I. Introduction

"Credit derivatives" are instruments recently traded on the financial markets by means of which the credit risk inherent in loans, bonds or other risk assets or market risk positions are transferred to third parties acting as so-called protection sellers. The original credit relationships of the so-called protection buyers (the parties transferring the credit risk) are neither changed nor newly established by this process.

Credit derivatives differ from other, traditional forms of credit risk transfer, such as guarantees or providing collateral security, in that these, as derivatives, are normally

• concluded under standardised master agreements,
• subject to an ongoing market valuation,
• subject to special risk controlling and management.

An additional difference is that the drawing on the credit derivative does not directly constitute a claim on the debtor of the underlying position for the protection seller.

On the following pages I will comment on the questions raised by various institutions from the credit industry regarding the treatment of credit derivatives when applying Part Two and Five of Principle I in the wording of the Announcement of 29 October 1997 (Federal Gazette 1997 p. 13555) - Principle I -, and large exposures or million loans reporting rules.

But first of all, it should be mentioned that the regulations applicable to credit derivatives are based on the current international banking supervisory framework ^[1]. The treatment of credit derivatives is presently discussed in the corresponding fora with the aim to agree on an international solution. The following weighting rules therefore constitute a preliminary solution until the matter has been clarified finally in the competent EU fora or the Basle Committee on Banking Supervision.

Inclusion of credit derivatives on the basis of the existing weighting system means that the prevailing principle of the counting of each risk asset on individual basis remains in place. Accordingly, in Principle I risk-reducing effects which may arise from an active risk management as a result of an improved risk structure of credit portfolios are not considered beyond the level inherent in the current capital requirements, which already constitute a mixed rate. However, if the risk structure of individual institutions deteriorates noticeably owing to an accumulation of credit risks, I shall consider to apply higher capital requirements ("negative Sonderverhältnisse").

II. Basic Types of Credit Derivatives

Basically, three types of products can be distinguished, depending on the kind of risk transferred by the credit derivative:

1. total return swaps
2. credit default swaps
3. credit linked notes

The inclusion of credit derivatives in Principle I as well as under the large exposures and million loans reporting rules as stipulated within the framework of this Circular refers initially to these basic types. If an institution uses credit derivatives which deviate considerably from the basic structures described below or have a different structure as a matter of principle, their consideration under Principle I as well as under the large exposures and million loans reporting rules must be agreed with the Bundesaufsichtsamt für das Kreditwesen (Federal Banking Supervisory Office) in each individual case. This also includes structured products which are deemed to be credit derivatives and classified as such by the institutions only by the combination of their components.

(i) Total Return Swap

In the case of a total return swap, the protection buyer swaps the returns on a reference asset (e.g. a bond) and increases in its value periodically with the protection seller in exchange for payment of a variable or fixed reference interest and compensation of losses in the value of the reference asset

Thus, the protection seller assumes from the protection buyer the overall market risk as well as the credit risk from the reference asset for the term of the transaction.

(ii) Credit Default Swap

In the case of a credit default swap, on the other hand, the protection seller makes a credit default payment only if a pre-defined credit event occurs on the part of the debtor of the reference asset, and receives in return a one-off option premium or, if appropriate, an annualised premium in the case of longer maturities.

The credit default payment may be made

• in the amount of the par value in exchange for physical delivery of the reference asset, or
• in the form of a compensation amounting to the difference between the par value and the recovery value of the reference asset after the occurrence of the credit event, or
• as agreed fixed amount.

As the protection seller is obliged to make the credit default payment only in case of a credit event, merely the credit risk and thus, depending on its specification, only part of the specific market risk is hedged. The protection buyer remains unprotected against those changes in value which are not due to the credit event.

Owing to their asymmetric payment and risk structure, such products have an optional character. Leaving aside annualised premium payments, the contracts also lack the feature of a periodic exchange of pre-defined flows of payments. Nevertheless, they are here referred to as 'swaps', the term usually used in the credit industry. Regardless of this, the treatment of these products under the large exposures and million loans reporting regimes follows the provisions for options.

