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Banks’ Equity Contract Exposure Method Challenged
September 2008
The Palau Financial Institutions Commission has issued guidelines for calculating the credit equivalent amounts of equity contracts, including forwards, swaps, purchased options, and similar derivatives.
Calculating Credit Equivalent Amounts
Banks are required to calculate the credit exposure of their equity contract portfolio using one of two methods:
- Method 1: Adding the total replacement cost of all contracts with positive value, obtained by “marking-to-market,” and then adding an add-on for potential future credit exposure based on the total notional principal amount.
- Method 2: Using a matrix-based approach, where they multiply the credit equivalent amounts by the weight applicable to the corresponding on-balance-sheet asset category. The matrix takes into account factors such as residual maturity, interest rate, and commodity type.
Bilateral Netting Agreements
Bilateral netting agreements can be used to reduce the credit exposure of banks’ equity contract portfolios. However, contracts containing walk-away clauses are not eligible for netting when calculating capital requirements.
Risk Weighting
The rules provide guidance on risk weighting, with credit equivalent amounts weighted based on the category of counterparty and taking into account exposures backed by eligible guarantees and collateral.
New Add-on Factors
The guidelines introduce new add-on factors to calculate potential future credit exposure:
- For contracts with residual maturity of one year or less, the add-on factor is 0%.
- For contracts with residual maturity over five years, the add-on factor is 1.5%.
Netting Arrangements
Banks are required to have:
- Written and reasoned legal opinions that demonstrate their exposure to be a net amount under relevant laws and jurisdictions.
- Procedures in place to ensure that the legal characteristics of netting arrangements are kept under review.
Impact on Banks
The new guidelines are expected to increase the capital requirements for banks with significant equity contract portfolios. However, the rules aim to provide greater transparency and consistency in calculating credit equivalent amounts, which will help to reduce systemic risk in the financial system.
Conclusion
In conclusion, the Financial Institutions Commission’s guidelines on equity contracts aim to improve the resilience of the banking sector by providing a more robust framework for calculating credit equivalent amounts. The new rules are expected to have a significant impact on banks’ capital requirements and risk management practices.