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March 2015
Calculating the Credit Equivalent Amount of Derivatives
Products for the UAE Banks Using the Original Exposure ...
Margin Trading
Cross-currency/Commodity/Interest Rate (Profit Rate) Swaps
Equity swaps
Total return swaps
4) Licensing req...
(1) Original Exposure Method
In case of full conditions contract without netting agreement Credit equivalent amount (CEA) ...
Data and Methodology
The top banks in the UUAE we investigate for the year 2014 (Year End) are as follows:
1. Abu Dhabi Co...
ADCB
NBAD
Emirates NBD
First Gulf Bank
In this section we will chose one of these banks and do the full calculation for the credit equivalent
amo...
Calculating the credit equivalent amount CEA according to the Current Exposure Method
Under this method we will need to kn...
Conclusion
The Largest bank among these four banks in terms of total assets is NBAD, also NBAD has the biggest
Positive Ma...
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Calculating the Credit Equivalent Amount of Derivatives Products for the UAE Banks

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Calculating the Credit Equivalent Amount of Derivatives Products for the UAE Banks

  1. 1. March 2015 Calculating the Credit Equivalent Amount of Derivatives Products for the UAE Banks Using the Original Exposure and Current Exposure Methods Tamer Halawani Montes (Previous Risk Analyst at Deutsche Bank and JP Morgan) Abstract This paper show that calculating the credit equivalent amount (CEA) for derivatives contracts within the UAE big banks using the Current Exposure Method will generate less exposure than using the Original Exposure Method. The observation from the data taken in this paper lead us to conclude that it is better for banks in UAE to calculate their credit equivalent amount using the Current Exposure Method Introduction and Objective 1 Overview of the GCC Markets (UAE) and the Status of Derivatives The financial services sector in MENA has high profit margins, access to cheap cost of funds and low international credit exposure. Improving business activity and domestic confidence is accelerating lending growth in the region. The banks are well capitalized, maintaining capital adequacy ratios that meet or are above the Basel III requirements with low levels of non-performing loans. A rise in public sector spending, and improved consumer and business activity, particularly in the UAE and Saudi Arabia, are expected to support lending growth in MENA. Credit ratings agency Moody’s forecasts credit growth of 7%–10% in 2015. Stability in local real estate markets would help banks lower their provisioning expenses and drive profitability. With 60–90% of banks’ funding sourced from deposits, the credit strength is likely to be retained in 2015 In a research study conducted on the UAE financial markets for derivatives, the following points were observed regarding the market for derivatives instrument: 1) Recognised need for increased risk management across the region has led to the development of conventional and Islamic derivatives market across the GCC 2) Development hindered by lack of legislation/regulation/ISDA netting opinions 3) Unsophisticated market. Most common types of derivative products are:
  2. 2. Margin Trading Cross-currency/Commodity/Interest Rate (Profit Rate) Swaps Equity swaps Total return swaps 4) Licensing requirements: Derivatives trading is a “commercial banking activity”; counterparties must be licensed by the relevant regulatory body unless all conduct with regard to derivative transactions is conducted outside relevant jurisdiction 5) Conducting KYC: Verify that counterparties have power and authority to enter into derivative transactions 6) Dubai Court of Cassation relied on international banking practices to hold that currency futures trading does not violate the Commercial Transactions Code for impermissible risk or uncertainty; emphasis on counterparty being a professional licensed investor 7) Three Abu Dhabi court decisions in which foreign currency derivatives were invalidated for speculation 8) If a derivative transaction is purely speculative or “excessively uncertain” there is considerable risk that UAE courts (especially Abu Dhabi) will adopt conservative approach where Limited guidance from Civil Code and case law means it is difficult to predict with certainty how the UAE courts will interpret a derivative transaction and its enforceability in UAE 9) No legalisation addressing close-out netting and no ISDA netting opinions According to researchers conducted by MARKAZ (Kuwait Financial Centre S.A.K) on the Derivatives market in the GCC countries it reveals that GCC market structure is still incomplete with inadequate growth of debt market and absence of derivatives market 2 Risk Exposures for Derivatives In order to for banks to reports the risk exposure for Basel reporting requirement, the bank (1) will need to multiply the book value, on the reporting day, of every item of assets and obligations, as appeared on the financial statement, with the risk weights. If the assets and obligations are in foreign currencies, they shall be converted into the local currency (UAE Dirham) (2) Multiply each asset with the relevant risk weights (3) In case of the obligations in the form of financial derivative the banks shall calculate the credit equivalent amount (CEA) with current exposure method or original exposure method, then, multiply the outcome with the risk weights of each type of asset In this paper we will only examine calculating the credit equivalent amount (CEA), we will also calculate some ratios such as Derivatives Exposure (the one shown as part of the bank’s assets “referred to as the positive mark-to-market”) over the bank’s total assets, derivatives outstanding notional over bank’s total assets, credit equivalent amount (CEA) over bank’s total assets and compare the ratios between the banks we examined Literature Review The literature on risk disclosures and calculating the credit equivalent amount by banks is relatively broad. Below are some main guidelines that we will be using in our calculations based on previous literature reviews: The calculation of credit equivalent amount (CEA) for financial derivatives can be performed under two methods; 1) Original Exposure Method and 2) Current Exposure Method.
