Memorandum To: Credit Risk Standing Group

Date: 10 August 2005

From: Robert Hudson

Subject: Two FAQs

In this note we give draft responses to two FAQs that have been raised by the BBA.

FAQ 1: Risk Weighting for Margin Lending

a) Please confirm that the FSA plans to adopt a similar approach to the FDIC for QIS. The FDIC published a FAQ which reads as follows:

Question:

For certain loan asset classes, specifically margin lending, banks mitigate credit risk by hedging the credit exposure in whole or in part by taking eligible financial collateral. For such transactions, there is little or no reliance on the obligor and no process to measure and assign a risk-rating to the obligor. The focus is on assessing the credit risk of the facility as a function of the sufficiency of the collateral. For QIS-4 purposes, will banks be required to assess probabilities of default (PDs) for each client for every facility? Will banks be required to manage these exposures on a pool basis, or can they continue to manage the exposure of the facility on a collateralized basis?

Answer:

Given the significant similarities of these types of exposures to retail margin lending, for QIS-4 purposes, please slot them on the Input sheet along with Retail Margin Loans (line 113). This approach should be taken with the understanding that this is a very low -- virtually no -- credit risk business because of the high collateralization of these exposures, much like retail margin loans. Note that for QIS-4, all exposures listed on the "Retail Margin Loans" line item receive a zero percent risk-weight under the advanced internal ratings-based approach and a 100 percent risk-weight under the current US capital adequacy rules.

We assume that retail margin loans are similar to the product referred to in Europe as Lombard Lending, i.e. a loan where banks mitigate credit risk by taking eligible financial collateral (usually with a substantial margin). For such transactions, there is little or no reliance on the obligor's general credit worthiness and no process to measure and assign a risk rating. The focus is on assessing the credit risk of the facility as a function of the sufficiency of the collateral.

Ideal Answer:

For QIS-4 purposes as above.

Draft FSA Response

The draft QIS-5 workbook does not contain an explicit line for retail margin loans similar to that in the US QIS-4 workbook referred to above. The suggested treatment is therefore not possible under QIS-5. We suggest that if firms are unable to estimate a PD and LGD for these assets, and are not including them under the Standardised Approach, then they should be recorded for QIS purposes in line 149 as "other retail assets, not included".

b) For Basel 2 purposes how should Lombard Lending be treated? Will the level of collateralisation and the way the business is managed (collateral and/or exposures) determine the risk weight to be applied? Firms operating this type of portfolio in their European operations would appreciate a discussion with the FSA on the subject.

Draft FSA Response

[Note: The BBA did not provide a suggested response to this question]

We are aware that there are potentially different approaches to Lombard Lending being developed in different jurisdictions. This is in principle undesirable and we would be willing to discuss with interested firms – as well as with other supervisors – how a consistent approach could be developed.

Some amendments relating to this kind of business are yet to be voted on by the European Parliament. We do not yet, therefore, know exactly what constraints will be placed on our position by the final text of the Directive. We will need to bear this in mind when reaching our conclusion.

As a first step, we would welcome a discussion, as suggested by the BBA, on how this could be taken forward.

[Note: A BBA working group on this topic has now been established]

FAQ 2: 'Capital Notes' issued by the Special Investment Vehicles (SIPs)

Firms are interested in where the FSA feels SIVs would fall in the Basel framework (ie. what treatment would they get under IRB - noting that the investor does not have sufficient information to drill-down to the underlying investment grade assets).

* [aka LIPICs - limited purpose investment companies] An SIV is a limited purpose operating company that undertakes arbitrage activities by purchasing medium to long-term assets and funding this primarily in the short-term.

Thus SIVs fund a diversified portfolio of highly rated assets by issuing commercial paper, mtn's and capital notes. As such, an SIV capital note is the most junior security in a highly leveraged capital structure (normally they work to c. 14x leverage). These FRNs are issued at Libor (possibly, but not necessarily, plus a base coupon) and also entitle the investor to a share of the profits of the portfolio.

Draft FSA Response:

[Note: The BBA did not provide a proposed answer to this question.]

We are not in a position to give a generic answer to this question as structures can vary. However, a possible treatment might be to apply the securitisation rules. We stated in CP05/3 (paragraph 14.5) that we would look to the economic substance rather than the legal form in deciding whether the securitisation rules should apply. Some characteristics of SIVs (for example their funding through securities of differing seniority) could be taken as similar to securitisations.

Assuming that the securitisation rules are applied, the IRB treatment would depend on the tranche of the investment. If – as is implied by the original question - the investment is unrated and the firm is unable to estimate KIRB, a weighting of 1250% may apply.

If firms wish to discuss more concrete examples with us, where the characteristics of a particular structure can be taken into account, we would be willing to consider alternative proposals.