White Papers for Basel II Capital Accord (Basel II)

Treatment of Double-Default and Double-Recovery Effects for Hedged Exposures under Pillar I of the Proposed New Basel Capital Accord

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Under proposed rules for the new Basel capital accord (Basel II), an Advanced Internal-Ratings-Based (A-IRB) bank that purchases credit protection from a qualifying third-party guarantor is permitted to use the probability of default (PD) and loss given default (LGD) associated with the guarantor in assessing regulatory capital charges for the exposure. Some industry representatives have argued that this treatment is too
conservative because it fails to account for the fact that both an obligor and a guarantor must default for a bank to incur a loss on a hedged credit exposure. On the other hand, bank supervisors are concerned that providing greater capital relief under Pillar I for exposures hedged using credit guarantees might be imprudent because of the current state of development of risk management practices and because of practical constraints on supervisors' ability to properly monitor banks that rely heavily on guarantees to mitigate credit risk.This paper presents staff research on how a more nuanced Pillar I treatment of credit guarantees might be structured. This research is exploratory and should not be taken to represent a firm proposal for modifying the way Basel II handles credit guarantees. It is presented at this early stage with the hope that it will stimulate useful and focused feedback from interested parties. To that end, the document at many points makes explicit requests for comment on topics of particular concern.Parties can mutually transfer risk through a variety of contractual mechanisms including traditional financial guarantees, credit default swaps, total return swaps, and credit-linked notes.

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