Hi, Mr. Harper, for the following question, although I get the correct answer, can you explain the meaning of credit substitution approach? and why D is wrong?View attachment 744
Dr. Jayanthi Sankaran
Well-Known Member
Hi @no_ming,
The approach traditionally taken by the Basel Committee for handling guarantees and credit derivatives such as credit default swaps is the "credit substitution" approach. Suppose that a AA-rated company guarantees a loan to a BBB-rated company. For the purposes of calculating credit risk capital, the credit rating of the guarantor is substituted for the credit rating of the borrower so that the capital is calculated as though the loan had been made to the AA-rated company.
This overstates the credit risk because, for the lender to lose money, both the guarantor and the borrower must default (with the guarantor defaulting before the borrower). The Basel Committee has addressed this issue. In July 2005, it published a document concerned with the treatment of double defaults under Basel II (see Bank for International Settlements, "The Application of Basel II to Trading Activities and the Treatment of Double Defaults," July 2005)
That is why (D) is wrong because it states that the "credit substitution approach" often understates the credit risk involved. Instead it overstates the credit risk as shown above!
Hope that helps!
The approach traditionally taken by the Basel Committee for handling guarantees and credit derivatives such as credit default swaps is the "credit substitution" approach. Suppose that a AA-rated company guarantees a loan to a BBB-rated company. For the purposes of calculating credit risk capital, the credit rating of the guarantor is substituted for the credit rating of the borrower so that the capital is calculated as though the loan had been made to the AA-rated company.
This overstates the credit risk because, for the lender to lose money, both the guarantor and the borrower must default (with the guarantor defaulting before the borrower). The Basel Committee has addressed this issue. In July 2005, it published a document concerned with the treatment of double defaults under Basel II (see Bank for International Settlements, "The Application of Basel II to Trading Activities and the Treatment of Double Defaults," July 2005)
That is why (D) is wrong because it states that the "credit substitution approach" often understates the credit risk involved. Instead it overstates the credit risk as shown above!
Hope that helps!
Thanks for your help, Dr. Jayanthi Sankaran,
As you say the credit rating of borrower should be replaced by the credit rating of guarantor, the capital charge should be based on guarantor in this case, I still don't understand why it will overstate the credit risk unless the capital charge is still based on borrower and not guarantor under the credit substitution?
Dr. Jayanthi Sankaran
Well-Known Member
Hi @no_ming,
That is a good question. Let us look at what Basel II says about "credit substitution" and "double-default". Suppose the credit risk of an exposure is hedged with a credit default swap or a guarantee from a third party. Under Basel II there are two possible ways to account for hedged or guaranteed exposures:
(1) Substitution: The default probability of the "guarantor" (provider of protection or guarantee) may be substituted for the default probability of the original "obligor" (original counterparty). Assuming that the "guarantor" has a better credit quality, then there will be some reduction in risk
(2) Double-default: However, since 2005, the "double-default effect" has been recognized via a formula to account for the fact that risk arises only from "joint default". A key consideration in this formula is the correlation between the original counterparty and the guarantor. The double-default treatment has likely been developed keeping in mind mainly exposures such as loans and bonds, rather than complex derivative products.
The double-default formula (BCBS, 2005) respects the joint default probability in terms of a bivariate normal distribution function. This option is only available when using the IRB Approach under Basel II. Please look up Appendix 11.E of Gregory for the double-default formula used in Basel II, for computing capital for hedged or guaranteed exposures.
The main reduction in capital arises from the decrease in the default probability within the capital formula. The "substitution" approach is preferable only if the conditional default probability of the guarantor is lower than that of the counterparty. The double-default formula is always beneficial in recognition of the fact that the probability of both obligor and guarantor defaulting will be significantly less than the probability of the obligor defaulting.
Hope that helps!
