Counterparty Credit Risk: Why should Basel Committee revisit SA-CCR?

The Basel Committee on Banking Supervision's (BCBS) Standardised Approach to Counterparty Credit Risk (SA-CCR) was introduced to improve the risk sensitivity of capital framework for derivatives transactions without creating undue complexity for banks. One of the Committee’s key objectives in formulating the SA-CCR standard was to design an approach which would be applicable to a wide variety of derivatives, including both margined and unmargined, as well as bilateral and cleared transactions.

Prior to SA-CCR, which was finalised in 2014, banks were required to determine the exposure amount of the derivative contracts in their portfolios using either an Internal Model Method (IMM) or one of two non-internal model methods, namely the Current Exposure Method (CEM) and the Standardised Method (SM). As is well-known, non-IMMs were widely used widely by banks either in their entirety or for selected derivatives portfolios to calculate their Risk Weighted Assets (RWA) for counterparty credit risk exposures.

SA-CCR was the first of the Basel III standardized approaches to be finalised by the BCBS and remains one of the most critical elements of the prudential banking regulations, impacting not only RWAs for counterparty credit risk, but also credit valuation adjustment risk, the RWA output floor, leverage ratio and large exposure calculations. For Global Systemically Important Banks (G-SIB), it has also important implications with respect to the calculation of the G-SIB capital add on.

The SA-CCR standard was specifically designed to address deficiencies of non-internal models approaches, replacing them with a more risk-sensitive approach to counterparty credit exposures. As is well-known, the CEM had been severely criticised for a number of important shortcomings. For instance, it failed to differentiate between margined and unmargined transactions. It was also criticized on the grounds that the supervisory add-on factor did not sufficiently capture the level of volatilities as observed over severe stress periods in financial markets. Banks were also complaining that the recognition of netting benefits was too simplistic and not sensitive to relationships between derivatives positions. As a result, a key component of SA-CCR has been to introduce greater levels of risk sensitivity, while retaining some useful conceptual design features of the CEM.

The SM, on the other hand, was also criticised for several weaknesses even though it was offered by the BCBS as a more risk-sensitive approach than the CEM. Banks complained that the SM neither differentiated between margined and unmargined transactions nor sufficiently captured the level of volatilities observed over stress periods. Some banks also complained that the SM was not a non-IMM alternative for calculating exposure at default as it relied on IMM for computing delta-equivalents for non-linear transactions. Regarding the complexity of the SM, some banks were also concerned that the definition of hedging set caused them undue operational challenges and that only current exposure or potential future exposure was capitalised.

The SA-CCR standard was intended address these criticisms by introducing a more straightforward approach for calculating RWAs for counterparty credit risk associated with over-the-counter derivatives, exchange-traded derivatives and long settlement transactions. The new approach has naturally presented some important implications for banks from an operational standpoint with respect to derivative positions across their banking and trading books. As a result, while the Basel Committee’s main intention was to reduce the complexity, the reality has been different in practice. 

Regarding its capital implications, the impact of SA-CCR on capital requirements could vary materially across banks depending on their derivatives portfolios and netting positions. In more practical terms, while SA-CCR could lead to decrease in capital for diversified and perfectly offsetting trades portfolio of derivatives, it could also lead to increase in capital requirements for derivative portfolios consisting mostly of non-diversified, non-margined and non-cleared transactions.

From a strategic standpoint, this has made optimisation of portfolio positions for banks more critical than ever. Given the capital impact of the SA-CCR standard cannot be generalised, it does not necessarily create a burden from the perspective of capital management. Given the more risk-sensitive nature of SA-CCR compared to the CEM, in practice banks with portfolios where derivatives portfolios in netting sets reference the same asset classes are rewarded thanks to netting across asset classes.

However, this does not mean that the SA-CCR is a perfectly proportionate framework in terms of burden of compliance. While SA-CCR represents a step change in the calculation methodology of EAD for derivatives portfolio, it requires complex input parameters. It also requires granular data sets across business lines, with increasing complexity particularly in the case of more complex derivative products. The new approach comes with not only complicated calculation requirements but also complex data attributes, which has become a major challenge particularly for smaller banks whose risk and/or finance functions are not adequately equipped to handle risk sensitivities.

