated in one of the following two ways, subject to a floor of one year and a cap of five years:

1. (a)Weighted-average maturity, calculated as the weighted-average maturity of the contractual cash flows of the tranche:

1. (b)Legal maturity, based on final legal maturity of the tranche as follows:

   $$$$

    

   where M_L is the final legal maturity of the tranche in years.

43.Banks have discretion to choose either method to calculate tranche maturity. However, under the weighted-average maturity method, contractual payments must be unconditional and must not be dependent on the actual performance of the securitized assets. If such unconditional contractual payment dates are not available, the bank must use the legal maturity calculation.

44.When determining the maturity of a securitisation exposure, banks should take into account the maximum period of time they are exposed to potential losses from the securitized assets. In cases where a bank provides a commitment, the bank should calculate the maturity of the securitisation exposure resulting from this commitment as the sum of the contractual maturity of the commitment and the longest maturity of the assets to which the bank would be exposed after a draw has occurred. If those assets are revolving, banks should use the longest contractually possible remaining maturity of assets that might be added during the revolving period, rather than the longest maturity of the assets currently in the pool. An exception applies for credit protection instruments that are only exposed to losses that occur up to the maturity of that instrument. In such cases, a bank is allowed to apply the contractual maturity of the credit protection and is not required to look through to the protected position.

3.Standardized Approach (SEC-SA)
 

45.Under the SEC-SA, a bank calculates risk weights using a supervisory formula and the following bank-supplied inputs:

46.K_SA is the weighted-average capital charge of the entire portfolio of underlying exposures, calculated as 8% multiplied by the average risk weight of the underlying pool exposures. The average risk weight is the total risk-weighted asset amount divided by the sum of the underlying exposure amounts. This calculation should take into account the effects of any credit risk mitigation applied to the underlying exposures (either individually or to the entire pool). K_SA is expressed as a decimal between zero and one; that is, a weighted-average risk weight of 100% means that K_SA would equal 0.08.

47.For structures involving an SPE, banks should treat all of the SPE’s exposures related to the securitisation as exposures in the pool, including assets in which the sPE may-have invested such as reserve accounts or cash collateral accounts, and claims against counterparties resulting from interest swaps or currency swaps. A bank can exclude exposures from the calculation if the bank can demonstrate to the Central Bank that the risk does not affect its particular securitisation exposure or that the risk is immaterial, for example because it has been mitigated.

48.In the case of funded synthetic securitisations, any proceeds of the issuances of credit-linked notes or other funded obligations of the sPE that serve as collateral for the repayment of the securitisation exposure in question, and which the bank cannot demonstrate to the Central Bank are immaterial, must be included in the calculation of K_SA if the default risk of the collateral is subject to the tranched loss allocation.

49.In cases where a bank has set aside a specific provision or has a non-refundable purchase price discount on an exposure in the pool, K_SA must be calculated using the gross amount of the exposure without the specific provision and/or non-refundable purchase price discount.

50.The variable W equals the ratio of the sum of the nominal amount of delinquent underlying exposures to the nominal amount of underlying exposures. Delinquent underlying exposures are defined as underlying exposures that are 90 days or more past due, subject to bankruptcy or insolvency proceedings, in the process of foreclosure, held as real estate owned, or in default, where default is defined within the securitisation deal documents.

51.The inputs K_SA and W are used as inputs to calculate K_A, as follows:

52.If a bank does not know the delinquency status of the entire pool, the bank should adjust the calculation of K_A as follows, using the relevant nominal amounts of exposures in the pool (denoted EAD below):

However, if the portion of the pool for which the bank does not know the delinquency status exceeds 5 percent of the total pool, the securitisation exposure must be risk weighted at 1250%.

53.The capital requirement per unit of the securitisation exposure under the SEC-SA is:

54.The supervisory parameter ρ is set equal to 1 for a securitisation exposure that is not a resecuritisation exposure. (See below for the case of resecuritisation exposures.)

55.The risk weight assigned to a securitisation exposure when applying the SEC-SA is calculated as follows:

• •When D for a securitisation exposure is less than or equal to K_A, the exposure must be assigned a risk weight of 1250%.
• •When A for a securitisation exposure is greater than or equal to K_A, the risk weight of the exposure, expressed as a percentage, is 12.5×K.

56.The risk weight for market-risk hedges such as currency or interest rate swaps shall be inferred from a securitisation exposure that is pari passu to the swaps or, if such an exposure does not exist, from the next subordinated tranche.

57.The SEC-SA risk weights are subject to a floor risk weight of 15%. Moreover, when a bank applies the SEC-SA to an unrated junior exposure in a transaction where the more senior tranches (exposures) are rated and no rating can be inferred for the junior exposure, the resulting risk weight under SEC-SA for the junior unrated exposure shall not be lower than the risk weight for the next more senior rated exposure.

² The rating designations used in this an all other tables are for illustrative purposes only, and do not indicate any preference for, or endorsement of, any particular external assessment system.

58.Banks may apply a “look-through” approach to senior securitisation exposures, whereby the risk weight for the senior securitisation exposure is at most equal to the exposure-weighted average risk weight applicable to the underlying pool exposures. To apply a maximum risk weight from this look-through approach, the bank must be able to know the composition of the underlying exposures at all times. For an originating or sponsor bank, capital requirements on securitisation exposures are capped at what the capital requirement would have been on the underlying exposures if they had not been securitized.

59.The maximum required capital ratio for the aggregate of a bank’s securitisation exposures to a given securitisation shall be computed as K_SA multiplied by P, where P is the largest proportion of interest the bank holds.

• •For a bank that has one or more securitisation exposures that reside in a single tranche of a given pool, P equals the proportion (expressed as a percentage) of securitisation exposure that the bank holds in that given tranche (calculated as the bank’s total exposure in the tranche) divided by the total nominal amount of the tranche.
• •For a bank that has securitisation exposures that reside in different tranches of a given securitisation, P equals the maximum proportion of interest across tranches, where the proportion of interest for each of the different tranches should be calculated as described above.

60.Where this risk-weight cap results in a lower risk weight than the floor risk weight of 15%, the bank should use the risk weight resulting from the cap.

61.In applying the capital charge cap, banks must deduct the entire amount of any gain on sale, and the amount of credit-enhancing interest-only strips arising from the securitisation transaction.

62.The caps described here do not apply to resecuritisation exposures.

78.For regulatory capital purposes, only the following types of exposures can be STC-compliant:

• •Exposures to non-ABCP, traditional securitisations that meet the criteria in Appendix 1 below.
• •Exposures to ABCP conduits and/or transactions financed by ABCP conduits, where the conduit and/or the transactions financed meet the criteria in Appendix 2 below.

79Synthetic securitisations, securitisation of revolving credit facilities and resecuritisations are not considered as STC-compliant.

80.STC treatment will not be applied if banks having investment in international securitisation

81.The originator or sponsor must disclose to investors all necessary information at the transaction level to allow investors to determine whether the securitisation is STC-compliant. Based on the information provided by the originator or sponsor, the investor must make an assessment of the STC compliance status of the securitisation for regulatory capital purposes.

82.For retained positions where the originator has achieved significant risk transfer in accordance with the operational requirements of this Standard, the determination shall be made by the originator retaining the position.

