CONSULTATION ON CREDIT RISK MITIGATION ISSUES UNDER SECTION 29 OF THE BANKING ACT

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1 CONSULTATION ON CREDIT RISK MITIGATION ISSUES UNDER SECTION 29 OF THE BANKING ACT 1 Introduction 1.1 Feedback and comments received on the consultation on the credit risk mitigation ( CRM ) issues under Section 29 of the Banking Act, together with MAS responses are set out below. 2 General 2.1 Alignment with Basel II One bank noted that many of the provisions in the consultation paper mirrored those of Basel II, while others do not, and asked MAS to consider adopting a consistent basis for exposure measurement across the capital framework and the proposed amendments to Section 29 in order to minimize implementation costs for banks Banks should note that the objectives and therefore the calibration of the requirements under the Basel II capital regime differ from those of the large exposures regime. Notwithstanding the differences, MAS has decided to recognise the effect of CRM, while retaining the broad limits under Section 29. In formulating the list of permissible CRM techniques for Section 29 purposes, MAS took into account the divergent risk management practices and capabilities of banks operating in Singapore. While these considerations do not permit a complete alignment with Basel II requirements at this stage, we note that the extent of recognition of CRM techniques proposed is consistent with the practices of other leading regulators. 2.2 Use of Credit Ratings MAS had originally proposed that at least two credit ratings from Standard and Poor s, Moody s or Fitch Ratings will be required in instances where ratings were taken into consideration for the purposes of Section 29. In their feedback, several banks asked MAS to consider the following: i. recognising external ratings assigned by only one rating agency; ii. recognising the use of internal ratings; and iii. iii. recognising ratings from other rating agencies.

2 2.2.2 MAS recognises that only one credit rating may be available in certain cases. Accordingly, MAS will recognise the external rating provided by one of the three recognised rating agencies in instances where no other rating is available. Where a bank has access to two credit ratings, it shall use the rating associated with the higher risk (i.e. the poorer rating). Where a bank has three credit ratings, it shall use the higher of the two poorest ratings. This approach will be applicable to the use of credit ratings where specified in the Notice, including for the recognition of exempt exposures and eligible protection providers MAS is not inclined to accept the use of internal ratings for now as it is not possible to carry out an independent and adequate assessment and validation on the robustness of the internal rating capabilities of all banks, particularly in the case of foreign bank branches operating in Singapore. We note that a common problem among banks adopting the Internal Ratings-Based Approaches ( IRBA ) under Basel II is the lack of data, and that more time and data will be necessary to ensure that such models are robust. MAS will closely monitor Basel II implementation globally, particularly whether the use of internal ratings by IRBA banks have proven to be robust and will review the position on the use of internal ratings for Section 29 purposes accordingly MAS does not plan to accept credit ratings from other rating agencies at this juncture for the purposes of Section 29. This is consistent with the approach taken for Basel II implementation in Singapore. 3 Bilateral Netting 3.1 Netting Across DBU and ACU Books for Off balance Sheet Derivatives Transactions One bank noted that bilateral netting arrangements between two counterparties normally encompass all types of transactions/balances and these balances may be recorded in both the ACU/DBU books. As the requirements under Section 29 apply only to DBU balances in the case of a bank incorporated outside Singapore, the bank has asked if an exposure to a counterparty recorded in a bank's DBU may be reduced by offsetting balances recorded in its ACU books with the same counterparty to reflect the substance of the netting arrangement For the purposes of determining the net exposure to a single counterparty group under a netting arrangement, a bank incorporated outside Singapore which satisfies the requirements in the Notice may aggregate its ACU exposures with its DBU exposures ( combined net exposure ) to that single counterparty group for the purposes of Section 29. The bank may use the lower of the combined net exposure or its gross DBU exposure to determine its net exposure to that single counterparty group. 2

3 3.2 Monitoring of Net Exposures Under the proposed Notice, a bank is required to have in place a robust system and process to monitor and ensure accuracy of net exposures on a per counterparty basis. One bank asked if it was acceptable for such monitoring to be performed on a monthly basis Banks should ensure that systems are in place to monitor net exposures to each of its counterparties on a regular basis. MAS would normally consider a monthly frequency of monitoring to be sufficient for this purpose. 3.3 Legal Opinions Several banks sought clarification on whether an in-house legal opinion is adequate to opine on the legal enforceability of netting agreements MAS would view a written legal opinion provided by either external or inhouse legal counsel as meeting the requirement. In the case of a legal opinion provided by in-house legal counsel, MAS would expect such in-house legal counsel to be independent of the business unit that is directly involved in the transactions. 3.4 Notification to MAS of Netting Counterparties One respondent asked whether banks were required to notify MAS of the specific counterparties in respect of which they intend to recognize bilaterally netted exposures of off-balance sheet derivatives for the purposes of Section No, this is not necessary. Banks should however maintain an updated list of specific counterparties to which the bank has recognised netted exposures for the purposes of Section Grace Period for Ceasing of Netting One respondent requested that in the event that MAS issues a directive to a bank to cease computing exposures on a net basis, resulting in total exposure exceeding 25%, that a grace period be extended to give time for the bank to reduce exposures to its counterparty The Notice will provide for the extension of a grace period to be determined at the discretion of MAS. Nevertheless, a bank should take steps to ensure that its interests are protected with regard to its counterparties in the event of any regulatory action by MAS to revoke its ability to compute exposures on a net basis. 3

