By: Nathan Hummel and Justine Clark
This is the second article in a four-part series on the regulatory capital treatment of SBLC risk participations.
In the first article in this series, we examined how banks can achieve risk-weighted asset (RWA) relief on standby letters of credit (SBLCs) through the use of eligible guarantees and risk participations under the simple credit risk mitigation (CRM) framework. For the largest US banking organisations, however, additional capital efficiencies may be available through the advanced approaches under Regulation Q.
This article examines how advanced approaches recognise credit risk mitigation, the role of probability of default (PD) and loss given default (LGD) adjustments, and the circumstances under which banks may apply the more favourable double default methodology.
Advanced approaches
Large US banking organisations subject to the advanced approaches (generally, those with $250B+ assets or significant foreign exposure) calculate RWA using internal risk parameters under Subpart E of Regulation Q (12 C.F.R. Part 217) (collectively, the “advanced approaches”). Under the advanced approaches, banks determine credit risk RWA based on formulae that incorporate PD, LGD, EAD and maturity, among other factors.[1] The advanced approaches allow banks to recognise credit risk mitigation (CRM) from guarantees and credit derivatives in two principal ways: PD substitution (or LGD adjustment) (described in the preceding article in this series) and double default treatment (“double default”), discussed in the following subsection.
1. Double default approach
12 C.F.R. § 217.135 provides an alternative, potentially more favourable, capital treatment for hedged exposures when both the obligor and the eligible participant are relatively low-risk and not closely correlated. The “double default” framework recognises that the risk of both the borrower and a well-capitalised, independent guarantor defaulting on the same obligation is much lower than the risk of either defaulting alone. In technical terms, double default allows a reduced capital charge by accounting for the joint default probability. To use this treatment, several strict criteria must be met. Importantly, under the US rule, the guarantor must be an “eligible double default guarantor,” meaning a creditworthy, regulated financial firm whose normal business includes providing credit protection or managing credit risk.[2] If applicable, the double default capital requirement is computed by a special formula that scales down the capital requirement (K₀) of the underlying exposure by a factor that depends on the guarantor’s PD and the obligor’s PD, reducing RWA significantly when the PD for the borrower and the guarantor is low, reflecting the low likelihood of simultaneous default. Double default generally yields greater capital relief than simple substitution but comes with more stringent conditions and supervisory oversight (including a requirement that the bank have board-approved processes to detect excessive correlation between obligor and guarantor).[3]
2. Eligible guaranty criteria
a) For the SBLC risk participation to be recognised as a risk mitigant, it must meet the requirements of an “eligible guarantee.” US capital regulations define eligible guarantee in detail in 12 C.F.R. §217.2, which requires that the risk participation:
● (i) be in writing and legally enforceable,
● (ii) be unconditional,
● (iii) covers all or a proportional share of all contractual payments under the SBLC,
● (iv) provides for a direct claim against the participant for its share,
● (v) cannot be unilaterally cancellable by the protection provider (participant) for reasons other than beneficiary’s breach,
● (vi) must be legally enforceable against the protection provider in any jurisdiction where the provider has assets,
● (vii) requires the participant to pay without the bank first having to take legal action against the obligor,
● (viii) not contain provisions that increase the cost of protection due to deterioration in credit quality of the underlying obligor, and
● (ix) not be an affiliate of the bank, unless it is an affiliate that is a regulated bank, broker-dealer, or insurer and meets certain stringent conditions (no control, independent supervision).
b) In cases where the standardised approach is taken, the guarantee must be provided by an “eligible guarantor”, defined to include sovereign governments, US government agencies, banks, multilateral development banks, and entities with investment-grade debt or creditworthiness, excluding those predominantly engaged in credit protection like monoline insurers. Note that the need for an “eligible guarantor” does not apply to the advanced approaches.
3. Key eligibility and operational criteria for double default[4]
a) Eligible guarantor and instrument: The exposure must be hedged by an eligible guarantee (meeting all criteria as above) or eligible credit derivative, and the guarantor must qualify as an “eligible double default guarantor.” This term is defined (in 12 C.F.R §217.2 and in and 12 C.F.R §217.135) to mean a “creditworthy, regulated financial firm whose normal business includes the provision of credit protection or the management of a diversified portfolio of credit risk.”[5] Examples include banks, securities firms, insurance companies, or possibly large funds that are subject to prudential regulation and regularly engage in credit risk taking. In practice, a highly rated asset manager might qualify if, for instance, it manages a credit fund that provides such guarantees and the asset manager is a regulated entity (e.g., registered investment advisor managing a diversified portfolio of credit exposures). If the participant is not itself a regulated financial institution (e.g., an asset manager managing third-party money), it may or may not meet this definition; this is a point to evaluate. The 12 C.F.R. §217.135 criteria were originally written with entities like monoline insurers, banks, or securitisation conduits in mind. For our case, assume the asset manager is considered “creditworthy” and “regulated” (perhaps SEC-regulated, though not a prudential regulator) and in the business of managing credit risk. If there is uncertainty, the bank might opt for the substitution approach instead of double default, or seek clarification from regulators. Double default cannot be used unless the guarantor fits the definition.[6]
b) Pro rata or full coverage, single-name: The hedged exposure must be fully or pro rata covered by the guarantee on a single-name basis. This means exactly our scenario: a pro rata participation on one SBLC (not a basket or tranche). Nth-to-default basket swaps or tranched protections are generally excluded from double default (except a special nth-to-default case not relevant here).
