CAR18 chpt4

Guideline
Subject: Capital Adequacy Requirements (CAR)
Chapter 4 - Settlement and Counterparty Risk
Effective Date: November 2017 / January 20181
The Capital Adequacy Requirements (CAR) for banks (including federal credit unions), bank
holding companies, federally regulated trust companies, federally regulated loan companies and
cooperative retail associations are set out in nine chapters, each of which has been issued as a
separate document. This document, Chapter 4 – Settlement and Counterparty Risk, should be
read in conjunction with the other CAR chapters which include:
Chapter 1 Overview
Chapter 2 Definition of Capital
Chapter 3 Credit Risk – Standardized Approach
Chapter 4 Settlement and Counterparty Risk
Chapter 5 Credit Risk Mitigation
Chapter 6 Credit Risk – Internal Ratings Based Approach
Chapter 7 Structured Products
Chapter 8 Operational Risk
Chapter 9 Market Risk
Please refer to OSFI’s Corporate Governance Guideline for OSFI’s expectations of institution
Boards of Directors in regards to the management of capital and liquidity.
1
For institutions with a fiscal year ending October 31 or December 31, respectively
Banks/BHC/T&L/CRA Settlement and Counterparty Risk

August 2017 - DRAFT Chapter 4 - Page 1
Table of Contents
4.1. Treatment of counterparty credit risk and cross-product netting .............................. 4

4.1.1. Definitions and general terminology ................................................................... 4
4.1.1.1. General terms....................................................................................... 4
4.1.1.2. Transaction types ................................................................................. 6
4.1.1.3. Netting sets, hedging sets, and related terms ....................................... 6
4.1.1.4. Distributions ........................................................................................ 7
4.1.1.5. Exposure measures and adjustments ................................................... 8
4.1.1.6. CCR-related risks................................................................................. 9
4.1.2. Scope of application .............................................................................................. 9
4.1.3. Cross-product netting rules ................................................................................ 11
4.1.3.1. Legal Criteria..................................................................................... 11
4.1.3.2. Operational Criteria .......................................................................... 12
4.1.4. Approval to adopt an internal modelling method to estimate EAD .................. 12
4.1.5. Internal Model Method: measuring exposure and minimum requirements .... 13
4.1.5.1. Exposure amount or EAD under the internal model method ............. 13
4.1.5.2. Own estimates for alpha .................................................................... 15
4.1.5.3. Maturity.............................................................................................. 16
4.1.5.4. Margin agreements ............................................................................ 17
4.1.5.5. Model validation ................................................................................ 19
4.1.5.6. Operational requirements for EPE models........................................ 22
4.1.6. Current Exposure Method .................................................................................. 29
4.1.6.1. Add-on Factors .................................................................................. 30
4.1.6.2. Risk-weighted equivalent of non-netted contracts ............................. 31
4.1.6.3. Netting of forwards, swaps, purchased options and other similar
derivatives .......................................................................................... 34
4.1.7. CVA Risk Capital Charge ................................................................................... 38
4.1.7.1. Banks with IMM approval and Specific Interest Rate Risk VaR
model approval for bonds: Advanced CVA risk capital charge ........ 39
4.1.7.2. All other banks: standardised CVA risk capital charge .................... 42

4.1.8. Calculation of the aggregate CCR and CVA risk capital charges .................... 43
4.1.8.1. Banks with IMM approval and market-risk internal-models
approval for the specific interest-rate risk of bonds .......................... 44
4.1.8.2. Banks with IMM approval and without Specific Risk VaR
approval for bonds ............................................................................. 44
4.1.8.3. All other banks ................................................................................... 44
4.1.9. Central Counterparties ....................................................................................... 45
4.1.9.1. Exposures to Qualifying CCPs .......................................................... 45
4.1.9.2. Risk Sensitive Waterfall Approach..................................................... 51
4.1.9.3. Alternative Approach ......................................................................... 55
4.1.9.4. Exposures to Non-qualifying CCPs ................................................... 56
4.2. Capital treatment for failed trades and non-DvP transactions ................................. 56
4.2.1. Overarching principles ....................................................................................... 57
4.2.2. Capital requirements .......................................................................................... 58
Appendix 4-1............................................................................................................................ 59

Chapter 4 – Settlement and Counterparty Risk
[previously Annex 4]
1. This chapter is drawn from the Basel Committee on Banking Supervision (BCBS) Basel
II and Basel III frameworks, entitled: “International Convergence of Capital Measurement and
Capital Standards – June 2006”, “Basel III: A global regulatory framework for more resilient
banks and banking systems – December 2010 (rev June 2011)” and “Capital requirements for
bank exposures to central counterparties – July 2012”. For reference, the Basel II, Basel III and
Capital requirements for bank exposures to CCPs text paragraph numbers that are associated
with the text appearing in this chapter are indicated in square brackets at the end of each
paragraph2.
4.1. Treatment of counterparty credit risk and cross-product netting

2. This rule identifies permissible methods for estimating the Exposure at Default (EAD)
or the exposure amount for instruments with counterparty credit risk (CCR) under this
guideline.3 Banks may seek supervisory approval to make use of an internal modelling method
meeting the requirements and specifications identified herein. As alternatives banks may also
use the current exposure method. [BCBS June 2006 Annex 4 par 1]
4.1.1. Definitions and general terminology
3. This section defines terms that will be used throughout this text.
4.1.1.1. General terms
 Counterparty Credit Risk (CCR) is the risk that the counterparty to a transaction could
default before the final settlement of the transaction's cash flows. An economic loss
would occur if the transactions or portfolio of transactions with the counterparty has a
positive economic value at the time of default. Unlike a firm’s exposure to credit risk
through a loan, where the exposure to credit risk is unilateral and only the lending bank
faces the risk of loss, CCR creates a bilateral risk of loss: the market value of the
transaction can be positive or negative to either counterparty to the transaction. The
market value is uncertain and can vary over time with the movement of underlying
market factors.
 A central counterparty (CCP) is a clearing house that interposes itself between
counterparties to contracts traded in one or more financial markets, becoming the buyer
to every seller and the seller to every buyer and thereby ensuring the future performance
of open contracts. A CCP becomes a counterparty to trades with market participants
2
Following the format: [BCBS June 2006 par x], [BCBS June 2011 par x] and [BCBS July 2012, par x].
3
In the present document, the terms “exposure at default” and “exposure amount” are used together in order to
identify measures of exposure under both an IRB and a standardised approach for credit risk.

through novation, an open offer system, or another legally binding arrangement. For the
purposes of the capital framework, a CCP is a financial institution.
 A qualifying central counterparty (QCCP) is an entity that is licensed to operate as a
CCP (including a license granted by way of confirming an exemption), and is permitted
by the appropriate regulator/overseer to operate as such with respect to the products
offered. This is subject to the provision that the CCP is based and prudentially
supervised in a jurisdiction where the relevant regulator/overseer has established, and
publicly indicated that it applies to the CCP on an on-going basis, domestic rules and
regulations that are consistent with the CPSS-IOSCO Principles for Financial Market
Infrastructures.
As is the case more generally, OSFI still reserves the right to require banks to hold
additional capital against their exposures to such CCPs via Pillar 2. This might be
appropriate where, for example, an external assessment such as an Financial Sector
Assessment Program (FSAP) has found material shortcomings in the CCP or the
regulation of CCPs, and the CCP and/or the CCP regulator have not since publicly
addressed the issues identified.
Where the CCP is in a jurisdiction that does not have a CCP regulator applying the
Principles to the CCP, then OSFI may make the determination of whether the CCP meets
this definition.
In addition, for a CCP to be considered as a QCCP, the terms defined in paragraph 138
and 139 for the purposes of calculating the capital requirements for default fund
exposures must be made available or calculated in accordance with paragraph 141.
 A clearing member is a member of, or a direct participant in, a CCP that is entitled to
enter into a transaction with the CCP, regardless of whether it enters into trades with a
CCP for its own hedging, investment or speculative purposes or whether it also enters
into trades as a financial intermediary between the CCP and other market participants4.
 A client is a party to a transaction with a CCP through either a clearing member acting as
a financial intermediary, or a clearing member guaranteeing the performance of the client
to the CCP.
 Initial margin means a clearing member’s or client’s funded collateral posted to the CCP
to mitigate the potential future credit exposure of the CCP to the clearing member arising
from the possible future change in the value of their transactions. For the purposes of this
chapter, initial margin does not include contributions to a CCP for mutualised loss
sharing arrangements (i.e., in case a CCP uses initial margin to mutualise losses among
the clearing members, it will be treated as a default fund exposure).
 Variation margin means a clearing member’s or client’s funded collateral posted on a
daily or intraday basis to a CCP based upon price movements of their transactions.
4
For the purposes of this chapter, where a CCP has a link to a second CCP, that second CCP is to be treated as a
clearing member of the first CCP. Whether the second CCP’s collateral contribution to the first CCP is treated as
initial margin or a default fund contribution will depend upon the legal arrangement between the CCPs. National
supervisors should be consulted to determine the treatment of this initial margin and default fund contributions.

 Trade exposures (in section 4.1.9) include the current5 and potential future credit
exposure of a clearing member or a client to a CCP arising from OTC derivatives,
exchange traded derivatives transactions or securities financing transactions (SFTs), as
well as initial margin.
 Default funds, also known as clearing deposits or guaranty fund contributions (or any
other names), are clearing members’ funded or unfunded contributions towards, or
underwriting of, a CCP’s mutualised loss sharing arrangements. The description given
by a CCP to its mutualised loss sharing arrangements is not determinative of its status as
a default fund; rather, the substance of such arrangements will govern its status.
 Offsetting transaction means the transaction leg between the clearing member and the
CCP when the clearing member acts on behalf of a client (e.g. when a clearing member
clears or novates a client’s trade).
[BCBS June 2006 Annex 4 par 2A] or [BCBS July 2012, Annex 4 Section I, A]
4.1.1.2. Transaction types
 Long Settlement Transactions are transactions where a counterparty undertakes to

deliver a security, a commodity, or a foreign exchange amount against cash, other
financial instruments, or commodities, or vice versa, at a settlement or delivery date that
is contractually specified as more than the lower of the market standard for this particular
instrument and five business days after the date on which the bank enters into the
transaction.
 Securities Financing Transactions (SFTs) are transactions such as repurchase
agreements, reverse repurchase agreements, security lending and borrowing, and margin
lending transactions, where the value of the transactions depends on market valuations
and the transactions are often subject to margin agreements.
 Margin Lending Transactions are transactions in which a bank extends credit in
connection with the purchase, sale, carrying or trading of securities. Margin lending
transactions do not include other loans that happen to be secured by securities collateral.
Generally, in margin lending transactions, the loan amount is collateralised by securities
whose value is greater than the amount of the loan.
[BCBS June 2006 Annex 4 par 2B]
4.1.1.3. Netting sets, hedging sets, and related terms
 Netting Set is a group of transactions with a single counterparty that are subject to a
legally enforceable bilateral netting arrangement and for which netting is recognised for
regulatory capital purposes under chapters 3 and 5 or the Cross-Product Netting Rules set
forth in this chapter. Each transaction that is not subject to a legally enforceable bilateral
netting arrangement that is recognised for regulatory capital purposes should be
interpreted as its own netting set for the purpose of these rules.
5
For the purposes of this definition, the current exposure of a clearing member includes the variation margin due
to the clearing member but not yet received.

 Risk Position is a risk number that is assigned to a transaction under the CCR
standardised method (set out in this chapter) using a regulatory algorithm.
 Hedging Set is a group of risk positions from the transactions within a single netting set
for which only their balance is relevant for determining the exposure amount or EAD
under the CCR standardised method.
 Margin Agreement is a contractual agreement or provisions to an agreement under
which one counterparty must supply collateral to a second counterparty when an
exposure of that second counterparty to the first counterparty exceeds a specified level.
 Margin Threshold is the largest amount of an exposure that remains outstanding until
one party has the right to call for collateral.
 Margin Period of Risk is the time period from the last exchange of collateral covering a
netting set of transactions with a defaulting counterpart until that counterpart is closed out
and the resulting market risk is re-hedged.
 Effective Maturity under the Internal Model Method for a netting set with maturity
greater than one year is the ratio of the sum of expected exposure over the life of the
transactions in a netting set discounted at the risk-free rate of return divided by the sum of
expected exposure over one year in a netting set discounted at the risk-free rate. This
effective maturity may be adjusted to reflect rollover risk by replacing expected exposure
with effective expected exposure for forecasting horizons under one year. The formula is
given in paragraph 43.
 Cross-Product Netting refers to the inclusion of transactions of different product
categories within the same netting set pursuant to the Cross-Product Netting Rules set out
in this chapter.
 Current Market Value (CMV) refers to the net market value of the portfolio of
transactions within the netting set with the counterparty. Both positive and negative
market values are used in computing CMV.
[BCBS June 2006 Annex 4 par 2C]
4.1.1.4. Distributions
 Distribution of Market Values is the forecast of the probability distribution of net

market values of transactions within a netting set for some future date (the forecasting
horizon) given the realised market value of those transactions up to the present time.
 Distribution of Exposures is the forecast of the probability distribution of market values
that is generated by setting forecast instances of negative net market values equal to zero
(this takes account of the fact that, when the bank owes the counterparty money, the bank
does not have an exposure to the counterparty).
 Risk-Neutral Distribution is a distribution of market values or exposures at a future
time period where the distribution is calculated using market implied values such as
implied volatilities.

 Actual Distribution is a distribution of market values or exposures at a future time
period where the distribution is calculated using historic or realised values such as
volatilities calculated using past price or rate changes.
[BCBS June 2006 Annex 4 par 2D]
4.1.1.5. Exposure measures and adjustments
 Current Exposure is the larger of zero, or the market value of a transaction or portfolio
of transactions within a netting set with a counterparty that would be lost upon the default
of the counterparty, assuming no recovery on the value of those transactions in
bankruptcy. Current exposure is often also called Replacement Cost.
 Peak Exposure is a high percentile (typically 95% or 99%) of the distribution of
exposures at any particular future date before the maturity date of the longest transaction
in the netting set. A peak exposure value is typically generated for many future dates up
until the longest maturity date of transactions in the netting set.
 Expected Exposure is the mean (average) of the distribution of exposures at any
particular future date before the longest-maturity transaction in the netting set matures.
An expected exposure value is typically generated for many future dates up until the
longest maturity date of transactions in the netting set.
 Effective Expected Exposure at a specific date is the maximum expected exposure that
occurs at that date or any prior date. Alternatively, it may be defined for a specific date
as the greater of the expected exposure at that date, or the effective exposure at the
previous date. In effect, the Effective Expected Exposure is the Expected Exposure that
is constrained to be non-decreasing over time.
 Expected Positive Exposure (EPE) is the weighted average over time of expected
exposures where the weights are the proportion that an individual expected exposure
represents of the entire time interval. When calculating the minimum capital
requirement, the average is taken over the first year or, if all the contracts in the netting
set mature before one year, over the time period of the longest-maturity contract in the
netting set.
 Effective Expected Positive Exposure (Effective EPE) is the weighted average over
time of effective expected exposure over the first year, or, if all the contracts in the
netting set mature before one year, over the time period of the longest-maturity contract
in the netting set where the weights are the proportion that an individual expected
exposure represents of the entire time interval.
 Credit Valuation Adjustment is an adjustment to the mid-market valuation of the
portfolio of trades with a counterparty. This adjustment reflects the market value of the
credit risk due to any failure to perform on contractual agreements with a counterparty.
This adjustment may reflect the market value of the credit risk of the counterparty or the
market value of the credit risk of both the bank and the counterparty.
 One-Sided Credit Valuation Adjustment is a credit valuation adjustment that reflects
the market value of the credit risk of the counterparty to the firm, but does not reflect the
market value of the credit risk of the bank to the counterparty.

