OFF-BALANCE
SHEET ITEMS
This
is a fairly technical part of the Basel Accords.
For
those of you who are conversant with this class of exposures, I have
summarised the Basel IV changes in the summary below.
For
those of you who need an introduction to this risk class, the
concepts and mechanisms involved are explained in more details in the
“Concepts and scope of application” section.
SUMMARY
Changes
to the Standardised Approach
The
main changes are the following:
A
40% CCF
will apply to irrevocable undrawn commitments i.e. committed lines
of credit that cannot be cancelled unilaterally (See below).
This
treatment replaces the current treatment where irrevocable
commitments with an original maturity up to one year and commitments
with an original maturity over one year receive a CCF of 20% and 50%,
respectively.
A
10% CCF
will be applied to facilities that are unconditionally,
unilaterally, cancellable by the bank.
The
current CCF is 0%
This
is an entirely new capital charge, which will apply to the tens of
thousands of standard facility letters routinely issued by
Standardised Banks.
Alignment
of the Standardised and IRB Approaches
The
revised Standardised Approach treatment of off-balance sheet items is
“exported”, in its entirety, to the Foundation Approach
and to most of the Advanced Approach.
Foundation
Approach
Currently,
the only difference between the Standardised and the Foundation
Approach is the treatment of non-cancellable commitments, which
receive a 75% CCF regardless of the maturity of the commitment.
Under
Basel IV, the new 40% CCF replaces the 75% CCF and the treatment of
off-balance sheet items in the two Approaches will thus become
identical.
Advanced
Approach
Advanced
IRB banks will have to use the Standardised Approach CCF’s for
their off-balance sheet exposures to
banks (i.e.
their FI business) and to large
corporates
(with a turnover in excess of € 500 million).
This
is because Basel IV will no longer allow banks to use the Advanced
Approach for their exposures to banks and large corporates. They will
have to use the Foundation Approach, which uses the Standardised
Approach CCF’s as explained above.
Even
when the Advanced Approach is still allowed (E.g. for smaller
corporates), banks will have to use the Standardised Approach CCF’s
for all
their off-balance sheet
exposures (E.g. letters of credit, performance bonds etc.) except
for undrawn revolving
commitments.
Even
these undrawn revolving commitments however are subject to a CCF, as
Basel IV imposes a floor on the estimates of these off-balance sheet
exposures, which is calculated by applying a CCF equal to 50% of the
CCF that would be applicable in the Standardised Approach.
So,
undrawn
revolving commitments
remain, to a very limited extent, the only off-balance sheet exposure
for which Advanced banks can still use their own estimates of EAD.
CONCEPTS AND SCOPE OF APPLICATION
“Off-balance
sheet” items as a risk class
The
criterion on which this class of exposures is based is as old as it
is unfortunate.
This
is because being “off-balance sheet”, in and of itself,
has nothing to do with the risk inherent in an exposure.
The
real reason why this category exists and receives a special credit
risk treatment is that the amount of credit risk inherent in
some off-balance
sheet instruments or commitments is different from their nominal or
“face” value.
Generally
that credit risk tends to be lower, even a fraction of the face
value.
It
is the nature of these instruments that requires the conversion of
their nominal value into a “loan equivalent” through the
use of percentages called credit conversion factors (CCF), not the
fact that they happen to be “off-balance sheet”.
This
is why the successive Basel Accords, including Basel IV, have had to
create a bizarre category of “100%” CCF’s to deal
with those off-balance sheet items that do carry a credit risk equal
to that of a loan, and do not therefore require a specific treatment.
It
is bizarre because a 100% Credit “Conversion” Factor does
not of course convert anything and is nothing more than a
contradiction in terms.
If
this exposure class had been (properly) defined on the basis of the
credit risks of the instruments rather than their location in the
accounts, this 100% CCF category would not have existed.
What
is a CCF?
In
credit risk management the unit of reference is the loan, because the
credit risk of loans is equal to the amount disbursed to the
borrower, which is equal to the nominal amount or “face value”
of the loan.
But
if a bank extends an irrevocable 5-year term loan facility of 100
million, for which the borrower does not have an immediate need, the
credit risk of the bank is not 100 million.
The
risk is in fact somewhere between 0% and 100% of 100 million,
depending on the future drawdowns, which are uncertain.
In
the current Advanced IRB Approach, the bank itself will estimate its
future drawdowns, based on its own history and knowledge of the
transaction.
In
the Standardised Approach the regulator does in effect the same, not
of course on the basis of individual transactions, but by taking an
industrywide view, across all banks, of the likelihood of drawdowns
against committed facilities.
Mechanics
In
the current Standardised Approach, this likelihood is estimated by
the regulator as being 20% for undrawn irrevocable commitments of up
to 1 year and 50% for undrawn irrevocable commitments of 1 year or
more.
These
percentages, which are often confused with risk weights because the
amounts are similar, are called Credit Conversion Factors because
they convert the nominal value of an instrument into a “loan
equivalent” i.e. a loan that would carry the same risk as the
instrument.
In
the Standardised Approach, CCF’s are applied to the exposure,
in the IRB Approaches they are applied to the Exposure At Default
(EAD).
So,
to be perfectly clear, in the example of an undrawn commitment of,
say, 5 years the regulator tells us that the credit risk of the 100
million exposure is in fact the same as the risk of a loan of 50
million. In other words the loan equivalent of the commitment is 50
million.
