Directive 2006/48/EC of the European Parliament and of the council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast) (Text with EEA relevance) (repealed) (c. 48)

ANNEX VIII U.K. CREDIT RISK MITIGATION

PART 2 U.K. Minimum Requirements

2. UNFUNDED CREDIT PROTECTION AND CREDIT LINKED NOTES U.K.

2.1. Requirements common to guarantees and credit derivatives U.K.

14. Subject to point 16, for the credit protection deriving from a guarantee or credit derivative to be recognised the following conditions shall be met: U.K.

(a)

the credit protection shall be direct;

(b)

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

(c)

the credit protection contract shall not contain any clause, the fulfilment of which is outside the direct control of the lender, that:

(i)

would allow the protection provider unilaterally to cancel the protection;

(ii)

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

(iii)

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

(iv)

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

(d)

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

2.1.1. Operational requirements U.K.

15. The credit institution shall satisfy the competent authority that it has systems in place to manage potential concentration of risk arising from the credit institution's use of guarantees and credit derivatives. The credit institution must be able to demonstrate how its strategy in respect of its use of credit derivatives and guarantees interacts with its management of its overall risk profile. U.K.

2.2. Sovereign and other public sector counter‐guarantees U.K.

16. Where an exposure is protected by a guarantee which is counter‐guaranteed by a central government or central bank, a regional government or local authority, a public sector entity, claims on which are treated as claims on the central government in whose jurisdiction they are established under Articles 78 to 83, a multi-lateral development bank to which a 0 % risk weight is assigned under or by virtue of Articles 78 to 83, or a public sector entity, claims on which are treated as claims on credit institutions under Articles 78 to 83, the exposure may be treated as protected by a guarantee provided by the entity in question, provided the following conditions are satisfied: U.K.

(a)

the counter‐guarantee covers all credit risk elements of the claim;

(b)

both the original guarantee and the counter‐guarantee meet the requirements for guarantees set out in points 14, 15 and 18, except that the counter‐guarantee need not be direct; and

(c)

the competent authority is satisfied that the cover is robust and that nothing in the historical evidence suggests that the coverage of the counter‐guarantee is less than effectively equivalent to that of a direct guarantee by the entity in question.

17. The treatment set out in point 16 also applies to an exposure which is not counter‐guaranteed by an entity listed in that point if that exposure's counter‐guarantee is in turn directly guaranteed by one of the listed entities and the conditions listed in that point are satisfied. U.K.

2.3. Additional requirements for guarantees U.K.

18. For a guarantee to be recognised the following conditions shall also be met: U.K.

(a)

on the qualifying default of and/or non-payment by the counterparty, the lending credit institution shall have the right to pursue, in a timely manner, the guarantor for any monies due under the claim in respect of which the protection is provided. Payment by the guarantor shall not be subject to the lending credit institution first having to pursue the obligor.

In the case of unfunded credit protection covering residential mortgage loans, the requirements in point 14(c)(iii) and in the first subparagraph of this point have only to be satisfied within 24 months;

(b)

the guarantee shall be an explicitly documented obligation assumed by the guarantor; and

(c)

subject to the following sentence, the guarantee shall cover all types of payments the obligor is expected to make in respect of the claim. Where certain types of payment are excluded from the guarantee, the recognised value of the guarantee shall be adjusted to reflect the limited coverage.

19. In the case of guarantees provided in the context of mutual guarantee schemes recognised for these purposes by the competent authorities or provided by or counter‐guaranteed by entities referred to in point 16, the requirements in point 18(a) shall be considered to be satisfied where either of the following conditions are met: U.K.

(a)

the lending credit institution has the right to obtain in a timely manner a provisional payment by the guarantor calculated to represent a robust estimate of the amount of the economic loss, including losses resulting from the non‐payment of interest and other types of payment which the borrower is obliged to make, likely to be incurred by the lending credit institution proportional to the coverage of the guarantee; or

(b)

the lending credit institution can demonstrate that the loss-protecting effects of the guarantee, including losses resulting from the non-payment of interest and other types of payments which the borrower is obliged to make, justify such treatment.