(iii) Credit Linked Note

A credit linked note is a bond issued by the protection buyer which is to be redeemed at par value on maturity only if a pre-defined credit event does not occur for a reference asset. If the credit event occurs, the credit linked note is redeemed within a fixed period of time, less a compensation amounting, for instance, to the difference between the par value and the recovery value of the reference asset.

The credit linked note constitutes in this respect a combination of a bond and a credit default swap. As in the case of a credit default swap, only the credit risk from the reference asset is secured. Changes in value caused by events other than the pre-defined credit event are not covered on the other hand.

However, in contrast to the credit default and the total return swap, the protection seller makes his money payment in the amount of the loan in advance. On the part of the protection buyer, the collection of the proceeds from the issue of the credit linked note has the effect of a cash-collateralization of the original credit risk.

III. Allocation to the Banking Book or the Trading Book

Credit derivatives are acquired by an institution either as intermediary or as end-user (securing or deliberate assumption of credit risks). They are in principle to be allocated to the trading or to the banking book. Owing to the preliminary character of this Circular, no requirements regarding to the allocation are made for the time being that go beyond those set out in KWG section 1 (12).

Nevertheless, an allocation to the trading book is only possible for those total return or credit default swaps

• that are derivatives within the meaning of KWG section 1 (11) sentence 4 nos. 1 and 2, i.e. the reference assets of which are securities or money market instruments according to KWG section 1 (11) sentence 2 and 3, or
• the reference assets of which are claims meeting the requirements for inclusion in the trading book according to KWG section 1 (12), i.e. which are held with a view to reselling them with the intention to achieve a trading profit and are marked to market on a daily basis.

IV. Treatment under Principle I

1. Requirements for the Banking Supervisory Recognition of a Securing Effect

If the contractual terms of a credit derivative lead to a sufficient transfer of credit risks, this may be considered under Principle I in Part Two when calculating the weighted risk assets, and with a sufficient transfers of market risk in Part Five when calculating the capital charges for market risk positions.

For this purpose, a protection-buying institution must document that the following requirements are fulfilled. The documentation must be submitted to the Bundesaufsichtsamt für das Kreditwesen at the latter's request.

1.1 Effectiveness of the Risk Transfer

A general requirement for the recognition of a risk-reducing effect of credit derivatives when weighting the protected risk assets or market risk positions of the protection buyer under Principle I is that the credit or market risks in question are transferred to the protection seller in a verifiable and effective manner. In this context, it must be ensured that the factors which are of importance for the valuation of the asset to be protected, including also e.g. political risks, are considered in the specification of the credit event. As minimum, insolvency of the reference debtor must be assigned for credit event.

The effectiveness and legal validity of the transfer may be documented by the legal department of the protection-buying institution. This documentation must set out in a comprehensible manner that

• the envisaged transfer of risk is actually achieved by the terms of the contract, i.e., for example, that the credit events triggering the payment as well as the amount of the default payment are sufficiently defined and that there is agreement on the valuation method for the reference asset,
• the orderly performance of the contract does
• neither collide with legal regulations in the possible legal systems
• nor with arrangements in the contract itself or in relevant master agreements, such as exclusive rights of the protection seller to give notice of termination.

Where already documented contract texts or texts recommended by a central association of banks or financial services institutions are used, this fact may be referred to in the documentation.

Where the credit derivative is denominated in a different currency from the risk asset or market position collateralized, the amount of credit protection has to be reviewed regularly by marking to market procedures.

1.2 Identity of the Reference Asset and the Asset to Be Protected

For the regulatory recognition of a securing effect it is required that given the specification of the credit event the reference asset and the asset to be protected are identical as regards the credit risk to be considered according to the rules of Part Two or the market risk to be considered according to the rules of Part Five.