4 3.6 Scope of Netting One respondent asked whether a derivative booked out of an offshore branch is allowed to be netted off against the exposure of a Singapore branch of a foreign bank under another derivative transaction where a valid netting agreement is in place and the counterparty in respect of the derivative transactions is the same entity. Another respondent asked whether positive and negative mark-to-market value of derivatives contracted with a single counterparty can be netted off and if there any conditions to netting Recognition of netting for the purposes of Section 29 is limited to the named counterparties of a bilateral netting agreement. To the extent that a bank in Singapore and other offshore entities are covered under the netting agreement, the net exposures of the bank in Singapore may be recognised for the purposes of Section 29, subject to the bank meeting the requirements in the Notice Positive and negative marked-to-market exposures with a single counterparty may be netted off, subject to the conditions specified in the Notice. 4 Exemptions 4.1 Rating Requirement for Exempt Exposures and Qualifying Collateral The proposed Notice exempts exposures to certain AAA-rated entities from Section 29. This includes exposures to AAA-rated central governments, central banks, public sector entities ( PSE ) and multilateral development banks specified in the Notice. In addition, qualifying collateral is limited to any cash deposit pledged, charged or secured as collateral and any security issued by the same AAA-rated entities. Several respondents had asked whether the AAA rating requirement could be lowered The AAA rating requirement had been set because MAS is only prepared at this juncture to exempt exposures to high quality credits. We further note that the proposed exemptions are already concessions compared to the current Section 29 regime. In this regard, MAS will not be lowering the AAA rating requirement for exempt exposures and issuers of qualifying collateral. 4.2 Public Sector Entities One respondent asked whether (i) the Minister for Finance (Incorporated) ( MOF Inc ) is a PSE, and (ii) any Aaa-rated companies owned by the MOF Inc is also a PSE. The respondent also asked whether any PSEs and Aaa-rated companies owned by MOF Inc will be exempted from Section 29, and whether it would be necessary to aggregate exposures to all companies owned by the MOF Inc. 4

5 4.2.2 MAS considers MOF Inc as part of the Singapore Government. An entity will be regarded as a PSE only if they meet the definition of PSE in the Notice. Notwithstanding their ownership by MOF Inc, only exposures to entities that meet the relevant criteria for exemption in the Notice will be exempted from Section 29. Exposures to these entities need not be aggregated as a single exposure to MOF Inc or the Singapore Government. 5 Substitution of Exposures 5.1 Discretion to Substitute Several respondents asked whether banks could choose not to substitute its exposure even though the exposure may have been covered by eligible credit protection Where a bank has obtained credit protection from eligible protection providers for its exposures to a particular counterparty, the bank retains the discretion whether to substitute the exposure to its counterparty with that of the protection provider. 5.2 Rating of Eligible Protection Providers MAS had originally required eligible protection providers to have a minimum rating of A-. Several respondents noted that this was more stringent than Basel II. Other respondents requested that the minimum rating criteria for eligible protection providers be lowered to investment grade MAS continually seeks to strike a balance between prudential considerations and ease of implementation and monitoring for banks. We have considered the banks comments and will allow banks in Singapore to substitute exposures to their counterparties against that of protection providers if the provider is rated at least A- (or its equivalent) at the inception of the credit protection, and maintains at least a BBB- (or its equivalent) rating over the tenor of credit protection. We will amend the Notice to reflect the revised minimum rating criteria for eligible protection providers. 5.3 Maturity and Currency Mismatches MAS had originally proposed that a bank in Singapore may only substitute its exposures to a counterparty with that of the provider of credit protection if there is no mismatch in the currency or maturity of the credit protection with the underlying exposure. Several banks noted that this was inconsistent with Basel II Some banks pointed out that Credit Default Swaps ( CDS ) were now traded on a liquid basis for standard tenors and it may not be possible or may be too expensive to buy credit protection to match the maturity of a specific long-tenor exposure. Furthermore 5

