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
Wholesale exposures
Under
the proposed rule, a bank would be required to have an
internal risk rating system that indicates the
likelihood of default of each individual obligor and
would either use an internal risk rating system that
indicates the economic loss rate upon default of each
individual exposure or directly assign an LGD estimate
to each individual exposure.
A bank
would assign an internal risk rating to each wholesale
obligor that reflected the obligor’s likelihood of
default.
Several commenters objected to the proposed requirement
to assign an internal risk rating to each wholesale
obligor that reflected the obligor’s likelihood of
default.
Commenters asserted that this requirement was burdensome
and unnecessary where a bank underwrote an exposure
based solely on the financial strength of a guarantor
and used the PD substitution approach (discussed below)
to recognize the risk mitigating effects of an eligible
guarantee on the exposure.
In
such cases, commenters maintained that banks should be
allowed to assign a PD only to the guarantor and not the
underlying obligor.
While
the agencies believe that maintaining internal risk
ratings of both a protection provider and underlying
obligor provides helpful information for risk management
purposes and facilitates a greater understanding of
so-called double default effects, the agencies
appreciate the commenters’ concerns about burden in this
context.
Accordingly, the final rule does not require a bank to
assign an internal risk rating to an underlying obligor
to whom the bank extends credit based solely on the
financial strength of a guarantor, provided that all of
the bank’s exposures to that obligor are fully covered
by eligible guarantees and the bank applies the PD
substitution approach to all of those exposures.
A bank
in this situation is only required to assign an internal
risk rating to the guarantor.
However, a bank must immediately assign an internal risk
rating to the obligor if a guarantee can no longer be
recognized under this final rule.
In
determining an obligor rating, a bank should consider
key obligor attributes, including both quantitative and
qualitative factors that could affect the obligor’s
default risk.
From a
quantitative perspective, this could include an
assessment of the obligor’s historic and projected
financial performance, trends in key financial
performance ratios, financial contingencies, industry
risk, and the obligor’s position in the industry.
On the
qualitative side, this could include an assessment of
the quality of the obligor’s financial reporting,
non-financial contingencies (for example, labor problems
and environmental issues), and the quality of the
obligor’s management based on an evaluation of
management’s ability to make realistic projections,
management’s track record in meeting projections, and
management’s ability to effectively adapt to changes in
the economy and the competitive environment.
Under
the proposed rule, a bank would assign each legal entity
wholesale obligor to a single rating grade. Accordingly,
if a single wholesale exposure of the bank to an obligor
triggered the proposed rule’s definition of default, all
of the bank’s wholesale exposures to that obligor would
be in default for risk-based capital purposes.
In
addition, under the proposed rule, a bank would not be
allowed to consider the value of collateral
pledged to support a particular wholesale exposure (or
any other exposure-specific characteristics) when
assigning a rating to the obligor of the exposure.
A bank
would, however, consider all available financial
information about the obligor – including, where
applicable, the total operating income or cash flows
from all of the obligor’s projects or businesses – when
assigning an obligor rating.
While
a few commenters expressly supported the proposal’s
requirement for banks to assign each legal entity
wholesale obligor to a single rating grade, a
substantial number of commenters expressed reservations
about this requirement.
These
commenters observed
that in certain circumstances an exposure’s
transaction-specific
characteristics affect its likelihood of default.
Commenters asserted that the agencies should provide
greater flexibility and allow banks to depart from the
one-rating-perobligor requirement based on the economic
substance of an exposure.
In
particular,
commenters
maintained that income-producing real estate lending
should be exempt from
the
one-rating-per-obligor requirement.
The
commenters noted that the probability that an obligor
will default on any one such facility depends primarily
on the cash flows from the individual property securing
the facility, not the overall condition of the obligor.
Similarly, several commenters asserted that exposures
involving transfer risk and nonrecourse exposures should
be exempted from the one-rating-per-obligor requirement.
In
general, the agencies believe that a two-dimensional
rating system that strictly separates borrower and
exposure-level characteristics is a critical
underpinning of the
IRB approach.
