Credit risk mitigation · RiskAtoms Academy

By the end you will be able to

1Tell funded mitigation (collateral, netting) from unfunded (guarantees, credit derivatives), and the requirements both must meet.
2Apply the simple and comprehensive approaches, with supervisory haircuts scaled to the holding period.
3Work out the RWA of a guaranteed loan by substitution, under the SA and F-IRB.
4Adjust protection for a maturity or currency mismatch, and for a CDS without restructuring.
5Say when legal certainty or correlation stops a mitigant counting.

Why it matters

RiskAtoms Bank plc holds gilts and shares pledged by Bramwick, a bank guarantee on part of Hastemoor's loan, a credit default swap on Sallowmere and euro deposits from Ostreth. Its RWA in L4.1.04: Risk-weighted assets recognise none of them. Recognised under the rules, they would save £842.3m of RWA under the standardised approach and £739.3m under F-IRB. Each one has to pass tests first, and each is cut down for what could go wrong with it.

Core explanation

Cutting the exposure, or swapping the borrower

Illustrative dataRiskAtoms Bank plc's capital book

The same made-up UK bank as Level 3: £67bn of assets and £4bn of equity at 31 December 2025, in £ millions. Module 4.1 adds its regulatory layer: own funds, deductions, risk-weighted assets by risk type, buffers, the leverage exposure and MREL, computed from the Level 3 credit, trading, derivatives and operational risk books. Every figure is illustrative, not any bank's data.

Pro forma. The book applies Basel 3.1, the 2017 finalisation of Basel III, to the 31 December 2025 balance sheet. On that date the bank still reported under the old UK CRR. The UK applies Basel 3.1 from 1 January 2027, and the internal model approach for market risk from 1 January 2028 (PRA PS1/26, paras 1.23 and 1.24). So the book shows the bank as it would look under the new rules.

The credit figures are the Level 3 credit book (Module 3.3): its twelve corporate borrowers and three mortgage segments, each scaled up to stand for a slice of the bank's £12bn corporate and £30bn mortgage books. Grades, PDs and LGDs are unchanged.

The four mitigants are assumptions added in Module 4.2; the Module 3.3 book has no financial collateral, guarantees or CDS.

Two families, and the tests they share

L2.6.01: Four responses to risk listed transferring risk as one response to it, and L3.3.12: Collateral, guarantees and credit risk mitigation showed how lenders do it. Credit risk mitigation is how the capital rules give credit for it. There are two families:

Funded: collateral and netting. The bank holds something it can sell or set off, so the exposure shrinks.
Unfunded: guarantees and credit derivatives, such as the credit default swaps of L1.7.10: Credit default swaps. Someone else promises to pay, so the bank swaps the borrower's risk for the protection seller's.

Before either counts, two tests apply to all of them. Legal certainty: the documents must be “binding on all parties and legally enforceable in all relevant jurisdictions” (CRE22.9). And no correlation: the value of the protection must not fall with the borrower's credit quality (CRE22.7).

Collateral: simple or comprehensive

A bank uses one of two approaches for collateral in its banking book, not both (CRE22.19).

Simple: the secured part takes the collateral's own risk weight instead of the borrower's, but not below 20% (CRE22.33), with narrow exceptions for cash and sovereign bonds. The floor is a maximum of two values (M-A11: Min, max, floors and caps).
Comprehensive: the collateral reduces the exposure, after haircuts for how far its price could fall before the bank sells it. What is left is E*, risk weighted as the borrower (CRE22.46).

The haircuts in CRE22.49 assume a 10-day holding period. A secured loan is assumed to take 20 days to close out, so its haircuts scale up by the square root of time, $\sqrt{20/10}$ (CRE22.57, CRE22.59; M-A01: Percentages). For the collateral pledged against Bramwick Stores plc:

Holding period	Gilts, 1–3 years	FTSE 100 shares	Collateral after haircuts	E*
5 days	1.41%	14.14%	467.5	1,459.1
10 days	2.00%	20.00%	454.0	1,472.6
20 days	2.83%	28.28%	434.9	1,491.7

At 20 days the £300m of gilts count as £291.5m and the £200m of shares as £143.4m: E* is £1,491.7m and, at Bramwick's 100% weight, RWA fall by £434.9m. Under the simple approach the gilts would take 20% (their 0% lifted to the floor) and the shares nothing, because an equity weight of 250% is worse than Bramwick's: RWA £1,686.6m, against £1,491.7m under the comprehensive approach.