83.STC criteria must be met at all times. Checking compliance with some of the criteria might only be necessary at origination (or at the time of initiating the exposure, in case of guarantees or liquidity facilities). Investors and holders of the securitisation positions are expected to take into account developments that may invalidate previous compliance assessments, for example deficiencies in the frequency and content of the investor reports, in the alignment of interest, or changes in the transaction documentation at variance with relevant STC criteria. For dynamic pools, the criteria should be checked every time assets are added to the pool.

84.Securitisation transactions that are assessed as STC-compliant for capital purposes shall be subject to securitisation capital requirements as modified by this Standard. The resulting risk weights are subject to a floor risk weight of 10% for senior tranches, and 15% for non-senior tranches.

1.External Ratings-Based Approach for STC Securitisation Exposures
 

85.When the SEC-ERBA is used, for exposures with short-term ratings or an inferred rating based on a short-term rating, the risk weights in Table 3 apply.

Table 3: SEC-ERBA risk weights for STCs with short-term ratings

86.For STC exposures with long-term ratings, risk weights under SEC-ERBA are determined according to Table 4, with adjustments for tranche maturity and (for non-senior tranches) tranche thickness as discussed above in this Standard for non-STC exposures.

Table 4: SEC-ERBA risk weights for STCs with long-term ratings
(Subject to adjustment for tranche maturity and tranche thickness)

2.Standardized Approach for STC Securitisation Exposures
 

87.If a bank uses the SEC-SA for an STC securitisation exposure, the bank should set the supervisory parameter p equal to 0.5. The SEC-SA framework is otherwise unchanged for STC exposures.

This Appendix 1 provides criteria, as well as certain guidance and clarifications, for Simple, Transparent, and Comparable (STC) securitisation exposures, together with certain additional requirements that must be satisfied in order for a securitisation to receive alternative regulatory capital treatment. These criteria do not cover short-term securitisations such as ABCP conduits or similar programs; criteria for such short-term securitisations are covered in Appendix 2 below.

This Appendix provides criteria, including certain guidance and clarifications, for short-term Simple, Transparent, and Comparable (STC) securitisation exposures, together with certain additional requirements that must be satisfied in order for a securitisation to receive alternative regulatory capital treatment.

For an ABCP conduit to be considered STC, the criteria in this Appendix need to be met at both the conduit level and the transaction level.

• •For exposures at the conduit level (e.g. exposure arising from investing in the commercial paper issued by an ABCP program or sponsoring arrangements at the conduit/program level), compliance with the short-term STC capital criteria is achieved only if the criteria are satisfied at both the conduit level and the transaction level.
• •In the case of exposures at the transaction level, compliance with the short-term STC capital criteria is considered to be achieved if the transaction-level criteria are satisfied for the transactions to which support is provided.

In each section, any requirements specific to either the conduit level or the transaction level are noted separately, together with more general requirements that apply to both levels.

5.The capital charges, as explained below, for interest rate related instruments and equities would apply to the trading book. The capital charges for foreign exchange risk and for commodities risk will apply to banks’ total currency and commodity positions.

6.Banks must have clearly defined policies and procedures for determining which exposures to include in, and to exclude from, the trading book for purposes of calculating their regulatory capital, to ensure compliance with the criteria for trading book set forth in this Standard and taking into account the bank’s risk management capabilities and practices. These policies and procedures must be fully documented and subject to periodic internal audit, and at a minimum address the general considerations listed below:

• •The activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes;
• •The extent to which an exposure can be marked-to-market daily by reference to an active, liquid two-way market;
• •For exposures that are marked-to-model, the extent to which the bank can:
  • –Identify the material risks of the exposure;
  • –Hedge the material risks of the exposure and the extent to which hedging instruments would have an active, liquid two-way market;
  • –Derive reliable estimates for the key assumptions and parameters used in the model.
• •The extent to which the bank can and is required to generate valuations for the exposure that can be validated externally in a consistent manner;
• •The extent to which legal restrictions or other operational requirements would impede the bank’s ability to effect an immediate liquidation of the exposure;
• •The extent to which the bank is required to, and can, actively risk manage the exposure within its trading operations; and
• •The extent to which the bank may transfer risk or exposures between the banking and the trading books and criteria for such transfers.

7.The following will be the basic requirements for positions eligible to receive trading book capital treatment:

• •Clearly documented trading strategy for the position/instrument or portfolios, approved by senior management (which would include expected holding horizon);
• •Clearly defined policies and procedures for the active management of the position, which must include;
  • –positions are managed on a trading desk;
  • –position limits are set and monitored for appropriateness;
  • –dealers have the autonomy to enter into/manage the position within agreed limits and according to the agreed strategy;
  • –positions are marked to market at least daily and when marking to model the parameters must be assessed on a daily basis;
  • –positions are reported to senior management as an integral part of the institution’s risk management process; and
  • –positions are actively monitored with reference to market information sources (assessment should be made of the market liquidity or the ability to hedge positions or the portfolio risk profiles). This would include assessing the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market, etc; and
• •Clearly defined policy and procedures to monitor the positions against the bank’s trading strategy including the monitoring of turnover and stale positions in the bank’s trading book.

8.Term trading-related repo-style transactions that meet the requirements for trading- book treatment as stated in the paragraph above may be included in the bank’s trading book for regulatory capital purposes even if a bank accounts for those transactions in the banking book. If the bank does so, all such repo-style transactions must be included in the trading book, and both legs of such transactions, either cash or securities, must be included in the trading book. Regardless of where they are booked, all repo-style transactions are subject to a credit risk capital requirement under the Central Bank’s Standard for Credit Risk Capital.

9.When a bank hedges a banking book credit risk exposure using a credit derivative booked in its trading book (i.e. using an internal hedge), the banking book exposure is not deemed to be hedged for capital purposes unless the bank purchases from an eligible third party protection provider a credit derivative meeting the requirements in the Central Bank’s Standard for Credit Risk Capital. Where such third party protection is purchased and is recognized as a hedge of a banking book exposure for regulatory capital purposes, neither the internal nor external credit derivative hedge would be included in the trading book for regulatory capital purposes.

10.Positions in the bank’s own eligible regulatory capital instruments are deducted from capital. Positions in other banks’, securities firms’, and other financial entities’ eligible regulatory capital instruments, as well as intangible assets, will receive the same treatment as that set down by the Central Bank for such assets held in the banking book. Where a bank demonstrates to the Central Bank that it is an active market maker, then the Central Bank may establish a dealer exception for holdings of other banks’, securities firms’, and other financial entities’ capital instruments in the trading book. In order to qualify for the dealer exception, the bank must have adequate systems and controls surrounding the trading of financial institutions’ eligible regulatory capital instruments.

11.For the purposes of these Standards, the correlation trading portfolio incorporates securitisation exposures and nth-to-default credit derivatives that meet the following criteria:

• •The positions are neither resecuritisation positions, nor derivatives of securitisation exposures that do not provide a pro-rata share in the proceeds of a securitisation tranche; and
• •All reference entities are single-name products, including single-name credit derivatives, for which a liquid two-way market exists. This includes commonly traded indices based on these reference entities. Positions that reference an underlying that would be treated as a retail exposure, a residential mortgage exposure, or a commercial mortgage exposure under the standardized approach to credit risk are not included in the correlation-trading portfolio. Positions that reference a claim on a special purpose entity also are not included. A bank may include in the correlation trading portfolio positions that are hedges of securitisation exposures or nth-to-default credit derivatives, but that are not themselves either securitisation exposures or nth-to-default credit derivatives, where a liquid two-way market exists for the instrument or its underlying.