  3. 3. (1) Original Exposure Method In case of full conditions contract without netting agreement Credit equivalent amount (CEA) of current credit exposure can be calculated as follow: CEA = Σ (Notional Amount * CCF) Or equal to the sum of the product of notional amount1 of exchange rate derivatives and interest rate derivative of such counterparty and relevant Credit Conversion Factor (CCF) Credit Conversion Factor (CCF) of Exchange Rate and Interest Rate Derivatives under Original Exposure Method for full conditions contract without netting agreement Maturity Exchange Rate Derivative Interest Rate Derivative Less than 14 days 0 0 Less than 1 year 0.02 0.005 Over 1 year to 2 years 0.05 0.01 Every additional year 0.03 0.01 (2) Current Exposure Method Under the current exposure method, computation of credit equivalent exposure for interest rate and exchange rate related contracts is based on the summation of the following two elements: i) The replacement costs (obtained by marking-to-market) of all contracts with positive value (zero for contracts with negative replacement costs); and ii) ii) The amount of potential future exposure calculated by multiplying the national value of each contract by an “add-on” factor. Credit exposure = positive MTM + (NP x “add-on” factor (%)) where: MTM is Mark-to-Market NP is National Principal In certain cases, credit exposures arising from interest rate and exchange rate related contracts may already be reflected on balance sheet. For example, banking institutions may have recorded current credit exposures to counterparties (such as mark to market values) under foreign exchange and interest rate related contracts on the balance sheet as ‘other assets’ or ‘sundry debtors’. To avoid double counting, such exposures should be excluded from the on-balance sheet exposures and treated as off-balance sheet exposures Credit conversion faction of financial derivative under Current Exposure Method FX & Gold Interest Rate Equity Precious Metals Other Commodities Less than 14 days 0 0 0.06 0.07 0.10 Less than 1 year 0.01 0 0.06 0.07 0.10 Over 1 year to 5 years 0.05 0.005 0.08 0.07 0.12 Over 5 years 0.075 0.015 0.10 0.08 0.15 While according to the standardized method the CCF is calculated according to the below table
  4. 4. Data and Methodology The top banks in the UUAE we investigate for the year 2014 (Year End) are as follows: 1. Abu Dhabi Commercial Bank (ADCB) 2. National Bank of Abu Dhabi (NBAD) 3. Emirates NBD 4. First Gulf Banks Our source of data is derived from publicly disclosed regulatory report information on minimum regulatory capital requirements and the info that was found in the annual reports of the above banks Below we will be showing the snapshots related to the derivatives notional amounts and exposures for the four banks
  5. 5. ADCB
  6. 6. NBAD Emirates NBD
  7. 7. First Gulf Bank In this section we will chose one of these banks and do the full calculation for the credit equivalent amount (CEA), in our case we chose to calculate it for National Bank of Abu Dhabi (NBAD) as per the following: Calculating the credit equivalent amount CEA according to the Original Exposure Method Less than 3 Months between 3m - 1 year 1 - 3 years 3 - 5 Years over 5 years Total Total Notional 369,185,701,000 290,935,429,000 203,193,034,000 120,821,339,000 118,304,031,000 1,102,439,534,000 FX Derivatives 155,335,717,000 109,026,703,000 20,061,938,029 2,577,829,000 964,023,000 287,966,210,029 IR Derivatives 213,849,984,000 181,908,726,000 183,131,095,971 118,243,510,000 117,340,008,000 814,473,323,971 FX CCf 3,106,714,340 2,180,534,060 1,003,096,901 360,896,060 163,883,910 6,815,125,271 IR CCF 1,069,249,920 909,543,630 1,831,310,960 4,729,740,400 5,867,000,400 14,406,845,310 Total Exposure 4,175,964,260 3,090,077,690 2,834,407,861 5,090,636,460 6,030,884,310 21,221,970,581 CEA / Total Notional Size 1.93% 2% * 109,026,703,000 10% * 1,003,096,901 Notional Amount by Term to Maturity (UAE Dirham) We calculated the CCF based on the following schedule to conclude that the credit equivalent amount is 21,221,970,581 UAE Dirham or 1.93% of the Total Derivatives Notional Size Credit Conversion Factor (CCF) of Exchange Rate and Interest Rate Derivatives under Original Exposure Method for full conditions contract without netting agreement Maturity Exchange Rate Derivative Interest Rate Derivative Less than 14 days 0 0 Less than 1 year 0.02 0.005 Over 1 year to 2 years 0.05 0.01 Every additional year 0.03 0.01
