Basel III : Impact on the derivatives business

Abstract

The Basel Committee on Banking Supervision introduced new guidelines to reform the banking sector, making it more resilient in light of the Financial Crisis. The objective of the reforms is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spill over from the financial sector to the real economy. The guidelines highlight tighter minimum capital requirements, liquidity ratios and an emphasis on the counterparty credit risk measurement framework (CCR). It reinstates the importance of common equity and retained earnings as the predominant form of Tier I capital. My objective was to highlight some of the changes under the CCR framework and how they impact derivative trades. We looked at how the calculations for Risk Weighted Assets (RWA) have been modified by incorporating the notion of Stressed Parameters and Asset Value Correlation multiplier. Basel III also introduced changes in Credit Valuation Adjustment where there is introduction of a markto-market CVA capital charge on the Balance Sheet. Also known as CVA Volatility Add-On RWA, it aims to capture the heightened default risks from changing credit profiles of counterparties. We then looked briefly at the features of Credit Support Annex (CSAs), Central Counterparty Clearing (CCP) and their impact on RWA and CVA calculations. Finally, we highlight some opinion extracts of various industry experts from the risk and regulatory functions on aspects such as impact on revenue, business models as well as the practicality of implementing these Basel reforms in a consistent manner.