1.2.1 Banking Book

As both the realisation of the credit event and the amount of the credit default payments are influenced by the reference asset, applying the rules of Part Two a securing effect of a risk asset can only be recognised, if the reference asset underlying the derivative

• is owed by the same person as the risk asset in question,
• may not have priority over this risk asset in case of the debtor's insolvency,
• is linked with the risk asset by corresponding contractual clauses in respect of the triggering credit event^[2].

1.2.2 Trading Book

The capital charges for the general and the specific market risk are calculated in Part Five on the basis of net positions. The requirements for the netting of securities or of the securities legs resulting from the splitting of derivatives set out in Principle I section 19 (3) shall be applied to credit derivatives without restriction. Only if the requirements listed therein are met, one can expect precisely opposing market price changes justifying an offset.

Credit default swaps and credit linked notes protect solely against those parts of the specific market risk which are related to the credit event. Therefore, the changes in their market value will not be correlated completely negatively with the hedged position so that an offset between position and credit derivative in the case of a protection buying institution is not possible. This may be different if an institution appears as intermediary, i.e. if the offsetting situation between long and short positions in credit derivatives is considered. But even then, Principle I section 19 (3) will prevail.

1.3 Maturity Criterion in the Banking Book

To be recognised in terms of banking supervision, the risk asset to be protected must, in principle, be secured by a credit derivative for its entire residual maturity.

If the residual maturity of the credit derivative is shorter than that of the risk asset to be protected - maturity mismatch - the credit risk for the unprotected future period remains with the protection buyer. According to the usual requirements made on guarantees or the provision of security, supplying security for a risk asset by means of a credit derivative could not lead to a capital relief in these cases. However, the special character of credit derivatives - as outlined in the introduction - allows the treatment to diverge within narrow limits. Accordingly, in the case of a maturity mismatch a securing effect is recognised for the period over which the risk asset is protected, provided the credit derivative has a residual maturity of at least one year.

In this context it should be taken into account that assuming the entire credit risk from the protected asset at the end of the maturity of the credit derivative corresponds to the forward risk an institution is exposed to when undertaking to buy a particular position in the future. This forward risk for the unprotected period must additionally be counted on the part of the protection buyer at 50 % of the assessment basis of the risk asset, unless the capital charge exceeds the level before hedging.

However, if in the case of maturity mismatches the residual maturity of the credit derivative is less than one year, a capital relief resulting from the hedge is ruled out.

2. Weighting in Case of Risk Assets in Part Two of Principle I

2.1 Total Return Swap / Credit Default Swap

2.1.1 Consideration on the Part of the Protection Buyer

If an asset item within the meaning of Principle I section 4 sentence 2 no. 1 or an off-balance-sheet transaction within the meaning of Principle I section 4 sentence 2 no. 2 is protected by means of

• a total return swap against changes in value or
• a credit default swap against the risk of default by the debtor of the risk asset,

the protection-buying institution may consider it to be explicitly guaranteed if the requirements mentioned under IV.1.1 to IV.1.3 are fulfilled. When calculating the risk asset capital charge, the risk weight of the protection seller may then be considered in accordance with Principle I section 13^[3]. The extent to which the hedging is to be recognised is determined by the certainty of the default payment, which must be documented pursuant to IV.1.1.

In the case of a maturity mismatch, the forward risk must be counted in addition, unless the residual maturity of the credit derivative excludes a recognition of the securing effect.

If no effective hedging exists, a total return swap must be allocated to the risk assets of the protection buyer as swap transaction according to Principle I section 4 sentence 2 no. 3. A credit default swap without securing effect is disregarded because it involves no replacement risk.

2.1.2 Consideration on the Part of the Protection Seller

Regardless of whether the transfer of the credit risk is to be recognised from the view of the protection buyer, for the purposes of Principle I the obligation incurred by the protection seller is regarded as off-balance-sheet transaction within the meaning of Principle I section 4 sentence 2 no. 2, which must be counted at 100 % of the assessment basis pursuant to Principle I section 8 no. 1. Any collateral at the protection buyer's disposal may not be counted by the protection seller to reduce the capital charge.

