Question

Company Y is a shipping company that requires a constant stream of cash. The company has requested for an overdraft facility with a total maximum of $500 million for its working capital from UBS. The bank has agreed to provide this source of cash on a clean basis i.e. no collateral needed) after determining that company's Y has a strong credit rating i.e. AA on the bank's rating scale. This overdraft facility is available to be drawn at any time by company Y, reviewed on annual basis and is not subject to any conditions that allow the bank to cancel the facility without notice to the borrower. Assuming UBS uses the following PD scale below and from its past experience, knows that overdraft limits tend to be 95% drawn-down 1 year prior to a company's default. Phrased differently, this meant that company Y has a high propensity to borrow 95% of the maximum amount of money it is allowed, before defaulting if company Y defaults. (Please be noted in this case, the lending value is not determined by the collateral only. Instead, the bank needs to calculate the potential loss from the borrowing and gets prepared for the loss with a capital charge.) Rating AAA | ААА PD(%) 0.029 0.25 1.07 BBB BR 8.5 12.9 CCC 21.4 CC 26.7 32.1 Default 100 1. Compute the capital charge of the minimum capital ratio required is 8%.. 2. In the fourth year after granting the overdraft facility, if UBS unexpectedly discovered that there had been financial irregularities with the cash flow of company Y, calling into question its ability to fully repay the overdraft (which has since been fully drawn down). UBS also immediately downgrades company Y's rating to a 'C' upon realizing the irregularities. Is the capital charge calculated in #1 still sufficient? 3. What if the company can provide a property as a collateral? Assuming that the market value for the property is $300 million, and the haircut is $50 million, what would be the capital charge the bank should get prepared if company Y is rated as AA and BB, respectively?

Answer 1

1. The amount of Exposure = $ 500m x 95% = $ 475m (& no collateral); The PD is 0.25% for AA category

The capital charge = $ 475m x 0.25% x 0.08 = $ 0.095m

2. The amount of Exposure = $ 500m (full drawn)

The PD is 32.1% for C category

Capital Charge = $ 500m x 32.1% x 0.08 = $ 12.84m

Capital Charge as stated above would not be sufficient

3. Calculation of Capital Charge (calculation in $ m)

Particulars	AA Category	BB Category
Gross Exposure	500	500
Less: - Collateral (haircut adjusted - 50)	350	350
Net Exposure	150	150
PD	0.25%	8.5%
Risk weighted	0.375	12.75
Capital Charge ratio	0.08	0.08
Capital Charge	0.03	1.02