A Framework for Assigning Incremental Capital for Transfer Risk Under Basel Pillar 1

Abstract

In this paper we describe a framework for incorporating transfer risk into Pillar 1 regulatory capital calculations. In conjunction with an (A)IRB credit model, it involves a transaction-level consideration of whether an obligation bears transfer risk, and if it does, calculating an RWA add on. The starting point is the construction of a binary ‘assignment’ string for each obligation, determined based on a comparison of the currency of the exposure with each of the domestic currencies of the country of the obligor, the country of the booking location and, if applicable, the country of any guarantor(s), respectively. The assignment string determines the presence, the country and the counterparty deemed to bear any transfer risk. An adjustment is then made to the bearer’s default probability, from which the RWA add-on for transfer risk is calculated based on the difference between substituting the adjusted and unadjusted default probabilities into the standard Basel risk weight formula. Some worked numerical examples are provided.

Keywords: transfer risk, country risk, regulatory capital, foreign and local currency lending, PD estimation, RWA add on, Basel II

JEL Classification: C13