2.2 Credit Linked Note

2.2.1 Consideration on the Part of the Protection Buyer

If the requirements under IV.1.1 to IV.1.3 are fulfilled, the risk asset may be weighted at 0 % in accordance with Principle I section 13 (1) no. 2e). In the case of maturity mismatch, no securing effect shall be recognised if the credit linked note has a residual maturity of less than one year. In the case of longer maturities, the forward risk is to be considered
2.2.2 Consideration on the Part of the Protection Seller

The protection seller must include the credit linked note as on-balance-sheet asset at its assessment basis. Although the protection buyer is the obligor of the note, the amount of the redemption depends both on the financial standing of the debtor of the reference asset and also on that of the protection buyer. Therefore, the credit linked note must always be counted at the higher of the two risk weights (protection buyer/reference debtor).

Table 1: Consideration of Credit Derivatives in the Banking Book

Table 1: Consideration of Credit Derivatives in the Banking Book

	Protection buyer		Protection seller
	If securing effect is recognised*	Without securing effect
Total Return Swap	Recognition as guarantee plus counting of the forward risk in the case of a maturity mismatch	Counting as swap transaction	Counting of the incurred securing obligation as off-balance-sheet transaction according to Principle I section 4 sentence 2 no. 2
Credit Default Swap	Recognition as guarantee plus counting of the forward risk in the case of a maturity mismatch	No counting	Counting of the incurred securing obligation as off-balance-sheet transaction according to Principle I section 4 sentence 2 no. 2
Credit Linked Note	Recognition as cash collateral plus counting of the forward risk in the case of a maturity mismatch	No counting	Allocation of the credit linked note to the risk assets at the higher of the risk weights of the protection buyer or the reference debtor

* According to IV.1.1, IV.1.2.1 and IV.1.3 a recognition of the securing effect presupposes an effective transfer of risk, identity of reference and risk asset as well as in the case of residual maturities of less than one year maturity match of the credit derivative and the risk asset to be protected.

3. Weighting in the Case of Trading Book Risk Positions in Part Five of Principle I

3.1 Total Return Swap

Delivery rights and obligations from total return swaps to be included in the trading book risk positions shall be counted in accordance with the general rules set out in Part Five, i.e. a total return swap must be split up into two legs: a position in the reference asset (security component) and one from the interest component (financing component), which must be included as fictious floating rate note or fixed-interest security, depending on the form of the swap. For the financing component, only the general market risk must be considered; as so-called derivative net interest position it is disregarded in the calculation of the specific market risk, according to Principle I section 23 (2).

If the requirements of Principle I section 19 (3) are fulfilled, an existing long position in the asset and the short position resulting from the security component of the total return swap may be offset on the part of the protection buyer.

3.2 Credit Default Swap

The specific market risk inherent in a credit default swap must be considered by means of a synthetic position which amounts to the promised credit default payment upon the occurrence of the credit event and with maturity of the credit default swap (security component). It must be weighted at the nominal value, i.e. without discounting. As the credit default payment represents the specific market risk in respect of the debtor of the reference asset, it must be included as being owed by him. In the calculation of the partial capital charge for the general market risk, the credit default payment is disregarded.

The protection seller must include the specific market risk assumed through the credit default swap as synthetic long position, the protection buyer must include it as synthetic short position. If the protection buyer assumes no additional specific market risk from the acquired credit default swap, no specific market risk needs to be counted in addition to the market risk position to be hedged. But the short position must be considered, for example, if a protection-selling institution resells the credit risk as intermediary.

As a general rule, institutions may offset the synthetic positions in the respective credit default payments incurred from credit default swaps only if the requirements according to Principle I section 19 (3) are fulfilled.

If the protection buyer is obliged to pay a periodic premium to the protection seller, both parties must consider this payment as financing component of the swap when calculating the partial capital charge for the general market risk. In addition to that, no general market risk is to consider undertaking a position in a credit default swap.