1.Interest rate risk

12.This Standard describes the framework for measuring the risk of holding or taking positions in debt securities and other interest rate related instruments in the trading book. The instruments covered include all fixed-rate and floating-rate debt securities and instruments that behave like them, including non-convertible preference shares. Banks should treat convertible bonds as debt securities if they trade like debt securities and as equities if they trade like equities.

13.The minimum capital requirement is expressed in terms of two separately calculated charges, one applying to the “specific risk” of each security, whether it is a short or a long position, and the other to the interest rate risk in the portfolio (“general mark

et risk”) where long and short positions in different securities or instruments can be offset.

Specific risk

14.In measuring the capital charge for specific risk, offsetting of long and short positions is restricted to matched positions in the identical issue (including positions in derivatives). No offsetting is permitted between different issues, even if the issuer is the same.
 

15.The specific risk capital charges for interest rate risk are as specified in Table 1 below.

Table 1: Specific Risk Charges for Interest Rate Risk

16.The category “government” includes all forms of government paper as defined in the Central Bank’s Standard for Credit Risk. Exposure to the Federal Government and Emirates Government receive 0% risk weight, if such exposures are denominated and funded in AED or USD for a transition period of 7 years from the date of implementation of this Standard. After the transition period, 0% risk weights are only applied to exposures that are denominated and funded in AED. In general, only government debt rated AA- or better is eligible for the 0% specific risk charge. However, for debt rated below AA-, when the government paper is denominated in the domestic currency and funded by the bank in the same currency, the Central Bank uses national discretion to apply a 0% specific risk charge.²¹ The national discretion is limited to GCC Sovereigns.

17.The “qualifying” category includes securities issued by public sector entities and multilateral development banks, plus other securities that are rated investment-grade by at least two credit rating agencies recognized by the Central Bank for this purpose per Central Bank standards, or are rated investment-grade by one rating agency and not less than investment-grade by any other rating agency recognized by the Central Bank. Unrated securities may be considered “qualifying” subject to Central Bank approval on a case-by-case basis if the bank deems them to be of comparable investment quality and the issuer has securities listed on a recognized stock exchange. Unrated securities that are considered “qualifying” by the Central Bank can be recategorised from time to time if the Central Bank deems this necessary.

18.The specific risk charges stated in Table 1 for instruments issued by a non-qualifying issuer may considerably underestimate the specific risk for certain debt instruments with a high yield to redemption relative to government debt securities. In such cases, the Central Bank may direct a bank to apply a higher specific risk charge to such instruments, and/or to disallow offsetting of general market risk between such instruments and any other debt instruments.

19.Banks must determine the specific risk capital charge for the correlation trading portfolio by computing (i) the total specific risk capital charges that would apply just to the net long positions from the net long correlation trading exposures combined, and (ii) the total specific risk capital charges that would apply just to the net short positions from the net short correlation trading exposures combined. The larger of these two amounts in terms of domestic currency is then the specific risk capital charge for the correlation-trading portfolio.

Specific risk rules for positions covered under the securitisation framework

20.The specific risk charges for securitisation exposures held in the trading book are based on the risk weights assigned to securitisation exposures under the Central Bank’s Standard on Required Capital for Securitisation Exposures. Specifically, banks should determine the applicable risk weight applied to such positions in the banking book, and multiply the result by 8% to obtain the specific risk charge for the trading book exposure.
 

21.A securitisation exposure subject to a risk weight of 1250% under the Central Bank requirements (and therefore to a 100% specific risk charge under this Standard) may be excluded from the calculation of capital for general market risk.

Limitation of the specific risk capital charge to the maximum possible loss

22.Banks may limit the capital required for an individual position in a credit derivative or securitisation instrument to the maximum possible loss. For a short risk position, this limit can be calculated as the change in value due to the underlying names immediately becoming default risk-free. For a long risk position, the maximum possible loss could be calculated as the change in value in the event that all the underlying names were to default with zero recoveries. The maximum possible loss must be calculated for each individual position.
 

Specific risk capital charges for positions hedged by credit derivatives

23.Full allowance and offset can be recognized when the values of two legs, that is, long and short, always move in opposite directions and move broadly to the same extent. This would be the case when the two legs consist of completely identical instruments (e.g. two instruments with exactly the same issuer, coupon, currency, and maturity), or when a long cash position is hedged by a total rate of return swap (or vice versa) and there is an exact match between the reference obligation and the underlying cash position. (The maturity of the swap itself may be different from that of the underlying exposure.) In these cases, no specific risk capital requirement applies to either side of the position.
 

24.An 80% offset can be recognized when the value of long and short legs always move in opposite directions, but do not move broadly to the same extent. This would be the case when a long cash position is hedged by a credit default swap or a credit linked note (or vice versa) and there is an exact match in terms of the reference obligation, the maturity of both the reference obligation and the credit derivative, and the currency of the underlying exposure. In addition, key features of the credit derivative contract should not cause the price movement of the credit derivative to materially deviate from the price movements of the cash position. To the extent that the transaction transfers risk, that is taking account of restrictive payout provisions such as fixed payouts and materiality thresholds, an 80% specific risk offset can be applied to the side of the transaction with the higher capital charge, while the specific risk requirement on the other side is zero.

25.Partial allowance and offset can be recognized when the value of the long and short legs usually, but not necessarily always, move in opposite directions. This is the case in the following situations:

• •The position would meet the conditions for full allowance but there is not an exact match between the reference obligation and the underlying exposure; the position otherwise meets the operational requirements for credit derivatives for credit risk mitigation under the Central Bank’s Standard for Credit Risk Capital.
• •The position would meet the conditions for full allowance but there is a currency or maturity mismatch between the credit protection and the underlying asset.
• •The position would meet the conditions for full allowance but there is an asset mismatch between the cash position and the credit derivative. However, the underlying asset is included in the (deliverable) obligations in the credit derivative documentation.

In each of the cases above, rather than adding the specific risk capital requirements for each side of the transaction (i.e. the credit protection and the underlying asset), the bank can apply only the higher of the two capital requirements. Otherwise, in cases that do not meet the conditions above, a specific risk capital charge must be assessed against both sides of the position.

26.The capital charge for specific risk for a first-to-default credit derivative is the lesser of (1) the sum of the specific risk capital charges for the individual reference credit instruments in the basket, and (2) the maximum possible credit event payment under the contract. Where a bank has a risk position in one of the reference credit instruments underlying a first-to-default credit derivative and this credit derivative hedges the bank’s risk position, the bank may reduce with respect to the hedged amount both the capital charge for specific risk for the reference credit instrument and that part of the capital charge for specific risk for the credit derivative that relates to this particular reference credit instrument. Where a bank has multiple risk positions in reference credit instruments underlying a first-to-default credit derivative, this offset is allowed only for that underlying reference credit instrument having the lowest specific risk capital charge.

27.For nth-to-default credit derivatives with n greater than one, no offset of the capital charge for specific risk with any underlying reference credit instrument is allowed. If the nth-to-default credit derivative is externally rated, then the protection seller must calculate the specific risk capital charge using the approach applied for securitisation exposures held in the trading book. Specifically, banks should determine the applicable risk weight applied to such positions as securitisation exposures in the banking book, and multiply the result by 8% to obtain the specific risk charge for the derivative exposure. Otherwise, the capital charge for specific risk for nth-to-default credit derivative with n greater than one is the lesser of (1) the sum of the specific risk capital charges for the individual reference credit instruments in the basket but disregarding the n-1 obligations with the lowest specific risk capital charges; and (2) the maximum possible credit event payment under the contract. The capital charge for nth-to-default credit derivative positions applies irrespective of whether the bank has a long or short position, that is, whether the bank obtains or provides protection.

