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MIPRU 4.2C Credit risk mitigation

Application

MIPRU 4.2C.1R

This section applies to a firm carrying on any home financing connected to regulated mortgage contracts or home financing and home financing administration connected to regulated mortgage contracts see 1MIPRU 4.2.23 R where it applies credit risk mitigation1 to the calculation of its risk weighted exposure amounts under MIPRU 4.2A (Credit risk capital requirement)1.

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Purpose

MIPRU 4.2C.2G

MIPRU 4.2C sets out the provisions a firm should comply with when calculating risk weighted exposure amounts for calculating the credit risk capital requirement1 under MIPRU 4.2.23 R.

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Organisation1

MIPRU 4.2C.2AG

1This section is organised as follows:

  1. (1)

    High-level principles (MIPRU 4.2C.5 R to MIPRU 4.2C.9 R)

  2. (2)

    Minimum operational requirements (MIPRU 4.2C.10 R to MIPRU 4.2C.15 R)

  3. (3)

    Eligibility (MIPRU 4.2C.16 R)

  4. (4)

    Calculating the effects of credit risk mitigation (MIPRU 4.2C.17 R to MIPRU 4.2C.31 G)

  5. (5)

    Sovereign guarantees (MIPRU 4.2C.32 R)

  6. (6)

    Combinations of credit risk mitigation (MIPRU 4.2C.33 R to MIPRU 4.2C.34 R)

1

High-level principles1

MIPRU 4.2C.5R

1A firm may recognise credit risk mitigation under this section in calculating risk weighted exposure amounts for calculating the credit risk capital requirement.

MIPRU 4.2C.6R
  1. (1)

    1If a firm transfers part of the risk of a loan in one or more tranches, MIPRU 4.2BA (Securitisation) applies.

  2. (2)

    Materiality thresholds below which no payment shall be made by the provider of credit protection in the event of loss are considered to be equivalent to retained first-loss positions and to give rise to a tranched transfer of risk.

MIPRU 4.2C.7R

1The technique used to provide credit protection, together with the actions and steps taken and procedures and policies implemented by a firm, must result in credit protection arrangements which are legally effective and enforceable in all relevant jurisdictions.

MIPRU 4.2C.8R
  1. (1)

    1A firm must not recognise credit protection as eligible until it has conducted an adequate legal review confirming that the credit protection arrangements are legally effective and enforceable in all relevant jurisdictions, in accordance with MIPRU 4.2C.7 R.

  2. (2)

    A firm must conduct further legal reviews as necessary, to ensure continuing enforceability and effectiveness.

MIPRU 4.2C.9R

1A firm must take steps to ensure the effectiveness of the credit protection arrangement and to address related risks.

1Minimum requirements: operational

MIPRU 4.2C.10R
  1. (1)

    1A firm must satisfy the FCA that it has adequate risk management processes to control the risks to which it may be exposed as a result of carrying out credit risk mitigation.

  2. (2)

    These processes must include appropriate stress tests and scenario analyses relating to those risks, including residual risk and the risks relating to the intrinsic value of the credit risk mitigation.

MIPRU 4.2C.11R

1A firm must:

  1. (1)

    satisfy the FCA that it has systems to manage risks arising from its use of credit protection; and

  2. (2)

    demonstrate how its strategy on the use of credit protection interacts with the firm's management of its overall risk profile.

MIPRU 4.2C.12R

1Even where a firm recognises credit risk mitigation when calculating risk weighted exposure amounts, it must:

  1. (1)

    continue to undertake full credit-risk assessment of the underlying exposure; and

  2. (2)

    demonstrate to the FCA the fulfilment of the requirement in (1).

1Minimum requirements: effectiveness

MIPRU 4.2C.13R

1For credit protection to be recognised, the following conditions must be met:

  1. (1)

    it must be direct;

  2. (2)

    the extent of the credit protection must be clearly defined and incontrovertible;

  3. (3)

    the credit protection contract must not contain any clause which is outside the direct control of the lender to fulfil and which:

    1. (a)

      would allow the protection provider unilaterally to cancel the protection; or

    2. (b)

      would increase the effective cost of protection as a result of deteriorating credit quality of the protected exposure; or

    3. (c)

      could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original borrower fails to make any payments due; or

    4. (d)

      could allow the maturity of the credit protection to be reduced by the protection provider; and

  4. (4)

    it must be legally effective and enforceable in all jurisdictions which are relevant at the time of the conclusion of the credit agreement.