 Debit Valuation Adjustment is a valuation adjustment that reflects the market value of
the credit risk of the bank to the counterparty (i.e., changes in the reporting bank’s own
credit risk), but does not reflect the market value of the credit risk of the counterparty to
the bank. [Added by OSFI]
[BCBS June 2006 Annex 4 par 2E unless otherwise noted]
4.1.1.6. CCR-related risks
 Rollover Risk is the amount by which expected positive exposure is understated when
future transactions with a counterpart are expected to be conducted on an ongoing basis,
but the additional exposure generated by those future transactions is not included in
calculation of expected positive exposure.
 General Wrong-Way Risk arises when the probability of default of counterparties is
positively correlated with general market risk factors.
 Specific Wrong-Way Risk arises when the exposure to a particular counterpart is
positively correlated with the probability of default of the counterparty due to the nature
of the transactions with the counterparty.
[BCBS June 2006 Annex 4 par 2F]
4.1.2. Scope of application
4. The methods for computing the exposure amount under the standardised approach for
credit risk or EAD under the internal ratings-based (IRB) approach to credit risk described in this
chapter are applicable to SFTs and OTC derivatives. [BCBS June 2006 Annex 4 par 3]
5. Such instruments generally exhibit the following abstract characteristics:

 the transactions generate a current exposure or market value;
 the transactions have an associated random future market value based on market
variables;
 the transactions generate an exchange of future payments or an exchange of a financial
instrument (including commodities) against payment;
 the transactions are undertaken with an identified counterparty against which a unique
probability of default can be determined6
[BCBS June 2006 Annex 4 par 4]
6. Other common characteristics of the transactions to be covered may include the

following:
 collateral may be used to mitigate risk exposure and is inherent in the nature of some
transactions;
6
Transactions for which the probability of default is defined on a pooled basis are not included in this treatment of
CCR.

 short-term financing may be a primary objective in that the transactions mostly consist of
an exchange of one asset for another (cash or securities) for a relatively short period of
time, usually for the business purpose of financing. The two sides of the transactions are
not the result of separate decisions but form an indivisible whole to accomplish a defined
objective;
 netting may be used to mitigate the risk;
 positions are frequently valued (most commonly on a daily basis), according to market
variables.
 remargining may be employed
7. Exposures to central counterparties arising from OTC derivatives, exchange traded

derivatives transactions and SFTs will be subject to the counterparty credit risk treatment laid out
in section 4.1.9. Exposures arising from settlement of cash transactions (equities, fixed income,
spot FX and spot commodities) are not subject to this treatment. The settlement of cash
transactions remains subject to the treatment described in section 4.2. and [BCBS July 2012,
Annex 4, section II par 6(i)]
8. When the clearing member-to-client leg of an exchange traded derivative transaction is

conducted under a bilateral agreement, both the client and the clearing member are to capitalize
that transaction as an OTC derivative. [BCBS July 2012, Annex 4, section II par 6(ii)]
9. Under the two methods identified in this chapter, when a bank purchases credit
derivative protection against a banking book exposure, or against a counterparty credit risk
exposure, it will determine its capital requirement for the hedged exposure subject to the criteria
and general rules for the recognition of credit derivatives, i.e. substitution or double default rules
as appropriate. Where these rules apply, the exposure amount or EAD for counterparty credit
risk from such instruments is zero. [BCBS June 2006 Annex 4 par 7]
10. The exposure amount or EAD for counterparty credit risk is zero for sold credit default
swaps in the banking book where they are treated in the framework as a guarantee provided by
the bank and subject to a credit risk charge for the full notional amount. [BCBS June 2006
Annex 4 par 8]
11. Under the internal model and current exposure methods, the exposure amount or EAD
for a given counterparty is equal to the sum of the exposure amounts or EADs calculated for
each netting set with that counterparty. [BCBS June 2006 Annex 4 par 9]
12. Outstanding EAD for a given OTC derivative counterparty is defined as the greater of
zero and the difference between the sum of EADs across all netting sets with the counterparty
and the credit valuation adjustment (CVA) for that counterparty which has already been
recognised by the bank as an incurred write-down (i.e. a CVA loss). This CVA loss is calculated
without taking into account any offsetting debit valuation adjustments which have been deducted
from capital under Chapter 2 – Definition of Capital, Section 2.3.1 Regulatory Adjustment to
Common Equity Tier 1 Capital, Cumulative gains and losses due to changes in own credit risk

on fair valued financial liabilities7. RWAs for a given OTC derivative counterparty may be
calculated as the applicable risk weight under the Standardised or IRB approach multiplied by
the outstanding EAD of the counterparty. This reduction of EAD by incurred CVA losses does
not apply to the determination of the CVA risk capital charge. [BCBS June 2011 addition to
Annex 4 par 9]
4.1.3. Cross-product netting rules8
13. Banks that receive approval to estimate their exposures to CCR using the internal model
method may include within a netting set SFTs, or both SFTs and OTC derivatives subject to a
legally valid form of bilateral netting that satisfies the following legal and operational criteria for
a Cross-Product Netting Arrangement (as defined below). The bank must also have satisfied any
prior approval or other procedural requirements that its national supervisor determines to
implement for purposes of recognising a Cross-Product Netting Arrangement. [BCBS June 2006
Annex 4 par 10]
4.1.3.1. Legal Criteria
14. The bank has executed a written, bilateral netting agreement with the counterparty that
creates a single legal obligation, covering all included bilateral master agreements and
transactions (“Cross-Product Netting Arrangement”), such that the bank would have either a
claim to receive or obligation to pay only the net sum of the positive and negative (i) close-out
values of any included individual master agreements and (ii) mark-to-market values of any
included individual transactions (the “Cross-Product Net Amount”), in the event a counterparty
fails to perform due to any of the following: default, bankruptcy, liquidation or similar
circumstances. [BCBS June 2006 Annex 4 par 11]
15. The bank has written and reasoned legal opinions that conclude with a high degree of
certainty that, in the event of a legal challenge, relevant courts or administrative authorities
would find the firm’s exposure under the Cross-Product Netting Arrangement to be the Cross-
Product Net Amount under the laws of all relevant jurisdictions. In reaching this conclusion,
legal opinions must address the validity and enforceability of the entire Cross-Product Netting
Arrangement under its terms and the impact of the Cross-Product Netting Arrangement on the
material provisions of any included bilateral master agreement.
 The laws of “all relevant jurisdictions” are: (i) the law of the jurisdiction in which the
counterparty is chartered and, if the foreign branch of a counterparty is involved, then
7
The incurred CVA loss deduced from exposures to determine outstanding EAD is the CVA loss gross of all debit
value adjustments (DVA) which have been separately deducted from capital. To the extent DVA has not been
separately deducted from a bank’s capital, the incurred CVA loss used to determine outstanding EAD will be net
of such DVA.
8
These Cross-Product Netting Rules apply specifically to netting across SFTs, or to netting across both SFTs and
OTC derivatives, for purposes of regulatory capital computation under IMM. They do not revise or replace the
rules that apply to recognition of netting within the OTC derivatives, repo-style transaction, and margin lending
transaction product categories under this guideline. The rules in this guideline continue to apply for purposes of
regulatory capital recognition of netting within product categories under IMM or other relevant methodology.

also under the law of the jurisdiction in which the branch is located, (ii) the law that
governs the individual transactions, and (iii) the law that governs any contract or
agreement necessary to effect the netting.
 A legal opinion must be generally recognised as such by the legal community in the
firm’s home country or a memorandum of law that addresses all relevant issues in a
reasoned manner.
16. The bank has internal procedures to verify that, prior to including a transaction in a
netting set, the transaction is covered by legal opinions that meet the above criteria. [BCBS June
2006 Annex 4 par 13]
17. The bank undertakes to update legal opinions as necessary to ensure continuing
enforceability of the Cross-Product Netting Arrangement in light of possible changes in relevant
law. [BCBS June 2006 Annex 4 par 14]
18. The Cross-Product Netting Arrangement does not include a walkaway clause. A
walkaway clause is a provision which permits a non-defaulting counterparty to make only
limited payments, or no payment at all, to the estate of the defaulter, even if the defaulter is a net
creditor. [BCBS June 2006 Annex 4 par 15]
19. Each included bilateral master agreement and transaction included in the Cross-Product
Netting Arrangement satisfies applicable legal requirements for recognition of (i) bilateral
netting of derivatives contracts in section 4.1.14.1.6.3, or (ii) credit risk mitigation techniques in
chapter 5. [BCBS June 2006 Annex 4 par 16]
20. The bank maintains all required documentation in its files. [BCBS June 2006 Annex 4
par 17]
4.1.3.2. Operational Criteria
21. The supervisory authority is satisfied that the effects of a Cross-Product Netting
Arrangement are factored into the firm’s measurement of a counterparty’s aggregate credit risk
exposure and that the bank manages its counterparty credit risk on such basis. [BCBS June 2006,
Annex 4 par 18]
22. Credit risk to each counterparty is aggregated to arrive at a single legal exposure across
products covered by the Cross-Product Netting Arrangement. This aggregation must be factored
into credit limit and economic capital processes. [BCBS June 2006 Annex 4 par 19]
4.1.4. Approval to adopt an internal modelling method to estimate EAD
23. A bank (meaning the individual legal entity or a group) that wishes to adopt an internal
modelling method to measure exposure or EAD for regulatory capital purposes must seek
approval from its supervisor. The internal modelling method is available both for banks that
adopt the internal ratings-based approach to credit risk and for banks for which the standardised

approach to credit risk applies to all of their credit risk exposures. The bank must meet all of the
requirements given in Section 4.1.5 of this chapter and must apply the method to all of its
exposures that are subject to counterparty credit risk, except for long settlement transactions.
24. A bank may also choose to adopt an internal modelling method to measure CCR for
regulatory capital purposes for its exposures or EAD to only OTC derivatives, to only SFTs, or
to both, subject to the appropriate recognition of netting specified above. The bank must apply
the method to all relevant exposures within that category, except for those that are immaterial in
size and risk. During the initial implementation of the internal models method, a bank may use
the current exposure method for a portion of its business. The bank must submit a plan to its
supervisor to bring all material exposures for that category of transactions under the internal
model method. [(BCBS June 2006 Annex 4 par 21]
25. For all OTC derivative transactions and for all long settlement transactions for which a
bank has not received approval from its supervisor to use the internal models method, the bank
must use the current exposure method. [BCBS June 2006 Annex 4 par 22]
26. Exposures or EAD arising from long settlement transactions can be determined using
the current exposure method regardless of the methods chosen for treating OTC derivatives and
SFTs. In computing capital requirements for long settlement transactions banks that hold
permission to use the internal ratings-based approach may opt to apply the risk weights under the
standardised approach for credit risk on a permanent basis and irrespective to the materiality of
such positions. [BCBS June 2006 Annex 4 par 23]
27. After adoption of the internal model method, the bank must comply with the above
requirements on a permanent basis. Only under exceptional circumstances or for immaterial
exposures can a bank revert to the current exposure method for all or part of its exposure. The
bank must demonstrate that reversion to a less sophisticated method does not lead to an arbitrage
of the regulatory capital rules. [BCBS June 2006 Annex 4 par 24]
4.1.5. Internal Model Method: measuring exposure and minimum requirements
4.1.5.1. Exposure amount or EAD under the internal model method
28. CCR exposure or EAD is measured at the level of the netting set as defined in Sections
4.1.1 and 4.1.3. A qualifying internal model for measuring counterparty credit exposure must
specify the forecasting distribution for changes in the market value of the netting set attributable
to changes in market variables, such as interest rates, foreign exchange rates, etc. The model
then computes the firm’s CCR exposure for the netting set at each future date given the changes
in the market variables. For margined counterparties, the model may also capture future
collateral movements. Banks may include eligible financial collateral as defined in paragraph 45
of section 5.1.3 and chapter 9 in their forecasting distributions for changes in the market value of
the netting set, if the quantitative, qualitative and data requirements for internal model method
are met for the collateral. [BCBS June 2006 Annex 4 par 25]

29. To determine the default risk capital charge for counterparty credit risk as defined in
paragraph 117, banks must use the greater of the portfolio-level capital charge (not including the
CVA charge in paragraphs 109 -116) based on Effective EPE using current market data and the
portfolio-level capital charge based on Effective EPE using a stress calibration. The stress
calibration should be a single consistent stress calibration for the whole portfolio of
counterparties. The greater of Effective EPE using current market data and the stress calibration
should be applied on a total portfolio level and not on a counterparty by counterparty basis.
[BCBS June 2011 Annex 4 par 25(i)]
OSFI Notes
30. OSFI expects banks to have in place a policy for verifying the adequacy of, and
updating, their choice of stress period. This policy would have to be approved in advance by
OSFI as part of the IMM model approval process. Changes to this policy would constitute a
major modification of the IMM model.
31. To the extent that a bank recognises collateral in exposure amount or EAD via current
exposure, a bank would not be permitted to recognise the benefits in its estimates of LGD. As a
result, the bank would be required to use an LGD of an otherwise similar uncollateralised
facility. In other words, the bank would be required to use an LGD that does not include
collateral that is already included in EAD. [BCBS June 2006 Annex 4 par 26]
32. Under the Internal Model Method, the bank need not employ a single model. Although
the following text describes an internal model as a simulation model, no particular form of model
is required. Analytical models are acceptable so long as they are subject to supervisory review,
meet all of the requirements set forth in this section and are applied to all material exposures
subject to a CCR-related capital charge as noted above, with the exception of long settlement
transactions, which are treated separately, and with the exception of those exposures that are
immaterial in size and risk. [BCBS June 2006 Annex 4 par 27]
33. Expected exposure or peak exposure measures should be calculated based on a

distribution of exposures that accounts for the possible non-normality of the distribution of
exposures, including the existence of leptokurtosis (“fat tails”), where appropriate. [BCBS June
34. When using an internal model, exposure amount or EAD is calculated as the product of
alpha times Effective EPE, as specified below (except for counterparties that have been
identified as having explicit specific wrong way risk – see paragraph 74):
EAD =   Effective EPE (1)
[BCBS June 2006 and June 2011 Annex 4 par 29]
35. Effective EPE (“Expected Positive Exposure”) is computed by estimating expected

exposure (EEt) as the average exposure at future date t, where the average is taken across
possible future values of relevant market risk factors, such as interest rates, foreign exchange

rates, etc. The internal model estimates EE at a series of future dates t1, t2, t3…9 Specifically,
“Effective EE” is computed recursively as
Effective EEtk = max(Effective EEtk-1, EEtk) (2)
where the current date is denoted as t0 and Effective EEt0 equals current exposure.
36. In this regard, “Effective EPE” is the average Effective EE during the first year of future
exposure. If all contracts in the netting set mature before one year, EPE is the average of
expected exposure until all contracts in the netting set mature. Effective EPE is computed as a
weighted average of Effective EE:
min(1year ,maturity )
Effective EPE  
k 1
Effective EEtk  tk (3)
where the weights Δtk = tk – tk-1 allows for the case when future exposure is calculated at
dates that are not equally spaced over time.
37. Alpha () is set equal to 1.4. [BCBS June 2006 Annex 4 par 32]
38. Supervisors have the discretion to require a higher alpha based on a firm’s CCR
exposures. Factors that may require a higher alpha include the low granularity of counterparties;
particularly high exposures to general wrong-way risk; particularly high correlation of market
values across counterparties; and other institution-specific characteristics of CCR exposures.
4.1.5.2. Own estimates for alpha
39. Banks may seek approval from their supervisors to compute internal estimates of alpha
subject to a floor of 1.2, where alpha equals the ratio of economic capital from a full simulation
of counterparty exposure across counterparties (numerator) and economic capital based on EPE
(denominator), assuming they meet certain operating requirements. Eligible banks must meet all
the operating requirements for internal estimates of EPE and must demonstrate that their internal
estimates of alpha capture in the numerator the material sources of stochastic dependency of
distributions of market values of transactions or of portfolios of transactions across
counterparties (e.g. the correlation of defaults across counterparties and between market risk and
default). [BCBS June 2006 Annex 4 par 34]
9
In theory, the expectations should be taken with respect to the actual probability distribution of future exposure
and not the risk-neutral one. Supervisors recognise that practical considerations may make it more feasible to
use the risk-neutral one. As a result, supervisors will not mandate which kind of forecasting distribution to
employ.

40. In the denominator, EPE must be used as if it were a fixed outstanding loan amount.
41. To this end, banks must ensure that the numerator and denominator of alpha are
computed in a consistent fashion with respect to the modelling methodology, parameter
specifications and portfolio composition. The approach used must be based on the firm’s
internal economic capital approach, be well-documented and be subject to independent
validation. In addition, banks must review their estimates on at least a quarterly basis, and more
frequently when the composition of the portfolio varies over time. Banks must assess the model
risk given the significant variation in estimates of alpha can arise from the possibility for mis-
specification in the models used for the numerator, especially where convexity is present. The
assessment of model risk must be part of the independent model validation and approval process
and model performance monitoring. [BCBS June 2006 and June 2011 Annex 4 par 36]
42. Where appropriate, volatilities and correlations of market risk factors used in the joint
simulation of market and credit risk should be conditioned on the credit risk factor to reflect
potential increases in volatility or correlation in an economic downturn. Internal estimates of
alpha should take account of the granularity of exposures. [BCBS June 2006 Annex 4 par 37]
4.1.5.3. Maturity
43. If the original maturity of the longest-dated contract contained in the set is greater than
one year, the formula for effective maturity (M) in Chapter 6 - Internal Ratings Based Approach
paragraph 120 of chapter 6 is replaced with the following:
tk 1year maturity

k 1
Effective EEk  tk  dfk  
tk 1year
EEk  tk  dfk
M tk 1year

k 1
Effective EEk  tk  dfk
where dfk is the risk-free discount factor for future time period tk and the remaining symbols
are defined above. Similar to the treatment under corporate exposures, M has a cap of five
years10.
44. For netting sets in which all contracts have an original maturity of less than one year,
the formula for effective maturity (M) in Chapter 6 - Internal Ratings Based Approach paragraph
120 is unchanged and a floor of one year applies, with the exception of short-term exposures as
described in Chapter 6 - Internal Ratings Based Approach, paragraphs 121 to 123. [BCBS June
10
Conceptually, M equals the effective credit duration of the counterparty exposure. A bank that uses an internal
model to calculate a one-sided credit valuation adjustment (CVA) can use the effective credit duration estimated
by such a model in place of the above formula with prior approval of its supervisor.

