Counterparty credit risk and Capital Requirements Regulation II

The cost of monitoring regulatory developments and changes to regulatory interpretations or expectations, and updating reporting systems accordingly, can go beyond the purely financial. Indeed, while asset managers may not be familiar with the full length of CRR II, they must still be able to meet their banking investors’ CRR II inquiries accurately and promptly. As this can be a challenging task that is not immune from reputational risk, this could explain, amongst other considerations such as cost efficiency, the growing trend in asset managers’ requiring third-party assistance in these regulatory matters.

Therefore, we are pleased to present you with an overview of these changes and, more specifically, the ones related to counterparty credit risk that will affect investment funds. We aim to show you how the different capital requirements have evolved with this new regulatory update. And, we will also give you our insight into how to get ready for 28 June 2021.

Approaches for determining the risk weight applicable to investments in funds

Average solvability ratios under CRR II

Deloitte analysis: this chart was compiled using a sample of portfolio data for 340 sub-funds as at 30 September 2020.

To optimize the solvability ratios, the following steps are required:

1. A full look through on an investment fund’s (CIU) portfolio: this will largely reduce the capital charge for credit risk. While CRR I states that credit institutions will have to apply a 8% capital charge (respectively 12% for highly risked CIUs), CRR II applies a more conservative approach with a 100% capital charge if the investments in the fund are not looked through and the calculations not certified.
2. The disclosure principle: CRR II implements a capital requirement penalty. If the credit institution does not have access to the holdings and calculation details of the solvability ratio, they will have to increase the calculated risk weight by 20%.
3. A full look through on target funds: if the CIU invests in other funds, the look-through or mandate-based approach must be applied. Otherwise, the impact on the solvability ratios may be important as these target funds will also be subject to a 1,250% risk weight (i.e. 100% capital charge ultimately for the credit institution). All the funds that use money market funds to manage their liquidity will be greatly affected.
4. The certification of the risk-weighted exposure amount: the solvability ratio certification that verifies whether the calculations were performed following all the CRR II’s rules is required to avoid the fallback approach in using a 1,250% solvability ratio (100% capital charge) according to article 132(2).

Approaches for potential future exposure calculation for investment funds within the counterparty credit risk framework—and illustrations

Until now, the exposure value of derivatives under CRR I was estimated by using either the mark-to-market method, the original exposure method (OEM), or the standardized method.

These methodologies were criticized for not allowing volatility levels to be consistent with stressed market conditions and for not easily recognizing that netting arrangements offset transactions and reduce counterparty credit risk.

To remedy these deficiencies, CRR II enacted a new methodology based on the Basel 3.5 guidelines for the exposure calculation. This so-called standardized approach for counterparty credit risk (SA-CCR) is more risk-sensitive and applies to both over-the-counter (OTC) derivatives and exchange-traded derivatives (Chapter 6, Section 3, CRR II). The SA-CCR revises the exposure computation (RC+PFE) and, more specifically, the second component—the potential future exposure (PFE).

As a result, the solvability ratios, the counterparty valuation adjustment, and the large exposures measurements will be affected.

The below table illustrates a practical example of interest rate swaps, to show the change in PFE computation between CRR I and CRR II: 

a. The maturity date of the contracts will have a higher impact

We can see that the rate of increase of the PFE slows as the maturity of the contract extends. This is due to the “supervisory duration factor” that has been introduced into CRR II.

b. The market value now has an impact on the PFE

Negative market value of derivatives contracts reduces the value of the potential future exposure under CRR II, as illustrated in the table below.

Comparing the Standardized Approach (SA) under CRR I to the SA CCR under CRR II we can foresee a major change in exposure compilation for Derivatives products. Funds holding such type of instruments will see their cost in capital for credit risk increase, creating additional interest for sub-funds not exposed to such instruments.

Counterparty valuation adjustment (CVA)

The SA-CCR highly affects the long-term exposure calculation for OTC products which mechanically lead to an increase of the CVA cost. To soften this impact the CRR II updated the calculation method should the institution opt for the look-through approach. Whether using the SA-CCR, Simplified SA-CCR or the OEM approaches (article 132a(3), CRR II), the credit valuation adjustment will simply be 50% of the own funds requirement for those OTC derivative exposures.

The example below uses the above example to showcase the difference in the CVA value between the application of the CRR I and the CRR II and for different maturities of Interest rate swaps:

The CVA value under the CRR II is lower for some short-term maturities (between 1 and 2 years). For longer maturities, the CVA value increase significantly, reflecting the mindset of the upcoming change to increase the cost in capital for holding OTC exposure with long maturities.

Conclusion

CRR II is likely to increase the capital requirements for credit institutions investing in collective investment funds. We expect these new SA-CCR rules to increase the capital charge for financial derivative instruments, resulting from credit risk and counterparty valuation adjustment risk. As a result, the new rules will mostly affect investment funds using long-dated financial derivative instruments such as corporate bond and high-yield funds, and the credit institutions holding such investments.

How we can assist you

Time is running out to implement the changes in the risk-weight computation for your investment funds before 28 June 2021. Deloitte’s team of specialists is ready to help you navigate these changes and estimate the capital requirements of your investment funds under the new CRR II rules. Our regulatory reporting specialists assist asset managers with more than 4,000 CRR reports per annum, and would be happy to support your CRR II transition.

Our audit department has also set up a team of specialists to provide you with an assurance service on the certification of CRR calculations for investment funds, allowing you to reduce the capital requirements for your investors.