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The Basel III rule in paragraph 75 is designed to ensure that an increase in the credit risk of a bank does not, via a reduction in the value of its liabilities, lead to an increase in its common equity.
Paragraph 75 required banks to "derecognise in the calculation of Common Equity Tier 1, all unrealised gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank's own credit risk". While this rule was originally developed in the context of debt instruments issued by banks, the principle extends also to fair valued OTC derivatives. However, the application of paragraph 75 to derivatives was not straightforward.
After consideration of responses, the Committee confirmed its intention to proceed with the baseline proposal included in the consultative document and has agreed that valuation adjustments to derivative liabilities arising from the bank's own credit risk should be fully derecognised from the calculation of common equity at each reporting date. While recognising that this rule might go beyond the principle in paragraph 75 for non-derivative liabilities, the Committee believes that valuation adjustments to derivative liabilities raise a wide range of prudential concerns, and therefore that conservatism should drive the policy framework in this area. In addition, the Committee believes that it is currently not feasible to implement alternative approaches in a consistent and sufficiently robust manner.
The above prudential treatment would be implemented according to the Basel III transitional provisions for regulatory adjustments, as stated in paragraph 94 (c) and (d). That is, the deduction from Common Equity Tier 1 of all accounting valuation adjustments to derivative liabilities arising from the bank's own credit risk will be phased in, starting with 20 per cent in 2014 and rising by 20 per cent per year thereafter until full deduction occurs from 1 January, 2018.