6 the standard market practice to trade a Credit Default Swap is to trade on the Inter Money Market dates, whereupon it would be more liquid and practical to hedge. While it was possible to buy/sell credit protection on non-standardised dates, the offer for protection would come at a premium and may also lead to lack of dealer liquidity Other banks noted that not allowing currency mismatches may be restrictive especially when it comes to G7 currencies which are generally stable. Furthermore there might be practical problems that may arise since most CDS contracts are denominated in Euros or US Dollars We have considered the practical considerations raised by the banks and will allow for currency and maturity mismatches between the credit protection and the underlying exposure subject to the conditions and haircuts specified in the Notice In the case of maturity mismatches, the conditions include the following: i. the original maturity of the purchased credit derivative is at least 1 year; and ii. the residual maturity of the purchased credit derivative is longer than 3 months In the case of currency mismatches, a standard haircut of 8% (of notional value of the purchased credit protection) will apply. 5.4 Credit Protection Bought By Related Parties MAS had originally proposed that only protection accorded by third party protection sellers will be recognised for the purposes of Section 29. One respondent noted that it leverages on its group network to hedge its positions, whereupon a related offshore entity may buy credit protection and subsequently on-sell that protection to the bank in Singapore, and asked for a reconsideration of MAS criteria After due consideration, we have decided to allow a bank in Singapore to record an exposure to the ultimate third party provider of credit protection in cases where a related party of the bank purchases credit protection on its behalf subject to the following: i. there is documented evidence indicating that the credit protection provided by the related party covers the operations of the bank; ii. relevant records and documents are made available to the Authority upon request; iii. in the case of a bank incorporated outside Singapore, the bank shall provide a written confirmation from its Head Office that the bank is subject to a large exposures regime in its home jurisdiction that is broadly equivalent to those set by the Authority, and which is applied to its exposures on a global basis including the exposures of the Singapore branch; and 6

7 iv. the ultimate provider of credit protection is financially independent of the counterparty and vice versa. 5.5 Centralised Risk Management Arrangements One respondent noted that for derivatives transactions, it has an arrangement within its banking group whereby credit protection is obtained from a related party, whereupon the bank in Singapore does not bear any counterparty credit risk. The respondent asked if such arrangements could be excluded from Section MAS recognises the increasing prevalence of globally centralised risk management arrangements, particularly for international banks. These help mitigate risks borne by the bank in Singapore to the extent that robust systems and processes, as well as valid legal and financial documentation are in place MAS will exempt from Section 29 an exposure arising from a bank incorporated outside Singapore that leverages on a central risk management function performed by its head office, any other branches of the bank or other subsidiary of the bank subject to the bank i. providing MAS with written notification from its head office confirming that: (A) (B) All fair value losses are undertaken by head office or other entities of the banking group as the case may be; and head office is subject to a large exposures regime in its home jurisdiction that is broadly equivalent to those set by the Authority, and which is applied to its exposures on a global basis including exposures of the branch in Singapore; ii. maintaining relevant records and documents evidencing the sub-paragraph (i)(a) above, and making these available upon request by MAS. 6 Qualifying Collateral 6.1 Securities Issued by Unrated Central Banks One respondent asked whether securities issued by a central bank in a country that is rated AAA even if the central bank is not rated by any rating agency could be considered as qualifying collateral, as this would be consistent with the exemption granted for securities issued by MAS, which is not rated Securities issued by a central bank in a country that is rated AAA may be exempted from Section 29 even if the central bank itself is unrated. Exposures to such central banks will also be exempted from Section 29. 7

8 6.2 Recognition of More Qualifying Collateral Several respondents noted that the restriction of qualifying collateral as proposed in the consultation paper is inconsistent with Basel II. The respondents asked if MAS could consider recognising a wider range of qualifying collateral. One respondent suggested that selected freehold properties in prime districts and shares of listed blue-chip companies be admitted as qualifying collateral MAS intends to retain the list of qualifying collateral as proposed at this juncture. We note that the proposed list is consistent with the practices of other leading jurisdictions. We further note that the calibration of the requirements under Basel II differs from that under Section 29, given the different policy objectives of the two frameworks. Wider recognition of qualifying collateral will not be appropriate for now given the differing valuation practices and risk management capabilities of banks operating in Singapore. 6.3 Cash Deposits One respondent sought confirmation whether offsetting of exposures is allowed when exposures to a counterparty is secured by cash deposits pledged or charged to the bank but held by a third party bank (not under a custodian arrangement), so long as the conditions for recognition of qualifying collateral are met MAS will permit offsetting of exposures in such a scenario provided: i. the bank is not assisting another bank in circumventing Section 29 or any other requirements; and ii. the bank takes all steps necessary to ensure that it is able to enforce its security interest Subject to the above, cash deposits held by a third party bank that is pledged to the bank will not be regarded as an exposure by the bank to the third party bank and may be excluded from the computation of the bank s Section 29 limits. 6.4 Offsetting of Long and Short Positions to the Same Issuer One respondent enquired if MAS would allow the offsetting of long and short positions in government securities of different series and maturities For long and short positions to a foreign government arising from purchase and sale of securities issued by the government, MAS will allow banks to net these positions across different series and maturities for the purpose of computing issuer risk, where they are exposures in the trading book. 8