MIPRU 4.2C.14G

1A clause that allows the protection provider unilaterally to cancel the contract after a reasonable period due to non-payment of premiums and other monies due under the contract will not normally indicate non-compliance with MIPRU 4.2C.13R (3)(a). The reason is that payment of such monies is within the control of the firm.

MIPRU 4.2C.15R

1For a guarantee, including those in the form of mortgage indemnity products, to be recognised, the following conditions must be met in addition to those in MIPRU 4.2C.13 R:

  1. (1)

    on the qualifying default of and/or non-payment by the borrower, the firm must have the right to pursue, in a timely manner, the guarantor for any monies due under the claim for which the protection is provided;

  2. (2)

    payment by the guarantor must not be subject to the firm first having to pursue the borrower;

  3. (3)

    for credit protection covering residential mortgage loans, the requirement in MIPRU 4.2C.13R (3)(c) and in this rule have only to be satisfied within 24 months;

  4. (4)

    the guarantee must contain an explicitly documented obligation assumed by the guarantor;

  5. (5)

    unless (6) applies, the guarantee must cover all types of payments the borrower is expected to make in respect of the claim, such as principal, interest payments and fees; and

  6. (6)

    where certain types of payment are excluded from the guarantee, the recognised value of the guarantee must be adjusted to reflect the limited coverage.

1Eligibility

MIPRU 4.2C.16R

1For unfunded credit protection:

  1. (1)

    to be eligible for recognition:

    1. (a)

      the party giving the undertaking must be sufficiently reliable; and

    2. (b)

      the protection agreement must be legally effective and enforceable in the relevant jurisdictions, to provide appropriate certainty as to the credit protection achieved, having regard to the approach used to calculate risk weighted exposure amounts and to the degree of recognition allowed; and

  2. (2)

    protection must be provided by central governments or central banks.

1Calculating the effects of credit risk mitigation

MIPRU 4.2C.17R

1The calculation of risk weighted exposure amounts may be modified in accordance with this section where a firm has complied with MIPRU 4.2C.7 R to MIPRU 4.2C.16 R.

MIPRU 4.2C.18R

1No exposure for which credit risk mitigation is obtained may produce a higher risk weighted exposure amount than an otherwise identical exposure for which there is no credit risk mitigation.

MIPRU 4.2C.19R

1Where the risk weighted exposure amount already takes account of credit protection, the calculation of the credit protection must not be further recognised under MIPRU 4.2C (Credit risk mitigation).

1Valuation

MIPRU 4.2C.20R

1The value of unfunded credit protection is the amount that the protection provider has undertaken to pay in the event of the default of, or non-payment by, the borrower or on the occurrence of other specified credit events.

1Currency mismatches

MIPRU 4.2C.21R

1Where unfunded credit protection is denominated in a currency different from that in which the exposure is denominated (a currency mismatch) the value of the credit protection must be reduced by the application of a volatility adjustment HFX as follows:

G* = G x (1-HFX)

where:

  1. (1)

    G is the nominal amount of the credit protection;

  2. (2)

    G* is G adjusted for any foreign currency risk; and

  3. (3)

    HFX is the volatility adjustment for any currency mismatch between the credit protection and the underlying obligation.

MIPRU 4.2C.22R

1For the purpose of MIPRU 4.2C.21 R, HFX is set at 10%.

MIPRU 4.2C.23R

1For the purpose of MIPRU 4.2C.21 R, where there is no currency mismatch:

G* = G

1Maturity mismatches

MIPRU 4.2C.24R
  1. (1)

    1In calculating risk weighted exposure amounts, a maturity mismatch occurs where the residual maturity of the credit protection is less than that of the protected exposure.

  2. (2)

    Protection of less than three months residual maturity, the maturity of which is less than the maturity of the underlying exposure, must not be recognised.

MIPRU 4.2C.25R

1Where there is a maturity mismatch the credit protection must not be recognised if the original maturity of the protection is less than one year.

MIPRU 4.2C.26R
  1. (1)

    1Subject to a maximum of five years, the effective maturity of the underlying exposure is the longest possible remaining time before the borrower is scheduled to fulfil its obligations.

  2. (2)

    Unless MIPRU 4.2C.27 R applies, the maturity of the credit protection is the length of time to the earliest date at which the protection may terminate or be terminated.

