Part 1 – An Overview
Over the next few weeks, we will be publishing a multipart series that analyses the Standardised Approach for Counterparty Credit Risk, known as SA-CCR, that is part of the overall Basel III regulatory reforms. The regulation unveiled by the Basel Committee is a new approach for measuring a bank’s Exposure at Default (EAD), which is the predicted amount of loss a bank may be exposed to in a derivatives contract. Understanding SA-CCR and its key risk drivers will play a central role in every bank’s capital management framework.
The SA-CCR aims to address a number of the shortcomings in the existing standardised approaches by replacing – the Current Exposure Method (CEM) and the Standardised Method (SM) for banks subject to the advanced approaches, while permitting smaller banks to use CEM or SA-CCR. The SA-CCR approach increases a bank’s risk sensitivity by looking at different risk-factor volatilities, and recognising the risk-reducing effect of netting and hedging sets.
At the very high level, SA-CCR consists of two components to calculate the total EAD, the replacement cost (RC) and the potential future exposure (PFE), arithmetically expressed as SA-CCR ???= ? ⋅(??+???), where Alpha (α) is a constant value set to 1.4 by the Basel Committee. The RC and PFE components are calculated differently for margined and unmargined netting sets. We will go into more detail on methodology in part 2 of this series.
The SA-CCR applies to over-the-counter (OTC) derivatives, exchange-traded derivatives and long settlement transactions. Banks that do not have approval to apply the internal model method (IMM) for the relevant transactions must use SA-CCR to compute their EAD.
However, the banks that have approval to utilise IMM are still impacted by the SA-CCR exposure metric as the introduction of the standardised output floor will require them to calculate standardised capital requirements. SA-CCR has much wider implications within the new Basel III framework as it forms a core component of the large exposure and leverage ratio framework computation as well as the credit valuation adjustment (CVA) risk capital charge.
The ISDA briefing paper emphasizes that SA-CCR will be used as the foundation of several key calculations in the overall capital framework. The figure below shows how SA-CCR will be used, highlighting its pivotal nature.
SA-CCR has been in place in Switzerland since January 2020 and is due to be implemented by European banks in June 2021 and US banks by January 1, 2022. The full OTC Derivatives Compliance calendar can be found here.
Written by: Safder Dhirani, Regulatory Consultant