The Basel Committee on Banking Supervision’s rules for determining the amount of capital relief banks can achieve by hedging credit risk have most likely been called a lot of things by tired and frustrated risk managers over the years. ‘Hot’ is probably a new one.

That, though, is exactly how the Wall Street Journal describes hedges that result in capital relief in a recent article (The Hot Thing for Wall Street Banks: Capital-Relief Trades). The starting point is a report published by the US Office of Financial Research back in June, which considers the use of credit default swaps (CDS) by banks. The WSJ picks up on some of the points in this report, and contains a variety of views on the extent and use of so-called capital-relief trades.

It’s an interesting article on an interesting topic. So we thought we’d add a few additional observations, building on some of the comments we made in our last media.comment post.

First, banks need to continually monitor and manage the risk posed by their loan books and other exposures. Left alone, these loan books would likely reflect the geographic and sector characteristics of their client base. Without active management of their portfolios, banks would quickly reach concentration limits, restricting their ability to lend further. Managing risks such as these is a primary motivation for banks when deciding whether to hedge.

Second, as the WSJ article points out, regulators have long allowed banks to obtain capital relief if they hedge the risks they are exposed to. The reason is intuitively quite simple. If a bank makes a loan to Company A, it’s exposed to the risk that Company A may go bankrupt and not be able to repay the loan. It has to hold capital against that risk – the riskier the borrower, the more capital the bank has to hold. By putting on a hedge, the bank is less exposed to the credit risk of the borrower, and so is able to reduce the amount of capital it has to hold against the loan. Buying CDS protection is one of the many ways banks manage the risk of their loan books, but there are strict rules governing the amount of capital relief banks can obtain.

That’s not quite the end of it, though. Banks have to hold capital against the CDS protection they’ve purchased too. That is largely determined by the counterparty credit risk posed by the protection seller. But capital requirements for single-name CDS transactions have increased across the board under Basel III.

Capital isn’t the only line of protection. The vast majority of these CDS hedges will also be backed by collateral (unlike many of the original loans). This collateral is meant to cover the possibility of a loss arising from one of the counterparties failing to meet its obligations under the derivatives trade. Under new margin rules for non-cleared derivatives, these trades will be subject to mandatory initial margin as well as variation margin from next year.

Turning to the issue of transparency: how do we know how much capital relief US banks have obtained through their CDS hedges? There are various ways. For one thing, US banks submit quarterly filings to the Federal Reserve, which includes data on the amount of credit protection recognized for regulatory capital purposes. As we pointed out in our last media.comment post, this information is publicly available. Second, those banks that apply the internal ratings based approaches to Basel III – so, pretty much all the big Wall Street banks mentioned in the WSJ article – have to publicly disclose the impact of credit risk mitigation techniques on risk-weighted assets (RWAs) within their Basel Pillar III disclosures (see page 32 of this document). Smaller banks using the standardized approach aren’t required to report pre- and post-credit derivatives RWAs, but they do have to disclose a variety of other information related to credit risk mitigation techniques.

A final point. Regulators can also discover the identity of the counterparties that have sold the CDS protection to the banks. Under the Dodd-Frank Act, all derivatives trades have to be reported to a trade repository, giving regulators the ability to scrutinize these transactions down to the counterparty level.