3.3 Credit Linked Note

A credit linked note can be considered to be a combination of a loan and a credit default swap. If the credit linked note is allocated to the trading book risk positions, the protection seller must count

• a long position in the bond issued by the protection buyer when calculating the partial capital charges for the general and the specific market risk, and
• solely for the area of the specific market risk, additionally a synthetic long position amounting to the maximum decrease of the redemption amount of the credit linked note and relating to the reference debtor (security component of the credit default swap).

If the protection buyer allocates the credit linked note to the trading book risk positions in accordance with KWG section 1 (12) sentence 1 no. 2, he must count

• a short position in the note issued by himself when calculating the partial capital charges for the general market risk, and
• for the area of the specific market risk, a synthetic short position amounting to the maximum decrease of the redemption amount of the credit linked note and relating to the reference debtor (financing component of the credit default swap).

But analogous to the credit default swap, no specific market risk needs to be counted in addition to that of the market risk position to be hedged, provided the protection buyer assumes no additional specific market risk through the credit linked note.

Table 2: Consideration of Credit Derivatives in the Trading Book

Table 2: Consideration of Credit Derivatives in the Trading Book

		Protection Buyer	Protection Seller
Total Return Swap	General market risk	Short position in the reference asset (offset against long position in the hedged instrument possible subject to Principle I section 19 (3)) and long position as financing component	Long position in the reference asset and short position from financing component
	Specific market risk	Short position in the reference asset (offset against long position in the hedged instrument possible subject to Principle I section 19 (3))	Long position in the reference asset
Credit Default Swap	General market risk	Counting of the financing component as position in the case of periodic premium payments	Counting of the financing component as position in the case of periodic premium payments
	Specific market risk	Synthetic short position in the amount of the credit default payment upon the occurrence of the credit event related to the reference debtor and with maturity of the swap transaction, but counting only as far as in excess of the position to be protected	Synthetic long position in the amount of the credit default payment upon the occurrence of the credit event related to the reference debtor and with maturity of the swap transaction
Credit Linked Note	General market risk	Short position in own bond	Long position in bond of the issuer
	Specific market risk	Synthetic short position in the amount of the credit default payment upon the occurrence of the credit event related to the reference debtor and with maturity of the note, but counting only as far as in excess of the position to be protected	Long position in loan of the issuer and additionally in the amount of the credit default payment upon the occurrence of the credit event related to the reference debtor and with the maturity of the note

4. Counterparty Risk

4.1 Banking Book

If, applying Principle I, a credit derivative is weighted according to the provisions of Part Two, no additional consideration of the counterparty risk from the derivative is required on the part of the protection seller because a possible failure of the protection buyer causes the protection seller no losses exceeding the level of the guarantee to be already considered according to IV.2.1.2.

If the securing effect from the credit derivative is recognised on the part of the protection buyer, the risk asset protected may be counted at the risk weight of the protection seller. Considering a counterparty risk in addition to that would exaggerate the actual risk. This is different, however, if the requirements for recognition of a securing effect are not fulfilled. In this case - as mentioned under IV.2.1.1 - a total return swap from which the protection buyer receives periodic payments must be allocated as swap to the risk assets, taking account of the counterparty risk.

4.2 Trading Book

4.2.1 Total Return Swap

In the case of a total return swap, both the protection buyer and the protection seller may be affected by a failure of the counterparty, depending on the development of the value of the reference asset. Therefore, both parties must weight the counterparty risk in accordance with Principle I section 27 (1) no. 4.

4.2.2 Credit Default Swap

In the case of a credit default swap, the risk from a failure of the counterparty is spread asymmetrically: Apart from annualised premium payments, where necessary, the protection seller suffers no loss from the failure of the protection buyer, whereas the protection buyer may incur replacement costs if the protection seller fails and a replacement contract is concluded. The protection buyer must take account of this by applying Principle I section 27 (1) no. 4.

4.2.3 Credit Linked Note

In the case of a credit linked note, the counterparty risk assumed by the protection seller buying the note is identical to the risk of a failure of the issuer. This is already taken account of because the loan must be counted as long position under the specific market risk net interest positions. Beyond this, no further counterparty risk must be considered.