Assuming
that the bank’s minimum capital requirement is the Basel
minimum of 8%, and the borrower is a corporate rated AA, the
calculation of capital is as follows:
100 million x 8% x 20% (risk weight for AA rated corporates) x 50% (CCF) = 800,000.00
The
same logic and process apply to the off-balance sheet items listed
below.
Current
treatment of off-balance sheet items
As
mentioned in the summary, irrevocable commitments with an original
maturity up to one year receive a CCF of 20% while commitments with
an original maturity over one year receive a CCF of 50%.
Apart
from these commitments, the most common “off-balance sheet”
instruments are the following:
Transaction-related
contingent items (e.g. performance bonds, bid bonds, warranties and
standby letters of credit related to particular transactions). CCF:
50%. This CCF remains unchanged under Basel IV.
The
issuing and confirming of short-term self-liquidating trade letters
of credit arising from the movement of goods (e.g. documentary
credits collateralised by the underlying shipment) CCF: 20%. This
CCF remains unchanged under Basel IV.
All
the instruments above are in effect guarantees, albeit of different
types, which the regulator deems to be, on the whole, less risky than
loans. Documentary credits for example are deemed less risky because
they are self-liquidating and collateralised.
These
guarantees must not be confused with the guarantees of indebtedness,
where a guarantor guarantees the payment of a debt (loan) to a
creditor (lender) if the debtor (borrower) fails to pay.
It
is worth mentioning because there is a common misconception that,
because they are “off-balance sheet” (again!), these
guarantees are a “smarter” or more “capital light”
way of lending money.
It
is wrong of course.
With
this type of guarantee, the guarantor in effect takes the place of
the lender, which is why these guarantees are called “credit
substitution guarantees” or “credit substitutes” as
the Basel Accords call them.
The
credit risk of these guarantees, and of all “credit
substitutes”, is identical to the credit risk of the debt
(loan) they guarantee, and they therefore must be allocated exactly
the same level of capital as loans.
And
there is no need to convert them into a loan equivalent, particularly
not with a 100% CCF like the Basel Accords insist on doing.
BASEL
IV CHANGES
Changes
to the Standardised Approach
As
explained in the summary above, two new CCF’s are created: a
40% CCF for committed lines of credit that cannot be cancelled
unilaterally and a 10%
CCF
for the facilities that are unconditionally, unilaterally,
cancellable by the bank.
The
40% CCF replaces the current treatment where irrevocable commitments
with an original maturity up to one year and commitments with an
original maturity over one year receive a CCF of 20% and 50%,
respectively.
The
10% CCF is an entirely new capital charge, which will apply, as
mentioned earlier, to the tens of thousands of standard facility
letters routinely issued not only by Standardised and Foundation
Approach banks but also to a large extent by Advanced Approach banks.
(See 2 below).
This
new charge aligns the Standardised banks (and the Foundation banks)
with the Advanced Approach banks, which were the only ones under
Basel II to allocate capital (through the EAD) to undrawn credit
lines that could be cancelled unilaterally.
Note
that the language used by the new rules to establish this new 10%
capital charge is counter intuitive and even at odds with market
practice: the terms “commitments” and “committed”
suggest that a facility may not
be cancelled unilaterally.
A
“commitment fee”, for example, is charged precisely
because the lender waives the right to cancel payment i.e. undertakes
to pay.
In
this case, the Basel Committee has decided, in its wisdom, to assign
a much wider meaning to “commitment”:
“For
these purposes, commitment means any contractual arrangement that has
been offered by the bank and accepted by the client to extend credit,
purchase assets or issue credit substitutes. It
includes any such arrangement that can be unconditionally cancelled
by the bank at any time without prior notice to the obligor.”
In
other words, it is the acceptance of a facility letter, not the
existence of a legal obligation to lend, which creates a commitment.
Alignment
of the Standardised and IRB Approaches
As
explained in the summary above, all the Standardised Approach CCF’s
(for commitments and guarantees) are “exported” to the
Foundation Approach and to most of the Advanced Approach.
The
explanations provided in this section should make this summary
accessible to all.
ASSESSMENT
Under
Basel IV the CCF’s applicable to transaction-related guarantees
(Performance bonds, bid bonds, Standby L/C’s etc.) and
documentary credits (20%) will have to be used regardless of the
Approach used by the bank.
This
is a good thing. These “off balance sheet items” are
banking products. Conservative estimates of EAD create a commercial
disadvantage for prudent banks and aggressive estimates give reckless
banks an unfair advantage.
The
Basel Accords are meant to create a level-playing field, not to
distort competition.
The
harmonisation of the treatment of irrevocable commitments with a
“middle of the road” CCF of 40 % applicable to (almost)
all irrevocable commitments, on the other hand, makes sense.
The
dual CCF (20%/50%) system of the Standardised Approach is a leftover
from Basel I and is at odds with the 75% of the Foundation Approach,
which was never supposed to be more conservative than the
Standardised Approach.
The
use of the 40% CCF’s for bank commitments to banks and large
corporates should restore the level playing field that used to exist
in the syndication markets with the Basel I 50% CCF applicable to
commitments of more than 1 year.
Why
Basel IV did not go all the way and apply the CCF treatment to all
irrevocable commitments, i.e. also to commitment to smaller
corporates is unclear, particularly in view of the 50% floor that
limits the estimates of EAD in any case.
Which
finally leaves us with the new 10% CCF applicable to unconditionally
cancellable commitments.
This new charge makes Standardised banks the losers of these reforms, particularly those that, as is common practice, generously issue, free of charge, solicitation facility letters to prospective clients. They will have to be more parsimonious with their facility letters, or charge for them.
I
hope they read this article.
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