4. Hedged exposure is a wholesale exposure
The underlying obligor exposure must be a wholesale exposure (corporate, bank, etc.), not a retail exposure and not a sovereign exposure. SBLCs to corporate customers are wholesale exposures, so that fits. The rule prevents double default for retail loans, likely due to modelling difficulty.
5. No excessive correlation
The bank must have a process in place (approved in writing by regulators) to detect “excessive correlation” between the creditworthiness of the obligor and the guarantor. If the obligor and guarantor are affiliated or vulnerably dependent on common factors, double default is disallowed. In practice, this means the participant (guarantor) should not be, for example, a parent or subsidiary of the obligor, or even too concentrated in the obligor’s industry such that a single event can impair both. In our scenario, an independent asset manager providing credit protection to an unrelated corporate obligor likely satisfies this (assuming no strange relationship like the asset manager’s fund only invests in the obligor’s company). The bank’s risk management should document that the obligor and guarantor are distinct credit profiles with no undue correlation (different industries, etc.).
6. No double counting of CRM
The bank can’t also use other CRM techniques on the same portion if applying double default (it must exclusively use double default for that hedged portion).
7. Advanced approaches mechanics
As discussed above, applying the advanced approaches, the bank effectively performs a bifurcation of the exposure into protected and unprotected portions.[7] For the protected portion, the bank uses either the guarantor’s PD (substitution) or applies the double default formula, and for the unprotected portion it uses the obligor’s PD with no credit from the guarantee. The total RWA is then the sum of the RWA for each portion.
a) PD substitution example: The account party (obligor) is a risky corporate with PD equivalent to, say, a BB rating (e.g., 2% PD), and the asset manager participant is highly rated with PD equivalent to an AA rating (e.g., 0.10% PD). The SBLC EAD is $100. If the bank keeps 50% and the participant covers 50%, the bank sets up two exposures: $50 with obligor PD 2%, LGD say 45%; and $50 with guarantor’s PD 0.10%, LGD adjusted if the guarantee isn’t full (the rules might allow lower LGD on the portion as well, acknowledging the bank’s loss is only if guarantor fails too). The capital requirement for the $50 guaranteed portion will drop significantly because the PD is an order of magnitude lower. The precise RWA depends on the risk-weight function formula, but clearly there is relief. The rules also ensure the capital for the guaranteed portion cannot be less than if the bank had an exposure directly to the guarantor for $50, which in this case would be very low anyway (since AA obligor risk weight is low).[8] The unprotected $50 remains with higher risk. Summing them yields a reduced total RWA.
b) Double default example: If the conditions are met (e.g., obligor is a corporate, guarantor is a regulated financial firm, not correlated), the bank can apply the double default formula to the $50 portion. The formula in12 C.F.R. §217.135 essentially multiplies the capital requirement for the underlying exposure (if unhedged) by a factor that includes a 0.15 base plus 160×PDg, capped by some function of LGDs.[9] If the guarantor’s PD is very low, this factor can be well below 1.0, thus reducing capital. Roughly speaking, double default might produce even less RWA than pure substitution because it acknowledges that the bank only loses if both defaults happen. In our numbers, obligor PD 2%, guarantor PD 0.10% might result in a factor like 0.15 + 160×0.001 = 0.31 (31%). If K₀ (capital requirement for $50 unhedged) was, say, $4 (for a high PD), under double default it becomes $4 * 0.31 ≈ $1.24. Compare this to substitution: capital if treating it as guarantor exposure of $50 (0.1% PD) maybe $0.50. Substitution might yield lower in some cases, but double default particularly shines when the guarantor PD is low relative to obligor. Regulators ensure it’s not overly generous by the formula’s floor.