The protection buyer is not required to consider a counterparty failure risk for the credit default swap component resulting from the splitting of the credit linked note either as the protection seller has already performed his obligation when buying the note.

4.3 Add-ons

The counterparty risk must be weighted in accordance with the marking-to-market method pursuant to Principle I section 10. The table listing the add-ons to be applied when employing the marking-to-market method (Principle I section 10 Table 1) provides no separate category for credit risks. Although no empirical figures regarding changes in the value of credit derivatives are available yet, application of the highest add-on category, as usually required in such cases, is not prescribed.

Owing to the different securing capacity of total return and credit default swaps, different add-ons are applied.

4.3.1 Total Return Swap

Total return swaps generate a synthetic position in the reference asset so that it must be assumed that the development of the value is primarily determined by the same factors as the reference asset. Accordingly, total return swaps attract the add-on category applicable to the asset underlying the swap.

4.3.2 Credit Default Swap

The main factor determining the development of the potential future replacement cost in the case of credit default swaps, however, is the development of the financial standing of the debtor from the reference asset. From the possible categories, the risk factor ‘financial standing’ is in so far best represented by the equity-price related risk as the latter includes the aspect of subordination in relation to the lender. Until further notice, the add-ons applicable to equity-price related transactions must therefore also be applied to credit default swaps. If the reference asset is deemed to be a qualifying paper within the meaning of Principle I section 23 (3) sentence 2, the add-ons applicable to interest-related transactions may be used.

Table 3: Consideration of the Counterparty Risk Involved in Credit Derivatives According to Principle I sections 9, 27 (1) No. 4

Table 3: Consideration of the Counterparty Risk Involved in Credit Derivatives According to Principle I sections 9, 27 (1) No. 4

	Banking Book	Trading Book
Total Return Swap	No weighting *	Add-on depending on the nature of the reference asset
Credit Default Swap	No weighting	Add-on applicable to interest-rate related transactions if the reference asset is a qualifying paper equity-price related add-on in all other cases
Credit Linked Note	No weighting	No weighting

* A counterparty risk must only be included if the securing effect is not recognised and, if so, solely on the part of the protection buyer. The add-on to be applied in this case depends on the nature of the reference asset.

V. Treatment Under the Provisions Concerning Large Exposures and Million Loans Reporting Regime

1. Provisions Concerning Large Exposures

1.1 Total Return Swap / Credit Default Swap

As regards the protection buyer, the securing effect from total return swaps, which is acknowledged under the large exposures regime, resembles the effect of credit default swaps. As regards the protection seller, however, differences result from the different payment and risk structures of these two product categories as already mentioned in the introduction. Owing to the option-like character of credit default swaps, the rules for options rather then swaps are to be applied to the extent they differ with respect to the provisions concerning large exposures and million loans reporting.

1.1.1 Consideration on the Part of the Protection Buyer

(a) Acknowledgement of the Securing Effect

Total return and credit default swaps reduce the weighted exposure in principle (the exception is described in the following paragraph) only analogous to the statutory requirements set forth in KWG section 20 (2) sentence 1 no. 1 subparagraph e); accordingly, the protection seller must belong to one of the categories of institutions listed in KWG section 20 (2) sentence 1 no. 1 subparagraphs a) to d). Furthermore, the protection seller must be explicitly responsible for the repayment of the loan or other exposure.

The situation is more favourable where the total return or credit default swap and the loan to be protected are allocated to the trading book. Here, it is possible to classify the securing transaction as forward sale according to GroMiKV^[**] section 38 (1) sentence 3 no. 1, provided the protection seller is also explicitly responsible for the repayment of this loan. The consideration of the securing effect with relief from weighting is irrespective of whether the protection seller belongs to a privileged category of counterparties.

