Applicability and calibration of the CRD for commodity firms

1. Applicability and calibration of the CRD for commodity firms CFRC WG meeting 23 November 2005 ISDA

2. Capital Requirements Directive (CRD) • Transposes the new Capital Accord into EU law. Approved on 28 September 2005 • Implementation staggered : • 1/1/2007 for firms using simple approaches • 1/1/2008 for firms using sophisticated approaches

3. CRD • CRD : 3 Pillar approach : • Pillar 1 : minimum capital requirements; • Pillar 2 : supervisory review. May lead to additional capital requirements • Pillar 3 : disclosure requirements • Fundamental question : Is CRD adapted to risks borne by commodity firms on their derivative business ?

4. CRD • Commodity firms do not pose same risks as financial institutions : • NO depositor/investor exposure • NO systemic risk (Enron failure) • Risks on the physical side already monitored by physical regulators • This has motivated light touch capital regulation in the EU • And no regulation in other key countries (US, Switzerland)

5. CRD • Commodity firms’ special case is acknowledged at political level in the EU: • CRD Recital 19 (b) The goal of liberalisation of gas and electricity markets is both an economically and politically important goal for the Community. With this in mind, the capital requirements, and other prudential rules, to be applied to firms active in those markets need to be proportionate and should not unduly interfere with achievement of the goal of liberalisation.”

6. CRD • Article 45d of the CAD further institutes a carve-out for commodity firms, which will become regulated by the earlier of end 2010 and the time by which the Commission has proposed an appropriate capital regime. • Calendar is set by the Commission : industry understands that they are planning to conduct the capital review in parallel with the MiFID exemptions review, i.e. conclude by spring 2008.

7. CRD • Conclusion : the case for applying the CRD to commodity firms has not been made • Further, even if a CRD type approach were retained, the target insolvency level may need to be distinct from that applied to financial institutions. • Target pursued for financial institutions based on Basel I. No equivalent regime to Basel I exists for commodity firms. • If a lower target is retained, e.g. 99th percentile instead of 99.9th, credit risk and operational risk capital charges are reduced respectively by 50% and 33%. QUESTION : DO MEMBERS OF THE CFRC WISH TO ARGUE FOR A RECALIBRATION OF THE CRD ? IF SO, WHAT PERCENTILE SHOULD BE USED ?

8. Credit charge re-calibrated at 99.9th perc.

9. Credit risk charge re-calibrated at 99th perc.

10. Operational risk charge re-calibrated at 99th perc. • Operational risk charge is intended to represent on average 12% of total regulatory capital for fis. • Commodity firms are likely to use the Basic Indicator Approach , i.e. calculate op risk capital as a fixed percentage, alpha, of average income. • Currently, alpha corresponding to a 99.9th worst case op risk scenario, is 15%. • We are seeking to re-calibrate alpha at the 99th percentile. • Assuming a split between the various forms of capital (market, credit and operational) in firms’ overall reg cap, it is possible to compute the % of income which the operational risk charge should represent if it were calibrated at the 99th percentile.

11. Operational risk charge re-calibrated at 99th perc. • Assumptions [To be verified, based on metal traders’ experience in the UK, and the EFET hypothetical testing exercise]: • Overall cap charge split as follows : • Market: 30% • Credit: 58% • Operational: 12% • Then, the operational risk charge should be computed as 10% of income under the Basic Indicator Approach, implying a reduction in alpha value of 1/3.

12. END • esebton@isda.org