Basel
ii in the United States of America
From the
Basel ii
Compliance Professionals Association (BCPA),
the largest association of Basel ii Professionals in the
world
Final Rule, USA: Risk-Based Capital Standards:
Advanced Capital Adequacy Framework — Basel II
Exposure at default (EAD)
Under
the proposed rule, EAD for the on-balance sheet
component of a wholesale or retail exposure generally
was
(i)
the bank’s carrying value for the exposure (including
net accrued but unpaid interest and fees)
less
any allocated transfer risk reserve for the exposure, if
the exposure was classified as held-to-maturity or for
trading; or
(ii)
the bank’s carrying value for the exposure (including
net accrued but unpaid interest and fees) less any
allocated transfer risk reserve for the exposure and any
unrealized gains on the exposure plus any unrealized
losses on the exposure, if the exposure was classified
as available-for-sale.
One
commenter asserted that banks should not be required to
include net accrued but unpaid interest and fees in EAD.
Rather, this commenter requested the flexibility to
incorporate such interest and fees in either EAD or LGD.
The
agencies believe that net accrued but unpaid interest
and fees represent credit exposure to an obligor,
similar to the unpaid principal of a loan extended to
the obligor, and thus are most appropriately
included in EAD.
Moreover, requiring all banks to include such interest
and fees in EAD rather than LGD promotes consistency and
comparability across banks for regulatory reporting and
public disclosure purposes.
The
agencies are therefore maintaining the substance of the
proposed rule’s definition of EAD for on-balance sheet
exposures in the final rule.
The
final rule clarifies that, for purposes of EAD, all
exposures other than securities classified as
available-for
sale
receive the treatment specified for exposures classified
as held-to-maturity or for under the proposal.
Some
exposures held at fair value, such as partially funded
loan commitments, may have both on-balance sheet and
off-balance sheet components.
In
such cases, a bank must compute EAD for both the
positive on- and off-balance sheet components of the
exposure.
For
the off-balance sheet component of a wholesale or retail
exposure (other than an OTC derivative contract, repo-style
transaction, or eligible margin loan) in the form of a
loan commitment or line of credit, EAD under the
proposed rule was the bank’s best estimate of net
additions to the outstanding amount owed the bank,
including estimated future additional draws of principal
and accrued but unpaid interest and fees, that were
likely
to occur over the remaining life of the exposure
assuming the exposure were to go into default.
This
estimate of net additions would reflect what would be
expected during a period of economic downturn
conditions.
This
treatment is retained in the final rule.
Also,
consistent with the New Accord, the final rule extends
this “own estimates” treatment to trade-related letters
of credit and for transaction-related contingencies.
Trade-related letters of credit are short-term
self-liquidating instruments used to finance the
movement of goods and are collateralized by the
underlying goods.
A
transaction related contingency includes such items as a
performance bond or performance-based
standby letter of credit.
For
the off-balance sheet component of a wholesale or retail
exposure other than an OTC derivative contract, repo-style
transaction, eligible margin loan, loan commitment, or
line of credit issued by a bank, EAD was the notional
amount of the exposure.
This
treatment is retained in the final rule.
One
commenter asked the agencies to permit banks to employ
the New Accord’s flexibility to reflect additional draws
on lines of credit in either LGD or EAD.
For
the same reasons that the agencies are requiring banks
to include net accrued but unpaid interest and fees in
EAD, the agencies have decided to continue the
requirement in the final rule for banks to reflect
estimates of additional draws in EAD, consistent with
the proposed rule.
Another commenter noted that the “remaining life of the
exposure” concept in the proposed definition of EAD for
off-balance sheet exposures is ambiguous and
inconsistent with defining PD over a one-year horizon.
To
address this commenter’s concern, the agencies have
modified the definition of EAD.
The
final rule requires a bank to estimate net additions to
the outstanding amount owed the bank in the event of
default over a one-year horizon.
Other
commenters noted that banks may reduce their exposure to
certain sectors in periods of economic downturn, and
inquired as to the extent to which such practices may be
reflected in EAD estimates.
The
agencies believe that such practices may be reflected in
EAD estimates for loan commitments, lines of credit,
trade-related letters of credit, and transaction-related
contingencies to the extent that those practices are
reflected in the bank’s data on defaulted exposures.
They
may be reflected in EAD estimates for on-balance sheet
exposures only at the time the on-balance sheet exposure
is actually reduced.
To
illustrate the EAD concept, assume a bank has a $100
unsecured, fully drawn, two-year term loan with $10 of
interest payable at the end of the first year and a
balloon payment of $110 at the end of the term.
Suppose it has been six months since the loan’s
origination, and accrued interest equals $5.
The
EAD of this loan would be equal to the outstanding
principal amount plus accrued interest, or $105.
Next,
consider the case of an open-end revolving credit line
of $100, on which the borrower had drawn $70 (the unused
portion of the line is $30).
Current accrued but unpaid interest and fees are zero.
The
bank can document that, on average, during economic
downturn conditions, 20 percent of the remaining undrawn
amounts are drawn in the year preceding a firm’s
default.
Therefore, the bank’s estimate of future draws is $6
(20% x $30). Additionally, the bank’s analysis indicates
that, on average, during economic downturn conditions,
such a facility can be expected to have accrued at the
time of default unpaid interest and commitment fees
equal to three months of interest against the drawn
amount and 0.5 percent against the undrawn amount, which
in this example is assumed to equal $0.25.
Thus,
the EAD for estimated future accrued but unpaid interest
and fees equals $0.25.
In
sum, the EAD should be the drawn amount plus estimated
future accrued but unpaid fees plus the estimated amount
of future draws =$76.25 ($70 + $0.25 + $6).
Under
the proposed rule, EAD for a segment of retail exposures
was the sum of the EADs for each individual exposure in
the segment.
The
agencies have changed this provision in the final rule,
recognizing that banks typically estimate EAD for a
segment of retail exposures rather than on an individual
exposure basis.
Under
the final and proposed rules, for wholesale or retail
exposures in which only the drawn balance has been
securitized, the bank must reflect its share of the
exposures’ undrawn balances in EAD.
The
undrawn balances of revolving exposures for which the
drawn balances have been securitized must be allocated
between the seller’s and investors’ interests on a pro
rata basis, based on the proportions of the seller’s and
investors’ shares of the securitized drawn balances.
For
example, if the EAD of a group of securitized exposures’
undrawn balances is $100, and the bank’s share (seller’s
interest) in the securitized exposures is 25 percent,
the bank must reflect $25 in EAD for
the
undrawn balances.
The
final rule (like the proposed rule) contains a separate
treatment of EAD for OTC derivative contracts, which is
in section 32 of the rule and discussed in more detail
in section V.C. of the preamble.
The
final rule also clarifies that a bank may use the
treatment of EAD in section 32 of the rule for repo-style
transactions and eligible margin loans, or the bank may
use the general definition of EAD described in this
section for such exposures.
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