(b) Exposure to the protection seller

Formally the protection buyer is exposed to the protection seller according to KWG section 19 (1) - group "derivatives (other than written option positions)"^[4]. Where the securing transaction results in a relief from weighting the exposure applying KWG section 20 (2) sentence 1 no. 1 subparagraph e), the exposure to the protection seller need not be considered in accordance with KWG section 20 (2) no. 1, (3) sentence 1. Where, however, the securing total return or credit default swap are allocated to the trading book and used to lower the issuer-related net long position, the exposure to the protection seller (KWG section 19 (1) - group "derivatives (other than written option positions)") must be considered^[5]

The legal requirements for consideration of the loan agreement with the protection seller would also be clearly fulfilled where no lower capital charges as a result of the securing effect can be applied because the protection seller does not belong to the bodies according to KWG section 20 (2) no. 1, for example, or due to a maturity mismatch. But in the end, an institution would be "punished" for securing - albeit incompletely - the counterparty risk resulting from the reference asset economically. Although this consequence would not clearly conflict with the objective of the law, it would rather be detrimental than beneficial to it. For this reason, it is conceded until further notice that an institution in such a constellation need not classify its claim from the credit derivative as exposure and count it towards exposure limits. This concession is subject to revision at short notice.

1.1.2 Consideration on the Part of the Protection Seller

(i) Total Return Swap

For the protection seller there are two exposures resulting from the swap transaction - regardless of maturity mismatches: one addressed to the protection buyer (KWG section 19 (1) - group "derivatives (other than written option positions)")^[6], the other addressed to the debtor of the reference asset (KWG section 19 (1) - group "other off-balance-sheet transactions")^[7]; the protection seller must charge his large exposure limits in respect of both counterparties correspondingly.

When calculating the utilisation of the aggregated large exposure limits^[8], only one exposure rather than both, namely the higher one, must be considered; the reason for this is that the counterparty risk can realise itself economically only once, either through decreases in the value of the reference asset, which are accompanied by negative replacements costs from the swap transaction, or in the case of positive replacement costs through a failure of the protection buyer. For the calculation of the capital charges for possible excess positions, the above mentioned shall be applied analogously. It corresponds to the treatment under banking book positions in Principle I.

(ii) Credit Default Swap

The protection seller must weight the credit default swap as exposure addressed to the debtor of the reference asset (KWG section 19 (1) - group" other off-balance-sheet transactions")^[9], provided he is responsible for the repayment of the loan to be protected or is, even if only temporarily, responsible for the solvency of the debtor.

The obligation to the protection buyer, which resembles the position of a put option writer, constitutes no separate exposure.

1.2 Credit Linked Note

1.2.1 Consideration on the Part of the Protection Buyer

(a) Acknowledgement of the Securing Effect

The amount which the protection-buying institution has received against the issue of the bond must be considered - analogous to KWG section 20 (2) sentence 1 no. 2 subparagraph b) - as amount not to be included in the computation of the large exposure limits^[10]. However, if the residual maturity of a credit linked note is shorter than that of the secured loan and an equivalent ongoing protection does not exist either, any application of acknowledgement is ruled out; the protection buyer must continue to include the entire exposure to be protected in the computation of the large exposure limits. In contrast to Principle I, the large exposure regulations stipulates that the problem of the ongoing protection - unless solved within the legal standards - precludes a relief for large exposure computation.

(b) Exposure to the Protection Seller

From the view of the protection buyer, the credit linked note constitutes no exposure within the meaning of KWG section 19 (1); therefore, the securing agreement does not burden the large exposure limits.

1.2.2 Consideration on the Part of the Protection Seller

For the protection seller/purchaser there are two exposures resulting from the purchase of the credit linked note - regardless of maturity mismatches: one addressed to the protection buyer (KWG section 19 (1) - group "balance-sheet assets")^[11], the other addressed to the debtor of the reference asset (KWG section 19 (1) - group "other off-balance-sheet transactions")^[12]. The protection seller must burden his large exposure limits in respect of both counterparties correspondingly. It is true that the protection seller/purchaser hands out the amount of money only once; but he puts its repayment to the solvency of both counterparties.