In either advanced approach method, partial guarantees are handled by dividing the exposure. 12 C.F.R.§§ 217.134 and 135 both instruct that if a guarantee covers less than the full exposure, the bank must treat the covered portion as a separate exposure and the remainder as another, for RWA purposes.[10] This means the bank must have the systems to allocate EAD accordingly. Practically, banks should ensure their capital reporting (e.g., FFIEC 101 for advanced RWA) reflects two exposures in such cases.
Comparison of available approaches
The simple CRM approach, while widely used and well known to regulators, results in a material overstatement in connection with calculations of RWA. Although only available to the largest, most complex banks ($250 Billion of more in assets or $10 Billion in foreign exposure), both the first advanced approach (using of the adjustments to PD and LGD calculations which utilises metrics that are incorporated into Regulations Q) and if available, utilization of the double default methodology results in the most accurate assessment of risk because it factors in the practical risk of a double default on the part of the obligor and the guarantor (or eligible participant).
While the advanced approaches and double default methodology can provide a more risk-sensitive assessment of credit exposure, their use depends on a number of requirements. One of the most important questions is the identity and status of the protection provider. The next article in this series will examine which entities may qualify as eligible participants and eligible guarantors for the purposes of regulatory capital relief.
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[1] Federal Register, 79 Fed. Reg. 44120, 44124 (July 30, 2014) (Interagency final rule revising definition of eligible guarantee) (removing requirement that a guarantor be an “eligible guarantor” for non-securitization exposures under advanced approaches) ( 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 ).
[2] 12 C.F.R. § 217.135(a) (criteria for double default treatment) (requires hedged exposure is wholesale, fully or pro-rata hedged by an eligible guarantee from an eligible double default guarantor; obligor is not an affiliate of guarantor; bank does not use any other CRM on the exposure; and bank has Board-approved process to detect excessive correlation) (.
[3] 12 C.F.R. § 217.135(f) (definition of “eligible double default guarantor” as a “creditworthy, regulated financial firm whose normal business includes the provision of credit protection or the management of a diversified portfolio of credit risk”) (Basel II Attachment 2).
[4] Federal Reserve Board, Basel II Final Rule – Technical Overview (Nov. 2007) at 30- 31 (explaining double default treatment: hedged exposure must be fully or pro-rata covered by single-reference guarantee from eligible double default guarantor; bank must determine no excessive correlation between obligor and guarantor) (Basel II Attachment 2) a (Basel II Attachment 2).
[5] Basel Committee on Banking Supervision, The Application of Basel II to Trading Activities and the Treatment of Double Default Effects (July 2005) at 2 (noting the need for a prudentially sound capital treatment recognizing that “the risk of both a borrower and a guarantor defaulting on the same obligation may be substantially lower than the risk of only one of the parties defaulting”) (The Application of Basel II to Trading Activities and the Treatment of Double Default Effects ).
[6] 12 C.F.R. § 217.135(e) (double default capital formula). See also Basel II, ¶283-287 (establishing the double default framework; capital requirement is function of PDs of obligor and guarantor and must not be less than the risk weight of a direct exposure to the guarantor) (12 CFR § 217.135 – Guarantees and credit derivatives: double default treatment.
[7] OCC Bank Accounting Advisory Series (BAAS), Topic 5: “Transfers of Financial Assets,” Q&A (Aug. 2024) (clarifying that an unfunded risk participation in a standby letter of credit, where the bank remains primarily obligated to the beneficiary, does not remove the contingent liability from the bank’s balance sheet, but the bank may still consider the risk transfer for risk management and capital purposes) (https://www.occ.gov/newsissuances/ NR news-releases2003-72b..
[8] FFIEC 101 Reporting Instructions for Schedule A, item 7 (credit risk mitigants – guarantees) (advanced approaches bank should reduce the risk-weighted asset amount for exposures with eligible guarantees, either through PD substitution or double default, as appropriate, and disclose the effect of guarantees in Pillar 3 reports, if material).
[9] Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards: A Revised Framework (Comprehensive Version, June 2006) ¶§ 189-194 (guarantee eligibility requirements under standardized approach) and ¶§ 480-487 (guarantees under IRB, disallowing double default in foundation IRB and introducing it in advanced IRB as an option) (International Convergence of Capital Measurement and Capital Standards – A Revised Framework, November 2005) (International Convergence of Capital Measurement and Capital Standards – A Revised Framework, November 2005).
[10] 12 C.F.R. § 217.32 and § 217.34 (Standardized Approach credit conversion factors for -offbalance sheet exposures) (financial standby letters of credit have a 100% credit conversion factor; performance standby letters 50%; demonstrating SBLCs are treated as full exposures for capital unless risk mitigated) (Part II. Risk-Weighted Assets) (Part II. Risk- Weighted Assets).
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