4.1.5.4. Margin agreements
45. If the netting set is subject to a margin agreement and the internal model captures the
effects of margining when estimating EE, the model’s EE measure may be used directly in
equation (2). Such models are noticeably more complicated than models of EPE for unmargined
counterparties. As such, they are subject to a higher degree of supervisory scrutiny before they
are approved, as discussed below. [BCBS June 2006 Annex 4 par 40]
46. An EPE model must also include transaction-specific information in order to capture the
effects of margining. It must take into account both the current amount of margin and margin
that would be passed between counterparties in the future. Such a model must account for the
nature of margin agreements (unilateral or bilateral), the frequency of margin calls, the margin
period of risk, the thresholds of unmargined exposure the bank is willing to accept, and the
minimum transfer amount. Such a model must either model the mark-to-market change in the
value of collateral posted or apply this Framework’s rules for collateral. [BCBS June 2011
Annex 4 after par 40]
47. Shortcut method: a bank that can model EPE without margin agreements but cannot
achieve the higher level of modelling sophistication to model EPE with margin agreements can
use the following method for margined counterparties subject to re-margining and daily mark-to-
market as described in paragraph 48.11 The method is a simple approximation to Effective EPE
and sets Effective EPE for a margined counterparty equal to the lesser of:
a) effective EPE without any held or posted margining collateral, plus any collateral that has
been posted to the counterparty independent of the daily valuation and margining process
or current exposure (i.e. initial margin or independent amount); or
b) an add-on that reflects the potential increase in exposure over the margin period of risk
plus the larger of
i. the current exposure net of and including all collateral currently held or posted,
excluding any collateral called or in dispute; or
ii. the largest net exposure including all collateral held or posted under the margin
agreement that would not trigger a collateral call. This amount should reflect all
applicable thresholds, minimum transfer amounts, independent amounts and
initial margins under the margin agreement.
The add-on is calculated as E[max(ΔMtM, 0)], where E[…] is the expectation (i.e. the
average over scenarios) and ΔMtM is the possible change of the mark-to-market value of
the transactions during the margin period of risk. Changes in the value of collateral need
to be reflected using the supervisory haircut method or the internal estimates method, but
no collateral payments are assumed during the margin period of risk. The margin period
of risk is subject to the supervisory floor specified in paragraphs 48 to 50. Backtesting
11 Where a bank generally uses this shortcut method to measure Effective EPE, this shortcut method may be used by a bank that
is a clearing member in a CCP for its transactions with the CCP and with clients, including those client transactions that result
in back-to-back trades with a CCP.

should test whether realised (current) exposures are consistent with the shortcut method
prediction over all margin periods within one year. If some of the trades in the netting set
have a maturity of less than one year, and the netting set has higher risk factor
sensitivities without these trades, this fact should be taken into account. If backtesting
indicates that effective EPE is underestimated, the bank should take actions to make the
method more conservative, e.g. by scaling up risk factor moves.
48. For transactions subject to daily re-margining and mark-to-market valuation, a

supervisory floor of five business days for netting sets consisting only of repo-style transactions,
and 10 business days for all other netting sets is imposed on the margin period of risk used for
the purpose of modelling EAD with margin agreements. In the following cases a higher
supervisory floor is imposed:
 for all netting sets where the number of trades exceeds 5,000 at any point during a
quarter, a supervisory floor of 20 business days is imposed for the margin period of risk
for the following quarter;
 for netting sets containing one or more trades involving either illiquid collateral, or an
OTC derivative that cannot be easily replaced, a supervisory floor of 20 business days is
imposed for the margin period of risk. For these purposes, “Illiquid collateral” and “OTC
derivatives that cannot be easily replaced” must be determined in the context of stressed
market conditions and will be characterised by the absence of continuously active
markets where a counterparty would, within two or fewer days, obtain multiple price
quotations that would not move the market or represent a price reflecting a market
discount (in the case of collateral) or premium (in the case of an OTC derivative).
Examples of situations where trades are deemed illiquid for this purpose include, but are
not limited to, trades that are not marked daily and trades that are subject to specific
accounting treatment for valuation purposes (e.g. OTC derivatives or repo-style
transactions referencing securities whose fair value is determined by models with inputs
that are not observed in the market).
 in addition, a bank must consider whether trades or securities it holds as collateral are
concentrated in a particular counterparty and if that counterparty exited the market
precipitously whether the bank would be able to replace its trades.
[BCBS June 2011 Annex 4 par 41(i))
49. If a bank has experienced more than two margin call disputes on a particular netting set
over the previous two quarters that have lasted longer than the applicable margin period of risk
(before consideration of this provision), then the bank must reflect this history appropriately by
using a margin period of risk that is at least double the supervisory floor for that netting set for
the subsequent two quarters. [BCBS June 2011 Annex 4 par 41(ii)]
50. For re-margining with a periodicity of N-days, irrespective of the shortcut method or
full IMM model, the margin period of risk should be at least equal to the supervisory floor, F,
plus the N days minus one day. That is,
Margin Period of Risk = F + N - 1.

[BCBS June 2011 Annex 4 par 41(iii)]
51. Banks using the internal models method must not capture the effect of a reduction of
EAD due to any clause in a collateral agreement that requires receipt of collateral when
counterparty credit quality deteriorates. [BCBS June 2011 Annex 4 par 41(iv)]
4.1.5.5. Model validation
52. It is important that supervisory authorities are able to assure themselves that banks using
models have counterparty credit risk management systems that are conceptually sound and
implemented with integrity. Accordingly the supervisory authority will specify a number of
qualitative criteria that banks would have to meet before they are permitted to use a models-
based approach. The extent to which banks meet the qualitative criteria may influence the level
at which supervisory authorities will set the multiplication factor referred to in paragraph 37
(Alpha) above. Only those banks in full compliance with the qualitative criteria will be eligible
for application of the minimum multiplication factor. The qualitative criteria include:
 the bank must conduct a regular programme of backtesting, ie an ex-post comparison of
the risk measures12 generated by the model against realised risk measures, as well as
comparing hypothetical changes based on static positions with realised measures;
 the bank must carry out an initial validation and an on-going periodic review of its IMM
model and the risk measures generated by it. The validation and review must be
independent of the model developers;
 senior management should be actively involved in the risk control process and must
regard credit and counterparty credit risk control as an essential aspect of the business to
which significant resources need to be devoted. In this regard, the daily reports prepared
by the independent risk control unit must be reviewed by a level of management with
sufficient seniority and authority to enforce both reductions of positions taken by
individual traders and reductions in the bank’s overall risk exposure;
 the bank’s internal risk measurement exposure model must be closely integrated into the
day-to-day risk management process of the bank. Its output should accordingly be an
integral part of the process of planning, monitoring and controlling the bank’s
counterparty credit risk profile;
 the risk measurement system should be used in conjunction with internal trading and
exposure limits. In this regard, exposure limits should be related to the bank’s risk
measurement model in a manner that is consistent over time and that is well understood
by traders, the credit function and senior management;
12
“Risk measures” refers not only to Effective EPE, the risk measure used to derive regulatory capital, but also to
the other risk measures used in the calculation of Effective EPE such as the exposure distribution at a series of
future dates, the positive exposure distribution at a series of future dates, the market risk factors used to derive
those exposures and the values of the constituent trades of a portfolio.

 banks should have a routine in place for ensuring compliance with a documented set of
internal policies, controls and procedures concerning the operation of the risk
measurement system. The bank’s risk measurement system must be well documented,
for example, through a risk management manual that describes the basic principles of the
risk management system and that provides an explanation of the empirical techniques
used to measure counterparty credit risk;
 an independent review of the risk measurement system should be carried out regularly in
the bank’s own internal auditing process. This review should include both the activities
of the business trading units and of the independent risk control unit. A review of the
overall risk management process should take place at regular intervals (ideally no less
than once a year) and should specifically address, at a minimum:
o the adequacy of the documentation of the risk management system and process;
o the organisation of the risk control unit;
o the integration of counterparty credit risk measures into daily risk management;
o the approval process for counterparty credit risk models used in the calculation of
counterparty credit risk used by front office and back office personnel;
o the validation of any significant change in the risk measurement process;
o the scope of counterparty credit risks captured by the risk measurement model;
o the integrity of the management information system;
o the accuracy and completeness of position data;
o the verification of the consistency, timeliness and reliability of data sources used
to run internal models, including the independence of such data sources;
o the accuracy and appropriateness of volatility and correlation assumptions;
o the accuracy of valuation and risk transformation calculations; and
o the verification of the model’s accuracy as described below in paragraphs 53 - 56.
 the on-going validation of counterparty credit risk models, including backtesting, must be
reviewed periodically by a level of management with sufficient authority to decide the
course of action that will be taken to address weaknesses in the models.
53. Banks must document the process for initial and on-going validation of their IMM
model to a level of detail that would enable a third party to recreate the analysis. Banks must
also document the calculation of the risk measures generated by the models to a level of detail
that would allow a third party to re-create the risk measures. This documentation must set out
the frequency with which backtesting analysis and any other on-going validation will be
conducted, how the validation is conducted with respect to data flows and portfolios and the
analyses that are used. [BCBS June 2011 Annex 4 par 43]
54. Banks must define criteria with which to assess their EPE models and the models that
input into the calculation of EPE and have a written policy in place that describes the process by

which unacceptable performance will be determined and remedied. [BCBS June 2011 Annex 4
par 44]
55. Banks must define how representative counterparty portfolios are constructed for the
purposes of validating an EPE model and its risk measures. [BCBS June 2011 Annex 4 par 45]
56. When validating EPE models and its risk measures that produce forecast distributions,
validation must assess more than a single statistic of the model distribution. [BCBS June 2011
Annex 4 par 46]
57. As part of the initial and on-going validation of an IMM model and its risk measures,
the following requirements must be met:
 a bank must carry out backtesting using historical data on movements in market risk
factors prior to supervisory approval. Backtesting must consider a number of distinct
prediction time horizons out to at least one year, over a range of various start
(initialisation) dates and covering a wide range of market conditions;
 banks must backtest the performance of their EPE model and the model’s relevant risk
measures as well as the market risk factor predictions that support EPE. For
collateralised trades, the prediction time horizons considered must include those
reflecting typical margin periods of risk applied in collateralised/margined trading, and
must include long time horizons of at least 1 year;
 the pricing models used to calculate counterparty credit risk exposure for a given scenario
of future shocks to market risk factors must be tested as part of the initial and on-going
model validation process. These pricing models may be different from those used to
calculate Market Risk over a short horizon. Pricing models for options must account for
the non-linearity of option value with respect to market risk factors;
 an EPE model must capture transaction specific information in order to aggregate
exposures at the level of the netting set. Banks must verify that transactions are assigned
to the appropriate netting set within the model;
 static, historical backtesting on representative counterparty portfolios must be a part of
the validation process. At regular intervals as directed by its supervisor, a bank must
conduct such backtesting on a number of representative counterparty portfolios. The
representative portfolios must be chosen based on their sensitivity to the material risk
factors and correlations to which the bank is exposed. In addition, IMM banks need to
conduct backtesting that is designed to test the key assumptions of the EPE model and the
relevant risk measures, e.g. the modelled relationship between tenors of the same risk
factor, and the modelled relationships between risk factors;
 significant differences between realised exposures and the forecast distribution could
indicate a problem with the model or the underlying data that the supervisor would
require the bank to correct. Under such circumstances, supervisors may require
additional capital to be held while the problem is being solved;

 the performance of EPE models and its risk measures must be subject to good backtesting
practice. The backtesting programme must be capable of identifying poor performance in
an EPE model’s risk measures;
 banks must validate their EPE models and all relevant risk measures out to time horizons
commensurate with the maturity of trades for which exposure is calculated using an
internal modelling method;
 the pricing models used to calculate counterparty exposure must be regularly tested
against appropriate independent benchmarks as part of the on-going model validation
process;
 the on-going validation of a bank’s EPE model and the relevant risk measures include an
assessment of recent performance;
 the frequency with which the parameters of an EPE model are updated needs to be
assessed as part of the validation process;
 under the IMM, a measure that is more conservative than the metric used to calculate
regulatory EAD for every counterparty, may be used in place of alpha times Effective
EPE with the prior approval of the supervisor. The degree of relative conservatism will
be assessed upon initial supervisory approval and at the regular supervisory reviews of
the EPE models. The bank must validate the conservatism regularly;
 the on-going assessment of model performance needs to cover all counterparties for
which the models are used;
 the validation of IMM models must assess whether or not the bank level and netting set
exposure calculations of EPE are appropriate.
[BCBS June 2011 Annex 4 par 46(i)]
OSFI Notes
58. In the case where the pricing model used to calculate counterparty credit risk exposure
is different than the pricing model used to calculate Market Risk over a short horizon, OSFI
expects banks to provide documented justification for the use of two different pricing models,
including an assessment of the resulting model risk.
4.1.5.6. Operational requirements for EPE models
59. In order to be eligible to adopt an internal model for estimating EPE arising from CCR
for regulatory capital purposes, a bank must meet the following operational requirements. These
include meeting the requirements related to the qualifying standards on CCR Management, a use
test, stress testing, identification of wrong-way risk, and internal controls. [BCBS June 2006
Annex 4 par 47]

Qualifying standards on CCR Management
60. The bank must satisfy its supervisor that, in addition to meeting the operational
requirements identified in paragraphs 61 to 87 below, it adheres to sound practices for CCR
management. [BCBS June 2006 Annex 4 par 48]
Use test
61. The distribution of exposures generated by the internal model used to calculate effective
EPE must be closely integrated into the day-to-day CCR management process of the bank. For
example, the bank could use the peak exposure from the distributions for counterparty credit
limits or expected positive exposure for its internal allocation of capital. The internal model’s
output must accordingly play an essential role in the credit approval, counterparty credit risk
management, internal capital allocations, and corporate governance of banks that seek approval
to apply such models for capital adequacy purposes. Models and estimates designed and
implemented exclusively to qualify for the internal models method are not acceptable. [BCBS
June 2006 Annex 4 par 49]
62. The bank must have an independent risk control unit that is responsible for the design
and implementation of the bank’s counterparty credit risk management system. The unit should
produce and analyse daily reports on the output of the bank’s risk measurement model, including
an evaluation of the relationship between measures of counterparty credit exposure and trading
limits. The unit must be independent from the business trading units and should report directly
to senior management of the bank. [BCBS June 2011 Annex 4 par 49(i)]
63. A bank must have a credible track record in the use of internal models that generate a
distribution of exposures to CCR. Thus, the bank must demonstrate that it has been using an
internal model to calculate the distributions of exposures upon which the EPE calculation is
based that meets broadly the minimum requirements for at least one year prior to supervisory
approval. [BCBS June 2006 Annex 4 par 50]
64. Banks employing the internal model method must have an independent control unit that
is responsible for the design and implementation of the firm’s CCR management system,
including the initial and on-going validation of the internal model. This unit must control input
data integrity and produce and analyse reports on the output of the firm’s risk measurement
model, including an evaluation of the relationship between measures of risk exposure and credit
and trading limits. This unit must be independent from business credit and trading units; it must
be adequately staffed; it must report directly to senior management of the firm. The work of this
unit should be closely integrated into the day-to-day credit risk management process of the firm.
Its output should accordingly be an integral part of the process of planning, monitoring and
controlling the firm’s credit and overall risk profile. [BCBS June 2006 Annex 4 par 51]
65. Banks applying the internal model method must have a collateral management unit that
is responsible for calculating and making margin calls, managing margin call disputes and
reporting levels of independent amounts, initial margins and variation margins accurately on a
daily basis. This unit must control the integrity of the data used to make margin calls, and ensure

that it is consistent and reconciled regularly with all relevant sources of data within the bank.
This unit must also track the extent of reuse of collateral (both cash and non-cash) and the rights
that the bank gives away to its respective counterparties for the collateral that it posts. These
internal reports must indicate the categories of collateral assets that are reused, and the terms of
such reuse including instrument, credit quality and maturity. The unit must also track
concentration to individual collateral asset classes accepted by the banks. Senior management
must allocate sufficient resources to this unit for its systems to have an appropriate level of
operational performance, as measured by the timeliness and accuracy of outgoing calls and
response time to incoming calls. Senior management must ensure that this unit is adequately
staffed to process calls and disputes in a timely manner even under severe market crisis, and to
enable the bank to limit its number of large disputes caused by trade volumes. [BCBS June 2011
Annex 4 par 51(i)]
66. The bank’s collateral management unit must produce and maintain appropriate
collateral management information that is reported on a regular basis to senior management.
Such internal reporting should include information on the type of collateral (both cash and non-
cash) received and posted, as well as the size, aging and cause for margin call disputes. This
internal reporting should also reflect trends in these figures. [BCBS June 2011 Annex 4 par
51(ii)]
67. A bank employing the internal models method must ensure that its cash management
policies account simultaneously for the liquidity risks of potential incoming margin calls in the
context of exchanges of variation margin or other margin types, such as initial or independent
margin, under adverse market shocks, potential incoming calls for the return of excess collateral
posted by counterparties, and calls resulting from a potential downgrade of its own public rating.
The bank must ensure that the nature and horizon of collateral reuse is consistent with its
liquidity needs and does not jeopardise its ability to post or return collateral in a timely manner.
[BCBS June 2011 Annex 4 par 51(iii)]
68. The internal model used to generate the distribution of exposures must be part of a
counterparty risk management framework that includes the identification, measurement,
management, approval and internal reporting of counterparty risk.13 This framework must
include the measurement of usage of credit lines (aggregating counterparty exposures with other
credit exposures) and economic capital allocation. In addition to EPE (a measure of future
exposure), a bank must measure and manage current exposures. Where appropriate, the bank
must measure current exposure gross and net of collateral held. The use test is satisfied if a bank
uses other counterparty risk measures, such as peak exposure or potential future exposure (PFE),
based on the distribution of exposures generated by the same model to compute EPE. [BCBS
69. A bank is not required to estimate or report EE daily, but to meet the use test it must
have the systems capability to estimate EE daily, if necessary, unless it demonstrates to its
13 This section draws heavily on the Counterparty Risk Management Policy Group’s paper, Improving Counterparty Risk
Management Practices (June 1999); a copy can be found online at
http://www.mfainfo.org/washington/derivatives/Improving%20Counterparty%20risk.pdf.