Under F-IRB the same haircut collateral lowers the LGD instead. Financial collateral has an LGD of 0%, so LGD* = 40% × the unsecured share (CRE32.10 to 32.11): 30.97% for Bramwick, and RWA fall from £1,650.1m to £1,277.6m.

Guarantees and credit derivatives: substitution

A guarantee or credit derivative must be a direct claim on the provider, explicitly tied to the exposure, irrevocable and unconditional (CRE22.71). The provider must be eligible: sovereigns, banks and other regulated financial firms, or rated companies, in each case with a lower risk weight than the borrower (CRE22.76). Then substitution: “The protected portion is assigned the risk weight of the protection provider” (CRE22.79).

Hastemoor Construction Ltd is unrated, at 100%, with £603.3m of exposure. A bank rated A guarantees £300m of it. Under the SA that part takes the bank's 30%, and RWA fall from £603.3m to £393.3m. Under F-IRB the guaranteed part uses the guarantor's PD of 0.14% in the corporate function with the 45% LGD for a financial institution (CRE32.24 to 32.26, CRE32.6): risk weight 36.0% instead of 129.0%, and RWA from £778.1m to £499.1m.

Maturity mismatch

Protection that ends before the loan leaves the bank exposed for the rest. With a maturity mismatch, protection counts only if it was bought for at least a year and has at least three months left, and then only in part (CRE22.12 to 22.13). The bank bought a £500m CDS on Sallowmere Logistics GmbH for 5 years; it has 2 years left, and the loan 4. It counts as £233.3m, and less each year:

Protection left (t)	2 years	1 years	0.5 years	0.2 years
Pa (£m)	233.3	100.0	33.3	0.0

If the CDS does not treat a restructuring of the loan as a credit event, the bank could lose on a restructuring without being paid, so only 60% of the hedge counts (CRE22.75): £140m.

Try itMaturity mismatch

Protection: years left (t)2.00

Loan: years left (T)4.00

Restructuring a credit event?

Notional P£500m

T used = min(5, loan years)4.00

Pa = P × (2.00 − 0.25) / (4.00 − 0.25)£233.3m

Protection recognised£233.3m

Only 47% of the notional counts, and it falls to zero as the protection runs down to three months.

Starts at the bank's CDS on Sallowmere. With a mismatch, protection must also have an original maturity of at least one year (CRE22.12); this CDS was bought for five.

Netting, and the currency haircut

Where a legally enforceable netting agreement covers a customer's loans and deposits, the bank may treat the deposits as cash collateral (CRE22.68 to 22.69). Cash takes no haircut, but a currency mismatch does: Ostreth Energie GmbH holds £150m of euro deposits against a sterling loan (assumed). With “A 10-business day holding period” for netting (CRE22.69), the 10-day Hfx is 8%, so the deposits count as £138.0m.

Sort itDoes it count?

For each mitigant, decide whether the bank can recognise it in full, in part, or not at all.

Cash in the loan's currency, pledged under an enforceable agreement
A guarantee the guarantor can cancel at any time
A CDS with nine months left on a loan with three years left
Shares in the borrower's own parent company
Collateral pledged under a contract whose enforceability abroad has never been checked
Gilts pledged against a secured loan, same currency

The formal version

Comprehensive approach and haircuts (CRE22.46, CRE22.59), F-IRB LGD* (CRE32.10), mismatch (CRE22.13):

\begin{aligned} E^* &= \max\big(0,\ E\,(1 + H_e) - C\,(1 - H_c - H_{fx})\big) \\ H &= H_{10}\,\sqrt{T_M / 10} \\ \text{LGD}^* &= \text{LGD}_U \cdot \frac{E_U}{E\,(1+H_e)} + \text{LGD}_S \cdot \frac{E_S}{E\,(1+H_e)} \\ P_a &= P \cdot \frac{t - 0.25}{T - 0.25} \end{aligned}

