By: Nathan Hummel and Justine Clark

This article is the first in a four-part series on the regulatory capital treatment of SBLC risk participations.

In this instalment, we examine the foundational question of whether a US bank can obtain risk-weighted asset (RWA) relief by selling an unfunded, non-recourse participation in an SBLC to an eligible third party. Later articles explore advanced capital treatment, participant eligibility, and implementation considerations.

Issue

Whether a US bank may reduce the risk-weighted assets (“RWA”) associated with a standby letter of credit (“SBLC”) when it sells an unfunded, non-recourse, pro-rata risk participation in the SBLC to certain highly rated entities (“eligible participant”) under a true participation structure. Specifically, we address if and how US regulatory capital rules permit RWA relief in such transactions, despite the bank’s continued GAAP obligation on the full SBLC amount, and provide specific guidance on the identification of an eligible participant.

Summary

US banking organisations can obtain RWA reduction on SBLC exposures by selling pro-rata risk participations to eligible participants, third parties, provided the participation agreement meets the criteria of an “eligible guarantee” under the regulatory capital framework. Under US Basel III rules Regulation Q ((12 C.F.R. Part 217), credit risk mitigants such as guarantees and participations allow a bank to substitute the risk weight of the eligible participant for that of the obligor, or to apply “double default”[1] treatment in the advanced approaches, thereby lowering RWA.[2] The regulatory capital rules focus on legal risk transfer and credit enhancement provided by the participation, rather than GAAP accounting de-recognition.[3] If the participation constitutes a bona fide unfunded credit risk transfer (true sale participation), the bank may reflect the risk-sharing in its RWA calculations and regulatory reports.

Our analysis includes:

●      discussion of basic concepts used in RWA calculations

●      description of the “Simple CRM Approach” relying primarily on PD Substitution and LGD Adjustment (each as defined below) together with sample mechanics for application of that approach

●      description of the “Advanced Approach” relying on PD Substitution, LGD Adjustment and Double Default methodology (See Section 1. Subsections A-C)

●      comparison of the relative benefits of applying the respective approaches (See Part 2 of this series).

In Part 3 of this series, we have identified various eligible participants and included a discussion of the potential inclusion of additional entities as eligible participants.

We discuss relevant regulatory guidance in Part 4 of this series.

Regulatory capital framework

Some basic concepts

Calculation of RWA depends on the determination of four key factors:

1. Probability of default (“PD”) is calculated by the bank projecting the likelihood of default, often running a migration analysis on similarly rated loans or other extensions of credit (like letters of credit) to determine the percentage that default over a set period.
2. Loss given default (“LGD”) estimates the percentage of an exposure that a lender would lose if a borrower defaulted, and allows for consideration of additional factors, such as collateral and other mitigating factors to accurately determine the true risk of loss.
3. Exposure at default (“EAD”) factors in undrawn but available credit exposure (where applicable) and is calculated by adding (i) the current exposure plus (ii) the product of the credit conversion factor multiplied by the undrawn (but available) credit exposure.
4. The credit conversion factor (“CCF”) is determined by regulators based on the type and risk of an off-balance-sheet item, converting it into a “credit equivalent” amount that can then be risk-weighted.

Simple CRM approach (PD substitution / LDG adjustment)

Under §217.134, a bank may treat an eligible guarantee as if the exposure’s PD or LGD is that of the protection provider. In effect, the guarantor’s risk profile “substitutes” for the obligor’s risk on the guaranteed portion. The rules provide that if an exposure is fully or pro-rata covered by an eligible guarantee, the bank can use either:

1. a PD substitution approach; using the guarantor’s PD for the covered portion (or a blend of obligor/ guarantor PDs if partial cover), and possibly adjust LGD; or
2. an LGD adjustment approach; assign a lower LGD to the portion due to the guarantee).[4]

For example, if Bank A issues an SBLC backing a client (obligor) and obtains a pro-rata participation from an eligible participant, Bank A could, for the participated portion, use the eligible participant’s PD in its risk-weight formula. If the eligible participant has a stronger credit profile than the underlying obligor, the PD is lower, directly reducing the RWA on that portion. The unguaranteed portion continues to use the obligor’s PD. The foregoing approach essentially treats the transaction as two exposures; one to the obligor (for the unprotected share) and one to the Eligible Participant (for the protected share).[5] In either case, the capital requirement for the protected portion should not be less than the capital requirement of a direct exposure to the guarantor alone.