supervisor that its exposures to CCR warrant some less frequent calculation. It must choose a
time profile of forecasting horizons that adequately reflects the time structure of future cash
flows and maturity of the contracts. For example, a bank may compute EE on a daily basis for
the first ten days, once a week out to one month, once a month out to eighteen months, once a
quarter out to five years and beyond five years in a manner that is consistent with the materiality
and composition of the exposure. [BCBS June 2006 Annex 4 par 53]
70. Exposure must be measured out to the life of all contracts in the netting set (not just to
the one year horizon), monitored and controlled. The bank must have procedures in place to
identify and control the risks for counterparties where exposure rises beyond the one-year
horizon. Moreover, the forecasted increase in exposure must be an input into the firm’s internal
economic capital model. [BCBS June 2006 Annex 4 par 54]
Stress testing
71. A bank must have in place sound stress testing processes for use in the assessment of
capital adequacy. These stress measures must be compared against the measure of EPE and
considered by the bank as part of its internal capital adequacy assessment process. Stress testing
must also involve identifying possible events or future changes in economic conditions that
could have unfavourable effects on a firm’s credit exposures and assessment of the firm’s ability
to withstand such changes. Examples of scenarios that could be used are; (i) economic or
industry downturns, (ii) market-place events, or (iii) decreased liquidity conditions. [BCBS June
72. Banks must have a comprehensive stress testing program for counterparty credit risk.
The stress testing program must include the following elements:
 banks must ensure complete trade capture and exposure aggregation across all forms of
counterparty credit risk (not just OTC derivatives) at the counterparty-specific level in a
sufficient time frame to conduct regular stress testing;
 for all counterparties, banks should produce, at least monthly, exposure stress testing of
principal market risk factors (eg interest rates, FX, equities, credit spreads, and
commodity prices) in order to proactively identify, and when necessary, reduce outsized
concentrations to specific directional sensitivities;
 banks should apply multi-factor stress testing scenarios and assess material non-
directional risks (i.e. yield curve exposure, basis risks, etc.) at least quarterly. Multiple-
factor stress tests should, at a minimum, aim to address scenarios in which a) severe
economic or market events have occurred; b) broad market liquidity has decreased
significantly; and c) the market impact of liquidating positions of a large financial
intermediary. These stress tests may be part of bank-wide stress testing;
 stressed market movements have an impact not only on counterparty exposures, but also
on the credit quality of counterparties. At least quarterly, banks should conduct stress
testing applying stressed conditions to the joint movement of exposures and counterparty
creditworthiness;

 exposure stress testing (including single factor, multifactor and material non-directional
risks) and joint stressing of exposure and creditworthiness should be performed at the
counterparty-specific, counterparty group (e.g. industry and region), and aggregate bank-
wide CCR levels;
 stress tests results should be integrated into regular reporting to senior management. The
analysis should capture the largest counterparty-level impacts across the portfolio,
material concentrations within segments of the portfolio (within the same industry or
region), and relevant portfolio and counterparty specific trends;
 the severity of factor shocks should be consistent with the purpose of the stress test.
When evaluating solvency under stress, factor shocks should be severe enough to capture
historical extreme market environments and/or extreme but plausible stressed market
conditions. The impact of such shocks on capital resources should be evaluated, as well
as the impact on capital requirements and earnings. For the purpose of day-to-day
portfolio monitoring, hedging, and management of concentrations, banks should also
consider scenarios of lesser severity and higher probability;
 banks should consider reverse stress tests to identify extreme, but plausible, scenarios that
could result in significant adverse outcomes;
 senior management must take a lead role in the integration of stress testing into the risk
management framework and risk culture of the bank and ensure that the results are
meaningful and proactively used to manage counterparty credit risk. At a minimum, the
results of stress testing for significant exposures should be compared to guidelines that
express the bank’s risk appetite and elevated for discussion and action when excessive or
concentrated risks are present.
Wrong-way risk
73. Banks must identify exposures that give rise to a greater degree of general wrong-way
risk. Stress testing and scenario analyses must be designed to identify risk factors that are
positively correlated with counterparty credit worthiness. Such testing needs to address the
possibility of severe shocks occurring when relationships between risk factors have changed.
Banks should monitor general wrong way risk by product, by region, by industry, or by other
categories that are germane to the business. Reports should be provided to senior management
on a regular basis that communicate wrong way risks and the steps that are being taken to
manage that risk. [BCBS June 2011 Annex 4 par 57]
74. A bank is exposed to “specific wrong-way risk” if future exposure to a specific

counterparty is highly correlated with the counterparty’s probability of default. For example, a
company writing put options on its own stock creates wrong-way exposures for the buyer that is
specific to the counterparty. A bank must have procedures in place to identify, monitor and
control cases of specific wrong way risk, beginning at the inception of a trade and continuing
through the life of the trade. To calculate the CCR capital charge, the instruments for which
there exists a legal connection between the counterparty and the underlying issuer, and for which
specific wrong way risk has been identified, are not considered to be in the same netting set as

other transactions with the counterparty. Furthermore, for single-name credit default swaps
where there exists a legal connection between the counterparty and the underlying issuer, and
where specific wrong way risk has been identified, EAD in respect of such swap counterparty
exposure equals the full expected loss in the remaining fair value of the underlying instruments
assuming the underlying issuer is in liquidation. The use of the full expected loss in remaining
fair value of the underlying instrument allows the bank to recognise, in respect of such swap, the
market value that has been lost already and any expected recoveries. Accordingly LGD for
Advanced or Foundation IRB banks must be set to 100% for such swap transactions 14. For
banks using the Standardised Approach, the risk weight to use is that of an unsecured
transaction. For equity derivatives, bond options, securities financing transactions etc.
referencing a single company where there exists a legal connection between the counterparty and
the underlying company, and where specific wrong way risk has been identified, EAD equals the
value of the transaction under the assumption of a jump-to-default of the underlying security.
Inasmuch this makes re-use of possibly existing (market risk) calculations (for IRC) that already
contain an LGD assumption, the LGD must be set to 100%. [BCBS June 2011 Annex 4 par 58]
Integrity of Modelling Process
75. Other operational requirements focus on the internal controls needed to ensure the
integrity of model inputs; specifically, the requirements address the transaction data, historical
market data, frequency of calculation, and valuation models used in measuring EPE. [BCBS
76. The internal model must reflect transaction terms and specifications in a timely,
complete, and conservative fashion. Such terms include, but are not limited to, contract notional
amounts, maturity, reference assets, collateral thresholds, margining arrangements, netting
arrangements, etc. The terms and specifications must reside in a secure database that is subject
to formal and periodic audit. The process for recognising netting arrangements must require
signoff by legal staff to verify the legal enforceability of netting and be input into the database by
an independent unit. The transmission of transaction terms and specifications data to the internal
model must also be subject to internal audit and formal reconciliation processes must be in place
between the internal model and source data systems to verify on an ongoing basis that
transaction terms and specifications are being reflected in EPE correctly or at least
conservatively. [BCBS June 2006 Annex 4 par 60]
77. When the Effective EPE model is calibrated using historic market data, the bank must
employ current market data to compute current exposures and at least three years of historical
data must be used to estimate parameters of the model. Alternatively, market implied data may
be used to estimate parameters of the model. In all cases, the data must be updated quarterly or
more frequently if market conditions warrant. To calculate the Effective EPE using a stress
14
Note that the recoveries may also be possible on the underlying instrument beneath such swap. The capital
requirements for such underlying exposure are to be calculated under the Accord without reduction for the swap
which introduces wrong way risk. Generally this means that such underlying exposure will receive the risk
weight and capital treatment associated with an unsecured transaction (i.e. assuming such underlying exposure is
an unsecured credit exposure).

calibration, the bank must also calibrate Effective EPE using three years of data that include a
period of stress to the credit default spreads of a bank’s counterparties or calibrate Effective EPE
using market implied data from a suitable period of stress. The following process will be used to
assess the adequacy of the stress calibration:
 the bank must demonstrate, at least quarterly, that the stress period coincides with a
period of increased CDS or other credit spreads – such as loan or corporate bond spreads
– for a representative selection of the bank’s counterparties with traded credit spreads. In
situations where the bank does not have adequate credit spread data for a counterparty,
the bank should map each counterparty to specific credit spread data based on region,
internal rating and business types;
 the exposure model for all counterparties must use data, either historic or implied, that
includes the data from the stressed credit period, and must use such data in a manner
consistent with the method used for the calibration of the Effective EPE model to current
data.
OSFI Notes
78. When two different calibration methods are used for different parameters within the
Effective EPE model, OSFI expects banks’ model development and validation groups to provide
documented justification for the choice of calibration methods that includes an assessment of the
resulting model risk.
79. If a bank wished to recognise in its EAD calculations for OTC derivatives the effect of
collateral other than cash of the same currency as the exposure itself, then it must model
collateral jointly with the exposure., If the bank is not able to model collateral jointly with the
exposure then it must use either haircuts that meet the standards of the financial collateral
comprehensive method with own haircut estimates or the standard supervisory haircuts. [BCBS
June 2011 Annex 4 par 61(i)]
80. If the internal model includes the effect of collateral on changes in the market value of
the netting set, the bank must model collateral other than cash of the same currency as the
exposure itself jointly with the exposure in its EAD calculations for securities-financing
transactions. [BCBS June 2011 Annex 4 par 61(ii)]
81. The EPE model (and modifications made to it) must be subject to an internal model
validation process. The process must be clearly articulated in firms’ policies and procedures.
The validation process must specify the kind of testing needed to ensure model integrity and
identify conditions under which assumptions are violated and may result in an understatement of
EPE. The validation process must include a review of the comprehensiveness of the EPE model,
for example such as whether the EPE model covers all products that have a material contribution
to counterparty risk exposures. [BCBS June 2006 Annex 4 par 62]
82. The use of an internal model to estimate EPE, and hence the exposure amount or EAD,
of positions subject to a CCR capital charge will be conditional upon the explicit approval of the

firm’s supervisory authority. Home and host country supervisory authorities of banks that carry
out material trading activities in multiple jurisdictions will work co-operatively to ensure an
efficient approval process. [BCBS June 2006 Annex 4 par 63]
83. In the revised Framework and in prior documents, the Committee has issued guidance
regarding the use of internal models to estimate certain parameters of risk and determine
minimum capital charges against those risks. Supervisors will require that banks seeking to
make use of internal models to estimate EPE meet similar requirements regarding, for example,
the integrity of the risk management system, the skills of staff that will rely on such measures in
operational areas and in control functions, the accuracy of models, and the rigour of internal
controls over relevant internal processes. As an example, banks seeking to make use of an
internal model to estimate EPE must demonstrate that they meet the Committee’s general criteria
for banks seeking to make use of internal models to assess market risk exposures, but in the
context of assessing counterparty credit risk.15 [BCBS June 2006 Annex 4 par 64]
84. Pillar 2 of the revised Framework provides general background and specific guidance to
cover counterparty credit risks that may not be fully covered by the Pillar 1 process. [BCBS
85. No particular form of model is required to qualify to make use of an internal model.
Although this text describes an internal model as a simulation model, other forms of models,
including analytic models, are acceptable subject to supervisory approval and review. Banks that
seek recognition for the use of an internal model that is not based on simulations must
demonstrate to their supervisors that the model meets all operational requirements. [BCBS June
86. For a bank that qualifies to net transactions, the bank must have internal procedures to
verify that, prior to including a transaction in a netting set, the transaction is covered by a legally
enforceable netting contract that meets the applicable requirements of section 4.1.6.3 and chapter
5, or the Cross-Product Netting Rules set forth in this chapter. [BCBS June 2006 Annex 4 par
67]
87. For a bank that makes use of collateral to mitigate its CCR, the bank must have internal
procedures to verify that, prior to recognising the effect of collateral in its calculations, the
collateral meets the appropriate legal certainty standards as set out in chapter 5. [BCBS June
4.1.6. Current Exposure Method
88. Banks that do not have approval to apply the internal models method may use the
current exposure method. The current exposure method is to be applied to OTC derivatives only;
SFTs are subject to the treatments set out under the Internal Model Method of this chapter or in
Chapter 5 of the CAR Guideline. [BCBS, June 2006, Annex 4, par 91]
15
Amendment to the Capital Accord to Incorporate Market Risk, Basel Committee on banking Supervision (1996),
Part B.1., “General Criteria,”.

89. Institutions should calculate the credit equivalent amount these contracts using the
current exposure method by adding
 the amount for potential future credit exposure (or "add-on") of all contracts (this is
calculated by multiplying the notional principal amounts by the add-on factors in the
following table)
 the replacement cost (obtained by "marking to market") of all its contracts with positive
value.
[BCBS, June 2006, Annex 4, par 92(i)]
90. The add-on applied in calculating the credit equivalent amount depends on the maturity
of the contract and on the volatility of the rates and prices underlying that type of instrument.
Options purchased over the counter are included with the same conversion factors as other
instruments.
4.1.6.1. Add-on Factors
Current Exposure Method Add-on Factors

Residual maturity Banking & Trading book Credit Derivatives
Contract Type One year or Over one year Over five Trading Banking Book
less to five years years Book sold Protection
Interest Rate 0.0% 0.5% 1.5%
Foreign Exchange and
Gold
1.0% 5.0% 7.5%
Equity 6.0% 8.0% 10.0%
Precious Metals Except
Gold
7.0% 7.0% 8.0%
Other Commodities 10.0% 12.0% 15.0%
Qualifying Single Name CEM not
Credit 5.0%
applicable.
Derivative
Non-Qualifying Single
Treat as direct
Name
10.0% credit substitute
Credit
100% of notional
Derivative
[BCBS, June 2006, Annex 4, par 92(i) and par 707]
91. The calculation of counterparty credit risk requirements is the same whether an
institution uses the standardized or models approach to credit and market risk.
92. For a total rate of return product, each party relies on the other for payment; therefore,
each party records a counterparty credit risk charge. The counterparty credit risk for credit
default swaps is determined on the same basis as any other over-the-counter option contract. The
beneficiary of the swap (fixed payer) relies on the guarantor/protection provider (variable payer)

to pay if a credit event occurs and, therefore, must record a counterparty credit risk charge
against the guarantor/protection provider. The guarantor/protection provider in the swap is
exposed to the beneficiary only if there are future premiums or interest related payments, but the
guarantor/protection provider must always record an exposure to the reference asset. There is no
counterparty credit risk charge for credit-linked notes as the guarantor/protection provider has
pre-funded its potential obligation arising from the reference asset.
93. The appropriate add-on factor to use to calculate the potential future credit exposure to
counterparty credit risk for single name credit derivatives under the Current Exposure Method
depends on whether the reference asset is a qualifying asset as defined in section 9.10.1.1 of
chapter 9. For total rate of return products and credit default swaps, the add-on factor is 5% if
the reference asset is a qualifying asset, and 10% otherwise; the factor does not depend on the
residual maturity of the contract. The add-on is required for both buyers and sellers of credit
protection, with one exception: The add-on factor is only required for protection sellers under
credit default swaps if the swap is subject to closeout upon the insolvency of the protection buyer
while the reference entity is still solvent. In this case, the add-on is capped at the amount of
unpaid premiums. [BCBS, June 2006, par 707]
94. The add-on factor for counterparty credit risk in basket transactions is determined by
allocating the lowest credit quality assets in the basket to the number of assets required to default
in order to trigger a payout. Thus, in a first-to-default transaction, the add-on is determined by
the lowest credit quality asset in the basket, so that if there are any non-qualifying assets in the
basket then the 10% factor applies. In a second-to-default transaction, the add-on is determined
by the second lowest credit quality asset, and so on. [BCBS, June 2006, par 708]
95. Since all credit derivative positions are exposed to counterparty risk, the full
counterparty risk charge is required for each leg of an offsetting transaction, even if the positions
are completely matched.
4.1.6.2. Risk-weighted equivalent of non-netted contracts
A worksheet similar to that set out below could be used to determine the risk-weighted
equivalent of non-netted contracts:
Potential
Notional Positive Risk Risk-
Add-On Future Credit
Principal Replacement Weight Weighted
Type of Contract Factor % Credit Equivalent
Amount Cost (MTM) % Equivalent
Exposure
1 2 3 1x3=4 2+4=5 6 5x6=7
Interest Rate
 1 year 0.0 0
0.0 20
0.0 50
0.0 100
0.0 150

