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Set out the assorted capital requirements imposed by regulators.

FRM® Part II · Credit Risk Measurement and Management · Margin (Collateral) and Settlement · FRM2.CR.17.k

The idea

Regulators set several capital and margin requirements around collateral. Under Basel III, counterparty credit exposure uses SA-CCR, the standardized approach. Here RC is replacement cost, PFE is potential future exposure, and alpha is 1.4. EAD = α × (RC + PFE). For margined netting sets, V is the contract value, C the collateral held, TH the threshold and NICA the net independent collateral amount. Replacement cost recognises that unsecured exposure can persist. RC = max(V − C, TH + MTA − NICA, 0). Here RW is the risk weight, and 8% is the minimum capital ratio on risk-weighted assets. Capital = EAD × RW × 8%. There is a separate CVA capital charge. In the comprehensive approach, E is the exposure, C the collateral, and the H terms are haircuts. Here NE is the net exposure after haircuts. NE = max(0, E × (1 + He) − C × (1 − Hc − Hfx)). The BCBS-IOSCO rules require variation and initial margin on non-cleared derivatives between covered entities. Initial margin is calibrated to a 99% one-tailed, 10-day stress and is segregated. Know the formulas and the 99% and 10-day parameters.

Formulas

SA-CCR exposure at default

EAD = α × (RC + PFE)

α
the alpha multiplier, 1.4
RC
replacement cost, the current exposure
PFE
potential future exposure

Netting sets under Basel III's standardised approach. Alpha multiplies the whole sum; applying it to RC alone, or leaving it out, is the usual slip.

SA-CCR replacement cost of a margined netting set

RC = max(V − C, TH + MTA − NICA, 0)

V
the current value of the contracts
C
the collateral held
TH
the threshold
MTA
the minimum transfer amount
NICA
the net independent collateral amount

Margined netting sets only. The middle term is a floor for exposure that can persist unsecured; using V − C alone misses it.

Counterparty credit capital

Capital = EAD × RW × 8%

EAD
exposure at default
RW
the counterparty risk weight

EAD × RW is risk-weighted assets; capital is 8% of that. A separate CVA capital charge is added on top.

Net exposure under the comprehensive approach

NE = max(0, E × (1 + He) − C × (1 − Hc − Hfx))

E
the exposure
He
the haircut on the exposure
C
the market value of the collateral
Hc
the supervisory haircut on the collateral
Hfx
the extra haircut for a currency mismatch

Collateralised exposures. Both collateral haircuts reduce the collateral; leaving out Hfx when the currencies differ overstates the protection.

A practice question

From the question bank, with the reason each wrong option is wrong.

In the Basel SA-CCR framework, exposure at default for a netting set is:

  1. 1.4 x potential future exposure onlyWhy not: Omits replacement cost, the current exposure.
  2. Replacement cost + potential future exposure, with no scalingWhy not: Omits the alpha factor of 1.4.
  3. Replacement cost x 1.4 less collateral heldWhy not: Treats alpha as applying to replacement cost only and subtracts collateral again.
  4. 1.4 x (replacement cost + potential future exposure) - correct

SA-CCR sets EAD = alpha x (RC + PFE), with alpha equal to 1.4.

A harder one

A margined netting set has mark-to-market V = USD 12 million, collateral held C = USD 8 million, threshold 5 million, MTA 1 million and a net independent collateral amount of zero. Replacement cost under SA-CCR is closest to:

  1. USD 6 million - correct
  2. USD 5 millionWhy not: Uses the threshold alone and omits the MTA.
  3. USD 4 millionWhy not: Uses V - C only and misses the floor of threshold plus MTA.
  4. USD 12 millionWhy not: Ignores collateral, which is the unmargined formula.

RC = max(V - C, TH + MTA - NICA, 0) = max(4, 6, 0) = USD 6 million.

The hardest tier

A bank has a USD 100 million loan (no exposure haircut) secured by bonds with market value USD 60 million. The supervisory haircut on the bonds is 4%, and an additional 8% FX haircut applies for a currency mismatch. Under the comprehensive approach, net exposure is closest to:

  1. USD 40.0 millionWhy not: Ignores both haircuts and subtracts full market value of the bonds.
  2. USD 42.4 millionWhy not: Omits the FX haircut, using 60 x (1 - 0.04) as collateral value.
  3. USD 47.2 million - correct
  4. USD 52.8 millionWhy not: Reports the haircut-adjusted collateral value instead of the net exposure.

E* = max(0, 100 - 60 x (1 - 0.04 - 0.08)) = 100 - 52.8 = USD 47.2 million.

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