In addition, although the SA-CCR standard was intended to minimize discretion used by national authorities and banks, keeping up to date with its adoption at the jurisdiction level has been an on-going challenge for large international banks, where regional variations, implementation timelines and inconsistencies have caused a major headache for their risk and finance functions, not to mention various complexities they have also created for other functions such as legal, operations, compliance, data, reporting and IT.

While it is absolutely true that SA-CCR is a much more risk sensitive approach for calculating exposure at default for counterparty credit risk compared to the CEM, the industry thinks that there remain aspects of the standard that the BCBS should revisit. Banks are particularly concerned that as it stands SA-CCR results in excessive risk exposures with associated impact on capital management and end-user costs. The industry attributes this by and large to a lack of reflection of structural changes in the derivatives market and the overall regulatory framework since the introduction of the SA-CCR standard by the BCBS in 2014, as well the lack of risk sensitivity in its calibration.

In the European Union (EU), to ease the compliance burden for smaller and less complex banks, the revised Capital Requirements Directive and Regulation (CRD 5 and CRR 2) has made important amendments to SA-CCR, allowing the use of a more proportionate and less complex approach subject to certain conditions. In line with the Basel IV framework, CRR 2 adopts a new SA-CCR, which is a more risk sensitive measure of counterparty risk reflecting netting, hedging and collateral benefits, as well as being better calibrated to observed volatilities. The final framework also adopts a simplified SA-CCR and retains the Original Exposure Method for smaller banks.

Going one step further than the Basel IV framework, CRR 2 also includes a simplified approach for banks that meet pre-defined eligibility criteria with respect to contract netting agreements. More precisely, the use of this approach is subject to the size of the on-and off-balance sheet derivative business being equal to or less than 10% of the institution’s total assets and €300m, which makes the simplified approach available to banks that have a more sizeable on-and off-balance sheet derivative business than initially proposed in 2016. This makes compliance easier for the EU banks that have very limited derivatives exposures or for those who would find the use of the simplified SA-CCR too burdensome to implement. 

SA-CCR was subsequently introduced as an input to the capital output floor under CRR 3, which aims to achieve full implementation of the Basel IV standards in the EU. On the other hand, the Banking Package 2021 aligned the classification of retail exposures under SA-CR with those under the Internal Ratings Based approach. Deviating from the Basel IV standards, it also introduced a number of EU-specific provisions for defining exposure classes and assigning the respective risk weights, .

Turning to the United States (US), “Standardized Approach for Calculating the Exposure Amount of Derivative Contracts”, which was published in November 2019, included some modifications to mitigate the associated regulatory capital costs, introducing a material degree of fragmentation between the EU and the US. This raised concerns with respect to further watering down of Basel IV standards in the US, which could result in the US banks receiving undue regulatory benefit, giving them an unfair advantage over the EU banks.

Concerned about potential inconsistencies with respect to implementation of the SA-CCR standard in various jurisdictions, the International Swaps and Derivatives Association (ISDA), the Institute of International Finance and the Global Financial Markets Association has recently requested the Basel Committee to reconsider the SA-CCR standard due to excessive risk exposures with associated impact on capital and end-user costs. While the BCBS is expected to take this request into account, the outcome remains uncertain.

Market fragmentation is indeed an important risk and inconsistent application of SA-CCR can jeopardise post-crisis reform efforts of the BCBS. The calibration of SA-CCR needs to be revisited quickly to recognise recent developments in markets. In particular, increase in collateralisation thanks to initial margin requirements for non-centrally cleared derivatives should be properly accounted for as a material risk mitigant. The BCBS should also take into account the ISDA’s recent master netting agreement, setting new rules for exposure calculation across secured financing transactions and derivatives. In addition, the BCBS should also redesign certain aspects of SA-CCR to accommodate the new digital asset classes.

A holistic review of SA-CCR at the BCBS level is necessary to ensure a more consistent and timely implementation of the standard, achieving greater harmonisation in national banking regulations, bridging the gaps across different jurisdictions and reducing the need for future country-specific measures which could result in further fragmentation across the regions.