Season’s gifts and other irritations December 22, 2010 at 3:14 pm

Goodness, what munificence. We have not one but five documents from Basel, plus notices of proposed rule making from the FED, OCC and FDIC on both market risk capital and the Collins Amendment. The Basel III material has received a lot of notice, so let me instead comment on a less well known Basel document, the consultation on exposures to central counterparties, and on the US rule makings. Central counterparties first: the Americans tomorrow.

In their consultation on exposures to CCPs, the Basel Committee faced two dilemmas. The first, relatively easy one, was what risk weight should attach to a CCP. In order to figure out how much capital to attribute to a counterparty, you need to know their risk weight. What should it be for CCPs? The Committee could have declined to answer this, letting banks instead make their own assessment of the credit quality of CCPs. However that assessment is difficult to make as CCP disclosures are sometimes less fulsome than one would wish: moreover the result might well not incentivise central clearing. Therefore the Committee set the risk weight at 2%. This decision had been well flagged, so it was hardly a surprise. Personally I find it hard to see how a CCP is ten times less risky than a single A rated corporate and twenty five times less than a BBB, but this risk weight isn’t about risk, it is about providing an incentive for banks to use CCPs.

The harder question that the Committee asked was what capital should support default fund contributions. A CCP’s default fund is the sum clearing members provide to cover risks beyond margin. If you think of the portfolio of the CCP’s exposures as a CDO, then the default fund is a mezz tranche. And mezz tranches in Basel are punitively treated. So, what to do? The Committee tentatively proposes to use this idea, and figure out whether the CCP’s first line of defence – margin – is enough to cover the capital that would be required for its portfolio of exposures. If it is, then default fund contributions aren’t that risky; if not, then they are acting in part like capital (i.e. margin is too low), and thus they should be treated as pretty risky.

The idea is a reasonable one. But the details are delicate. I haven’t run any numbers yet, and for once I’m excited about seeing how they come out. Will the major CCPs turn out to have enough margin based on the Basel methodology? Stay tuned for the results next year.

2 Responses to “Season’s gifts and other irritations”

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