Credit risk mitigation can either take the form of funded or unfunded protection. Here, we provide a high-level explanation of the prudential treatment of the Government’s credit guarantee scheme’. For a full and detailed understanding of the requirements please refer to BIPRU.

Guarantees are one form of unfunded credit risk mitigation recognised under the Banking Consolidation Directive (BCD). Because the protection is unfunded it relies exclusively on the creditworthiness of the guarantor. Consequently the most creditworthy guarantees are likely to be those provided by a government, with the most effective being where both the guarantee and the underlying exposure are in that government’s own domestic currency.

The UK Government’s 2008 Credit Guarantee Scheme for UK-incorporated banks and building societies debt issuance, allows exposures to be zero weighted under the standardised approach where both the Government guarantee and the exposure are denominated in sterling (BIPRU 5.7.25). Under this rule, non-sterling exposures guaranteed by the UK Government will not be eligible for a zero risk weight. However, a guaranteed non-sterling exposure may still be zero weighted under the standardised approach (BIPRU 3.4.1-3.4.3) which deals instead with the creditworthiness of the guarantor.

An alternative approach for calculating a firm’s capital requirements is the Internal Ratings Based (IRB) approach. Under the IRB approach capital requirements are not prescriptive, instead based on a firm’s own estimates of certain parameters, together with other parameters set out in the BCD. The key parameters that need to be determined are the probability of default (PD) and the loss given default (LGD) which are used to determine the expected loss (EL).

The FSA opinion is that securities backed by this UK Government guarantee are capable of achieving a zero risk weight under the standardised approach (see also paragraph 18).  However, as more firms take advantage of these guarantees it is not possible to predict with reasonable certainty what might be negotiated and finally agreed especially on points of detail.  Given this, firms should continue to check what is finally agreed and put in place against the relevant BIPRU requirements to ensure that such securities are eligible for a zero risk weight under the standardised approach.