General market risk

28.For general market risk, positions are slotted into time bands. The capital charge is the sum of four components calculated from amounts in each time band:

• •The net short or long position in the whole trading book;
• •A small proportion of the matched positions in each time-band (the “vertical disallowance”);
• •A larger proportion of the matched positions across different time-bands (the “horizontal disallowance”); and
• •Where applicable, a net charge for positions in options.

29.A bank can choose between two principal methods of slotting positions into time bands for general market risk: a “maturity” method and a “duration” method.

30.In the maturity method, long or short positions in debt securities and other sources of interest rate exposures including derivative instruments are slotted into a maturity ladder comprising thirteen time-bands (or fifteen time-bands in case of low coupon instruments). Fixed rate instruments must be allocated according to the residual term to maturity and floating-rate instruments according to the residual term to the next repricing date. Opposite positions of the same amount in the same issues (but not different issues by the same issuer), whether actual or notional, can be omitted from the interest rate maturity framework, as can closely matched swaps, forwards, futures, and forward rate agreements (FRAs) that meet the conditions set out below in this Standard on allowable offsetting of matched positions.

31.The first step in the calculation is to weight the positions in each time-band by a risk weight designed to reflect the price sensitivity of those positions to assumed changes in interest rates. The weights for each time-band are set out in the risk-weight column of Table 2. Zero-coupon bonds and deep-discount bonds (defined as bonds with a coupon of less than 3%) should be slotted according to the time-bands set out in the column labeled “Coupon less than 3%” in Table 2.

Table 2: Risk Weights and Assumed Yield Changes for General Market Risk, by Zone and Time Band

32.The next step in the calculation is to offset the weighted longs and shorts in each time-band, resulting in a single short or long position for each band. A 10% capital charge to reflect basis risk and gap risk – the vertical disallowance – is levied on the smaller of the offsetting long or short positions in each time-band. The result is two sets of weighted positions, the net long or short positions in each time-band and the vertical disallowances, which have no sign.

33.Next, banks are allowed to conduct two rounds of “horizontal offsetting,” subject to disallowances expressed as a fraction of the matched positions. First, the weighted long and short positions in each of three zones identified in Table 2 may be offset, subject to the matched portion attracting a within-zone disallowance factor that is part of the capital charge:

34.Second, the residual net position in each zone may be carried over and offset against opposite positions in other zones, subject to a second set of disallowance factors that apply between zones:

35.Under the alternative duration method, banks with the necessary capability may, with the Central Bank’s consent, calculate the price sensitivity of each position separately. Banks must elect and use this method on a continuous basis unless a change in method is approved by the Central Bank. To apply the duration method, banks should apply the following steps in order:

• •Calculate the price sensitivity of each instrument in terms of a change in interest rates of between 0.6 and 1.0 percentage points depending on the maturity of the instrument per the last column of Table 2;
• •Slot the resulting sensitivity measures into the fifteen time-bands set out in the “Coupon less than 3%” column of Table 2;
• •Subject long and short positions in each time-band to a 5% vertical disallowance to reflect basis risk; and
• •Carry forward the net positions in each time-band for horizontal offsetting subject to the within-zone and between-zone horizontal disallowances specified above.

36.Under either the maturity method or the duration method, separate maturity ladders should be used for each currency, and capital charges should be calculated for each currency separately and then summed with no offsetting across currencies between positions of opposite sign.

37.In the case of currencies in which business is insignificant, the bank may construct a single maturity ladder, and slot within each appropriate time-band the net long or short position for each currency. However, these individual net positions must be summed within each time-band, irrespective of whether they are long or short positions, to produce a gross position figure. These gross positions in each time band are then subject to the risk weights from Table 2, with no further offsetting permitted.

Interest rate derivatives

38.Interest rate risk calculations for market risk capital should include all interest rate derivatives and off-balance-sheet instruments held in the trading book that respond to changes in interest rates. The derivatives should be converted into equivalent positions in the relevant underlying, and then be subject to the specific and general market risk requirements as described above. Amounts reported should be the market value of the notional amount of the underlying or of the notional underlying. For instruments where the apparent notional amount differs from the effective notional amount, banks must use the effective notional amount.

39.Futures and forward contracts, including forward rate agreements, should be treated as a combination of a long position and a short position in a notional government security. The contractual period until delivery or exercise of a future or FRA, plus the life of the underlying instrument where applicable, should be used as the maturity. Where a range of deliverable instruments may be delivered to fulfil the contract, the bank can choose which deliverable security goes into the maturity or duration ladder, but should take into account any conversion factor defined by the exchange. In the case of a future on a corporate bond index, the position should be included in the maturity or duration ladder at the market value of the notional underlying portfolio of securities.

40.Swaps should be treated as two notional positions in government securities with relevant maturities. For swaps that pay or receive a fixed or floating interest rate against some other reference price such as an equity price, the interest rate component should be slotted into the appropriate repricing maturity category, with the equity component being included in the equity framework. The separate legs of cross-currency swaps are to be reported in the relevant maturity ladders for the currencies concerned.

Allowable offsetting of matched positions

41.If a bank has matching long and short positions in the trading book, where both actual and notional match in identical instruments with exactly the same issuer, coupon, currency and maturity, those positions may be excluded from interest rate capital framework altogether, for both specific and general market risk. A matched position in a future or forward and its corresponding underlying may be fully offset, and thus excluded from the calculation. When the future or forward comprises a range of deliverable instruments, offsetting of positions in the future or forward contract and its underlying is only permissible in cases where there is a readily identifiable underlying security that is most profitable for the trader with a short position to deliver. No offsetting is allowed between positions in different currencies; the separate legs of cross-currency swaps or forward foreign exchange deals are to be treated as notional positions in the relevant instruments and included in the appropriate calculation for each currency.

42.Under certain conditions, opposite positions in the same category of instruments, including options at their delta-equivalent value and the separate legs of different swaps, can be regarded as matched and allowed to offset fully. The positions must relate to the same underlying instruments, be of the same nominal value, and be denominated in the same currency. In addition:

1. (i)for futures: offsetting positions in the notional or underlying instruments to which the futures contract relates must be for identical products and mature within seven days of each other;
2. (ii)for swaps and FRAs: the reference rate (for floating rate positions) must be identical and the coupon closely matched (within 15 basis points); and
3. (iii)for swaps, FRAs and forwards: the next interest fixing date or, for fixed coupon positions or forwards, the residual maturity must correspond to one another within the following limits:
   1. (a)less than one month hence: must be same day;
   2. (b)between one month and one year hence: must be within seven days of one another; or
   3. (c)over one year hence: must be within thirty days of one another.

Specific risk for interest rate derivatives

43.Interest rate and currency swaps, FRAs, forward foreign exchange contracts, and interest rate futures are not subject to a specific risk charge. This exemption also applies to futures on an interest rate index. However, in the case of futures contracts where the underlying is a debt security, or an index representing a basket of debt securities, such a specific risk charge does apply.
 

General market risk for interest rate derivatives

44.General market risk applies to positions in all derivative products in the same manner as for cash positions, subject only to the allowable offsetting of fully or very closely matched positions in identical instruments as defined above in this Standard. The various categories of instruments should be slotted into the maturity ladder and treated according to the rules identified earlier.