9 7 Operational Requirements for Credit Derivatives 7.1 Changes to Terminology MAS had prescribed a list of operational requirements for the recognition of credit derivatives. One respondent suggested that the terminology used in the list of operational requirements for credit derivatives be amended to reflect those found in ISDA Credit Derivatives Definitions MAS recognises that some of the requirements may be met by widely-used standardised agreements and to the extent possible, will reflect these in the Notice. Notwithstanding, it should be noted that the list of operational requirements set out the minimum criteria that MAS feels are necessary to protect the interests of the protection buyer for the purposes of Section 29, and is not designed to mirror any particular standardized agreement that currently exist or will be available in the industry in the future. MAS expects banks, as a matter of good risk management practice, to review their credit derivatives documentation (including the use of standardized agreements) against MAS requirements on an ongoing basis. 7.2 Haircuts for Partial Recognition of Credit Derivatives MAS had proposed that in the event when only the restructuring of the underlying exposure is not specified as a credit event in the contract, partial recognition of the credit derivative under a substitution approach will be allowed. If the credit protection cover provided by the credit derivative is less than or equal to the amount of the underlying exposure, only 60% of the amount of the hedge can be attributed to the provider of credit protection while the residual exposure is attributed to the original obligor for the purposes of Section 29. If the amount of the credit derivative is larger than that of the underlying exposure, the amount of eligible hedge is capped at 60% of the amount of the underlying exposure; Several banks asked for the rationale for this requirement and noted that the amounts of the eligible hedge do not seem proportionate The prescribed haircuts are intended to take into account the additional risks posed to the protection buyer in the event that the credit derivative documentation does not specify restructuring of the underlying exposure as a credit event. 7.3 Material Positive Correlation One of the operational requirements for credit derivatives stated there should not be material positive correlation between the creditworthiness of the provider of credit protection and the obligor of the underlying exposure. One respondent requested for additional guidance on the factors to consider when determining material positive correlation. 9

10 7.3.2 It is not possible to prescribe an exhaustive list of factors to determine whether there is a material positive correlation between the provider of credit protection seller and the obligor of the underlying exposure. Nevertheless, a bank may wish to take into consideration among other things, the relationship, the nature and diversity of the business, and the extent of business and financial interdependencies between the two parties. 8 Operational Requirements for Guarantees 8.1 Types of Guarantees One bank sought clarification if a bill aval or acceptance by a bank can be considered as guarantee to qualify as credit protection. Another bank asked if a standby letter of credit ( SBLC ) and banker s guarantee would be considered a guarantee MAS will recognise a bill aval, SBLC and banker s guarantee as eligible guarantees for the purposes of Section 29 as long as these meet the operational requirements in the Notice. Notwithstanding this, we note that if the issuer of the Bill of Exchange is unable to repay, the Bill Avaler is bound to pay as the giver of an aval is bound in the same manner as the person whom he guarantees. In this case, a bank should ensure that all risks have been transferred to the Bill Avaler. 8.2 Grandfathered Guarantees Several respondents noted that some guarantees have a clause that allow the guarantor to unilaterally cancel the guarantee with prior notice although obligations incurred / transactions entered into prior to the cancellation would continue to be guaranteed by the guarantor. Some other guarantees are stated to be for a specified period but will either be automatically extended for successive periods until a party gives notice of cancellation, or require parties to expressly extend for succeeding periods. Similarly, obligations incurred / transactions entered into prior to the expiry/cancellation would continue to be guaranteed by the guarantor. For such grandfathered guaranteed obligations / transactions, the respondents asked if recognition of the guarantee would still be allowed for the purpose of Section MAS will allow such guarantees to be recognised for the purposes of Section 29 provided that it is clearly documented that obligations incurred / transactions entered into prior to the cancellation continue to be guaranteed by the guarantor. When the exposure is no longer covered by the guarantee, the bank shall record an exposure to the underlying obligor. MONETARY AUTHORITY OF SINGAPORE 27 March

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