Basel III: Credit Risk Mitigation requirements - What are they and why are they important to banks

In this article we examine credit insurance and risk participation arrangements as forms of credit risk mitigation in Singapore.

What is credit risk mitigation for banks?

Credit risk mitigation refers to the strategies which banks employ to reduce the risk of losses which they may incur from defaulted debts.

Common forms of credit risk mitigation include:

• collateralisation where the borrower pledges its assets to the bank as security for its debt
• netting where there is a setting off or offsetting of obligations between counterparties
• guarantees where a third party becomes obligated to make payments when the borrower defaults
• credit derivatives which use a financial instrument like a credit default swap to transfer credit risk to another party

Collateralisation and netting are regarded as forms of funded credit risk mitigation techniques.

Guarantees (which includes both credit insurance and risk participation arrangements) and credit derivatives are regarded as forms of unfunded credit risk mitigation techniques.

Strict eligibility criteria must be met in order for a bank to recognise the credit risk mitigation effects of an instrument.

In Singapore this eligibility criteria is set out in a notice issued by the Monetary Authority of Singapore (MAS) known as MAS Notice 637 (Risk Based Capital Adequacy Requirements for Banks Incorporated in Singapore) ("MAS Notice 637").

Why is credit risk mitigation important?

Generally the core business of a bank is to provide debt. As such, monitoring and mitigating credit risk is key to maintaining a bank's financial stability.

The largest bank failure due to debt losses was the Lehman Brothers collapse in 2008. The bank filed for bankruptcy with US$619 billion in debt against US$639 billion in assets.

The Lehman Brothers collapse triggered the start of the global financial crisis and marked a pivotal moment in that era.

In a direct response to that crisis, the Basel Committee on Banking Supervision developed Basel III, an international regulatory standard which sets out minimum bank capital requirements.

Worded simply, Basel III is about ensuring banks have enough capital to absorb losses and prevent a repeat of the global financial crisis.

As Basel III is not directly law, it has to be implemented into local law.

In Singapore this took the form of MAS Notice 637. In Europe this took the form of Capital Requirements Regulation 575/2013 (CRR). In the UK, the CRR forms part of domestic law by virtue of the European Union (Withdrawal) Act 2018, as amended by relevant regulations¹.

MAS has been the frontrunner in terms of the implementation of the Basel III framework.

In contrast to the delayed implementation targets in the UK and EU, Singapore has almost completed its implementation.

Most targets have come into effect as of 1 January 2025 other than the requirements relating to the output floor whereby the full phased in approach will be completed on 1 January 2029.

What qualifies as eligible credit protection?

When a bank calculates its credit risk-weighted exposure under MAS Notice 637, it may recognise the credit risk mitigation effects of eligible credit protection.

An "eligible credit protection" is defined as any guarantee (or other instruments as MAS may allow) or credit derivative².

The requirements for a "guarantee"³ as a form of eligible credit protection apply to unfunded instruments like risk participations and credit insurance.

Where a bank relies on a risk participation arrangement as eligible credit protection, the participant acts as the protection provider, and must make payment to the bank (as grantor of the participation) if the credit event occurs.

Where a bank relies on credit insurance as eligible credit protection, the insurer acts as the protection provider and is obligated to indemnify the bank as an insured party for any loss due to the credit event.

References to a bank below shall refer to a Reporting Bank (incorporated in Singapore) looking to fulfil the credit risk mitigation requirements under MAS Notice 637.

Why are we focusing on risk participation and credit risk insurance?

Both instruments are popular forms of unfunded credit risk mitigation arrangements used by banks for regulatory capital relief.

There are no standard terms applicable to these instruments.

However the Loan Market Association (LMA) Risk Participation (Par) template is widely regarded as a form of industry standard.

For credit risk insurance, the key providers are Allianz Trade, Coface and Atradius. Their policy terms would be regarded as what sets the standard for the market.

What are the key requirements for a risk participation and credit insurance to qualify as eligible credit protection?

The legal requirements are set out in Annex 7H of MAS Notice 637 ("Annex 7H").

We discuss a few of these requirements below.

Eligible protection provider⁴

A protection provider must be an "eligible protection provider".⁵

This includes a government entity, a bank, an entity holding a capital markets services license in Singapore, an entity licensed to carry on insurance business in Singapore, a securities firm in a foreign country or jurisdiction or an entity licensed to carry on insurance business in a foreign country or jurisdiction.

Direct claim on the protection provider⁶

The guarantee must represent a direct claim on the protection provider.

This is typically satisfied where the bank and protection provider are parties to the relevant risk participation agreement, or where the bank is the insured party under a credit insurance policy.

This may be problematic if the bank is for example just a loss payee under a credit insurance policy and does not have rights to make a direct claim on the insurer.

Another example to avoid is if there is a need for another party to certify to the insurer that the bank is entitled to make a claim.

These procedural impediments may cast doubts on the ability on the bank as insured party to make a direct claim on the insurer.

Irrevocable obligation to pay out a pre-determined amount⁷

The protection provider's obligation to pay a pre-determined amount upon the occurrence of a credit event must be irrevocable.

One acceptable exception to such an obligation is if it is due to the non-payment by the bank of money due to the protection provider in respect of the guarantee.

For insurance policies, the above qualification is important as it is common for an insurer to provide that it may cancel the policy if policy premiums are not paid.

Payout in a timely manner⁸

If a credit event occurs, any conditions in the guarantee which could prevent the protection provider from being obliged to pay out in a timely manner must be within the direct control of the bank.

In credit insurance policies, there may be waiting periods before an insurer pays out, or there may be extensions granted to the borrower to make payment.

There is no specific guidance as to what qualifies as timely payment.

However it is important to consider whether these provisions affect this requirement for timely payout and whether the fulfilment of any conditions are within the bank's direct control.

Risk participation agreements typically provide that following service of a notice, by the grantor to the participant, that a credit event has occurred, the participant shall immediately make payment to the grantor.

We advise clients regularly on whether specific risk participation agreements and credit insurance policies qualify as "guarantees" for capital relief.

Please do contact us if you have any queries.

Authors: Jean Woo, Partner, Global Loans, Ashurst and Ernest Koh, Senior Associate, Ashurst ADTLaw.