2.4. Additional requirements for credit derivatives U.K.

20. For a credit derivative to be recognised the following conditions shall also be met: U.K.

(a)

subject to point (b), the credit events specified under the credit derivative shall at a minimum include:

(i)

the failure to pay the amounts due under the terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with or shorter than the grace period in the underlying obligation);

(ii)

the bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and

(iii)

the restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. value adjustment or other similar debit to the profit and loss account);

(b)

where the credit events specified under the credit derivative do not include restructuring of the underlying obligation as described in point (a)(iii), the credit protection may nonetheless be recognised subject to a reduction in the recognised value as specified in point 83 of Part 3;

(c)

in the case of credit derivatives allowing for cash settlement, a robust valuation process shall be in place in order to estimate loss reliably. There shall be a clearly specified period for obtaining post-credit-event valuations of the underlying obligation;

(d)

if the protection purchaser's right and ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation shall provide that any required consent to such transfer may not be unreasonably withheld; and

(e)

the identity of the parties responsible for determining whether a credit event has occurred shall be clearly defined. This determination shall not be the sole responsibility of the protection provider. The protection buyer shall have the right/ability to inform the protection provider of the occurrence of a credit event.

21. A mismatch between the underlying obligation and the reference obligation under the credit derivative (i.e. the obligation used for the purposes of determining cash settlement value or the deliverable obligation) or between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible only if the following conditions are met: U.K.

(a)

the reference obligation or the obligation used for purposes of determining whether a credit event has occurred, as the case may be, ranks pari passu with or is junior to the underlying obligation; and

(b)

the underlying obligation and the reference obligation or the obligation used for purposes of determining whether a credit event has occurred, as the case may be, share the same obligor (i.e., the same legal entity) and there are in place legally enforceable cross-default or cross-acceleration clauses.

2.5. Requirements to qualify for the treatment set out in Annex VII, Part 1, point 4 U.K.

22. To be eligible for the treatment set out in Annex VII, Part 1, point 4, credit protection deriving from a guarantee or credit derivative shall meet the following conditions: U.K.

(a)

the underlying obligation shall be to:

• a corporate exposure as defined in Article 86, excluding insurance and reinsurance undertakings;

• an exposure to a regional government, local authority or Public Sector Entity which is not treated as an exposure to a central government or a central bank according to Article 86; or

• an exposure to a small or medium sized entity, classified as a retail exposure according to Article 86(4);

(b)

the underlying obligors shall not be members of the same group as the protection provider;

(c)

the exposure shall be hedged by one of the following instruments:

• single-name unfunded credit derivatives or single-name guarantees,

• first-to-default basket products — the treatment shall be applied to the asset within the basket with the lowest risk‐weighted exposure amount, or

• n^th-to-default basket products — the protection obtained is only eligible for consideration under this framework if eligible (n-1)th default protection has also be obtained or where (n-1) of the assets within the basket has/have already defaulted. Where this is the case the treatment shall be applied to the asset within the basket with the lowest risk‐weighted exposure amount;

(d)

the credit protection meets the requirements set out in points 14, 15, 18, 20 and 21;

(e)

the risk weight that is associated with the exposure prior to the application of the treatment in Annex VII, Part 1, point 4, does not already factor in any aspect of the credit protection;

(f)

a credit institution shall have the right and expectation to receive payment from the protection provider without having to take legal action in order to pursue the counterparty for payment. To the extent possible, a credit institution shall take steps to satisfy itself that the protection provider is willing to pay promptly should a credit event occur;

(g)

the purchased credit protection shall absorb all credit losses incurred on the hedged portion of an exposure that arise due to the occurrence of credit events outlined in the contract;

(h)

if the payout structure provides for physical settlement, then there shall be legal certainty with respect to the deliverability of a loan, bond, or contingent liability. If a credit institution intends to deliver an obligation other than the underlying exposure, it shall ensure that the deliverable obligation is sufficiently liquid so that the credit institution would have the ability to purchase it for delivery in accordance with the contract;

(i)

the terms and conditions of credit protection arrangements shall be legally confirmed in writing by both the protection provider and the credit institution;

(j)

credit institutions shall have a process in place to detect excessive correlation between the creditworthiness of a protection provider and the obligor of the underlying exposure due to their performance being dependent on common factors beyond the systematic risk factor; and

(k)

in the case of protection against dilution risk, the seller of purchased receivables shall not be a member of the same group as the protection provider.