Transcript No Slide Title

Commodities and the
Capital Requirements Directive
RWE Workshop
December 2005
Slides prepared by ISDA
ISDA ®
International Swaps and Derivatives Association, Inc.
What is set to change ?
• MiFID Article 2.1(i) and (k) exemptions are to be reviewed
by the Commission in March/April 2008, and may then be
amended or repealed.
• If so, some commodity firms may become subject to CRD
for their financial activities.
• Questions :
– What will be the perimeter of their business subject to capital
rules?
– Is the CRD the appropriate regulatory instrument ?
– Should the CRD be recalibrated to a different solvency target ?
– Should approaches to each one of the risks identified in the CRD
be amended for commodity firms ?
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Advocacy tactics
• Joint Working Group set up by ISDA, EFET, FOA
• Various sources of information :
– FOA-KPMG questionnaire
– EFET hypothetical portfolio testing
– CFRC Compendium ( www.isda.org )
• Breakdown of responsibilities :
– ISDA : credit risk/credit risk mitigation
– EFET: market risk
– FOA: operational risk
• Group has established contact with Commission and domestic
regulators (FSA, BaFIN)
• All relevant documents produced in the WG are available at
https://www.isdadocs.org/c_and_a/risk_manage.html#COMMODITY
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Perimeter of activities subject to capital
requirements
• Starting point will be MiFID. Products included
are defined at Annex I Section C and include most
commodity derivatives, with the exception of
contracts entered into for commercial purposes.
(7) Options, futures, swaps, forwards and any other
derivative contracts relating to commodities, that can be
physically settled not otherwise mentioned in C.6 and
not being for commercial purposes, which have the
characteristics of other derivative financial instruments,
having regard to whether, inter alia, they are cleared
and settled through recognised clearing houses or are
subject to regular margin calls.
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Perimeter of activities subject to capital
requirements
• Key questions for capital purposes :
– 1) Should the proposed capital regime apply to the whole
consolidated balance sheet of firms ? Or just to their trading
activities?
– 2) Do participants believe that the scope of the proposed capital
framework should be the same as that of MiFID ? In particular,
would it make sense to also include SPOT commodity positions in
the calculation of market risk capital ? Further, for credit risk
purposes, is it reasonable to focus purely on derivatives entered
into for non commercial purposes, where netting sets might also
include commercial transactions ?
– 3) If a firm has trading outlets in several EU countries, should it
be supervised at a consolidated level ? On what basis should the
consolidating supervisor be determined ?
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Capital Requirements Directive
(CRD)
• Transposes the new Capital Accord into EU law.
Approved on 28 September 2005
• Implementation staggered :
– 1/1/2007 for firms using simple approaches
– 1/1/2008 for firms using sophisticated approaches
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CRD
• CRD : 3 Pillar approach :
– Pillar 1 : minimum capital requirements;
– Pillar 2 : supervisory review. May lead to additional
capital requirements
– Pillar 3 : disclosure requirements
• Fundamental question : Is CRD adapted to risks
borne by commodity firms on their derivative
business ?
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CRD
• Commodity firms do not pose the same risks as financial
institutions :
– NO depositor/investor exposure
– NO systemic risk (Enron failure)
– Risks on the physical side already monitored by physical
regulators
• This has motivated light touch capital regulation in the EU
• And no regulation in other key countries (US, Switzerland)
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CRD
• Commodity firms’ special case is acknowledged at
political level in the EU:
• CRD Recital 19 (b) The goal of liberalisation of gas and
electricity markets is both an economically and politically
important goal for the Community. With this in mind, the
capital requirements, and other prudential rules, to be
applied to firms active in those markets need to be
proportionate and should not unduly interfere with
achievement of the goal of liberalisation.”
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CRD
• Article 45d of the CAD further institutes a carve-out for
commodity firms, which will become regulated by the
earlier of end 2010 and the time by which the Commission
has proposed an appropriate capital regime.
• Calendar is set by the Commission : industry understands
that they are planning to conduct the capital review in
parallel with the MiFID exemptions review, i.e. conclude
by spring 2008.
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CRD
• Conclusion : the case for applying the CRD to commodity
firms has not been made
• Further, even if a CRD type approach were retained, the
target insolvency level should be distinct from that applied
to financial institutions.
– Target pursued for financial institutions based on Basel I. No
equivalent regime to Basel I exists for commodity firms.
– If a lower target is retained, e.g. 99th percentile instead of 99.9th,
credit risk and operational risk capital charges are reduced
respectively by 50% and 33%.
QUESTION : DO MEMBERS OF THE CFRC WISH TO ARGUE
FOR A RECALIBRATION OF THE CRD ?
IF SO, WHAT PERCENTILE SHOULD BE USED ?
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Credit charge re-calibrated at 99.9th perc.
Comparison of K IRB (99.9%) with K IRB (99%)
Capital charge for Exposure=100
25.0000
99.90%
20.0000
15.0000
99%
10.0000
5.0000
0.0000
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
Probability of default
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Credit risk charge re-calibrated at 99th perc.