45.Table 3 below presents a summary of the regulatory treatment for interest rate derivatives for market risk purposes. Note that a contract for which the underlying instrument is a government debt security rated AA- or better has no capital requirement for specific risk. Also, note that the specific risk charge relates to the issuer of the instrument that is referenced by the derivative contract; the derivative is still subject to a separate capital charge for counterparty credit risk under the Central Bank’s Standard for Counterparty Credit Risk.

Table 3: Summary of treatment of interest rate derivatives

2.Equity position risk

46.This section covers market risk capital for positions in equities held in the trading book. It applies to long and short positions in all instruments that exhibit market behavior similar to equities. It applies to common stocks – whether voting or non-voting – convertible securities that behave like equities, and commitments to buy or sell equity securities, but not to non-convertible preference shares.
 

47.As with debt securities, the minimum capital standards for equities includes two separately calculated charges, one for the “specific risk” of holding a long or short position in an individual equity, and one for the “general market risk” of holding a long or short position in the market as a whole. The requirements apply in modified form to equity derivative products, stock indices, and index arbitrage; the relevant modifications are described later in this Standard.

Specific and general market risk

48.Specific risk is calculated as a percentage of the bank’s gross equity positions, that is, the sum of all long equity positions and all short equity positions, summed without regard to sign (that is, the sum of the absolute values of the positions in each equity). The capital charge for specific risk is calculated as 8% of gross equity positions.

49.General market risk is calculated based on overall net position in an equity market, which is the difference between the sum of the longs and the sum of the shorts. The capital charge for general market risk is calculated as 8% of overall net equity positions.

50.Long and short positions in the same issue may be reported on a net basis. The long or short position in the market must be calculated on a market-by-market basis, that is, a separate calculation has to be carried out for each national market in which the bank holds equities.

Equity derivatives

51.Equity derivatives and off-balance-sheet positions that are affected by changes in equity prices should be included in the measurement system, with the exception of certain options positions as described further below. This includes futures and swaps on both individual equities and on stock indices.

Calculation of positions

52.To calculate specific and general market risk, derivatives are converted into equivalent positions in the relevant underlying. Positions in derivatives should be converted into notional equity positions as follows:

• •Futures and forward contracts relating to individual equities should be reported at current market prices;
• •Futures relating to stock indices should be reported as the marked-to-market value of the notional underlying equity portfolio;
• •Equity swaps should be treated as two notional positions; and
• •Equity options and stock index options should either be “carved out” together with the associated underlying or be incorporated in the measure of general market risk described in this section according to the delta-plus method.

53.Matched positions in each identical equity or stock index in each market may be fully offset, resulting in a single net short or long position to which the specific and general market risk charges will apply. For example, a future in a given equity may be offset against an opposite cash position in the same equity. Any interest rate risk arising out of the future, however, should be treated per the requirements for interest rate risk in the trading book.

Specific Risk and General Market Risk for Equity Derivatives

54.Table 4 below presents a summary of the regulatory treatment for equity derivatives for market risk purposes. Note that derivatives are also subject to a separate capital charge for counterparty credit risk under the Central Bank’s Standard for Counterparty Credit Risk.

Table 4: Summary of treatment of equity derivatives

55.In addition to the general market risk requirement, a further capital charge of 2% must be applied to the net long or short position in index contracts on a diversified portfolio of equities, to cover factors such as execution risk.

56.Where a bank engages in a deliberate arbitrage strategy under which a basket of stocks is matched against a futures contract on a broadly-based index, a modified capital requirement applies, provided:

• •The trade has been deliberately entered into and separately controlled as part of the strategy; and
• •The composition of the basket of stocks represents at least 90% of the index when broken down into its notional components.

In such a case, the capital requirement is 2% of the gross value of the positions on each side. This requirement applies even if all of the stocks comprising the index are held in identical proportions. Any excess value of the stocks comprising the basket over the value of the futures contract or excess value of the futures contract over the value of the basket must be treated as an open long or short equity position.

57.However, on certain futures-related arbitrage strategies, the additional 2% capital charge is applied to only one side of the trade, with the opposite position exempt from this capital charge. This special treatment applies:

• •When a bank takes an opposite position in exactly the same index at different dates or in different market centers; or
• •When a bank has opposite positions in contracts involving different but similar indices at the same date (in which case, the Central Bank may determine whether the two indices in such a strategy are sufficiently similar, with sufficient common components).

58.A bank with a position in depository receipts against an opposite position in the underlying equity, or identical equities in different markets, may offset the positions the long and short positions, provided that any costs on conversion are fully taken into account. (Such trades may also introduce foreign exchange risk requiring market risk capital.)

3.Foreign exchange risk

59.This section sets out minimum capital standards to cover the risk of holding or taking positions in foreign currencies, including gold. Gold is treated as a foreign exchange position for purposes of market risk rather than as a commodity, because its volatility is more in line with foreign currencies and because banks typically manage gold exposures in a similar manner to foreign currencies. These requirements apply to all foreign currency and gold exposures throughout the entire bank, in both the trading book and the banking book.

Measuring the exposure in a single currency

60.The bank’s net open position in each currency, long or short, should be calculated by summing:

• •The net spot position calculated as all asset items less all liability items denominated in a given currency, including accrued interest and accrued expenses;
• •The net forward position calculated as all amounts to be received less all amounts to be paid under forward foreign exchange transactions in a given currency, including currency futures and the principal on currency swaps not included in the spot position;
• •Guarantees (and similar instruments) in the given currency that are certain to be called and are likely to be irrecoverable;
• •At the discretion of the reporting bank, net future income and expenses not yet accrued but already fully hedged;
• •Any other item representing a profit or loss in foreign currencies; and
• •The net delta-based equivalent of the total book of foreign currency options. (Options are also subject to additional considerations as described below in this Standard.)

61.Expected but unearned future interest and expenses may be excluded unless the amounts are certain and have been hedged. If a bank includes future income and expenses, it must do so on a consistent basis, and is not permitted to select only those expected future flows that reduce required capital.

62.Positions in composite currencies (such as SDRs or synthetic currencies) should be separately reported, but may be either treated as currencies in their own right or split into their component parts for measuring the bank’s open positions. While either approach may be used, the selected approach should be used consistently by the bank.

63.Positions (either spot or forward) in gold should first be expressed in common units (e.g. kilos or pounds), with the net position converted at current spot rates into UAE Dirham equivalent value. Where gold is part of a forward contract (quantity of gold to be received or to be delivered), any interest rate or foreign currency exposure from the other leg of the contract should be reported as set out for interest rate and currency exposures under this Standard.

64.Forward positions may be valued at current spot market exchange rates. However, banks that use net present values of positions in their normal management accounting are expected to use those net present values, discounted using current interest rates and valued at current spot rates, for measuring their forward currency and gold positions.

65.Items that are deducted from a bank’s capital when calculating its capital base, such as investments in non-consolidated subsidiaries, or other long-term participations denominated in foreign currencies, which are reported in the published accounts at historic cost, do not need to be included as foreign currency exposures for the foreign exchange risk calculation.

66.When assessing foreign exchange risk on a consolidated basis, it may be technically impractical in the case of some marginal operations to include the currency positions of some foreign branches or subsidiaries. In such cases, the bank may use an established internal position limit in each currency as a proxy for the actual position, provided there is adequate ex-post monitoring of actual positions against such limits to confirm that the limits are effective. The bank should add the limits, without regard to sign, to the net open position in each currency.