In the standardised risk-based capital rules (which many smaller banks and also large banks, for their non-advanced calculations, use), a direct substitution rule applies. If an SBLC (which is an off-balance-sheet commitment) is covered by an eligible guarantee, the bank can substitute the risk weight of the guarantor for the portion covered, while the uncovered portion retains the obligor’s risk weight.[6] Off-balance sheet exposures like SBLCs are first converted to a credit-equivalent amount by applying a credit conversion factor (typically 100% for financial SBLCs).

For example, assume a $100 SBLC to a corporate client that normally carries a 100% risk weight (if unrated in the US standardised approach, most corporate exposures are effectively 100% risk weight). If the bank participates out 50% ($50) to an investment-grade-rated bank (20% risk weight category), it can risk-weight $50 at 20% and the remaining $50 at 100%. The RWA calculation would be: $50 20% + $50 100% = $10 + $50 = $60, versus $100 if no participation. This yields a 40% RWA reduction. Banks report this by allocating the credit equivalent amount across the appropriate columns of Schedule RC-R.

Indeed, the call report instructions explicitly say to include in the 20% risk weight bucket any portion of an SBLC that is “conveyed” to a US bank (20% risk weight) or guaranteed by a party that qualifies for 20%.[7] They similarly mention portions qualifying for 50% or 0% in those buckets. Thus, the mechanics are straightforward: split the exposure and apply the risk weights according to guarantor vs obligor.

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[1] 12 C.F.R. § 217.36(a)(1) (Standardized Approach substitution treatment permitting a bank to use the protection provider’s risk weight for the exposure) (12 C.F.R. 217.36 — Guarantees and credit derivatives: substitution treatment.).

[2] 12 C.F.R. § 217.36(a)(2)(ii) (eligible guarantee may cover credit risk on a pro rata basis, with losses shared proportionately by guarantor and bank) (12 C.F.R. 217.36 — Guarantees and credit derivatives: substitution treatment.).

[3] OCC, Risk-Based Capital Guidelines, 12 C.F.R. Part 3, Appendix A, §2(c)(16)(xvi) (definition of “Risk participation” as a participation where the originating bank remains liable for the full amount of the obligation OCC News Release NR 2003-72.

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[4] 12 C.F.R. § 217.134(a)(1) (Advanced approaches: wholesale exposure credit risk fully or pro-rata covered by eligible guarantee may be recognized for mitigation) 12 C.F.R.- Guarantees and credit derivatives: PD substitution and LGD adjustment approaches (12 C.F.R. § 217.134).; see also Basel Committee, Basel II Framework ¶189 (guarantees must be direct, explicit, irrevocable, and unconditional to be recognized).

[5] Federal Financial Institutions Examination Council (FFIEC) Call Report Instructions, RC-R – Regulatory Capital, which direct banks to allocate the credit equivalent amount of guaranteed portions of off-balance sheet exposures to the corresponding risk weight of the guarantor. E.g., “Include in column C–0% risk weight, the portion of financial standby letters of credit … that are secured by collateral or has a guarantee that qualifies for the zero percent risk weight… Include in column G–20% risk weight, the credit equivalent amount of the portion of financial standby letters of credit … that has been conveyed to US depository institutions…” (Part II. Risk-Weighted Assets) (Part II. Risk- Weighted Assets).

[6] 12 C.F.R. § 217.2 (definition of “eligible guarantee”) (guarantee must be written, unconditional, cover all or pro-rata payments, give a direct claim, not be cancellable by guarantor, be legally enforceable, provide for timely payment without first requiring action against the borrower, not increase cost on deterioration, and, for certain purposes, be provided by an eligible guarantor) (Federal Register : Regulatory Capital Rules: Advanced Approaches Risk-Based Capital Rule, Revisions to the Definition of Eligible Guarantee ) (Federal Register : Regulatory Capital Rules: Advanced Approaches Risk-Based Capital Rule, Revisions to the Definition of Eligible Guarantee ).

[7] 12 C.F.R. § 217.2 (definition of “eligible guarantor”) (includes sovereigns, agencies, banks, bank holding companies, and “an entity (other than a special purpose entity) that, at III. the time the guarantee is issued, has issued and outstanding an unsecured debt security without credit enhancement that is investment grade”; also excludes insurance companies primarily engaged in credit protection (monoline insurers).

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