$E$ : current exposure; $C$ : current value of the collateral; $H_e$ , $H_c$ : haircuts on exposure and collateral (zero on a cash loan); $H_{fx}$ : 8% at 10 days for a currency mismatch.
$H_{10}$ : the 10-day supervisory haircut; $T_M$ : the holding period, 5, 10 or 20 business days. This form assumes daily remargining or revaluation; CRE22.59 adds a term for the business days between revaluations.
$E_S = \min(C(1-H_c-H_{fx}),\ E(1+H_e))$ , $E_U$ the rest. $\text{LGD}_U$ : 40% (45% for financial institutions); $\text{LGD}_S$ : 0% for financial collateral.
$P$ : protection amount; $t$ : its residual maturity, capped at $T$ , the exposure's residual maturity capped at five years; both in years. $P_a = 0$ if $t < 0.25$ .
Substitution: $\text{RWA} = P_a \cdot \text{RW}_{\text{provider}} + (E - P_a) \cdot \text{RW}_{\text{borrower}}$ (60% of $P_a$ without restructuring).

Try it

Start with gilts against Bramwick. Change the collateral to main index shares and watch the haircut jump. Cut the holding period to 5 days, then flip the currency. Finally pledge enough cash to cover the loan.

Try itCollateral, haircuts and E*

Collateral

Market value of the collateral, £m500

Holding period (business days)

Collateral currency

Hc = 2.0% × √(20/10)2.83%

Hfx0.00%

Collateral after haircuts£485.9m

E* = max(0, 1,926.6 − C(1 − Hc − Hfx))£1,440.7m

SA RWA at 100%£1,440.7m

SA saving£485.9m

F-IRB saving£416.1m

F-IRB LGD* = 40% × E(unsecured) / E29.91%

F-IRB RWA£1,234.0m

Each £1 of this collateral removes 0.972 of exposure.

Starts at Bramwick Stores plc: E £1,926.6m, PD 1.13%, SA risk weight 100%, F-IRB LGD 40% unsecured, M 2.5. Haircuts are the 10-day supervisory haircuts of CRE22.49, scaled by the square root of time. Illustrative.

Worked example

Four mitigants on four loans

The four cases, £ millions. Each is worked under the SA and under F-IRB.

The four cases

Step 1 of 5

1
Bramwick: collateral
$\begin{aligned} C(1-H) &= 300\,(1 - 2.83\%) + 200\,(1 - 28.28\%) = 434.9 \\ E^* &= 1{,}926.6 - 434.9 = 1{,}491.7, \qquad \text{LGD}^* = 40\% \times \tfrac{1{,}491.7}{1{,}926.6} = 30.97\% \end{aligned}$

Borrower	Mitigant	SA RWA before	SA after	F-IRB before	F-IRB after
Bramwick Stores plc	Gilts and FTSE 100 shares, comprehensive approach	1,926.6	1,491.7	1,650.1	1,277.6
Hastemoor Construction Ltd	£300m guarantee from an A-rated bank	603.3	393.3	778.1	499.1
Sallowmere Logistics GmbH	£500m CDS, 2 years left on a 4-year loan	898.3	770.0	459.7	416.0
Ostreth Energie GmbH	£150m euro deposits netted, 10-day Hfx	974.8	905.8	623.7	579.6
Saving			842.3		739.3

The netting case uses the 10-day holding period of CRE22.69. Scaling the currency haircut to the 20 days of a secured loan instead, as the module's data first did, gives Hfx 11.31% and savings of £839.8m and £737.7m. Collateral and the CDS were applied to the whole facility at its EAD; under F-IRB Sallowmere Logistics GmbH keeps its physical collateral on the unprotected part. The 20-day period for the gilts and shares is CRE22.57's for secured lending.

Regulatory lens

CRM under the SA is CRE22; under IRB, CRE32 for LGD and guarantees. Statements on jurisdictions are as at 3 November 2026 as at 3 Nov 2026.

In the UK

The UK CRR sets out credit risk mitigation in Articles 192 to 241, with the maturity mismatch formula in Article 239(3) in the same form as CRE22.13. The Basel 3.1 version applies from 1 January 2027 (PS1/26, para 1.23).