Potential
Exposure
1 2 3 1x3=4 2+4=5 6 5x6=7
 1 year  5 0.5 0
years 0.5 20
0.5 50
0.5 100
0.5 150
5 years 1.5 0
1.5 20
1.5 50
1.5 100
1.5 150
Foreign Exchange Rate and Gold
 1 year 1.0 0
1.0 20
1.0 50
1.0 100
1.0 150
 1 year  5 5.0 0
years 5.0 20
5.0 50
5.0 100
5.0 150
 5 years 7.5 0
7.5 20
7.5 50
7.5 100
7.5 150
Equity
 1 year 6.0 0
6.0 20
6.0 50
6.0 100
6.0 150
 1 year  5 8.0 0
years 8.0 20
8.0 50
8.0 100
8.0 150
 5 years 10.0 0
10.0 20
10.0 50
10.0 100
10.0 150
Precious Metals Except Gold
1 year 7.0 0
7.0 20
7.0 50
7.0 100
7.0 150

Potential
Exposure
1 2 3 1x3=4 2+4=5 6 5x6=7
 1 year  5 7.0 0
years 7.0 20
7.0 50
7.0 100
7.0 150
 5 years 8.0 0
8.0 20
8.0 50
8.0 100
8.0 150
Other Commodities
 1 year 10.0 0
10.0 20
10.0 50
10.0 100
10.0 150
 1 year  5 12.0 0
years 12.0 20
12.0 50
12.0 100
12.0 150
 5 years 15.0 0
15.0 20
15.0 50
15.0 100
15.0 150
OSFI Notes:
96. Notes to the matrix and worksheet:
 trade exposures to QCCPs are subject to separate treatment in section 4.1.9;
 for contracts with multiple exchanges of principal, the factors are to be multiplied by the
number of remaining payments in the contract;
 for contracts that are structured to settle outstanding exposure following specified
payment dates and where the terms are reset such that the market value of the contract is
zero on these specified dates, the residual maturity would be set equal to the time until
the next reset date. In the case of interest rate contracts with remaining maturities of
more than one year and that meet these criteria, the add-on factor is subject to a floor of
0.5%;
 contracts not covered by any of the rows of this matrix are to be treated as "other
commodities";
 no potential future credit exposure would be calculated for single currency
floating/floating interest rate swaps; the credit exposure on these contracts would be

evaluated solely on the basis of their mark-to-market value (replacement cost);
 the add-ons are based on effective rather than stated notional amounts. In the event that
the stated notional amount is leveraged or enhanced by the structure of the transaction,
institutions must use the actual or effective notional amount when determining potential
future credit exposure. For example, a stated notional amount of $1 million with
payments calculated at two times LIBOR would have an effective notional amount of $2
million;
 potential future credit exposure is to be calculated for all OTC contracts (with the
exception of single currency-floating/floating interest rate swaps), regardless whether the
replacement cost is positive or negative.
[BCBS, June 2006 Annex 4, par 92(i)]
97. Banks can obtain capital relief for collateral as defined in Chapter 5, Section 5.1.3 and
chapter 9. The methodology for the recognition of eligible collateral follows that of the
applicable approach for credit risk. [BCBS June 2006 Annex 4 par 93]
98. The counterparty credit risk exposure amount or EAD for single name credit derivative
transactions in the trading book will be calculated using the potential future credit exposure add-
on factors set out in this chapter. [BCBS June 2006 Annex 4 par 94]
99. To determine capital requirements for hedged banking book exposures, the treatment for
credit derivatives in this guideline applies to qualifying credit derivative instruments. [BCBS
100. Where a credit derivative is an nth-to-default transaction (such as a first-to-default

transaction), the treatment specified in paragraph 94 applies. [BCBS June 2006 Annex 4 par 96]
4.1.6.3. Netting of forwards, swaps, purchased options and other similar derivatives
[Moved from Chapter 3 – Credit Risk Standardized Approach, Section 3.5]
101. Institutions may net contracts that are subject to novation or any other legally valid form
of netting. Novation refers to a written bilateral contract between two counterparties under
which any obligation to each other to deliver a given currency on a given date is automatically
amalgamated with all other obligations for the same currency and value date, legally substituting
one single amount for the previous gross obligations. [BCBS, June 2006 Annex 4 par 96(i)]
102. Institutions that wish to net transactions under either novation or another form of
bilateral netting will need to satisfy OSFI16 that the following conditions are met:
 the institution has executed a written, bilateral netting contract or agreement with each
counterparty that creates a single legal obligation, covering all included bilateral
16
If any supervisor is dissatisfied about enforceability under the laws of its country, neither counterparty can net
the contracts for capital purposes.

transactions subject to netting. The result of such an arrangement would be that the
institution only has one obligation for payment or one claim to receive funds based on the
net sum of the positive and negative mark-to-market values of all of the transactions with
that counterparty in the event that counterparty fails to perform due to any of the
following: default, bankruptcy, liquidation or similar circumstances;
 the institution must have written and reasoned legal opinions that, in the event of any
legal challenge, the relevant courts or administrative authorities would find the exposure
under the netting agreement to be the net amount under the laws of all relevant
jurisdictions. In reaching this conclusion, legal opinions must address the validity and
enforceability of the entire netting agreement under its terms.
o the laws of “all relevant jurisdictions” are: a) the law of the jurisdictions where
the counterparties are chartered and, if the foreign branch of a counterparty is
involved, the laws of the jurisdiction in which the branch is located b) the law
governing the individual transactions; and c) the law governing any contracts or
agreements required to effect netting;
o a legal opinion must be generally recognised as such by the legal community in
the firm’s home country or by a memorandum of law that addresses all relevant
issues in a reasoned manner.
 the institution has internal procedures to verify that, prior to including a transaction in a
netting set, the transaction is covered by legal opinions that meet the above criteria;
 the institution must have procedures in place to update legal opinions as necessary to
ensure continuing enforceability of the netting arrangements in light of possible changes
in relevant law;
 the institution maintains all required documentation in its files.
[BCBS, June 2006 Annex 4 par 96(ii)]
103. Any contract containing a walkaway clause will not be eligible to qualify for netting for
the purpose of calculating capital requirements. A walkaway clause is a provision within the
contract that permits a non-defaulting counterparty to make only limited payments, or no
payments, to the estate of the defaulter, even if the defaulter is a net creditor. [BCBS, June 2006
Annex 4 par 96(iii)]
104. Institutions that are approved to estimate their exposures to CCR using the internal
model method may use the cross-product netting rules as set out in this chapter. Cross-product
netting of repo-style transactions against OTC derivative transactions is not permitted under the
current exposure method.
105. Credit exposure on bilaterally netted forwards, swaps, purchased options and other
similar derivatives transactions is calculated as the sum of the net mark-to-market replacement
cost, if positive, plus an add-on for potential future credit exposure based on the notional
principal of the individual underlying contracts. However, for purposes of calculating potential
future credit exposure of contracts subject to legally enforceable netting agreements in which

notional principal is equivalent to cash flows, notional principal is defined as the net receipts
falling due on each value date in each currency. The reason that these contracts are treated as a
single contract is that offsetting contracts in the same currency maturing on the same date will
have lower potential future credit exposure as well as lower current exposure. For multilateral
netting schemes, current exposure (i.e., replacement cost) is a function of the loss allocation rules
of the clearing-house. [BCBS, June 2006 Annex 4 par 96(iv)]
106. The calculation of the gross add-ons should be based on the legal cash flow obligations
in all currencies. This is calculated by netting all receivable and payable amounts in the same
currency for each value date. The netted cash flow obligations are converted to the reporting
currency using the current forward rates for each value date. Once converted, the amounts
receivable for the value date are added together and the gross add-on is calculated by multiplying
the receivable amount by the appropriate add-on factor.
107. The potential future credit exposure for netted transactions (ANet) equals the sum of: (i)
40% of the add-on as presently calculated (AGross)17; and (ii) 60% of the add-on multiplied by the
ratio of net current replacement cost to gross current replacement cost (NGR).
Where
NGR = level of net replacement cost/level of gross replacement cost for transactions
subject to legally enforceable netting agreements.
[BCBS, June 2006 Annex 4 par 96(iv)]
108. The calculation of NGR can be made on a counterparty-by-counterparty basis or on an

aggregate basis for all transactions, subject to legally enforceable netting agreements. On a
counterparty-by-counterparty basis a unique NGR is calculated for each counterparty. On an
aggregate basis, one NGR is calculated and applied to all counterparties.
Steps for determining the credit equivalent amount of netted contracts
1. For each counterparty subject to bilateral netting, determine the add-ons and replacement
costs of each transaction. A worksheet similar to that set out below could be used for this
purpose.
17
AGross equals the sum of the potential future credit exposures (i.e., notional principal amount of each transaction
times the appropriate add-on factor from Section 4.1.6) for all transactions subject to legally enforceable netting
agreements.

Counterparty 1
Transaction Notional Add-on Potential Gross Negative
Principal Factor Future Replacement Replacement
Amount (ref. 4-3-2) Credit Cost Cost
Exposure
1 2 1x2=3 4 5
1
2
3
Etc.
Total AGross R+ R-
2. Calculate the net replacement cost for each counterparty; it is equal to the greater of:
 zero; or
 the sum of the gross and negative replacement costs (R+ + R-) (note: negative
replacement costs for one counterparty cannot be used to offset gross replacement
costs for another counterparty).
3. Calculate the NGR.
For institutions using the counterparty-by-counterparty basis, the NGR is the net
replacement cost (from step 2) divided by the gross replacement cost (amount R+
calculated in step 1).
For institutions using the aggregate basis, the NGR is the sum of the net replacement
costs of all counterparties subject to bilateral netting divided by the sum of the gross
replacement costs for all counterparties subject to bilateral netting.
A simple example of calculating the NGR ratio is set out below:
Counterparty 1 Counterparty 2 Counterparty 3

Mark to Mark to Mark to
Transaction Notional Market Notional market Notional market
amount Value amount value amount value
Transaction 1 100 10 50 8 30 -3
Transaction 2 100 -5 50 2 30 1
Gross replacement cost (R+) 10 10 1
Net replacement cost (NR) 5 10 0
NGR (per counterparty) 0.5 1 0
NGR (aggregate) NR/R+ = 15/21 = 0.71

4. Calculate ANet.
ANet must be calculated for each counterparty subject to bilateral netting; however, the
NGR applied will depend on whether the institution is using the counterparty-by-
counterparty basis or the aggregate basis. The institution must choose which basis it will
use and use it consistently for all netted transactions.
ANet is:
For netted contracts where the net replacement cost is > 0
(.4*AGross) + (.6*AGross *NGR)
For netted contracts where the net replacement cost is = 0
.4*AGross
5. Calculate the credit equivalent amount for each counterparty by adding the net replacement
cost (step 2) and ANet (step 4). Aggregate the counterparties by risk weight and enter the
total credit equivalent amount on Schedule 40.
Note: Contracts may be subject to netting among different types of derivative instruments (e.g.,
interest rate, foreign exchange, equity, etc.). If this is the case, allocate the net
replacement cost to the types of derivative instrument by pro-rating the net replacement
cost among those instrument types which have a gross positive replacement cost.
4.1.7. CVA Risk Capital Charge
109. In addition to the default risk capital requirements for counterparty credit risk
determined based on the standardised or internal ratings-based (IRB) approaches for credit risk, a
bank must add a capital charge to cover the risk of mark-to-market losses on the expected
counterparty risk (such losses being known as credit value adjustments, CVA) to OTC
derivatives. The CVA capital charge will be calculated in the manner set forth below depending
on the bank’s approved method of calculating capital charges for counterparty credit risk and
specific interest rate risk. A bank is not required to include in this capital charge (i) transactions
with a central counterparty (CCP); and (ii) securities financing transactions (SFT), unless their
supervisor determines that the bank’s CVA loss exposures arising from SFT transactions are
material. [BCBS June 2011 Annex 4 par 97]

4.1.7.1. Banks with IMM approval and Specific Interest Rate Risk VaR model18 approval for
bonds: Advanced CVA risk capital charge
110. Banks with IMM approval for counterparty credit risk and approval to use the market
risk internal models approach for the specific interest-rate risk of bonds must calculate this
additional capital charge by modelling the impact of changes in the counterparties’ credit spreads
on the CVAs of all OTC derivative counterparties, together with eligible CVA hedges according
to new paragraphs 114 and 115, using the bank’s VaR model for bonds. This VaR model is
restricted to changes in the counterparties’ credit spreads and does not model the sensitivity of
CVA to changes in other market factors, such as changes in the value of the reference asset,
commodity, currency or interest rate of a derivative. Regardless of the accounting valuation
method a bank uses for determining CVA, the CVA capital charge calculation must be based on
the following formula for the CVA of each counterparty:
𝑇
𝑠𝑖−1 × 𝑡𝑖−1 𝑠𝑖 × 𝑡𝑖 𝐸𝐸𝑖−1 × 𝐷𝑖−1 + 𝐸𝐸𝑖 × 𝐷𝑖
𝐶𝑉𝐴 = (𝐿𝐺𝐷𝑀𝐾𝑇 ) × ∑ 𝑀𝐴𝑋 [0; exp⁡(− ) − exp (− )] × ( )⁡
𝐿𝐺𝐷𝑀𝐾𝑇 𝐿𝐺𝐷𝑀𝐾𝑇 2
𝑖=1
Where
 ti is the time of the i-th revaluation time bucket, starting from t0=0;
 tT is the longest contractual maturity across the netting sets with the counterparty;
 si is the credit spread of the counterparty at tenor ti, used to calculate the CVA of the
counterparty. Whenever the CDS spread of the counterparty is available, this must be
used. Whenever such a CDS spread is not available, the bank must use a proxy spread
that is appropriate based on the rating, industry and region of the counterparty;
 LGDMKT is the loss given default of the counterparty and should be based on the spread
of a market instrument of the counterparty (or where a counterparty instrument is not
available, based on the proxy spread that is appropriate based on the rating, industry and
region of the counterparty). It should be noted that this LGDMKT, which inputs into the
calculation of the CVA risk capital charge, is different from the LGD that is determined
for the IRB and CCR default risk charge, as this LGDMKT is a market assessment rather
than an internal estimate;
 the first factor within the sum represents an approximation of the market implied
marginal probability of a default occurring between times ti-1 and ti. Market implied
default probability (also known as risk neutral probability) represents the market price of
buying protection against a default and is in general different from the real-world
likelihood of a default;
 EEi is the expected exposure to the counterparty at revaluation time ti, as defined in
paragraph 35 (regulatory expected exposure), where exposures of different netting sets
for such counterparty are added, and where the longest maturity of each netting set is
18
“VaR model” refers to the internal model approach to market risk.

given by the longest contractual maturity inside the netting set. For banks using the short
cut method (paragraph 47) for margined trades, the paragraph 111 should be applied;
 Di is the default risk-free discount factor at time ti, where D0 = 1.
111. The formula in paragraph 110 must be the basis for all inputs into the bank’s approved
VaR model for bonds when calculating the CVA risk capital charge for a counterparty. For
example, if this approved VaR model is based on full repricing, then the formula must be used
directly. If the bank’s approved VaR model is based on credit spread sensitivities for specific
tenors, the bank must base each credit spread sensitivity on the following formula19:
𝑠𝑖 × 𝑡𝑖 𝐸𝐸𝑖−1 × 𝐷𝑖−1 − 𝐸𝐸𝑖+1 × 𝐷𝑖+1

