Basel Developments: A Renewed Focus on Credit Risk Mitigation Transactions and Regulatory Capital Arbitrage

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Transactions that reduce regulatory capital requirements for banks have recently come under media and regulatory scrutiny. The New York Times characterized them as a “trading sleight of hand.” The Basel Committee on Banking Supervision has proposed limiting the ways in which capital requirements can be reduced by such transactions. This client note discusses the new Basel proposals in light of prior guidance published by Basel and the Federal Reserve. As banks seek ways to meet heightened capital requirements and surcharges that are being implemented, they may find greater difficulties in reducing their exposures.

Background

On March 22, 2013, the Basel Committee on Banking Supervision (“Basel Committee”) published a proposal (the “Proposal”) intended to reduce incentives for regulatory capital arbitrage related to certain credit risk mitigation (“CRM”) transactions. The Proposal is intended to ensure that the costs of credit protection are recognized in regulatory capital. If adopted by national supervisors, this proposal could limit banks’ ability to reduce risk weighted assets (“RWA”) at a time when Basel III’s higher capital requirements and surcharges for systemically important financial institutions are being implemented. Examples of transactions that might be caught by these new requirements, specified in the technical guidance (the “Technical Guidance”) that accompanies the Proposal, include the purchase of credit protection on securitization exposures and single name corporate exposures. Under Basel II, CRM transactions may be used to reduce capital requirements,subject to certain conditions. Basel III did not amend the Basel II approach to CRM transactions.

Please see full memo below for more information.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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