MIPRU 4.2C.27R
  1. (1)

    1Where there is an option to terminate the protection which is at the discretion of the protection seller, the maturity of the protection must be taken to be the length of time to the earliest date at which that option may be exercised.

  2. (2)

    Where there is an option to terminate the protection which is at the discretion of the protection buyer and the terms of the arrangement at the origination of the protection contain a positive incentive for the firm to call the transaction before contractual maturity, the maturity of the protection must be taken to be the length of time to the earliest date at which that option may be exercised; otherwise such an option may be considered not to affect the maturity of the protection.

MIPRU 4.2C.28R
  1. (1)

    1The maturity of the credit protection and that of the exposure must be reflected in the adjusted value of the credit protection according to the following formula:

    GA = G* x (t-t*)/(T-t*)

    where:

    1. (a)

      G* is the amount of the protection adjusted for any currency mismatch;

    2. (b)

      GA is G* adjusted for any maturity mismatch;

    3. (c)

      t is the number of years remaining to the maturity date of the credit protection calculated in accordance with MIPRU 4.2C.27 R to MIPRU 4.2C.28 R, or the value of T, whichever is the lower;

    4. (d)

      T is the number of years remaining to the maturity date of the exposure calculated in accordance with MIPRU 4.2C.27 R to MIPRU 4.2C.28 R, or five years, whichever is the lower; and

    5. (e)

      t* is 0.25.

  2. (2)

    GA is then taken as the value of the credit protection for the purposes of MIPRU 4.2C.6 R, MIPRU 4.2C.21 R to MIPRU 4.2C.23 R and MIPRU 4.2C.29 R to MIPRU 4.2C.31 G.

Full protection

MIPRU 4.2C.29R

1Under MIPRU 4.2A.9 R, MIPRU 4.2A.12 R, MIPRU 4.2A.17A R and MIPRU 4.2A.17B R, g is the risk weight to be assigned to an exposure, the exposure value (E) of which is fully protected by unfunded credit protection (GA), where:

  1. (1)

    g is the risk weight of exposures to the protection provider;

  2. (2)

    GA is the value of G* as calculated under MIPRU 4.2C.22 R further adjusted for any maturity mismatch under MIPRU 4.2C.24 R to MIPRU 4.2C.28 R; and

  3. (3)

    E is the exposure value according to MIPRU 4.2A.6 R.

1Partial protection: equal seniority

MIPRU 4.2C.30R
  1. (1)

    1Proportional regulatory capital relief is afforded if:

    1. (a)

      the protected amount is less than the exposure value; and

    2. (b)

      the protected and unprotected portions are of equal seniority, i.e. the firm and the protection provider share losses on a pro-rata basis.

  2. (2)

    Under MIPRU 4.2A.9 R, MIPRU 4.2A.12 R, MIPRU 4.2A.17A R and MIPRU 4.2A.17B R, risk weighted exposure amounts must be calculated in accordance with the following formula:

    (E-GA) x r + GA x g

    where:

    1. (a)

      E is the exposure value according to MIPRU 4.2A.6 R;

    2. (b)

      GA is the value of G* as calculated under MIPRU 4.2C.21 R further adjusted for any maturity mismatch under MIPRU 4.2C.24 R to MIPRU 4.2C.28 R;

    3. (c)

      r is the risk weight of exposures to the borrower; and

    4. (d)

      g is the risk weight of exposures to the protection provider.

MIPRU 4.2C.31G

1Where the protected and unprotected portions of the exposure are not of equal seniority, MIPRU 4.2C.6 R applies.

1Sovereign guarantees

MIPRU 4.2C.32R

1A firm may assign a risk weight of 0% to exposures or parts of exposures guaranteed by the UK government or its central bank if the following conditions are met:

  1. (1)

    the guarantee is denominated in the domestic currency of the borrower; and

  2. (2)

    the exposure is funded in that currency.

Combinations of credit risk mitigation

MIPRU 4.2C.33R

1Where a firm calculating risk weighted exposure amounts has more than one form of credit risk mitigation covering a single exposure:

  1. (1)

    it must divide the exposure into parts covered by each type of credit risk mitigation; and

  2. (2)

    the risk weighted exposure amount for each portion must be calculated separately in accordance with MIPRU 4.2A (Credit risk capital requirement).

MIPRU 4.2C.34R

1When credit protection provided by a single protection provider has differing maturities, a similar approach to that described in MIPRU 4.2C.33 R must be applied.