BSP to monitor investments in new form of credit derivative instrument

The Bangko Sentral ng Pilipinas (BSP) will be monitoring the use of the so-called credit-linked notes (CLN), a type of derivative instrument becoming more common in the local banking industry.

This as the Monetary Board (MB), the policy-making body of the BSP, approved the guidelines on how to book the CLNs, specifically defining the capital treatment of CLNs to allow regulators to monitor if banks are complying with the 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 BSP said that the repayment of the CLN was 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 lifespan 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," said BSP Deputy Governor Alberto V. Reyes. "These guidelines would clarify what the risk exposures are, given the higher complexity of credit derivatives."

Reyes explained that an investment in a CLN exposes a bank to both the offshore issuer and the reference entity.

The capital treatment for a CLN would therefore depend on whether it is held in a bank’s banking book or trading book.

Reyes explained that investments held in the banking book would be subject to the credit risk capital requirements under Circular No. 280 issued by the BSP on March 29, 2001.

However, the CLN would bear the risk weight of the issuer or the reference entity, whichever is higher, he said.

If the CLN is held in the trading book, Reyes said the bank would be required to compute the specific and general market risk charges on the note as well as the specific risk charge on the reference obligations as provided in Circular No. 360 issued on December 2002.

"The bank may choose to employ the standardized approach or the internal model approach in calculating the market risk capital requirement," Reyes said. "The use of internal models is, however, subject to prior approval of the BSP."

Reyes, however, cautioned that some CLNs are more complicated and have as reference multiple entities. These instruments pay out on the basis of the first, second, or nth entity to default.

Some CLNs, on the other hand, might be issued by special purpose vehicles backed by a mixed bag of high-grade securities and credit default swaps.

"The guidelines also covered these situations," Reyes said.

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," Reyes said. "This is necessary to balance the obvious high yield that may unduly attract investor banks."