67.Banks should convert the nominal amount (or net present value) of the net position in each foreign currency and in gold at current spot rates into UAE Dirham (AED) equivalent for purposes of reporting and capital calculations.

Measuring market risk for foreign exchange positions

68.Calculation of market risk capital for foreign currency positions is based on the net open positions in foreign currencies and in gold. For purposes of market risk capital requirements, the Central Bank takes into account the stable relationship between the AED and the US dollar, which results in UAE banks facing no material foreign exchange market risk with respect to open US dollar positions.
 

69.A bank should calculate its overall net open foreign exchange position for the bank as follows:

• •Calculate the sum of all net short foreign currency positions, and the sum of all net long foreign currency positions, excluding the net open position in the US dollar.
• •Take the larger of the two sums, from the step above, and add the absolute value of the net position (short or long) in gold.

The capital charge for foreign exchange market risk is 8% of the position resulting from the calculation above.

70.A bank doing negligible business in foreign currency that does not take foreign exchange positions for its own account may, at the discretion of the Central Bank, be exempted from capital requirements on these positions provided that:

• •Its foreign currency business, measured as the greater of the sum of its gross long positions and the sum of its gross short positions in all foreign currencies including the US dollar, does not exceed 100% of total capital; and
• •Its overall net open foreign exchange position as defined in this section does not exceed 2% of total capital.

4.Commodities risk

71.This section establishes a minimum capital standard to cover the risk of holding or taking positions in commodities, including precious metals but excluding gold. Banks may choose between two alternative approaches for measuring commodities position risk: a maturity ladder approach based on seven time-bands, and a simplified approach.

72.Under either approach, long and short positions may be offset to calculate open positions in each commodity. Banks first express each commodity position (spot plus forward) in a standard unit of measurement (barrels, kilos, grams etc.), then convert the net position in each commodity into a value in AED at current spot rates. For markets that have daily delivery dates, any contracts maturing within ten days of one another may be offset.

73.In general, long and short positions in different commodities may not be offset. However, the Central Bank permits banks to offset long and short positions in different commodities within a given commodity type in cases where the commodities are deliverable against one another, where “commodity type” has the meaning as defined in the Counterparty Credit Risk Standard. The Central Bank may also permit offsetting if the commodities are close substitutes for each other and a minimum correlation of 0.9 between their price movements can be clearly established by the bank over a minimum period of one year. However, a bank basing its capital calculation on correlations must satisfy the Central Bank of the accuracy of the method chosen for assessing correlation, and must obtain the Central Bank’s prior approval. In addition, the bank must have an approved process for identifying commodity types under the Counterparty Credit Risk Standard.²²

74.All commodity derivatives and off-balance-sheet positions that are affected by changes in commodity prices should be included in this measurement framework. This includes commodity futures, commodity swaps, and options where the “delta plus” method is used. In order to calculate the risk, commodity derivatives should be converted into notional commodities positions and assigned to maturities as follows:

• •Futures and forward contracts relating to individual commodities should be incorporated in the measurement system as notional amounts of barrels, kilos etc. and should be assigned a maturity with reference to expiry date.
• •Commodity swaps where one leg is a fixed price and the other is the current market price should be incorporated as a series of positions equal to the notional amount of the contract, with one position corresponding to each payment on the swap and slotted into the maturity ladder accordingly. The positions would be long positions if the bank is paying fixed and receiving floating, and short positions if the bank is receiving fixed and paying floating.

75.Banks should incorporate commodity swaps where the legs are in different commodities into the relevant maturity ladder, with no offsetting allowed.

Maturity ladder approach

76.Under the maturity ladder approach, the bank assigns positions in each commodity to one of seven time bands, as shown in Table 5 below. Banks must use a separate maturity ladder for each commodity. Holdings of physical stocks of any commodity should be allocated to the shortest time band (that is, 0-1 month).

Table 5: Time-bands for the maturity ladder

77.Capital for commodity market risk consists of two broad components: a set of capital charges on the gross positions (long plus short) in each time band and capital charges against a series of net position calculations. Each component is described further below.

78.For the first component, the bank should calculate 1.5% of the gross position (long plus short, without offsetting) in each of the seven time bands, and sum the results across time bands.

79.For the second component, the bank should first calculate 0.6% of the net position (the absolute value of the difference between long and short positions) in time band 1. To this, the bank should add 0.6% of the net position in time bands 1 and 2 combined. The bank should do the same for time bands 1 through 3 combined, 1 through 4 combined, 1 through 5 combined, and 1 through 6 combined, each time adding 0.6% of the calculated net position. Finally, the bank should add 15% of the net position across all time bands (1 through 7).

80.Required capital for commodity market risk is then the sum of the two broad components calculated per the two paragraphs above.

Simplified approach

81.Under the simplified approach, the capital charge is set at 15% of the net position, long or short, in each commodity. However, each commodity is subject to an additional capital charge of 3% of the bank’s gross position - long plus short - in that particular commodity. In valuing the gross positions in commodity derivatives for this purpose, banks should use the current spot price.
 

5.Treatment of options

82.Two alternative approaches apply to options. Banks with purchased options only (rather than written or sold options) can choose to use a simplified approach described below. Banks with more complex option positions that also write options must use the delta- plus approach rather than the simplified approach.

83.If a bank has written option positions, but all of those written options are hedged by perfectly matched long positions in exactly the same options, no capital is required for market risk on those options.

Simplified approach

84.Under the simplified approach, banks use the following treatments for option positions as noted:

Purchased call or purchased put: The capital charge is the lesser of (1) the market value of the underlying security multiplied by the sum of specific and general market risk charges for the underlying, or (2) the market value of the option. Where the position does not fall within the trading book (i.e. options on certain foreign exchange or commodities positions not belonging to the trading book), it may be acceptable to use the book value instead of the market value.

Purchased put with a long position in the underlying cash instrument, or purchased call with a short position in the underlying cash instrument: The capital charge is the market value of the underlying security multiplied by the sum of specific and general market risk charges for the underlying, less the amount the option is in the money (if any), bounded at zero. For options with a residual maturity of more than six months, the strike price should be compared with the forward, not current, price. A bank unable to do this must take the in-the-money amount to be zero.

85.In some cases, such as foreign exchange, it may be unclear which side is the “underlying security.” In such cases, the asset that would be received if the option were exercised should be considered as the underlying. In addition, the nominal value should be used for items where the market value of the underlying instrument could be zero, such as caps and floors, swaptions, or similar instruments.

Delta-plus approach

86.Options should be included in market risk calculations for each type of risk as a delta-weighted position equal to the market value of the underlying multiplied by the delta.
 

87.For options with equities as the underlying, the delta-weighted positions should be incorporated into the equity market risk capital calculation described above in this Standard. For purposes of this calculation, each national market should be treated as a separate underlying. Similarly, the capital charge for options on foreign exchange and gold positions should be based on the method set out in the section on foreign exchange risk. The net delta-based equivalent of the foreign currency and gold options should be incorporated into the measurement of the exposure for the respective currency (or gold) position. The capital charge for options on commodities should be based on either the simplified or the maturity ladder approach.

88.Delta-weighted positions with debt securities or interest rates as the underlying should be slotted into the interest rate time-bands, using either the maturity method or the duration method, under the following procedure. A two-legged approach should be used as for other derivatives, requiring one entry at the time the underlying contract takes effect and a second at the time the underlying contract matures. For instance, a purchased call option on a June three-month interest-rate future should in April be considered, on the basis of its delta-equivalent value, to be a long position with a maturity of five months and a short position with a maturity of two months. A written option should be similarly slotted as a long position with a maturity of two months and a short position with a maturity of five months. Floating rate instruments with caps or floors should be treated as a combination of floating rate securities and a series of European-style options.

