Title[ Part 2: The First Pillar - Minimum Capital Requirements
Section[ II. Credit Risk — The Standardised Approach
50. The Committee proposes to permit banks a choice between two broad methodologies for calculating their capital requirements for credit risk. One alternative will be to measure credit risk in a standardised manner, supported by external credit assessments.14
51. The alternative methodology, which is subject to the explicit approval of the bank’s supervisor, would allow banks to use their internal rating systems for credit risk.
52. The following section sets out revisions to the 1988 Accord for risk weighting banking book exposures. Exposures that are not explicitly addressed in this section will retain the current treatment; however, exposures related to securitisation are dealt with in Section IV. Furthermore, the credit equivalent amount of Securities Financing Transactions (SFT)15 and OTC derivatives that expose a bank to counterparty credit risk16 is to be calculated under the rules set forth in Annex 417. In determining the risk weights in the standardised approach, banks may use assessments by external credit assessment institutions recognised as eligible for capital purposes by national supervisors in accordance with the criteria defined in paragraphs 90 and 91. Exposures should be risk-weighted net of specific provisions. 18
14 The notations follow the methodology used by one institution, Standard & Poor’s. The use of Standard & Poor’s credit ratings is an example only; those of some other external credit assessment institutions could equally well be used. The ratings used throughout this document, therefore, do not express any preferences or determinations on external assessment institutions by the Committee.
15 Securities Financing Transactions (SFT) are transactions such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on the market valuations and the transactions are often subject to margin agreements.
16 The counterparty credit risk is defined as the risk that the counterparty to a transaction could default before the final settlement of the transaction’s cash flows. An economic loss would occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default. Unlike a firm’s exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending bank faces the risk of loss, the counterparty credit risk creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction. The market value is uncertain and can vary over time with the movement of underlying market factors.
17 Annex 4 of this Framework is based on the treatment of counterparty credit risk set out in Part 1 of the Committee’s paper The Application of Basel II to Trading Activities and the Treatment of Double Default Effects (July 2005).