Title[ Part 3: The Second Pillar - Supervisory Review Process
Section[ 3. Residual risk
767. The Framework allows banks to offset credit or counterparty risk with collateral, guarantees or credit derivatives, leading to reduced capital charges. While banks use credit risk mitigation (CRM) techniques to reduce their credit risk, these techniques give rise to risks that may render the overall risk reduction less effective. Accordingly these risks (e.g. legal risk, documentation risk, or liquidity risk) to which banks are exposed are of supervisory concern. Where such risks arise, and irrespective of fulfilling the minimum requirements set out in Pillar 1, a bank could find itself with greater credit risk exposure to the underlying counterparty than it had expected. Examples of these risks include:
w Inability to seize, or realise in a timely manner, collateral pledged (on default of the counterparty);
w Refusal or delay by a guarantor to pay; and
w Ineffectiveness of untested documentation.
768. Therefore, supervisors will require banks to have in place appropriate written CRM policies and procedures in order to control these residual risks. A bank may be required to submit these policies and procedures to supervisors and must regularly review their appropriateness, effectiveness and operation.
769. In its CRM policies and procedures, a bank must consider whether, when calculating capital requirements, it is appropriate to give the full recognition of the value of the credit risk mitigant as permitted in Pillar 1 and must demonstrate that its CRM management policies and procedures are appropriate to the level of capital benefit that it is recognising. Where supervisors are not satisfied as to the robustness, suitability or application of these policies and procedures they may direct the bank to take immediate remedial action or hold additional capital against residual risk until such time as the deficiencies in the CRM procedures are rectified to the satisfaction of the supervisor. For example, supervisors may direct a bank to:
w Make adjustments to the assumptions on holding periods, supervisory haircuts, or volatility (in the own haircuts approach);
w Give less than full recognition of credit risk mitigants (on the whole credit portfolio or by specific product line); and/or
w Hold a specific additional amount of capital.
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