Issue 18

# Capital Accord

Designed to ensure that banks and other financial institutions maintain sufficient capital relative to the risks associated with their portfolios, the Basle Committee Capital Accord has been in place for roughly a decade. The original framework was developed in the 1980s using a building block approach, whereby the amount of capital is measured against a sum of the risk-weighted assets - the ratio of capital to risk-weighted assets to be maintained above a minimum ratio of 8%. The framework has been under constant evolution and now encompasses market risk as well as the original credit risk component.

In this article, our aim is to explain the important facets of the capital requirements and highlight key calculations in the framework. We consider the basic capital requirements of a lending transaction and the implications of a more complex portfolio of short -term FX derivatives and a longer-term hedge transaction.

### Credit risk of a loan

A loan transaction is generally a hold-to-maturity asset, and as such, the capital requirement is described as a banking book requirement. This treatment is different from trading book assets, which are deemed to be liquid trackable instruments where the risks are managed on a mark-to-market (MTM) basis. The capital required is the nominal multiplied by the counterparty weighting multiplied by the Fl's particular capital ratio. Therefore, for a gold loan of I0,000 ounces to a corporate where the FI's capital ratio is 8%:

Capital = Loan Nominal * Counterparty weighting* BIS capital ratio

= 10,000* 285 * 100 % * 8 % = \$228,000

In summary, the FI must maintain capital above \$228,000 to maintain its capital adequacy ratio above 8%. The framework prescribes a building-block approach such that each transaction in the loan portfolio requires its own capital. Any return on capital employed for a transaction can be measured relative to the amount of capital required.

### Credit risk of a portfolio of derivatives

For an off-balance sheet or trading book asset such as an FX derivative, the calculation is somewhat more complex and is dependent on two variables. The first is the MTM, of the transaction and the second is an add-on factor. This add-on is added to the MTM to take into account the potential future exposure of the transaction. For a gold FX trade where the FI receives 10,000 ounces for US dollars two years forward from a FI counterparty where the current MTM is SI 111:

Capital = ((Add-on * Notional) + MTM) * counterparty weighting * BIS capital ratio

= ((10 ,000 ' 285 * 5%) + 1,000,000) * 20% * 8% = \$18,280

The add-on applied to the notional of a transaction is dependent on the type of precious metal and the residual maturity of the transaction.

From the table below we can see that as the residual maturity drops below one year the add-on decreases substantially (since the potential exposure is deemed to have reduced). For comparison, we have included the add-ons for equity and interest rate product.

For a portfolio of derivatives, the calculation is additive for the MTM element but cumulative for the add-on. This is to say that where we have an appropriate netting agreement with a counterparty, we can sum the MTM of each transaction to that counterparty. However, the add-on is cumulative by transaction. This is a generally deemed to be conservative and the UK FSA docs give a dispensation on the cumulative effect of add-ons because of the natural off-set within a portfolio of derivatives:

NGR is described as the ratio of the net MTM of the portfolio to the gross MT M. The gross MTM is the simple sum of the trades with positive MTM.

Using the building block approach, the amount of capital required for a portfolio of derivatives comprises the MTM clement plus the add-on element multiplied by the counterparty weighting, which is then multiplied by the capital ratio. Each counterparty, therefore, requires a certain portion of regulatory capital to support the credit risk.

### Credit risk of a long-term hedge transaction

Since the normal gold forward curve is upward sloping, we can derive that on a forward basis the MTM of a long-term hedge transaction will be positive if we actually reach the forward rate. At the inception of a long-term transaction we can, therefore, estimate the cost of capital for a transaction within certain parameters. It is also very important to evaluate the stressed exposure of a transaction to a given level of co,1fidence not only to evaluate the potential credit risk but also to evaluate the potential return on capital of a transaction

### Market risk

The second additive element of capital required to support a portfolio of precious metal transactions is the market risk. The regulator of a complex FI will review the risk management and value at risk (YAR) models used to manage the market risk of the portfolio. Where a regulator is comfortable with the FI's approach to risk management and the actual application of the models, the amount of capital required is set in relation to the output of the internal models. Therefore, the amount of capital needed to support the market risk is specific to the FI and the types of risks managed.

### Conclusion

The capital requirement of a precious metal portfolio is complex and very sensitive to the prevailing market rates of the metal and interest rates. These rates drive the MTM that is the major component of the credit risk capital requirement. Given the variability of the add-on and the scope for the mark-to-market movements over time, the capital requirement is also sensitive to tenor and notional.

From a credit risk perspective, the importance of having a strong ISDA master agreement should also be emphasised. These netting agreements are essential in credit risk management and also lead to efficient capital management where netting is enforceable. We would also add that the framework is evolving and as such is planned to encompass a requirement for operational risk in the future.