That is a good question. Let us look at what Basel II says about "credit substitution" and "double-default". Suppose the credit risk of an exposure is hedged with a credit default swap or a guarantee from a third party. Under Basel II there are two possible ways to account for hedged or guaranteed exposures:
(1) Substitution: The default probability of the "guarantor" (provider of protection or guarantee) may be substituted for the default probability of the original "obligor" (original counterparty). Assuming that the "guarantor" has a better credit quality, then there will be some reduction in risk
(2) Double-default: However, since 2005, the "double-default effect" has been recognized via a formula to account for the fact that risk arises only from "joint default". A key consideration in this formula is the correlation between the original counterparty and the guarantor. The double-default treatment has likely been developed keeping in mind mainly exposures such as loans and bonds, rather than complex derivative products.
The double-default formula (BCBS, 2005) respects the joint default probability in terms of a bivariate normal distribution function. This option is only available when using the IRB Approach under Basel II. Please look up Appendix 11.E of Gregory for the double-default formula used in Basel II, for computing capital for hedged or guaranteed exposures.
The main reduction in capital arises from the decrease in the default probability within the capital formula. The "substitution" approach is preferable only if the conditional default probability of the guarantor is lower than that of the counterparty. The double-default formula is always beneficial in recognition of the fact that the probability of both obligor and guarantor defaulting will be significantly less than the probability of the obligor defaulting.
Hope that helps!
Hi, Dr. Jayanthi Sankaran, I conclude the following, is that right? @Dr. Jayanthi Sankaran
"Credit substitution approach lower PD by using CDS swapping to a higher credit rating counterparty, but in case of joint-default, double-default treatment with lower risk will be used instead, in this case, using credit substitution approach will overstate the credit risk."
"Credit substitution approach lower PD by using CDS swapping to a higher credit rating counterparty, but in case of joint-default, double-default treatment with lower risk will be used instead, in this case, using credit substitution approach will overstate the credit risk."
Dr. Jayanthi Sankaran
Well-Known Member
Hi @no_ming,
The Credit Substitution approach will lower the PD by hedging the exposure, if and only if the conditional default probability of the guarantor is lower than that of the counterparty. This would mean that the counterparty has a lower credit rating, than the guarantor which has a higher credit rating.
Under the double-default formula, the probability that both guarantor and the counterparty will default, will be significantly less than the probability of the counterparty defaulting. As you rightly said, in this case, using credit substitution approach will overstate the credit risk.
Clearly, the double-default formula will depend on the default probability of the guarantor. When the guarantor default probability is low, in relation to the counterparty default probability, then the capital reduction will be significant. However, if the guarantor default probabilities are relatively high, the capital reduction will be small and may be even zero.
Thanks!
The Credit Substitution approach will lower the PD by hedging the exposure, if and only if the conditional default probability of the guarantor is lower than that of the counterparty. This would mean that the counterparty has a lower credit rating, than the guarantor which has a higher credit rating.
Under the double-default formula, the probability that both guarantor and the counterparty will default, will be significantly less than the probability of the counterparty defaulting. As you rightly said, in this case, using credit substitution approach will overstate the credit risk.
Clearly, the double-default formula will depend on the default probability of the guarantor. When the guarantor default probability is low, in relation to the counterparty default probability, then the capital reduction will be significant. However, if the guarantor default probabilities are relatively high, the capital reduction will be small and may be even zero.
Thanks!
Hi, @Dr. Jayanthi Sankaran & Mr @David Harper CFA FRM
The following question is from 2014 Practice exam Q15, I would like to know whether the answer is still (C) if the call option is less than 5 years. Besides, why (D) is not the answer as the S.debt is over 5 years and I cannot find the reference for the case of the S.bond guaranteed by the subsidiary. Thanks.
The following question is from 2014 Practice exam Q15, I would like to know whether the answer is still (C) if the call option is less than 5 years. Besides, why (D) is not the answer as the S.debt is over 5 years and I cannot find the reference for the case of the S.bond guaranteed by the subsidiary. Thanks.
