Credit Derivatives and Their Use in Credit Risk Transfer
Alpha Bank holds a €10 billion portfolio of corporate loans with a current regulatory Risk-Weighted Asset (RWA) of €7.5 billion. To manage its capital, the bank undertakes two credit risk transfer initiatives:
1. **Synthetic Securitization:** Alpha Bank issues a 5-year Credit-Linked Note (CLN) for €500 million, synthetically transferring the risk of the mezzanine tranche covering losses between 5% and 10% of the portfolio's principal. The CLN is fully collateralized by cash in a bankruptcy-remote SPV, meeting all regulatory conditions for a qualifying synthetic securitization. Alpha Bank retains the first-loss tranche (0-5%) and the senior tranche (10-100%).
2. **Single-Name CDS:** Separately, Alpha Bank enters into a 3-year, €100 million single-name Credit Default Swap (CDS) to hedge a specific exposure within its *retained* first-loss tranche. The protection is purchased from a B-rated financial counterparty. Regulatory guidelines stipulate that unfunded credit protection from non-qualifying guarantors for retained residual risks not fully transferred requires a 100% RWA charge on the protected amount.
Considering these transactions, what is the most likely net change in Alpha Bank's total regulatory RWA?
A.A decrease of €350 million.
B.A decrease of €450 million.
C.A decrease of €375 million.
D.An increase of €25 million.
Rationale:
The net change in RWA is determined by summing the RWA impact of each credit risk transfer initiative.
First, consider the **Synthetic Securitization (CLN)**:
* The original portfolio has an RWA density of €7.5 billion / €10 billion = 0.75 (or 75%).
* The CLN transfers the risk of the mezzanine tranche covering losses between 5% and 10% of the portfolio's principal. This tranche has a nominal value of 5% of €10 billion = €500 million.
* The original RWA associated with this €500 million mezzanine tranche was €500 million * 0.75 = €375 million.
* Since the CLN is a qualifying synthetic securitization and fully collateralized, this RWA is effectively transferred, resulting in a **decrease of €375 million** in Alpha Bank's RWA.
Second, consider the **Single-Name CDS**:
* The CDS covers €100 million of exposure within the *retained* first-loss tranche.
* The problem states that the protection is from a non-qualifying guarantor and that "Regulatory guidelines stipulate that unfunded credit protection from non-qualifying guarantors for retained residual risks not fully transferred requires a 100% RWA charge on the protected amount."
* This means that for the €100 million portion of the first-loss tranche supposedly hedged by the CDS, Alpha Bank must now hold an RWA of €100 million (100% RWA charge).
* The original RWA for the *entire* first-loss tranche (€500 million nominal) was €500 million * 0.75 = €375 million.
* After applying the CDS rule, the RWA for the first-loss tranche is calculated as:
* RWA for the €100 million portion (under CDS) = €100 million (due to 100% RWA charge).
* RWA for the remaining €400 million portion (uncovered first-loss) = €400 million * 0.75 = €300 million.
* Total RWA for the retained first-loss tranche = €100 million + €300 million = €400 million.
* Compared to the original RWA of €375 million for the first-loss tranche, this represents an **increase of €25 million** (€400 million - €375 million) in Alpha Bank's RWA.
Finally, the **retained senior tranche** (10-100% of the portfolio, or €9 billion nominal) remains with Alpha Bank. Its RWA contribution remains unchanged at €9 billion * 0.75 = €6.75 billion, so there is no *change* in RWA from this portion.
Combining the impacts:
Net Change in RWA = (Decrease from CLN) + (Increase from CDS) = -€375 million + €25 million = -€350 million.
Regarding the incorrect options:
* The option suggesting a decrease of €450 million incorrectly assumes the single-name CDS provides RWA relief. If the €100 million CDS provided proportional RWA relief (i.e., €100M * 0.75 = €75M relief), the total decrease would be €375M + €75M = €450M. However, the regulatory guidelines for non-qualifying guarantors specifically negate this relief and impose a higher charge.
* The option suggesting a decrease of €375 million ignores the RWA impact of the single-name CDS, assuming it has no net effect or provides no relief, but also doesn't consider the specific 100% RWA charge for non-qualifying protection.
* The option suggesting an increase of €25 million correctly identifies the RWA increase due to the CDS but fails to account for the substantial RWA decrease from the qualifying synthetic securitization.