  8. 8. Calculating the credit equivalent amount CEA according to the Current Exposure Method Under this method we will need to know the Positive Market Value to reach the figure of CEA of the derivatives exposure (review the section of the Literature review) Off course under this method the CCF are different than the first method (the original exposure) Less than 3 Months between 3m - 1 year 1 - 3 years 3 - 5 Years over 5 years Total Total Notional 369,185,701,000 290,935,429,000 203,193,034,000 120,821,339,000 118,304,031,000 1,102,439,534,000 FX Derivatives 155,335,717,000 109,026,703,000 20,061,938,029 2,577,829,000 964,023,000 287,966,210,029 IR Derivatives 213,849,984,000 181,908,726,000 183,131,095,971 118,243,510,000 117,340,008,000 814,473,323,971 FX CCf 1,553,357,170 1,090,267,030 401,238,761 51,556,580 19,280,460 3,115,700,001 IR CCF 0 0 915,655,480 591,217,550 1,760,100,120 3,266,973,150 Total Exposure 1,553,357,170 1,090,267,030 1,316,894,240 642,774,130 1,779,380,580 6,382,673,150 Positive Market Value 7,422,828,000 CEA = Positive Market Value +Total Notional size of Derivatives 13,805,501,150 CEA / Total Notional Size 1.25% Notional Amount by Term to Maturity (UAE Dirham) We calculated the CEA under this method to conclude that the credit equivalent amount is 13,805,501,150 UAE Dirham or 1.25% of the Total Derivatives Notional Size, hence under this method the CEA is lower than the previous method Results Since there is no space to do all the calculations here, the results of all the calculations for all the banks are shown in below: Bank Name ADCB NBAD EMIRATES NBD First Gulf Bank Total Assets 204,019,463,000 376,098,712,000 363,020,991,000 212,168,501,000 Derivatives Positive Market Value 4,288,506,000 7,422,828,000 1,310,455,000 1,526,250,000 Derivatives Notional size 294,969,979,000 1,102,439,534,000 288,723,438,000 98,544,062,000 Derivatives Market Value / Assets 2.10% 1.97% 0.36% 0.72% Derivatives Notional size / Assets 144.58% 293.13% 79.53% 46.45% Credit Equivalent Amount (Original Method) only FX & Rates 2,329,052,458 21,221,970,581 7,100,413,010 2,160,817,930 Credit Eqivalent Amount (Current Method) All Asset Classes 569,468,375 13,805,501,150 4,020,140,515 2,478,570,099 CEA (Original Method) / Derivatives Size 0.79% 1.93% 2.46% 2.19% CEA (Current Method) / Derivatives Size 0.19% 1.25% 1.39% 2.52% CEA (Current Method) / Total Assets 0.28% 3.67% 1.11% 1.17%
  9. 9. Conclusion The Largest bank among these four banks in terms of total assets is NBAD, also NBAD has the biggest Positive Market Value for Derivatives and the biggest notional size of derivatives But when looking at each bank Assets (on balance sheets items) we will find that ADCB has the biggest % of On-Balance sheet derivatives among them, while NBAD Derivatives notional size of contracts is even exceeding the total assets of the bank (293%) which is almost 3 times as the size of their total assets. If banks are only holding Rates and FX derivatives it would be better for them to use the Current Exposure Method to calculate their Credit Equivalent amount as it would come back with lower figure hence they will need to hold less capital against it Finally ADCB credit equivalent amount of their derivatives compared to their total assets is the lowest (0.28%) and that is because 94% of their derivatives contracts have maturity of less than 1 year and they focus their derivatives on two asset classes (FX and Rates) since these two asset classes would require less Credit conversion Factor (CCF) References - Basel Committee on Banking Supervision International Convergence of Capital Measurement and Capital Standards, a Revised Framework Updated November 2005. http://www.bis.org/publ/bcbs118.pdf - Derivatives and Risk Management Made Simple –JP Morgan Bank Research - Credit Risk – Estimation Techniques, Crisil global research and analytics - Hirtle B. (2003): What Market Risk Capital Reporting Tells Us About Bank Risk, Federal Reserve Bank of New York, Economic Policy Review, September 2003 - National Bank of Abu Dhabi Annual Review 2014 - Abu Dhabi Commercial Bank Annual Review 2014 - First Gulf Bank Annual Review 2014 - Emirates NBD Annual review 2014 - Berkowitz, Christoffersen, and Pelletier (2009). “Evaluating Value-at-Risk Models with Desk- Level Data” Management Science, Articles in Advance, pp. 1–15. http://erm.ncsu.edu/az/erm/i/chan/library/pelletier-research-partners-2009.pd - Gulf Banks' Capital Positions Compare Well With Those Of Global Banks, Standard & Poor's, June 2012 - Guideline for Calculation of Credit Risk for Commercial Banks, Central Bank of Thailand Study - MENA - Alternative Investment Strategy 2015, Al-Masah Capital Research Study - The Relationship between Overcoming New Investors’ Fear in Investing in Derivatives in Stock Markets; And Revitalizing Stock Markets to Support Economies in the GCC, Ahmad Adel Mustafa, March 2014 - An Update on Worldwide Derivatives and Related Regulatory Initiatives, K& L Gates, Natalie Boyd, 2014

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