However, the agencies agree that exposures to the same
borrower denominated in different currencies may have
different default probabilities.
For
example, a sovereign government may impose prohibitive
exchange restrictions that make it impossible for a
borrower to transfer payments in one particular
currency.
In
addition, the agencies agree that certain
income-producing real estate exposures for which the
bank, in economic substance, does not have recourse to
the borrower beyond the real estate serving as
collateral for the exposure, have default probabilities
distinct from that of the borrower.
Such
situations would arise, for example, where real estate
collateral is located in a state where a bank, under
applicable state law, effectively does not have recourse
to the borrower if the bank pursues the real estate
collateral in the event of default (for example, in a
“one-action” state or a state with a similar law).
In
one-action states such as Arizona, California, Idaho,
Montana, Nevada, and Utah, or in a state with a similar
law, such as New York, the applicable foreclosure laws
materially limit a bank’s ability to collect against
both the collateral and the borrower.
A
third instance in which exposures to the same borrower
may have significantly different default probabilities
is when a borrower enters bankruptcy and the bank
extends additional credit to the borrower under the
auspices of the bankruptcy proceedings.
This
so-called debtor in possession (DIP) financing is unique
from other exposure types because it typically has
priority over existing debt, equity, and other claims on
the borrower.
The
agencies believe that because of this unique priority
status, if a bank has an exposure to a borrower that
declares bankruptcy and defaults on that exposure, and
the bank subsequently provides DIP financing to that
obligor, it may not be appropriate to require the bank
to treat the DIP financing exposure at inception as an
exposure to a defaulted borrower.
To
address these circumstances and clarify the application
of the one-rating-perobligor requirement, the agencies
added a definition of obligor in the final rule.
The
final rule defines an obligor as the legal entity or
natural person contractually obligated on a
wholesale exposure except that a bank may treat three
types of exposures to the same legal entity or natural
person as having separate obligors.
First,
exposures to the same legal entity or natural person
denominated in different currencies.
Second,
(i)
income producing real estate exposures for which all or
substantially all of the repayment of the exposure is
reliant on cash flows of the real estate serving as
collateral for the exposure;
the
bank, in economic substance, does not have recourse to
the borrower beyond the real estate serving as
collateral for the exposure; and no cross-default or
cross-acceleration clauses are in place other than
clauses obtained solely in an abundance of caution; and
(ii)
other credit exposures to the same legal entity or
natural person.
Third,
(i)
wholesale exposures authorized under section 364 of the
U.S. Bankruptcy Code (11 U.S.C. 364) to
a
legal entity or natural person who is a
debtor-in-possession for purposes of Chapter 11 of the
Bankruptcy Code; and
(ii)
other credit exposures to the same legal entity or
natural person.
All
exposures to a single legal entity or natural person
must be treated as exposures to a single obligor unless
they qualify for one of these three exceptions in the
final rule’s definition of obligor.
A
bank’s obligor rating system must have at least seven
discrete (non overlapping) obligor grades for
non-defaulted obligors and at least one obligor grade
for defaulted obligors.
The
agencies believe that because the risk-based capital
requirement of a wholesale exposure is directly linked
to its obligor rating grade, a bank must have at least
seven non-overlapping obligor grades to differentiate
sufficiently the creditworthiness of non-defaulted
wholesale obligors.
A bank
must capture the estimated loss severity upon default
for a wholesale exposure either by directly assigning an
LGD estimate to the exposure or by grouping the exposure
with other wholesale exposures into loss severity rating
grades (reflecting the bank’s estimate of the LGD of the
exposure).
LGD is
described in more detail below.
Whether a bank chooses to assign LGD values directly or,
alternatively, to assign exposures to rating grades and
then quantify the LGD for the rating grades, the key
requirement is that the bank must identify exposure
characteristics that influence LGD.
Each
of the loss severity rating grades must be associated
with an empirically supported
LGD estimate.
Banks
employing loss severity grades must have a sufficiently
granular loss severity grading system to avoid grouping
together exposures with widely ranging
LGDs.
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