Derivatives

Credit

Credit Derivatives Research Deutsche Bank@

Global Markets Research

Credit Derivatives: Issues & Trends

US bank regulators discuss BIS capital reform September 28, 2000
& credit derivatives

In meetings recently with senior bank regulators at the Fed and the
OCC, it was clear that the ongoing process to revise the Basle capital
accord of 1988 is a high priority. The BIS Committee is planning to issue
a revised proposal early next year, which promises to be quite different
from the initial proposal issued in June 1999. It also promises to be
quite controversial.

US regulators confirmed that BIS Committee is planning to permit banks

to use their internal rating systems to set capital requirements, in lieu of
relying on external ratings published by the rating agencies. But there is
little clear sense of how banks would be required to validate internal
models.

One casualty of the Basle process may well be the US proposal to allow
triple-A rated structured securities to qualify for the 20% risk weighting.
In any case, it is unlikely to be issued this year.

At this point there is no clear implications for credit derivatives in the

process to revise the Basle capital accord. There is little question that
the proposal will address credit derivatives, presumably with an eye to
reducing the current inconsistencies in regulatory treatment across
countries.

Even though banks account for over one-half of the notional amount of
credit derivatives outstanding, there has been remarkably little
penetration into the US banking industry. Regulators say that only about
20 banks currently use credit derivatives, and many of them are in
dealer/market making capabilities. Their sense (and we concur) is that
broader use of credit derivatives will occur as banks begin using portfolio
management tools to manage loan book credit risk.
John .F. Tierney
(212) 469-6795
john.tierney@db.com
 Deutsche Bank@
External rating agency
approach widely panned
US proposal to set 20%
risk weighting for AAA-
rated ABS/CMBS remains
on hold
1
In June 1999, the Basle Committee on Banking Supervision issued for comment a proposed revision to the 1988 Capital Accord. Based on
comments received to date, the Basle Committee is preparing a second proposal that is expected to be issued for comment early next year. For an
extensive discussion of the likely shape of the revised proposal and summary of the original proposal, please see the recent Deutsche Bank research
report Basel Capital Accord Update, September 19, 2000, by Simon Adamson et al. It is available through the Deutsche Bank Research website or
from your Deutsche Bank representative.
2 Global Markets Research
September 28, 2000
Bank regulators are focusing on BIS capital reform
In meetings recently with senior regulators at the Federal Reserve Board (Fed) and the
Office of the Comptroller of the Currency (OCC) it was clear to us that one of their top
priorities is the process to revise the existing Basle Capital Accord of 1988.
Regulators confirmed that the original external ratings-based approach for setting risk
based capital was widely criticized by international banks and trade organizations. Many
banks and other commentators strongly recommended that the Basle Committee allow
banks to use their internal ratings systems in lieu of external ratings. It appears that the
next round of the proposal will permit banks to use internal rating systems. It is also likely
to be more granular i.e., to provide more risk buckets to better represent the relative
risk of different assets.1
US regulators do not know at this point how banks will be required to validate or calibrate
their internal rating models as a prelude to using them for risk based capital purposes.
Our sense is that very little work has been done on this issue to date, making it likely that
the next round of the proposal may take the route of seeking comments and guidance
from the industry rather than laying out specific proposed guidance. It is also uncertain
how or to what extent the new proposal will rely on external ratings. There is clearly a
range of views in the international regulatory community as to whether it is appropriate or
relevant to use external ratings. Some regulators oppose the use of external ratings
because the rating agencies have only a small presence in their home country. Other
regulators have philosophical concerns about ceding control of credit decisions a
quintessential bank function to outside agencies. This development may come as a
surprise to some US-based investors, some of whom seem to have come to the
conclusion that an external ratings based framework for risk-based capital is a done deal.
The Basle Committee is planning to issue a second proposal early next year. Regulators
report that there will be a six to nine month comment period, then the committee hopes
to issue a final rule that would be effective in 2002. This schedule seems aggressive to
us, but once the new proposal is issued we should have a better idea of when final rules
might be issued and be effective.
One casualty of the ongoing BIS process may be the proposal in the US to allow
triple-A ABS/CMBS to receive 20% risk weighting. A number of bank regulators have
pushed hard over the past five years for this change, but there has been continued
opposition by other regulators (and to some extent the banking industry), who are
concerned about the implications of basing bank capital policy on external rating agency
ratings. Now that the Basle Committee is addressing this issue head-on, some US
regulators want to hold off on the US proposal to see the outcome of the Basle process.
In any case, it is unlikely this rule will be issued this year.
As well as credit derivatives
US regulators continue to be interested in developments in the credit derivatives market.
One key issue for them the implications of physical versus cash settlement for credit
derivatives used in a banks loan book. Credit derivative contracts are generally moving in
the direction of physical settlement in event of default (or other credit event), but that
could be an issue for a bank that cant do physical settlement due to confidentiality
agreements. At this point in the markets development, this is largely academic because
September 28, 2000 Deutsche Bank@

banks tend to do default swaps on credits where there are a variety of deliverable bonds
and obligations should a default occur, as opposed to little-known and illiquid middle
market names. Other issues raised were documentation for credit derivative transactions
and approaches for analyzing the risk associated with maturity mismatches (i.e., when the
tenor of a credit derivative is shorter than that of the underlying bond or loan). We
understand that these issues have been under study by the Basle Committee, although
we dont have any particular insight now as to how credit derivatives will be treated in the
next proposal. Presumably international regulators will try to create a more level playing
field across countries for using credit derivatives than is presently the case.

Most banks have yet to One interesting statistic is that only about 20 US banks are currently using credit
begin using credit derivatives (out of about 400 that use derivatives and nearly 9,000 banks total). We
derivatives believe many of those 20 banks operate as dealers/market makers. Given that banks
make up more than one-half of the credit derivatives market (according to a recent survey
by the British Bankers Association) we would have expected somewhat deeper
penetration. Credit derivatives have been widely hailed as a tool to help banks more
efficiently manage credit risk in their loan portfolios, but it is apparent that many potential
users are still studying the product and how to use it.

Regulators said that the next version of the proposal is unlikely to permit banks to use
portfolio credit models to set risk-based capital levels. They are taking an active interest I
the efforts of banks to develop these modeling frameworks. But they said that to their
knowledge no bank to date has developed a credit portfolio model approach that covers
an entire loan book. Some banks have portfolio models for portions of their loan books,
but regulators would prefer to see these models being applied more broadly before
moving to allow banks to use them for regulatory capital purposes. Their view (with
which we concur) is that more widespread use of credit derivatives will occur as banks
develop credit portfolio modeling capabilities.

Global Markets Research 3

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