𝑅𝑒𝑔𝑢𝑙𝑎𝑡𝑜𝑟𝑦⁡𝐶𝑆01𝑖 = 0.0001 × 𝑡𝑖 × 𝑒𝑥𝑝 (− )×( )
𝐿𝐺𝐷𝑀𝐾𝑇 2
If the bank’s approved VaR model uses credit spread sensitivities to parallel shifts in credit
spreads (Regulatory CS01), then the bank must use the following formula20:
𝑇
𝑠𝑖 × 𝑡𝑖 𝑠𝑖−1 × 𝑡𝑖−1 𝐸𝐸𝑖−1 × 𝐷𝑖−1 + 𝐸𝐸𝑖 × 𝐷𝑖
𝑅𝑒𝑔𝑢𝑙𝑎𝑡𝑜𝑟𝑦⁡𝐶𝑆01 = 0.0001 × ∑ (𝑡𝑖 × 𝑒𝑥𝑝 (− ) − 𝑡𝑖−1 × 𝑒𝑥𝑝 (− )) × ( )
𝐿𝐺𝐷𝑀𝐾𝑇 𝐿𝐺𝐷𝑀𝐾𝑇 2
𝑖
If the bank’s approved VaR model uses second-order sensitivities to shifts in credit spreads
(spread gamma), the gammas must be calculated based on the formula in paragraph 110.
Banks using the short cut method for collateralised OTC derivatives (paragraph 47), must
compute the CVA risk capital charge according to paragraph 110, by assuming a constant EE
(expected exposure) profile, where EE is set equal to the effective expected positive exposure of
the shortcut method for a maturity equal to the maximum of (i) half of the longest maturity
occurring in the netting set and (ii) the notional weighted average maturity of all transactions
inside the netting set.
Banks with IMM approval for the majority of their businesses, but which use CEM (Current
Exposure Method) for certain smaller portfolios, and which have approval to use the market risk
internal models approach for the specific interest rate risk of bonds, will include these non-IMM
netting sets into the CVA risk capital charge, according to paragraph 110, unless the national
supervisor decides that paragraph 116 should apply for these portfolios. Non-IMM netting sets
are included into the advanced CVA risk capital charge by assuming a constant EE profile,
where EE is set equal to the EAD as computed under CEM for a maturity equal to the maximum
of (i) half of the longest maturity occurring in the netting set and (ii) the notional weighted
average maturity of all transactions inside the netting set. The same approach applies where the
IMM model does not produce an expected exposure profile.
19
This derivation assumes positive marginal default probabilities before and after time bucket t i and is valid for
i<T. For the final time bucket i=T, the corresponding formula is:
𝑠𝑇 × 𝑡 𝑇 𝐸𝐸𝑇−1 × 𝐷𝑇−1 + 𝐸𝐸𝑇 × 𝐷𝑇
𝑅𝑒𝑔𝑢𝑙𝑎𝑡𝑜𝑟𝑦⁡𝐶𝑆01 𝑇 = 0.0001 × 𝑡𝑇 × 𝑒𝑥𝑝 (− )×( )
𝐿𝐺𝐷𝑀𝐾𝑇 2
20
This derivation assumes positive marginal default probabilities.

For exposures to certain counterparties, the bank's approved market risk VaR model may not
reflect the risk of credit spread changes appropriately, because the bank's market risk VaR model
does not appropriately reflect the specific risk of debt instruments issued by the counterparty.
For such exposures, the bank is not allowed to use the advanced CVA risk charge. Instead, for
these exposures the bank must determine the CVA risk charge by application of the standardised
method in paragraph 116. Only exposures to counterparties for which the bank has supervisory
approval for modelling the specific risk of debt instruments are to be included into the advanced
CVA risk charge. [BCBS June 2011 Annex 4 par 99]
112. The CVA risk capital charge consists of both general and specific credit spread risks,
including Stressed VaR but excluding IRC (incremental risk charge). The VaR figure should be
determined in accordance with the quantitative standards described in paragraph 197 of chapter
9. It is thus determined as the sum of (i) the non-stressed VaR component and (ii) the stressed
VaR component.
i. when calculating the non-stressed VaR, current parameter calibrations for expected
exposure must be used;
ii. when calculating the stressed VaR future counterparty EE profiles (according to the
stressed exposure parameter calibrations as defined in paragraph 77) must be used. The
period of stress for the credit spread parameters should be the most severe one-year stress
period contained within the three year stress period used for the exposure parameters21.
113. This additional CVA risk capital charge is the stand alone market risk charge, calculated
on the set of CVAs (as specified in paragraph 110) for all OTC derivatives counterparties,
collateralised and uncollateralised, together with eligible CVA hedges. Within this standalone
CVA risk capital charge, no offset against other instruments on the bank’s balance sheet will be
permitted (except as otherwise expressly provided herein). [BCBS June 2011 Annex 4 par 101]
114. Only hedges used for the purpose of mitigating CVA risk, and managed as such, are
eligible to be included in the VaR model used to calculate the above CVA capital charge or in
the standardised CVA risk capital charge set forth in paragraph 116. For example, if a credit
default swap (CDS) referencing an issuer is in the bank’s inventory and that issuer also happens
to be an OTC counterparty but the CDS is not managed as a hedge of CVA, then such a CDS is
not eligible to offset the CVA within the standalone VaR calculation of the CVA risk capital
charge. [BCBS June 2011 Annex 4 par 102]
115. The only eligible hedges that can be included in the calculation of the CVA risk capital
charge under paragraphs 110 or 116 are single-name CDSs, single-name contingent CDSs, other
equivalent hedging instruments referencing the counterparty directly, and index CDSs. In case
of index CDSs, the following restrictions apply:
21
Note that the three-times multiplier inherent in the calculation of a bond VaR and a stressed VaR will apply to
these calculations.

 the basis between any individual counterparty spread and the spreads of index CDS
hedges must be reflected in the VaR. This requirement also applies to cases where a
proxy is used for the spread of a counterparty, since idiosyncratic basis still needs to be
reflected in such situations. For all counterparties with no available spread, the bank
must use reasonable basis time series out of a representative bucket of similar names for
which a spread is available;
 if the basis is not reflected to the satisfaction of the supervisor, then the bank must reflect
only 50% of the notional amount of index hedges in the VaR.
Other types of counterparty risk hedges must not be reflected within the calculation of the CVA
capital charge, and these other hedges must be treated as any other instrument in the bank’s
inventory for regulatory capital purposes. Tranched or nth to- default CDSs are not eligible CVA
hedges. Eligible hedges that are included in the CVA capital charge must be removed from the
bank’s market risk capital charge calculation.
4.1.7.2. All other banks: standardised CVA risk capital charge
116. When a bank does not have the required approvals to use paragraph 110 to calculate a
CVA capital charge for its counterparties, the bank must calculate a portfolio capital charge
using the following formula:
2
ℎ𝑒𝑑𝑔𝑒 ℎ𝑒𝑑𝑔𝑒 2
𝐾 = 2.33 × √ℎ × √(∑ 0.5 × 𝑤𝑖 × (𝑀𝑖 × 𝐸𝐴𝐷𝑖𝑡𝑜𝑡𝑎𝑙 − 𝑀𝑖 × 𝐵𝑖 ) − ∑ 𝑤𝑖𝑛𝑑 × 𝑀𝑖𝑛𝑑 × 𝐵𝑖𝑛𝑑 ) + ∑ 0.75 × 𝑤𝑖2 × (𝑀𝑖 × 𝐸𝐴𝐷𝑖𝑡𝑜𝑡𝑎𝑙 − 𝑀𝑖 × 𝐵𝑖 )
𝑖 𝑖𝑛𝑑 𝑖
Where
 h is the one-year risk horizon (in units of a year), h = 1;
 wi is the weight applicable to counterparty ‘i’. Counterparty ‘i’ must be mapped to one of
the seven weights wi based on its external rating, as shown in the table of this paragraph
below. When a counterparty does not have an external rating, the bank must, subject to
supervisory approval, map the internal rating of the counterparty to one of the external
ratings. If the bank does not have an approved rating system, then any unrated
counterparty will receive a weight of 2.0%;
 𝐸𝐴𝐷𝑖𝑡𝑜𝑡𝑎𝑙 is the exposure at default of counterparty ‘i’ (summed across its netting sets),
including the effect of collateral as per the existing IMM or CEM rules as applicable to
the calculation of counterparty risk capital charges for such counterparty by the bank.
For non-IMM banks the exposure should be discounted by applying the factor (1-exp (-
0.05*Mi))/(0.05*Mi). For IMM banks, no such discount should be applied as the
discount factor is already included in Mi;
 Bi is the notional of purchased single name CDS hedges (summed if more than one
position) referencing counterparty ‘i’, and used to hedge CVA risk. This notional amount
ℎ𝑒𝑑𝑔𝑒 ℎ𝑒𝑑𝑔𝑒
should be discounted by applying the factor (1-exp(- 0.05*𝑀𝑖 ))/(0.05*𝑀𝑖 );

 Bind is the full notional of one or more index CDS of purchased protection, used to hedge
CVA risk. This notional amount should be discounted by applying the factor (1-exp(-
0.05*Mind))/(0.05* Mind);
 wind is the weight applicable to index hedges. The bank must map indices to one of the
seven weights wi based on the average spread of index ‘ind’;
 Mi is the effective maturity of the transactions with counterparty ‘i’. For IMM banks, Mi
is to be calculated as per paragraph 43 of this chapter. For non-IMM banks, Mi is the
notional weighted average maturity as referred to in the third bullet point of paragraph
120 of chapter 6. However, for this purpose, Mi should not be capped at 5 years;
ℎ𝑒𝑑𝑔𝑒 ℎ𝑒𝑑𝑔𝑒
 𝑀𝑖 is the maturity of the hedge instrument with notional Bi (the quantities 𝑀𝑖 x
Bi are to be summed if these are several positions);
 Mind is the maturity of the index hedge ‘ind’. In case of more than one index hedge
position, it is the notional weighted average maturity.
For any counterparty that is also a constituent of an index on which a CDS is used for hedging
counterparty credit risk, the notional amount attributable to that single name (as per its reference
entity weight) may, with supervisory approval, be subtracted from the index CDS notional
amount and treated as a single name hedge (Bi) of the individual counterparty with maturity
based on the maturity of the index.
The weights are given in this table, and are based on the external rating of the counterparty22:
Rating Weight Wi
AAA 0.7%
AA 0.7%
A 0.8%
BBB 1.0%
BB 2.0%
B 3.0%
CCC 10.0%
4.1.8. Calculation of the aggregate CCR and CVA risk capital charges
117. This paragraph deals with the aggregation of the default risk capital charge and the
CVA risk capital charge for potential mark-to-market losses. Note that outstanding EAD
referred to in the default risk capital charges below is net of incurred CVA losses according to
22
The notations follow the methodology used by one institution, Standard & Poor’s. The use of Standard & Poor’s
credit ratings is an example only; those of some other approved external credit assessment institutions could be
used on an equivalent basis. The ratings used throughout this document, therefore, do not express any
preferences or determinations on external assessment institutions by the Committee.

paragraph 12, which affects all items “i” below. In this paragraph, “IMM capital charge” refers
to the default risk capital charge for CCR based on the RWAs obtained when multiplying the
outstanding EAD of each counterparty under the IMM approach by the applicable credit risk
weight (under the Standardised or IRB approach), and summing across counterparties. Equally,
“CEM capital charge” refers to the default risk capital charges where outstanding EADs for all
counterparties in the portfolio are determined based on the CEM. [BCBS June 2011 Annex 4
par 105]
4.1.8.1. Banks with IMM approval and market-risk internal-models approval for the specific
interest-rate risk of bonds
118. The total CCR capital charge for such a bank is determined as the sum of the following
components:
i. the higher of (a) its IMM capital charge based on current parameter calibrations for EAD
and (b) its IMM capital charge based on stressed parameter calibrations for EAD. For
IRB banks, the risk weights applied to OTC derivative exposures should be calculated
with the full maturity adjustment as a function of PD with M capped at 1 in Chapter 6 –
Credit Risk – Internal Ratings Based Approach paragraph 80, provided the bank can
demonstrate to its national supervisor that its specific VaR model applied in paragraph
110 contains the effect of rating migrations. If the bank cannot demonstrate this to the
satisfaction of its national supervisor, the full maturity adjustment function, given by the
formula
(1 – 1.5 x b)^-1 × (1 + (M – 2.5) × b)23 should apply;
ii. the advanced CVA risk capital charge determined pursuant to paragraphs 110 to 115.
4.1.8.2. Banks with IMM approval and without Specific Risk VaR approval for bonds
119. The total CCR capital charge for such a bank is determined as the sum of the following
components:
i. the higher of (a) the IMM capital charge based on current parameter calibrations for EAD
and (b) the IMM capital charge based on stressed parameter calibrations for EAD;
ii. the standardised CVA risk capital charge determined by paragraph 116.
4.1.8.3. All other banks
120. The total CCR capital charge for such banks is determined as the sum of the following
two components:
23
Where “M” is the effective maturity and “b” is the maturity adjustment as a function of the PD, as defined in paragraph 80 of
chapter 6 of the CAR A-1 Guideline.

i. the sum over all counterparties of the CEM based capital charge with EADs determined
by paragraph 88;
ii. the standardised CVA risk capital charge determined by paragraph 116.
4.1.9. Central Counterparties
121. Regardless of whether a CCP is classified as a qualifying CCP (QCCP), a bank retains
the responsibility to ensure that it maintains adequate capital for its exposures. Under Pillar 2 of
Basel II, a bank should consider whether it might need to hold capital in excess of the minimum
capital requirements if, for example, (i) its dealings with a CCP give rise to more risky exposures
or (ii) where, given the context of that bank’s dealings, it is unclear that the CCP meets the
definition of a QCCP. [BCBS, July 2012, Annex 4 par 106]
122. Where the bank is acting as a clearing member, the bank should assess through
appropriate scenario analysis and stress testing whether the level of capital held against
exposures to a CCP adequately addresses the inherent risks of those transactions. This
assessment will include potential future or contingent exposures resulting from future drawings
on default fund commitments, and/or from a secondary commitments to take over or replace
offsetting transactions from clients of another clearing member in case of this clearing member
defaulting or becoming insolvent. [BCBS, July 2012, Annex 4 par 107]
123. A bank must monitor and report to senior management on a regular basis all of its
exposures to CCPs, including exposures arising from trading through a CCP and exposures
arising from CCP membership obligations such as default fund contributions. [BCBS, July 2012,
Annex 4 par 108]
124. Where a bank is trading with a Qualifying CCP (QCCP) as defined in Section 4.1.1.1,
paragraphs 125 to 141 will apply. In the case of non-qualifying CCPs, paragraphs 142 and 143
will apply. Within three months of a central counterparty ceasing to qualify as a QCCP, unless a
bank’s national supervisor requires otherwise, the trades with a former QCCP may continue to be
capitalised as though they are with a QCCP. After that time, the bank’s exposure with such a
central counterparty must be capitalised according to paragraphs 142 and 143. [BCBS, July
2012, Annex 4 par 109]
4.1.9.1. Exposures to Qualifying CCPs
A. Trade exposures
(i) Clearing member exposures to CCPs
125. Where a bank acts as a clearing member of a CCP for its own purposes a risk weight of
2% must be applied to the clearing bank’s trade exposure to the CCP in respect of OTC
derivatives, exchange traded derivative transactions and SFTs. Where a clearing member offers
clearing services to clients, the 2% risk weight also applies to the clearing member’s trade
exposure to the CCP that arise when the clearing member is obligate to reimburse the client for

any losses due to changes in the value of its transactions in the event that the CCP defaults.
[BCBS, July 2012, Annex 4 par 110]
126. The exposure amount for such trade exposure is to be calculated in accordance with this
chapter using the IMM24 or CEM, as consistently applied by such bank to such an exposure in
the ordinary course of its business, or Chapter 5 together with credit risk mitigation techniques
set forth in Basel II for collateralised transactions25.
Where the respective exposure methodology allows for it, margining can be taken into account.
In the case of IMM banks, the 20-day floor for the margin period of risk (MPOR) as established
in the first bullet point of paragraph 48, included by the Basel III framework, will not apply,
provided that the netting set does not contain illiquid collateral or exotic trades and provided
there are no disputed trades. This refers to exposure calculations under IMM, or the IMM short
cut method of paragraph 47 and for the holding periods entering the exposure calculation of
repo-style transactions in Chapter 5 – Credit Risk Mitigation, Section 5.1.3. [BCBS, July 2012,
Annex 4 par 111]
127. Where settlement is legally enforceable on a net basis in an event of default and
regardless of whether the counterparty is insolvent or bankrupt, the total replacement cost of all
contracts relevant to the trade exposure determination can be calculated as a net replacement cost
if the applicable close-out netting sets meet the requirements set out in26:
 Chapter 5 – Credit Risk Mitigation, paragraph 63 and, where applicable, also 64 in the
case of repo-style transactions;
 Paragraphs 101-103 in the case of derivative transactions;
 Paragraphs 13 to 22 in the case of cross-product netting.
To the extent that the rules referenced above include the term “master netting agreement”, this
term should be read as including any “netting agreement” that provides legally enforceable rights
of set-off27. If the bank cannot demonstrate that netting agreements meet these rules, each single
transaction will be regarded as a netting set of its own for the calculation of trade exposure.
24
Changes to IMM introduced in Basel III also apply for these purposes.
25
In particular, see Chapter 5 – Credit Risk Mitigation, Sections 5.1.3 and 5.2.1for OTC derivatives and standard
supervisory haircuts or own estimates for haircuts, respectively; and for SFTs, see Chapter 5 – Credit Risk
Mitigation, Section 5.2.4 for simple VaR model.
26
For the purposes of this section 4.1.9, the treatment of netting also applies to exchange traded derivatives.
27
This is to take account of the fact that for netting agreements employed by CCPs, no standardisation has
currently emerged that would be comparable to the level of standardisation with respect to OTC netting
agreements for bilateral trading.