Equivalent rating
AAA
AA
A
BBB
BB
B
PD
0.03%
0.04%
0.06%
0.21%
1.28%
6.69%
K IRB 99.9%
115.5%
137.4%
175.4%
360.6%
803.5%
1328.4%
K IRB 99%
34.0%
41.9%
56.2%
137.3%
405.5%
841.5%
Old Standardised New Standardised
160.0%
80.0%
160.0%
80.0%
400.0%
200.0%
800.0%
400.0%
800.0%
400.0%
1200.0%
600.0%
Standardised and IRB credit risk charges corresponding
to 99.9% and 99% stresses
Capital charge for Exposure=100
1400.0%
IRB 99.9%
1200.0%
CRD Standardised
1000.0%
800.0%
IRB 99%
600.0%
50% CRD standardised
400.0%
200.0%
0.0%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00%
Probability of default
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Operational risk charge re-calibrated at 99th perc.
• Operational risk charge is intended to represent on average 12% of
total regulatory capital for fis.
• Commodity firms are likely to use the Basic Indicator Approach , i.e.
calculate op risk capital as a fixed percentage, alpha, of average
income.
• Currently, alpha corresponding to a 99.9th worst case op risk scenario,
is 15%.
• We are seeking to re-calibrate alpha at the 99th percentile.
• Assuming a split between the various forms of capital (market, credit
and operational) in firms’ overall reg cap, it is possible to compute the
% of income which the operational risk charge should represent if it
were calibrated at the 99th percentile.
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Operational risk charge re-calibrated at 99th perc.
• Assumptions [To be verified, based on metal traders’
experience in the UK, and the EFET hypothetical testing
exercise]:
• Overall cap charge split as follows :
– Market: 30%
– Credit: 58%
– Operational: 12%
• Then, the operational risk charge should be computed as
10% of income under the Basic Indicator Approach,
implying a reduction in alpha value of 1/3.
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CRD Main Risks
• Under CRD, 3 main risks must be capitalised
– Credit Risk
– Market Risk
– Operational Risk
• All three risks are relevant to commodity firms’
commodity derivatives activities. Question is : should
CRD be modified with respect to each one of these risks
for commodity firms ?
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Counterparty credit risk
• Counterparty Credit Risk arising from commodity derivatives activities :
•
Capital = 8% . RW . EAD
– RW is the Risk Weight:
• Standardised, function of external rating of counterparty, and in the
absence of a rating, 100% (in general).
– Articles 78 to 83 of CID, Annex VI of CID- Basel Accord paras 53 to 68
• Internal Ratings Based: a function of the credit quality of the counterparty,
expected recovery rate and tenor of the credit risk (Effective Maturity M)
– Articles 84 to 89 of CID, Annex VII of CID- Basel Accord paras 271 to 324
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New approach to calculating EAD
Spectrum approach to calculating EAD:
EPE modelling
Approach
(IMM)
Standardised
Method
Current Exposure
Method (CEM)
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Counterparty credit risk
• Questions for commodity firms :
– Which approach will they use to calculate the RW. Are
there specific obstacles which they would like to see
removed in the CRD ?
– Which EAD computation approach would they like to
adopt ?
– Which amendments to these approaches would they
wish to see applied : e.g. more commodity buckets and
different CCFs under the SM, lower add-ons under the
CEM ?
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Credit Risk Mitigation (CRM) issues
• Credit Risk Mitigation recognised by regulators
subject to stringent criteria
(Articles 90-101 of CID, Annex VIII)
• Two main forms of mitigation:
– Funded (collateral)
– Unfunded (credit derivatives, guarantees, letters of
credit)
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CRM issues
• Questions for commodity firms:
– Are any forms of widely used credit risk mitigation not
recognised under the CRD ?
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Market risk
• Questions for commodity firms :
– Which approach are they likely to adopt ?
– What difficulties will they encounter in developing their chosen approach
? Should the rules be made more flexible to adjust for these ? E.g., under
the standardised approach, by relying on forward prices rather than spot
prices and removing the charge for matched positions within bands ?
– Is a simple modeling approach useful ?
• German commodity firms have proposed one to BaFIN, based on
historical simulation and VaR;
• Market values of last 51 days of trading are generated for the
portfolio; based on this set of data, a mean change in value, as well as
the standard deviation of value changes are calculated;
• The capital charge is set equal to :
[Normsinv(99%) *SQUROOT(10) * STDEV+10*Abs(MEAN)]*1.5
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Operational Risk
• Risk capitalised for the first time by regulators in Basel II
• Articles 103 to 105 of CID, Annex X
• Three approaches :
– Basic indicator approach:
• Charge = 15% of average net income over 3 years;
– Standardised approach:
• Charge= 18% (trading and sales) of average net income over 3
years (for firms mostly trading : 15% instead of 18%)
– Advanced measurement approach : loss data distributions (99.9%,
1 year) + external data + scenario testing.
• Which approach are commodity firms likely to choose ?
Any particular difficulty in implementing it ?
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Unsettled Transactions
• Scope: which transactions will be subject to
treatment?
• Where covered by scope, what is mechanism delivery vs payment/delivery, or not?
• What is the settlement period - over or under 5
days?
• Would a carve-out from the long settlement
treatment be justifiable ?
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Recap on key questions
• Should commodity firms be regulated for capital purposes
?
• What business should be regulated ?
• If regulation applies, should commodity firms be subject to
a lighter touch capital regime than financial institutions ?
For instance calibrated on a less onerous solvency
standard?
• Where could the capital requirements be made lighter ?
Operational risk ? Credit risk ? Market risk ? Large
exposures ?
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Useful contact details
• ISDA :
– [email protected] (CRD related matters)
– [email protected] (Energy, Commodity and
Developing Products Committee)
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