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C. Components of the Second Method
The three components that entered into the calculation of
FNBC’s initial credit adjustment under the second method were
the: (1) CEM amount, (2) credit risk class rating, and (3)
CRESCO loss reserve factor. Each of these components was
developed separately and independently for purposes other than
valuation and was not used in combination with the other two
components for any other business purpose. FNBC developed the
CEM amount to measure credit exposure for purposes of risk
management and banking regulatory requirements. FNBC developed
the risk class system for commercial loan purposes to evaluate
the creditworthiness of a borrower. FNBC developed the CRESCO
loss reserve factors to meet banking regulatory requirements on
loss reserves and capital adequacy requirements.
1. CEM Amount
a. Overview
Expected cashflows from an interest rate swap can vary as
interest rates change. When the expected cashflows from a swap
change, the credit exposure of one counterparty to the other
counterparty usually changes. FNBC’s CEM amount statistically
measured FNBC’s maximum potential loss (and not expected
exposure) on a swap, over its tenor and at a preselected cutoff
46(...continued)
part, the market and credit risk of another swap.
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