89.In addition to the capital charges arising from delta risk as described above, banks using the delta-plus approach are subject to capital charges for gamma and Vega risk as described below. Banks are required to determine the gamma and Vega for each option position (including hedge positions) separately. These sensitivities must be calculated using an approved exchange model, or using the bank’s proprietary options pricing models subject to oversight by the Central Bank. The capital charges should be calculated as follows:

1. (i)for each individual option a “gamma impact” should be calculated as:

   Gamma impact = ½ × Gamma × VU²
    

            where VU = Variation of the underlying of the option.

2. (ii)VU will be calculated as follows:
   • •For interest rate options if the underlying is a bond, the market value of the underlying should be multiplied by the risk weights set out in Table 2. An equivalent calculation should be carried out where the underlying is an interest rate, again based on the assumed changes in yield from Table 2;
   • •For options on equities and equity indices, the market value of the underlying should be multiplied by 8%;
   • •For foreign exchange and gold options, the market value of the underlying should be multiplied by 8%;
   • •For options on commodities, the market value of the underlying should be multiplied by 15%.
3. (iii)For the purpose of this calculation the following positions should be treated as the same underlying:
   • •For interest rates, each time-band as set out in Table 2;
   • •For equities and stock indices, each national market;
   • •For foreign currencies, each currency pair (and gold);
   • •For commodities, each individual commodity.
4. (iv)Each option on the same underlying will have a gamma impact that is either positive or negative. These individual gamma impacts should be summed; resulting in a net gamma impact for each underlying that is either positive or negative. Only those net gamma impacts that are negative should be included in the capital calculation.

90.The total gamma capital charge is the sum of the absolute value of the net negative gamma impacts as calculated above.

91.For volatility risk or Vega, banks are required to calculate the capital charges by multiplying the sum of the Vegas for all options on the same underlying, as defined above, by a proportional shift in volatility of +/-25%. The total capital charge for Vega risk is the sum of the absolute value of the individual capital charges that have been calculated for Vega risk.

²¹ This use of national discretion aligns the Market Risk Standard with the similar treatment under the Credit Risk Standard.

²² The Central Bank has exercised the national discretion provided under the BCBS framework to permit offsetting of long and short positions in closely related commodities under the conditions described in this Standards. The Central Bank believes that this approach provides appropriate recognition of the actual underlying risks, while requiring well-controlled processes to identify the relevant offsetting commodity positions. It also aligns the treatment of commodities under this Standards with the corresponding treatment of commodity positions with respect to market-driven exposure under the Central Bank’s counterparty credit risk requirements.

96.Banks must establish and maintain adequate systems and controls sufficient to give management and the Central Bank confidence that their valuation estimates are prudent and reliable. These systems must be integrated with other risk management systems within the organization (such as credit analysis). Such systems must include:

• •Documented policies and procedures for the process of valuation. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, guidelines for the use of unobservable inputs reflecting the bank’s assumptions of what market participants would use in pricing the position, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, end of the month and ad-hoc verification procedures; and
• •Clear and independent (i.e. independent of front office) reporting lines for the department accountable for the valuation process. The reporting line should ultimately be to a main board executive director.

1.Marking to market

97.Marking to market is the at-least-daily valuation of positions at readily available close out prices that are sourced independently. Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.

98.Banks must mark to market as much as possible. The more prudent side of a bid/offer spread should be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. Banks should maximize the use of relevant observable inputs and minimize the use of unobservable inputs when estimating fair value using a valuation technique. However, some observable inputs or transactions may not be relevant, such as in a forced liquidation or distressed sale, or transactions may not be observable, such as when markets are inactive. In such cases, the observable data should be considered, but may not be determinative.

2.Marking to model

99.Only where marking to market is not possible should banks mark to model, but this must be demonstrated to be prudent. Marking to model is defined as any valuation that has to be benchmarked, extrapolated, or otherwise calculated from a market input. When marking to model, an extra degree of conservatism is appropriate. The Central Bank will consider the following in assessing whether a mark-to-model valuation is prudent:

• •Senior management should be aware of the elements of the trading book or of other fair-valued positions that are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business.
• •Market inputs should be sourced, to the extent possible, in line with market prices (as discussed above). The appropriateness of the market inputs for the particular position being valued should be reviewed regularly.
• •Where available, generally accepted valuation methodologies for particular products should be used as far as possible.
• •Where the institution itself develops the model, it should be based on appropriate assumptions that have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. The model should be independently tested, including validation of the mathematics, the assumptions, and the software implementation.
• •There should be formal change control procedures in place, and a secure copy of the model should be held and periodically used to check valuations.
• •Risk management should be aware of the weaknesses or limitations of the models used, and should account for those model weaknesses or limitations when using the valuation output.
• •The model should be subject to periodic review to assess its performance (e.g. assessing continued appropriateness of the assumptions, analysis of P&L versus risk factors, comparison of actual close out values to model outputs).
• •Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation.

3.Independent price verification

100.Independent price verification is distinct from daily marking to market. It is the process by which market prices or model inputs are regularly verified for accuracy. While daily marking to market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently). It need not be performed as frequently as daily marking to market, since independent marking of positions should reveal any error or bias in pricing, which should result in the elimination of inaccurate daily marks.

101.Independent price verification entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting. For independent price verification, where pricing sources are more subjective, for example where there is only one available broker quote, prudent measures such as valuation adjustments may be appropriate.

4.Valuation adjustments

102.As part of their procedures for marking to market, banks must establish and maintain procedures for considering valuation adjustments. The Central Bank expects banks using third-party valuations to consider whether valuation adjustments are necessary. Such considerations are also necessary when marking to model.

103.The Central Bank expects the following valuation adjustments/reserves to be formally considered at a minimum: unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, and future administrative costs and, where appropriate, model risk.

104.Banks must establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. Banks should consider the need for an adjustment to a position’s valuation to reflect current illiquidity whether the position is marked to market using market prices or observable inputs, valued using third-party valuations, or marked to model. Such adjustments to the current valuation of less liquid positions should impact Tier 1 regulatory capital, and may exceed valuation adjustments made under financial reporting standards.

105.Bearing in mind that the assumptions made about liquidity in the market risk capital charge may not be consistent with the bank’s ability to sell or hedge out less liquid positions, where appropriate, banks must take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Closeout prices for concentrated positions and/or stale positions should be considered in establishing the adjustment. Banks must consider all relevant factors when determining the appropriateness of the adjustment for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking to model, and the impact of other model risks.

106.For complex products such as securitisation exposures and nth-to-default credit derivatives, banks must explicitly assess the need for valuation adjustments to reflect both the model risk associated with using a possibly incorrect valuation methodology, and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model.

4.Banks can apply one of two methods for calculating the Pillar 1 capital requirement for operational risk as below:

5.The Standardised Approach includes the Alternative Standardised Approach (ASA), which is a simplified version of the Standardised Approach that may be appropriate to small domestic banks focusing on retail or commercial banking activities.

6.Banks are encouraged to move from the BIA to SA as they develop more sophisticated operational risk measurement systems and practices. Qualifying criteria for the Standardised Approach are presented below in Section B.

7.Internationally active banks and banks with significant operational risk exposures (for example, specialised processing banks) are expected to use the SA.