(ii) Clearing member exposures to clients
128. The clearing member will always capitalise its exposure (including potential CVA risk
exposure) to clients as bilateral trades, irrespective of whether the clearing member guarantees
the trade or acts as an intermediary between the client and the CCP. However, to recognise the
shorter close-out period for cleared transactions, clearing members can capitalise the exposure to
their clients applying a margin period of risk of at least 5 days (if they adopt the IMM); or
multiplying the EAD by a scalar of no less than 0.71 (if they adopt the CEM).28 On a trade by
trade (or netting set) basis, the EAD after adjustment cannot be less than the positive replacement
cost of the trade/netting set. That is, the absolute value of the reduction in EAD cannot exceed
the amount of the trade’s/netting set’s potential future credit exposure. [BCBS, July 2012, Annex
4 par 113]
OSFI Notes
Paragraph 128(i) provides clarity on the interaction of paragraph 48 and 128.
128(i).Under paragraph 128, netting sets containing an illiquid trade are subject to an MPOR
floored at 20 days (for banks using the IMM) or the full EAD (for banks using the CEM). An
MPOR floor of 5 days (for banks using the IMM) and a scalar of no less than 0.71 (for banks
using the CEM) may be applied for netting sets containing more than 5,000 trades.
(iii) Client exposures
129. Where a bank is a client of a clearing member, and enters into a transaction with the
clearing member acting as a financial intermediary (i.e. the clearing member completes an
offsetting transaction with a CCP), the client’s exposures to the clearing member may receive the
treatment in paragraph 125-127 above if the following two conditions are met:
(a) the offsetting transactions are identified by the CCP as client transactions and collateral
to support them is held by the CCP and/or the clearing member, as applicable, under
arrangements that prevent any losses to the client due to: (i) the default or insolvency of
the clearing member, (ii) the default or insolvency of the clearing member’s other clients,
and (iii) the joint default or insolvency of the clearing member and any of its other
clients29.;
The client must be in a position to provide to the national supervisor, if requested, an

independent, written and reasoned legal opinion that concludes that, in the event of legal
28
The risk reduction in case the margin period of risk is greater than 5 days are as follows: 6 days – scalar=0.77; 7
days – scalar=0.84; 8 days – scalar=0.89; 9 days – scalar=0.95; 10 days – scalar=1.
29
That is, upon the insolvency of the clearing member, there is no legal impediment (other than the need to obtain a
court order to which the client is entitled) to the transfer of the collateral belonging to clients of a defaulting
clearing member to the CCP, to one or more other surviving clearing members or to the client or the client’s
nominee. National supervisors should be consulted to determine whether this is achieved based on particular
facts.

challenge, the relevant courts and administrative authorities would find that the client would
bear no losses on account of the insolvency of an intermediary clearing member or of any
other clients of such intermediary under relevant law:
- the law of the jurisdiction(s) of the client, clearing member and CCP;
- if the foreign branch of the client, clearing member or CCP are involved, then also
under the law of the jurisdiction(s) in which the branch are located;
- the law that governs the individual transactions and collateral; and
- the law that governs any contract or agreement necessary to meet this condition (a).
(b) relevant laws, regulation, rules, contractual, or administrative arrangements provide that
the offsetting transactions with the defaulted or insolvent clearing member are highly
likely to continue to be indirectly transacted through the CCP, or by the CCP, should the
clearing member default or become insolvent. In such circumstances, the client positions
and collateral with the CCP will be transferred at market value unless the client requests
to close out the position at market value.
Where a client enters into a transaction with the CCP, with a clearing member guaranteeing
its performance, the client’s exposures to the CCP may receive the treatment in paragraph
125-127 if the above conditions are met.
OSFI Notes
129(i). OSFI recognises the potential operational challenges around meeting the requirements in
paragraph 129(a). In light of these, Canadian banks who meet the following requirements will
be deemed to be in compliance with paragraph 129(a).
The client must have conducted sufficient legal review (and undertake such further review as
necessary to ensure continuing enforceability) to verify and have a well-founded basis to
conclude that, in the event of legal challenge, the relevant courts and administrative authorities
would find that such arrangements mentioned in paragraph 129(a) would be legal, valid, binding
and enforceable under the relevant laws of the relevant jurisdiction(s).
130. Where a client is not protected from losses in the case that the clearing member and
another client of the clearing member jointly default or become jointly insolvent, but all other
conditions in paragraph 129 are met, a risk weight of 4% will apply to the client’s exposure to
the clearing member. [BCBS, July 2012, Annex 4 par 115]
131. Where the bank is a client of the clearing member and the requirements in paragraphs
129 or 130 are not met, the bank will capitalise its exposure (including potential CVA risk
exposure) to the clearing member as a bilateral trade. [BCBS, July 2012, Annex 4 par 116]

(iv) Treatment of posted collateral
132. In all cases, any assets posted or collateral must, from the perspective of the bank
posting such collateral, receive the risk weights that otherwise applies to such assets or collateral
under the capital adequacy framework, regardless of the fact that such assets have been posted as
collateral. Where assets or collateral of a clearing member or client are posted with a CCP or a
clearing member and are not held in a bankruptcy remote manner, the bank posting such assets
or collateral must also recognise counterparty credit risk based upon the assets or collateral being
exposed to risk of loss based on the creditworthiness of the entity30 holding such assets or
collateral. [BCBS, July 2012, Annex 4 par 117]
133. Collateral posted by the clearing member (including cash, securities, other pledged
assets, and excess margin, also called overcollateralisation), that is held by a custodian 31, and is
bankruptcy remote from the CCP, is not subject to a capital requirement for counterparty credit
risk exposure to such bankruptcy remote custodian. [BCBS, July 2012, Annex 4 par 118]
134. Collateral posted by a client, that is held by a custodian, and is bankruptcy remote from
the CCP, the clearing member and other clients, is not subject to a capital requirement for
counterparty credit risk. If the collateral is held at the CCP on a client’s behalf and is not held on
a bankruptcy remote basis, a 2% risk-weight must be applied to the collateral if the conditions
established in paragraph 129 are met; or 4% if the conditions in paragraph 130 are met. [BCBS,
July 2012, Annex 4 par 119]
30
Where the entity holding such assets or collateral is the CCP, a risk-weight of 2% applies to collateral included in
the definition of trade exposures. The corresponding risk-weight of the CCP will apply to assets or collateral
posted for other purposes.
31
In this paragraph, the word “custodian” may include a trustee, agent, pledgee, secured creditor or any other
person that holds property in a way that does not give such person a beneficial interest in such property and will
not result in such property being subject to legally-enforceable claims by such persons creditors, or to a court-
ordered stay of the return of such property, should such person become insolvent or bankrupt.

B. Default fund exposures
OSFI Notes
135. The methodology for determining the capital charge for default fund exposures to
qualifying CCPs is set out below. In limited circumstances OSFI may provide an explicit waiver
to use the alternative approach for qualifying CCPs also set out below.
To apply for the waiver to use the Alternative approach to calculating capital requirements for
default fund exposures to QCCPs, OSFI is requesting that banks provide the following for each
of the CCPs for which it is applying for the waiver:
i. The rationale for the request
ii. Documentation supporting (i)
iii. Capital and RWA estimates for both the Risk Sensitive Waterfall approach and the
Alternative approach, if available.
iv. The period of time which the bank expects to require a waiver when the reason provided
in (i) is of a temporary nature
v. Confirmation from the bank that using the Alternative approach will not result in any
implementation issues from the bank’s perspective (e.g. a delay due to the use of a
different method)
136. Both the risk sensitive waterfall approach and the alternative approach are temporary
approaches which will be subject to a replacement at a future date.
137. Where a default fund is shared between products or types of business with settlement
risk only (e.g. equities and bonds) and products or types of business which give rise to
counterparty credit risk, i.e. OTC derivatives, exchange traded derivatives or SFTs, all of the
default fund contributions will receive the risk weight determined according to the formulae and
methodology set forth below, without apportioning to different classes or types of business or
products. However, where the default fund contributions from clearing members are segregated
by product types and only accessible for specific product types, the capital requirements for
those default fund exposures determined according to the formulae and methodology set forth
below must be calculated for each specific product giving rise to counterparty credit risk. In case
the CCP’s prefunded own resources are shared among product types, the CCP will have to
allocate those funds to each of the calculations, in proportion to the respective product specific
EAD. [BCBS, July 2012, Annex 4 par 120]

4.1.9.2. Risk Sensitive Waterfall Approach
138. Whenever a bank is required to capitalise for exposures arising from default fund
contributions to a qualifying CCP, clearing member banks will apply a risk weight to their
default fund contributions. This risk weight will be determined according to a risk sensitive
formula that considers (i) the size and quality of a qualifying CCP’s financial resources, (ii) the
counterparty credit risk exposures of such CCP, and (iii) the application of such financial
resources via the CCP’s loss bearing waterfall, in the case of one or more clearing member
defaults. The clearing member bank’s risk sensitive capital requirement for its default fund
contribution (KCMi) must be calculated using the formulae and methodology set forth below.
This calculation may be performed by a CCP, bank, supervisor or other body with access to the
required data, as long as the conditions in paragraph 141 are met. [BCBS, July 2012, Annex 4
par 122]
139. The steps for calculation will be the following:
(i) first, calculate the CCP’s hypothetical capital requirement due to its CCR exposures to all
of its clearing members32. This is calculated using the formula for KCCP:
𝐾𝐶𝐶𝑃 = ⁡ ∑ 𝑚𝑎𝑥(𝐸𝐵𝑅𝑀𝑖 − 𝐼𝑀𝑖 − 𝐷𝐹𝑖 ; 0) ∗ 𝑅𝑊 ∗ 𝐶𝑎𝑝𝑖𝑡𝑎𝑙⁡𝑅𝑎𝑡𝑖𝑜

𝑐𝑙𝑒𝑎𝑟𝑖𝑛𝑔⁡
𝑚𝑒𝑚𝑏𝑒𝑟𝑠⁡𝑖
Where
 RW is a risk weight of 20%33
 Capital Ratio means 8%
 𝑚𝑎𝑥(𝐸𝐵𝑅𝑀𝑖 − 𝐼𝑀𝑖 − 𝐷𝐹𝑖 ; 0) is the exposure amount of the CCP to CM ‘i’, with
all values relating to the valuation at the end of the day before the margin called
on the final margin call of that day is exchanged, and:
- EBRMi denoting the exposure value to clearing member ‘i’ before risk
mitigation under the CEM for derivatives or under the comprehensive
approach of Chapter 5 – Credit Risk Mitigation, Section 5.1.2 The
comprehensive approach, Adjustment for different holding periods and non
daily mark-to-market remargining and for SFTs under Section 5.1.3
Treatment of repo-style transactions covered under master netting agreement;
where, for purposes of this calculation, variation margin that has been
32
KCCP is a hypothetical capital requirement for a CCP, calculated on a consistent basis for the sole purpose of
determining the capitalisation of clearing member default fund contributions; it does not represent the actual
capital requirements for a CCP which may be determined by a CCP and its supervisor.
33
The 20% risk weight is a minimum requirement. As with other parts of the capital adequacy framework, the
national supervisor of a bank may increase the risk weight. An increase in such risk weight would be appropriate
if, for example, the clearing members in a CCP are not highly rated. Any such increase in risk weight is to be
communicated by the affected banks to the person completing this calculation.

exchanged (before the margin called on the final margin call of that day)
enters into the mark-to-market value of the transactions;
- IMi being the initial margin collateral posted by the clearing member with the
CCP;
- DFi being the prefunded default fund contribution by the clearing member that
will be applied upon such a clearing member’s default, either along with or
immediately following such member’s initial margin, to reduce CCP loss.
As regards the calculation in this first step:
a. for clarity, each exposure amount is the CCR exposure amount a CCP has to a
clearing member, calculated as a bilateral trade exposure for OTC derivatives and
exchange traded derivatives either using the Current Exposure Method (CEM) in
Section 4.1.6, or under Chapter 5 – Credit Risk Mitigation, Section 5.1.3 Collateral,
standard supervisory haircuts for SFTs. The holding periods for SFT calculations in
Chapter 5 – Credit Risk Mitigation remain even if more than 5000 trades are within
one netting set, i.e. the first bullet point of paragraph 48 will not apply in this
context.;
b. for the purposes of calculating KCCP via CEM the formula is:
ANet = 0.15*AGross + 0.85*NGR*AGross.
Where, for the purposes of this calculation, the numerator of the NGR is EBRMi -
as described above - without the CEM add-on in case of OTC derivatives, and the
denominator is the gross replacement cost.34 Moreover, for the purposes of this
calculation, the NGR must be calculated on a counterparty by counterparty basis
(i.e. the other option in paragraph 108 does not apply).
Further, if NGR cannot be calculated according to paragraph 108, a transitional
default value NGR value of 0.30 shall be applied for this calculation, until 31
March 2013. After this transitional period, the fallback approach established in
paragraph 143 will apply.
The PFE calculation under the CEM for options and swaptions that are transacted through a CCP
is adjusted by multiplying the notional amount of the contract by the absolute value of the
option’s delta, which is calculated according to paragraphs 1 and 2 Appendix 4-1 of this chapter.
The netting sets that are applicable to regulated clearing members are the same as those referred
to in paragraph 127. For all other clearing members, they need to follow the netting rules as laid
out by the CCP based upon notification of each of its clearing members. The national supervisor
can demand more granular netting sets than laid out by the CCP.
34
If the minimum variation margin settlement frequency is daily, but a CCP calls margin intraday, then NGR is to
be calculated just before margin is actually exchanged at the end of the day. NGR is expected to be non-zero.

(ii) second, calculate the aggregate capital requirement for all clearing members (prior to the
concentration and granularity adjustment), assuming a scenario where two average
clearing members default and, therefore, their default fund contributions are not available
to mutualise losses. This scenario is incorporated in the following risk-sensitive formula:
′
𝑐2 ∗ µ ∗ (𝐾𝐶𝐶𝑃 − 𝐷𝐹 ′ ) + 𝑐2 ∗ 𝐷𝐹𝐶𝑀 ⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡𝑖𝑓⁡𝐷𝐹 ′ < ⁡ 𝐾𝐶𝐶𝑃 ⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡(𝑖)
∗
𝐾𝐶𝑀 = { 𝑐2 ∗ (𝐾𝐶𝐶𝑃 − 𝐷𝐹𝐶𝐶𝑃 ) + 𝑐1 ∗ (𝐷𝐹 ′ − 𝐾𝐶𝐶𝑃 )⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡𝑖𝑓⁡𝐷𝐹𝐶𝐶𝑃 < 𝐾𝐶𝐶𝑃 ≤ 𝐷𝐹 ′ ⁡⁡⁡⁡⁡⁡⁡⁡⁡(𝑖𝑖)
′
𝑐1 ∗ 𝐷𝐹𝐶𝑀 ⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡𝑖𝑓⁡𝐾𝐶𝐶𝑃 ≤ 𝐷𝐹𝐶𝐶𝑃 ⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡⁡(𝑖𝑖𝑖)
Where
KCM* = Aggregate capital requirement on default fund contributions from all clearing
members prior to the application of the granularity and concentration
adjustment;
DFCCP = CCPs prefunded own resources (e.g. contributed capital, retained earnings,
etc.) which are required to be used by the CCP to cover its losses before
clearing members’ default fund contributions are used to cover losses;
DFCM’ = Prefunded default fund contributions from surviving clearing members

available to mutualise losses under the assumed scenario. Specifically:
′
𝐷𝐹𝐶𝑀 = 𝐷𝐹𝐶𝑀 − 2 ∗ ̅̅̅̅
𝐷𝐹𝑖 ,
where ̅̅̅̅
𝐷𝐹𝑖 ⁡is the average default fund contribution;
DF’ = Total prefunded default fund contributions available to mutualise losses

under the assumed scenario. Specifically:
′
𝐷𝐹 ′ = 𝐷𝐹𝐶𝐶𝑃 + 𝐷𝐹𝐶𝑀
c1 = A decreasing capital factor, between 0.16% and 1.6%, applied to the excess
prefunded default funds provided by clearing members (DFCM):
1.6%
𝑐1 = 𝑀𝑎𝑥 { 0.3 ; 0.16%}
′
(𝐷𝐹 ⁄𝐾 )
𝐶𝐶𝑃
c2 = 100%; a capital factor applied when a CCP’s own resources (DFCCP) are less
than such CCP’s hypothetical capital requirements (KCCP), and, as a results, the
clearing member default funds are expected to assist in the coverage of the
CCP’s hypothetical capital requirements (KCCP);
µ= 1.2; an exposure scalar of 1.2 is applied in respect of the unfunded part of a

CCP’s hypothetical capital requirements (KCCP).

