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Monetary Board Approves Guidelines for the Capital Treatment of Banks' Investment in Credit-Linked Notes

01.08.2004

The Monetary Board (MB) approved the guidelines on the capital treatment of local banks’ investments in credit-linked notes (CLNs) for purposes of monitoring compliance with risk-based capital adequacy requirements.

A CLN is a type of credit derivative instrument created by an offshore issuer. The CLN investor effectively accepts the transfer of credit risk pertaining to a reference asset or basket of assets issued by a reference entity or entities. The repayment of the CLN is contingent upon the non-occurrence of a defined credit event such as the failure to pay, bankruptcy, or repudiation or moratorium of the reference entity. If no credit event occurs during the life of the CLN, the CLN gets fully paid. On the other hand, if a credit event occurs, the note holder may receive reduced interest and principal payments or get paid with the defaulted obligation of the reference entity.

A bank may be interested in investing in a CLN because of its high yield, which would reflect its higher underlying risk. The guidelines seek to clarify what the risk exposures are, given the higher complexity of credit derivatives.

An investment in a CLN exposes a bank to both the offshore note issuer and the reference entity. The capital treatment for a CLN would depend on whether it is held in a bank's banking book or trading book. Investments held in the banking book will be subject to the credit risk capital requirements under Circular No. 280 dated 29 March 2001, as amended. However, the CLN will bear the risk weight of the issuer or the reference entity, whichever is higher.

If the CLN is held in the trading book, the bank will compute specific and general market risk charges on the note as well as the specific risk charge on the reference obligations in accordance with Circular No. 360 dated 3 December 2002. The bank may choose to employ the standardized approach or the internal model approach in calculating the market risk capital requirement. The use of internal models is, however, subject to prior approval of the BSP.

Some CLNs are more complicated and have as reference multiple entities and pay out on the basis of the first, second, or nth entity to default. Some CLNs, on the other hand, may be issued by special purpose vehicles backed by a mixed bag of high grade securities and credit default swaps. These situations are also covered by the guidelines.

Under the guidelines, only banks with expanded derivatives authority may invest in CLNs on the principle that such banks have a demonstrated capability to handle more complex products. As an exception to this general rule, a universal or commercial bank without expanded derivatives authority may invest in CLNs provided such are solely referenced to an obligation of or an obligation fully guaranteed by the Republic of the Philippines.

“The new guidelines are meant to clarify the underlying risk exposure that our banks assume when they take on credit-linked instruments so that they can match it with appropriate capital. This is necessary to balance the obvious high yield that may unduly attract investor banks,” BSP Deputy Governor Alberto V. Reyes said.

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