8.The Central Bank will review the capital requirement produced by the operational risk approach used by a bank (whether BIA or SA) for general credibility, especially in relation to a bank’s peer. In the event that credibility is lacking, the Central Bank will consider appropriate supervisory action under Pillar 2.

9.A bank is required to use the same approach, either the BIA or the SA, for all parts of its operations. The use of SA is subject to qualification by the Central Bank on the basis of the qualification criteria outlined in Section B.

10.A bank using the SA is not allowed without supervisory approval to choose to revert to the BIA once it has been approved for the SA. However, if the Central Bank determines that a bank using SA no longer meets the qualifying criteria for this approach, it may require the bank to revert to the BIA.

1.The Basic Indicator Approach (BIA)

11.Banks using the BIA shall hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero shall be excluded from both the numerator and denominator when calculating the gross income average.

12.The capital requirement shall be calculated as follows:

K_BIA = [∑(GI_1..n × α)]/n

2.The Standardised Approach (SA)

13.In the SA, banks’ activities are divided into eight business lines, including corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. The business lines are defined in the table under Paragraph 12.

Principles for business line mapping:

14.The principles that banks shall apply for mapping their own business lines into the regulatory eight business lines as defined by the SA for the purpose of calculating the minimum capital required for operational risk are listed below.

Mapping of Business Lines
 

1. (i)All activities must be mapped into the eight level 1 business lines in a mutually exclusive and jointly exhaustive manner;
2. (ii)Any banking or non-banking activity which cannot be readily mapped into the business line framework, but which represents an ancillary function must be allocated to the business line it supports. If more than one business line is supported through the ancillary activity, an objective mapping criteria must be used;
3. (iii)When mapping gross income, if an activity cannot be mapped into a particular business line then the business line yielding the highest charge must be used. The same business line equally applies to any associated ancillary activity;
4. (iv)Banks may use internal pricing methods to allocate gross income between business lines provided that total gross income for the bank (as would be recorded under the BIA) still equals the sum of gross income for the eight business lines;
5. (v)The mapping of activities into business lines for operational risk capital purposes must be consistent with the definitions of business lines used for regulatory capital calculations in other risk categories (i.e., credit and market risk). Any deviations from this principle must be clearly motivated and documented;
6. (vi)The mapping process used must be clearly documented. In particular, written business line definitions must be clear and detailed enough to allow third parties to replicate the business line mapping. Documentation must, among other things, clearly motivate any exceptions or overrides and be kept on record;
7. (vii)Processes must be in place to define the mapping of any new activities or products;
8. (viii)Senior management is responsible for the mapping policy (which is subject to the approval by the board of directors); and
9. (ix)The mapping process to business lines must be subject to independent review.

Supplementary business line mapping guidance:

15.There is a variety of valid approaches that banks may use to map their activities to the eight business lines, provided the approach used meets the business line mapping principles set out above. The following is therefore an example of one possible approach that could be used by a bank to map its gross income and it is hereby presented for guidance only.

1. (i)Gross income for retail banking consists of net interest income on loans and advances to retail customers and SMEs treated as retail, plus fees related to traditional retail activities, net income from swaps and derivatives held to hedge the retail banking book, and income on purchased retail receivables. To calculate net interest income for retail banking, a bank takes the interest earned on its loans and advances to retail customers less the weighted average cost of funding of the loans (from whatever source — retail or other deposits).
2. (ii)Similarly, gross income for commercial banking consists of the net interest income on loans and advances to corporate (plus SMEs treated as corporate), interbank and sovereign customers and income on purchased corporate receivables, plus fees related to traditional commercial banking activities including commitments, guarantees, bills of exchange, net income (e.g., from coupons and dividends) on securities held in the banking book, and profits/losses on swaps and derivatives held to hedge the commercial banking book. The calculation of net interest income is based on interest earned on loans and advances to corporate, interbank and sovereign customers less the weighted average cost of funding for these loans (from whatever source).
3. (iii)For trading and sales, gross income consists of profits/losses on instruments held for trading purposes (i.e., in the mark-to-market book), net of funding cost, plus fees from wholesale brokerage.
4. (iv)For the other five business lines, gross income consists primarily of the net fees/commissions earned in each of these businesses. Payment and settlement consists of fees to cover provision of payment/settlement facilities for wholesale counterparties. Payment and settlement losses related to bank’s own activities should also be incorporated in the loss experience of the affected business line. Asset management is management of assets on behalf of others.

Capital Calculation under the Standardised Approach:

16.Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted by beta) assigned to that business line. Beta serves as a proxy for the industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. It should be noted that in the SA gross income is measured for each business line, not the whole institution, (e.g., in corporate finance, the indicator is the gross income generated in the corporate finance business line).

17.The total capital charge is calculated as the three-year average of the simple summation of the regulatory capital charges across each of the business lines in each year. In any given year, negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit. However, where the aggregate capital charge across all business lines within a given year is negative, then the input to the numerator for that year shall be zero. The total capital charge may be expressed as:

Capital Calculation under the Alternative Standardised Approach:

18.The Central Bank may allow a bank to use the ASA provided the bank is able to satisfy the Central Bank that this alternative approach provides an improved basis for capturing its operational risk. Once a bank has been allowed to use the ASA, it will not be allowed to revert to use of the SA without the permission of the Central Bank. Large diversified banks in major markets are not authorized to use the ASA.

19.Under the ASA, the operational risk capital charge and methodology are the same as for the SA except for two business lines — retail banking and commercial banking. For these business lines, loans and advances — multiplied by a fixed factor ‘m’ — replaces grossincome as the exposure indicator. The betas for retail and commercial banking are unchanged from the SA. The ASA operational risk capital charge for retail banking (with the same basic formula for commercial banking) can be expressed as:

K_RB = β_RB × m × LA_RB

20.For the purposes of the ASA, total loans and advances in the retail banking business line consists of the total drawn amounts in the following credit portfolios: retail, SMEs treated as retail, and purchased retail receivables.

21.For commercial banking, total loans and advances consists of the drawn amounts in the following credit portfolios: corporate, sovereign, bank, specialised lending, SMEs treated as corporate and purchased corporate receivables. The book value of securities held in the banking book should also be included.

22.Under the ASA, banks may aggregate retail and commercial banking (if they wish to) using a beta of 15%.

23.Similarly, those banks that are unable to disaggregate their gross income into the other six business lines can aggregate the total gross income for these six business lines using a beta of 18%, with negative gross income treated as described in paragraph 15 above.

24.As under the SA, the total capital charge for the ASA is calculated as the simple summation of the regulatory capital charges across each of the eight business lines.

25.In order to qualify for use of the SA or ASA, a bank shall satisfy the Central Bank that, at a minimum:

26.The Central Bank may insist on a period of initial monitoring of a bank’s SA or ASA before it is used for regulatory capital purposes.

27.A bank shall develop specific policies and have documented criteria for mapping gross income for current business lines and activities into the standardised framework. The criteria shall be reviewed and adjusted for new or changing business activities as appropriate. These criteria shall be compliant with the principles for business line mapping that are set out above in paragraph 12.

28.Banks shall also meet the following additional criteria:

Additional Qualifying criteria specifically for the ASA

29.Large diversified banks are not allowed to use the ASA.

30.To be permitted to use the ASA, a bank shall demonstrate to the Central Bank that it meets all the following conditions:

31.The Central Bank may determine additional qualifying criteria for the ASA.