Equation (i) applies when a CCP’s total prefunded default fund contributions (DF) are
less than the CCP’s hypothetical capital requirements (KCCP). In such case, the clearing
members unfunded default fund commitments are expected to bear such loss and the
exposure for a clearing member bank is, due to the potential failure of other members to
make additional default fund contributions when called, expected to be greater than the
exposure if all default funds had been prefunded35. Therefore, an exposure scalar (µ) of
1.2 is applied in respect of the unfunded part of KCCP, to reflect the bank’s greater
exposure arising from reliance on unfunded default fund contributions. If a part of the
CCP’s own financial resources available to cover losses is used after all clearing
members’ default fund contributions (DFCM) are used to cover losses, then this part of the
CCP’s contribution to losses should be included as part of the total default fund (DF).
Equation (ii) applies when a CCP’s own resource contributions to losses (DFCCP) and the
clearing members’ default contributions (DFCM), are both required to cover the CCP’s
hypothetical capital (KCCP), but are, in the aggregate, greater than the CCP’s hypothetical
capital requirements KCCP. As noted in the above definition, for DFCCP to be included in
the total default fund available to mutualise losses (DF’), the CCP’s own resources must
be used before DFCM. If that is not the case and a part of CCP’s own financial resources
is used in combination, on a pro rata or formulaic basis, with the clearing members’
default fund contributions (DFCM) to cover CCP losses, then this equation needs to be
adapted, in consultation with national supervisors, such that this part of CCP contribution
is treated just like a clearing member’s default fund contribution.
Equation (iii) applies when a qualifying CCP’s own financial resource contribution to
loss (DFCCP) is used first in the waterfall, and is greater than the CCP’s hypothetical
capital (KCCP), so that the CCP’s own financial resources are expected to bear all of the
CCP’s losses before the clearing members’ default fund contributions (DFCM) are called
upon to bear losses.
(iii) finally, calculate the capital requirement for an individual clearing member ‘i’ (𝐾𝐶𝑀𝑖 ) by
∗
distributing 𝐾𝐶𝑀 to individual clearing members in proportion to the individual clearing
member's share of the total prefunded default fund contributions;36 and taking into
account the CCP granularity (through the factor that accounts for the number of members
‘N’) and the CCP concentration (through the factor ‘β’).
35
Where a CCP’s total prefunded default fund contributions (DF) are not sufficient to cover the CCP’s hypothetical
capital requirements (KCCP), and clearing members do not have an obligation to contribute more default funds
to offset a shortfall in CCP loss-absorbing resources, such clearing members are still subject to an additional
capital charge. The reason is that their trade exposures to such CCP are, in fact, riskier than would be the case if
the CCP had access to adequate resources to cover its hypothetical capital requirements. This reflects the
underlying assumption that CCPs, through own resources and member default funds, are expected to have
adequate loss-bearing, mutualised, financial resources to make defaults on their exposures highly unlikely.
36
Such allocation method is based on the assumption that losses would be allocated proportionate to prefunded DF
contributions of CMs. If the CCP practice differs, the allocation method should be adjusted in consultation with national
supervisors.

𝑁 𝐷𝐹𝑖 ∗
𝐾𝐶𝑀𝑖 = (1 + 𝛽 ∗ 𝑁−2) ∗ 𝐷𝐹 ∗ 𝐾𝐶𝑀 ,
𝐶𝑀
Where
𝐴𝑁𝑒𝑡,1 +𝐴𝑁𝑒𝑡,2
β= ∑𝑖 𝐴𝑁𝑒𝑡,𝑖
, where subscript 1 and 2 denote the clearing members with the
two largest ANet values. For OTC derivatives ANet is defined in paragraph 52;
and SFTs, ANet will be replaced by E*He + C*(Hc + Hfx), as defined in Chapter
5 – Credit Risk Mitigation, Section 5.1.3 (ii) The comprehensive approach.
N= Number of clearing members;
DFi = Prefunded default fund contribution from an individual clearing member ‘i’;
DFCM = Prefunded default fund contributions from all clearing members (or any other
member contributed financial resources that are available to bear mutualised
CCP losses).
Alternatively, where the above allocation method fails because of the fact that the CCP
does not have prefunded default fund contributions, the following hierarchy of
conservative allocation method applies:
∗
1. Allocate 𝐾𝐶𝑀 based upon each CM’s proportionate liability for default fund calls
(i.e. unfunded DF commitment);
∗
2. In the case such an allocation is not determinable; allocate 𝐾𝐶𝑀 based upon the size
of each CM’s posted IM.
These allocation approaches would replace (DFi / DFCM) in the calculation of KCMi.
4.1.9.3. Alternative Approach
140. Clearing member banks may apply a risk-weight of 1250% to its default fund exposures
to the CCP, subject to an overall cap on the risk-weighted assets from all its exposures to the
CCP (i.e. including trade exposures) equal to 20% times the trade exposures to the CCP. More
specifically, under this approach, the Risk Weighted Assets (RWA) for both bank i’s trade and
default fund exposures to CCPj are equal to:37
𝑀𝑖𝑛{(2% ∗ 𝑇𝐸𝑖 + 1250% ∗ 𝐷𝐹𝑖 ); (20% ∗ 𝑇𝐸𝑖 )}
37
Under this approach the, 2% risk weight on trade exposures given by paragraph 125 does not apply as it is
included in the equation in paragraph 140.

Where
 TEi is bank I’s trade exposure to CCPj, as measured by the bank according to
paragraphs 125 to 127 in this chapter; and
 DFi is bank I’s pre-funded contribution to CCP j’s default fund

141. The CCP, bank, supervisor or other body with access to the required data, must make a
calculation of KCCP, DFCM, and DFCCP in such a way to permit the supervisor of the CCP to
oversee those calculations, and it must share sufficient information of the calculation results to
permit each clearing member to calculate their capital requirement for the default fund and for
the bank supervisor of such clearing member to review and confirm such calculations. KCCP
should be calculated on a quarterly basis at a minimum; although national supervisors may
require more frequent calculations in case of material changes (such as the CCP clearing a new
product). The CCP, bank, supervisor or other body that did the calculations should make
available to the home supervisor of any bank clearing member sufficient aggregate information
about the composition of the CCP’s exposures to clearing members and information provided to
the clearing member for the purposes of the calculation of KCCP, DFCM, and DFCCP. Such
information should be provided no less frequently than the home bank supervisor would require
for monitoring the risk of the clearing member that it supervises. KCCP and KCMi must be
recalculated at least quarterly, and should also be recalculated when there are material changes to
the number or exposure of cleared transactions or material changes to the financial resources of
the CCP. [BCBS, July 2012, Annex 4 par 124]
4.1.9.4. Exposures to Non-qualifying CCPs
142. Banks must apply the Standardised Approach for credit risk in the main framework,
according to the category of the counterparty, to their trade exposure to a non-qualifying CCP.
143. Banks must apply a risk weight of 1250% to their default fund contributions to a non-
qualifying CCP. For the purposes of this paragraph, the default fund contributions of such banks
will include both the funded and the unfunded contributions which are liable to be paid should
the CCP so require. Where there is a liability for unfunded contributions (i.e. unlimited binding
commitments) the national supervisor should determine in its Pillar 2 assessments the amount of
unfunded commitments to which a 1250% risk weight should apply. [BCBS, July 2012, Annex 4
par 127]
4.2. Capital treatment for failed trades and non-DvP transactions

[previously Annex 3]
144. The capital requirement for failed trades and non-DvP transactions outlined in this
Chapter applies in addition to (i.e. it does not replace) the requirements for the transactions
themselves under this framework.

4.2.1. Overarching principles
145. Banks should continue to develop, implement and improve systems for tracking and
monitoring the credit risk exposures arising from unsettled and failed transactions as appropriate
for producing management information that facilitates action on a timely basis. [BCBS June
2006 Annex 3 par 1]
146. Transactions settled through a delivery-versus-payment system (DvP)38, providing

simultaneous exchanges of securities for cash, expose firms to a risk of loss on the difference
between the transaction valued at the agreed settlement price and the transaction valued at
current market price (i.e. positive current exposure). Transactions where cash is paid without
receipt of the corresponding receivable (securities, foreign currencies, gold, or commodities) or,
conversely, deliverables were delivered without receipt of the corresponding cash payment (non-
DvP, or free-delivery) expose firms to a risk of loss on the full amount of cash paid or
deliverables delivered. The current rules set out specific capital charges that address these two
kinds of exposures. [BCBS June 2006 Annex 3 par 2]
147. The following capital treatment is applicable to all transactions on securities, foreign
exchange instruments, and commodities that give rise to a risk of delayed settlement or delivery.
This includes transactions through recognised clearing houses and central counterparties that are
subject to daily mark-to-market and payment of daily variation margins and that involve a
mismatched trade39. Repurchase and reverse-repurchase agreements as well as securities lending
and borrowing that have failed to settle are excluded from this capital treatment 40. [BCBS June
2006 Annex 3 par 3] and [BCBS July 2012, Annex 3, par 3]
148. In cases of a system wide failure of a settlement, clearing system or central

counterparty, a national supervisor may use its discretion to waive capital charges until the
situation is rectified. [BCBS June 2006 Annex 3 par 4] and [BCBS July 2012, Annex 3, par 4]
149. Failure of a counterparty to settle a trade in itself will not be deemed a default for
purposes of credit risk under this guideline. [BCBS June 2006 Annex 3 par 5]
150. In applying a risk weight to failed free-delivery exposures, banks using the IRB
approach for credit risk may assign PDs to counterparties for which they have no other banking
book exposure on the basis of the counterparty’s external rating. Banks using the Advanced IRB
approach may use a 45% LGD in lieu of estimating LGDs so long as they apply it to all failed
trade exposures. Alternatively, banks using the IRB approach may opt to apply the standardised
approach risk weights or a 100% risk weight. [BCBS June 2006 Annex 3 par 6]
38
For the purpose of this guideline, DvP transactions include payment-versus-payment (PvP) transactions.
39
An exposure value of zero for counterparty credit risk can be attributed to payment transactions (e.g. funds
transfer transactions) and other spot transactions that are outstanding with a central counterparty (e.g. a clearing
house), when the central counterparty CCR exposures with all participants in its arrangements are fully
collateralised on a daily basis.
40
All repurchase and reverse-repurchase agreements as well as securities lending and borrowing, including those
that have failed to settle, are treated in accordance with Section 4.1 or the sections on credit risk mitigation of
this guideline.

4.2.2. Capital requirements
151. For DvP transactions, if the payments have not yet taken place five business days after
the settlement date, firms must calculate a capital charge by multiplying the positive current
exposure of the transaction by the appropriate factor, according to the Table 1 below.
Table 1
Number of working days after the Corresponding risk multiplier
agreed settlement date
From 5 to 15 8%
From 16 to 30 50%
From 31 to 45 75%
46 or more 100%
152. A reasonable transition period may be allowed for firms to upgrade their information
system to be able to track the number of days after the agreed settlement date and calculate the
corresponding capital charge. [BCBS June 2006 Annex 3 par 7]
153. For non-DvP transactions (i.e. free deliveries), after the first contractual
payment/delivery leg, the bank that has made the payment will treat its exposure as a loan if the
second leg has not been received by the end of the business day41. This means that a bank under
the IRB approach will apply the appropriate IRB formula set out in this guideline, for the
exposure to the counterparty, in the same way as it does for all other banking book exposures.
Similarly, banks under the standardised approach will use the standardised risk weights set forth
in this guideline. However, when exposures are not material, banks may choose to apply a
uniform 100% risk-weight to these exposures, in order to avoid the burden of a full credit
assessment. If five business days after the second contractual payment/delivery date the second
leg has not yet effectively taken place, the bank that has made the first payment leg will deduct
from capital the full amount of the value transferred plus replacement cost, if any. This
treatment will apply until the second payment/delivery leg is effectively made. [BCBS June
2006 Annex 3, par 8]
41
If the dates when two payment legs are made are the same according to the time zones where each payment is
made, it is deemed that they are settled on the same day. For example, if a bank in Tokyo transfers Yen on day
X (Japan Standard Time) and receives corresponding US Dollar via CHIPS on day X (US Eastern Standard
Time), the settlement is deemed to take place on the same value date.

Appendix 4-1
1. For OTC derivative with non-linear risk profiles (including options and swaptions), for
which the underlying is a debt instrument or a payment leg, the size of the risk position is
equal to the delta equivalent effective notional value of the financial instrument or payment
leg multiplied by the modified duration of the debt instrument or payment leg. [BCBS, June
2006, Annex 4, paragraph 77]
2. Banks may use the following formulas to determine the size and sign of a risk position:
a) for all but debt instruments:
effective notional value, or delta equivalent notional value =
𝜕𝑉
𝑝𝑟𝑒𝑓
𝜕𝑝
where
pref price of the underlying instrument, expressed in the reference currency
v value of the financial instrument (in case of an option: option price; in case of a
transaction with a linear risk profile: value of the underlying instrument itself)
p price of the underlying instrument, expressed in the same currency as v
b) for debt instruments and the payment legs of all transactions:
effective notional value multiplied by the modified duration, or delta equivalent in

notional value multiplied by the modified duration
𝜕𝑉
𝜕𝑟
where
v value of the financial instrument (in the case of an option: option price; in the case
of a transaction with a linear risk profile: value of the underlying instrument itself
or of the payment leg, respectively)
r interest level
If v is denominated in a currency other than the reference currency, the derivative must
be converted into the reference currency by multiplication with the relevant exchange
rate.
[BCBS, June 2006, Annex 4, paragraph 78]


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Guideline

Subject: Capital Adequacy Requirements (CAR)

Chapter 4 - Settlement and Counterparty Risk

Effective Date: November 2017 / January 20181

Chapter 2 Definition of Capital

Chapter 3 Credit Risk – Standardized Approach

Chapter 4 Settlement and Counterparty Risk

Chapter 5 Credit Risk Mitigation

Chapter 6 Credit Risk – Internal Ratings Based Approach

Chapter 7 Structured Products

Chapter 8 Operational Risk

Chapter 9 Market Risk

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

4.1. Treatment of counterparty credit risk and cross-product netting .............................. 4

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

4.1. Treatment of counterparty credit risk and cross-product netting

4.1.1. Definitions and general terminology

4.1.1.1. General terms

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

4.1.1.2. Transaction types

 Long Settlement Transactions are transactions where a counterparty undertakes to

4.1.1.3. Netting sets, hedging sets, and related terms

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

 Distribution of Market Values is the forecast of the probability distribution of net

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

4.1.1.5. Exposure measures and adjustments

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

4.1.1.6. CCR-related risks

4.1.2. Scope of application

5. Such instruments generally exhibit the following abstract characteristics:

6. Other common characteristics of the transactions to be covered may include the

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

7. Exposures to central counterparties arising from OTC derivatives, exchange traded

8. When the clearing member-to-client leg of an exchange traded derivative transaction is

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

4.1.3. Cross-product netting rules8

4.1.3.1. Legal Criteria

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

4.1.3.2. Operational Criteria

4.1.4. Approval to adopt an internal modelling method to estimate EAD

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

4.1.5. Internal Model Method: measuring exposure and minimum requirements

4.1.5.1. Exposure amount or EAD under the internal model method

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

33. Expected exposure or peak exposure measures should be calculated based on a

EAD =   Effective EPE (1)

[BCBS June 2006 and June 2011 Annex 4 par 29]

35. Effective EPE (“Expected Positive Exposure”) is computed by estimating expected

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

Effective EEtk = max(Effective EEtk-1, EEtk) (2)

[BCBS June 2006 Annex 4 par 30]

4.1.5.2. Own estimates for alpha

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

Banks/BHC/T&L/CRA Settlement and Counterparty Risk

48. For transactions subject to daily re-margining and mark-to-market valuation, a

(.4AGross) + (.6AGross *NGR)

ANet = 0.15AGross + 0.85NGR*AGross.