When calculating the utilisation of the aggregated large exposure limits^[13], only one (the higher) loan amount must be considered; the reason for this is that the counterparty risk can realise itself economically only once - namely to the maximum level of the notional amount of the note. For the calculation of the capital charges for possible excess positions, the above mentioned shall be applied analogously.

2. Million Loans Reporting

To avoid any double recording, GroMiKV section 50 (5) applies as a matter of principle.

2.1 Consideration on the Part of the Protection Buyer

In contrast to the large exposure regime, the loan protected by a credit derivative must be fully included in the million loans reporting as there is no legal basis for an exemption from the reporting requirements.

The exposure to the protection seller from a total return or credit default swap must be reported if their securing effect is taken account of in the large exposure regime according to V.1.1.1 (a). Otherwise, the facility according to V.1.1.1 (b) second paragraph applies, i.e. in the case of an incomplete hedge, the credit derivative is not considered as loan.

The issue of a credit linked note is in this context not subject to the reporting requirements.

2.2 Consideration on the Part of the Protection Seller

Analogous to the provisions in the large exposure regime under V.1.1.2 and V.1.2.2, in the case of total return swaps and credit linked notes two exposures must be reported - with regard to the protection-buying issuing institution and to the reference debtor.

If an institution supplies security for a loan by means of a credit default swap, on the other hand, it must only report the exposure to the reference debtor which results from the writing of the put option.

VI. Final Remarks

If an institution acquires credit derivatives and either uses them to hedge risk assets or allocates them to the net positions, the audit report on the annual accounts must comment on the compliance with the requirements regarding the effectiveness of the transfer of the credit risks. Moreover, it must address the influence on the credit risk structure, especially possible trends towards concentration, in the case of all institutions transacting credit derivatives business.

Finally, I would like to point out that my Statement Covering Minimum Requirements for the Trading Activities of Credit Institutions applies to credit derivatives without restrictions.

^[1]

These are the Directives of the Council of the European Communities 89/647/EEC of 18 December 1989 - Solvency Ratio Directive - and 93/6/EEC of 15 March 1993 - Capital Adequacy Directive - on the one hand, and the Capital Accord of the Basle Committee on Banking Supervision of July 1988, as supplemented by the Amendment to incorporate market risks of January 1996, on the other hand.

^[2]

This requirement that in master agreements is usually called cross or obligation default clause is meant to ensure that the occurrence of the credit event in the case of the risk asset also triggers the payment from the credit derivative based on the reference asset.

^[3]

A facilitated weighting according to Principle I section 13 (4) no. 1 is ruled out.

^[**]

Großkredit- und Millionenkreditverordnung - Regulation Governing Large Exposures and Million Loans Reporting

^[4]

Assessment basis for total return swaps GroMiKV section 2 no. 2, for credit default swaps GroMiKV section 2 no. 3

^[5]

Assessment basis for total return swaps GroMiKV section 2 no. 2, for credit default swaps GroMiKV section 2 no. 3

^[6]

Assessment basis GroMiKV section 2 no. 2

^[7]

Assessment basis GroMiKV section 2 no. 7

^[8]

The overall large exposure limit (KWG section 13 (3) sentence 5), the aggregate large exposure limit for overall business (KWG section 13a (4) sentence 5), and the aggregate excess position (KWG section 13a (5) sentence 3)

^[9]

Assessment basis GroMiKV section 2 no.7

^[10]

Large exposure definition limits, large exposure reporting limits, large exposure decision limits and overall large exposure limit

^[11]

Assessment basis GroMiKV section 2 no. 1, unless GroMiKV section 38 applies as specific provision for this area

^[12]

Assessment basis GroMiKV section 2 no. 7, unless GroMiKV section 38 applies as specific provision for this area

^[13]

The overall large exposure limit (KWG section 13 (3) sentence 5), the aggregate large exposure limit for overall business (KWG section 13a (4) sentence 5), and the aggregate excess position (KWG section 13a (5) sentence 3)