Hi @no_ming See page 18 of https://www.dropbox.com/s/a1cd3wwtsi62gyw/bcbs189.pdf?dl=0 i.e., emphasis mine to highlight why question is correct to exclude (d) and not the call minimum is five years
Many thanks, Mr. Harper, seems some information is not covered by the notes but still be examined.~
@no_ming to what notes do you refer?
Mr. Harper, I use the Schweser notes 2016 & I cannot find both of the topic and I am not searching for the valuation of CDS in internet for reference~
Moreover, Mr. Harper, when I read about the Basel III capital requirement, it seems that Basel III deleted the requirement of "Tier 2 capital is limited to 100% of Tier 1 capital", is that right?
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Hi @no_ming okay thank you for the clarification re notes: Re Basel III, technically what you say is true as an explicit rule but that's only because the Basel 3 capital rules already imply this. The source here is pretty good at http://www.bis.org/publ/bcbs189.htm where please note (page 12):
You can see Tier 1 Capital, which is CE Tier 1 + Additional Tier 1, needs to be at least 6.0% of the total capital which must be 8.0%, such that the rule you cite isn't really necessary. I hope that helps!
You can see Tier 1 Capital, which is CE Tier 1 + Additional Tier 1, needs to be at least 6.0% of the total capital which must be 8.0%, such that the rule you cite isn't really necessary. I hope that helps!
Mr Harper, assume RWA is 100, tier 1 capital is 6 and tier 2 is 10, it should fulfill the 8% RWA requirement. But tier 2 > tier 1, if this case is still vaild, it seems that the requirement in Basel III is deleted rather than implicit it. Do you agree?
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Hi @no_ming I think i agree, but I can't tell you that I am certain there is a difference. You are correct: Basel 2 includes the explicit "The total capital ratio must be no lower than 8%. Tier 2 capital is limited to 100% of Tier 1 capital." I would have thought that, in Basel 2, this nevertheless allows for a total capital under your scenario of 16 because, I had assumed the Tier 2 requirement refers to the qualifying 8%. But if we interpret it literally, then under your scenario, B2 would count only 12 (6+6) as total capital, and indeed it would seem that you are correct. I do agree that Basel 3 has eliminated this explicit requirement that T2 cannot exceed T1; I cannot find it. Therefore, until I can find evidence otherwise, I do agree with you Thank you!
Thank you!Hi @no_ming I think i agree, but I can't tell you that I am certain there is a difference. You are correct: Basel 2 includes the explicit "The total capital ratio must be no lower than 8%. Tier 2 capital is limited to 100% of Tier 1 capital." I would have thought that, in Basel 2, this nevertheless allows for a total capital under your scenario of 16 because, I had assumed the Tier 2 requirement refers to the qualifying 8%. But if we interpret it literally, then under your scenario, B2 would count only 12 (6+6) as total capital, and indeed it would seem that you are correct. I do agree that Basel 3 has eliminated this explicit requirement that T2 cannot exceed T1; I cannot find it. Therefore, until I can find evidence otherwise, I do agree with you
Hi, Mr. Harper, the answer of the following question B, but seems C can be the answer too, do you agree?
Moreover, if the question asked for whether the case met Basel requirement, should I consider the Capital conservation buffer as a whole? (e.g. requirement of Tier 1 CET = 4.5% + 2.5% = 7%, Tier 1 = 8.5%, Total capital = 10.5%?)
Also, when I calculating the capital requirement such as credit or Market risk charge, should I additionally add the CVA & Wrong Way risk value for the final adjustment?
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@no_ming @David Harper CFA FRM
It looks like this is one of our practice questions, and this same question is discussed here: https://forum.bionicturtle.com/thre...i-regulatory-capital-changes.7944/#post-30978
Thank you,
Nicole
Hi Nicole, thx for your help. But unfortunately, I dont have the permission to read it
Wait a second? You are posting here questions from our own set (that I personally wrote) but which have been stolen and re-purposed by somebody else. Do I have that correctly @no_ming ?
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