2. Some industry participants and supervisory authorities took the opportunity of the comment process to provide the results of empirical research on the effects of netting on potential future credit exposure and to submit alternative formulae for recognising netting effects in the calculation of add-ons. The Committee also has conducted further research in this area and now sees merit in incorporating into the add-ons methodology a formula for recognising netting effects on potential future exposure.

3. The Committee proposes the formula below to reduce the add-ons for transactions subject to legally enforceable netting agreements consistent with the requirements set out in the attached amendment to the Capital Accord on bilateral netting. Under the proposal the add-on for netted transactions (ANet) would equal the average of the add-on as presently calculated (AGross),³ reduced by the ratio of net current replacement cost to gross current replacement cost (NGR), and the AGross.

where

NGR = level of net replacement cost/level of gross replacement cost for transactions subject to legally enforceable netting agreements

4. The advantage of the formula from a supervisory perspective is that it uses bank-specific information (i.e. the NGR) but imposes greater stability over time and across banks than a formula giving full weight to the NGR. Moreover, using this formula banks will always hold capital against potential exposure as the net add-on can never be zero. In this context, the NGR can be seen as somewhat of a proxy for the impact of netting on potential future exposure but not as a precise indicator of future changes in net exposure relative to gross exposure, reflecting the fact that the NGR and potential exposure can be influenced by many idiosyncratic properties of individual portfolios. With the weight at 0.5 the reduction in add-on, assuming an NGR of 0.5, would be 25%.

5. In presenting the formula above the Committee has not specified whether the calculation of NGR should be made on a counterparty by counterparty basis or on an aggregate basis for all transactions subject to legally enforceable netting agreements which meet the Committee's requirements. The Committee invites specific comment on this issue, in particular whether the choice of method could bias the results, and whether there is a significant difference in calculation burden between the two. A highly simplified example of calculating the NGR in both ways is presented in Annex 2.

6. As a result of the comment process on the April 1993 netting proposal the Committee is aware of the view that internal simulation models may be useful in the calculation of add-ons for potential future credit exposure. The Committee believes this is an interesting approach and worthy of further consideration at some future date. However, for the time being the Committee wishes to enhance prudential coverage of derivatives under the existing methodology.

³ AGross equals the sum of notional principal amounts of all transactions subject to legally enforceable netting agreements times the appropriate add-on factors from Annex 3 of the Capital Accord.