Banks’ Exposure to Credit Risk: A Guide to Forwards, Swaps, and Options
The Financial Institutions Commission of the Republic of Palau has released guidelines on calculating banks’ exposure to credit risk when dealing with forwards, swaps, and options. These new rules aim to ensure that banks maintain sufficient capital buffers to absorb potential losses and promote a more robust and consistent approach to calculating credit risk exposure.
Calculating Credit Risk Exposure
To calculate their credit risk exposure, banks must add two components: the current exposure and the potential future credit exposure.
- Current Exposure: The total replacement cost of contracts with positive values.
- Potential Future Credit Exposure: Based on the notional principal amount of the contract.
The commission has provided a matrix to help banks determine the add-on factor for potential future credit exposure, which varies depending on the type of instrument and its maturity. For example:
- Interest rate swaps with a maturity of over five years: 1.4%
Bilateral Netting
Banks are allowed to use bilateral netting agreements to reduce their credit risk exposure. However, these agreements must be legally enforceable and meet certain conditions, such as having written legal opinions from independent lawyers.
The commission has provided a formula for calculating the add-on factor for bilaterally netted transactions, which takes into account both the gross add-on factor and the ratio of net current replacement costs to gross current replacement costs.
Risk Weighting
Banks must weight their credit equivalent amounts based on the category of counterparty, such as:
- Governments
- Multilateral development banks
- Local government guarantees
The risk weighting will also take into account whether the exposure is backed by eligible guarantees and collateral.
Conclusion
The new guidelines aim to reduce the risk of financial instability and protect the stability of the financial system by ensuring that banks maintain sufficient capital buffers. By promoting a more robust and consistent approach to calculating credit risk exposure, these rules will help to strengthen financial stability in the Republic of Palau.