In the EU

The EU uses the same CRR Articles, as amended by CRR3, which applies from 1 January 2025 (KPMG summary of CRR3, 2024).

In the US

The US standardized approach has its own simple approach, where the collateralised part's risk weight “may not be less than 20 percent”, and a collateral haircut approach in place of the comprehensive approach, for repo-style transactions, eligible margin loans and collateralised derivatives only (12 CFR 217.37). Guarantees and credit derivatives are in 12 CFR 217.36.

Spark Atoms

Spark AtomWhy the square root of time?

If daily price changes are independent, the variance of a move over n days is n times the daily variance, so its standard deviation, and the haircut, grow with √n. Doubling 10 days to 20 multiplies every haircut by 1.414.

Spark AtomThe restructuring clause

A loan can be restructured, with the lender taking a loss, without the borrower ever missing a payment. If the CDS pays only on bankruptcy or non-payment, the bank is left holding that loss. The Basel answer is a flat 60% (CRE22.75): £140m of Sallowmere's £233.3m.

Key takeaways

Funded mitigation shrinks the exposure; unfunded mitigation swaps the borrower's risk weight for the protection provider's.
Every mitigant needs legal certainty and no material positive correlation with the borrower.
The comprehensive approach haircuts collateral, scaled by √(holding period / 10): E* = E − C(1 − Hc − Hfx). The simple approach floors the secured part at 20%.
Protection that ends before the loan counts as P(t − 0.25)/(T − 0.25), and not at all in its last three months; a CDS without restructuring counts at 60%.
On four of the bank's loans the mitigants save £842.3m under the SA and £739.3m under F-IRB.

Reaction

Check what stuck

Question 1 · objective 2

A £100m loan is secured by £50m of sovereign bonds with a 10-day haircut of 4%, held at a 10-day holding period, same currency. What is E*, in £m?

£m

Question 2 · objective 2

A 10-day supervisory haircut of 20% applies to a repo with a 5-day holding period. What is the haircut, in %?

%

Question 3 · objective 4

A £100m CDS has 1.25 years left; the loan it protects has 3.25 years left. How much protection is recognised, in £m?

£m

Question 4 · objective 3

Under the SA, what risk weight does the guaranteed part of a loan get?

AThe guarantor's risk weight, if the guarantee meets the requirements and the guarantor is eligibleBThe average of the borrower's and the guarantor's risk weightsCThe borrower's risk weight less 20 percentage pointsDAlways 0%

Question 5 · objective 5

A borrower pledges its own shares as collateral. Can the bank recognise them?

ANo: their value would fall just as the borrower defaults, a material positive correlationBYes, at the main index haircutCYes, but only under the simple approachDOnly if the shares are listed abroad

Glossary

Credit risk mitigation: Credit risk mitigation (CRM): collateral, netting, guarantees and credit derivatives that the rules let a bank recognise to reduce the capital on an exposure.
Supervisory haircut: Supervisory haircut: the percentage cut from the value of collateral (or added to the exposure) for how far its price could move over the holding period (CRE22.49).
E*: E*: the exposure value after risk mitigation under the comprehensive approach: exposure plus its haircut, less collateral after its haircuts.
Holding period: Holding period: the business days the bank might need to sell collateral after a default: 5 for repos, 10 for other capital market deals, 20 for secured lending (CRE22.57).
Substitution: Substitution: the protected part of an exposure takes the risk weight of the guarantor or protection seller instead of the borrower's.
Maturity mismatch: Maturity mismatch: protection that runs out before the exposure does. Its value is scaled down, and it counts for nothing in its last three months (CRE22.10 to 22.13).
Currency mismatch haircut: Currency mismatch haircut Hfx: 8% at a 10-day holding period, applied when collateral or deposits are in a different currency from the exposure (CRE22.52).
Legal certainty: Legal certainty: CRM documents must be binding on all parties and enforceable in all relevant jurisdictions, backed by legal review (CRE22.9).

Deep Dives & Origins

Deep Dives

Basel Committee on Banking Supervision, CRE22: Standardised approach: credit risk mitigation: the full requirements and haircut tables. Intermediate.
L4.2.10: The securitisation framework: how securitisation transfers credit risk at scale. Intermediate.

Origins

Basel Committee on Banking Supervision, CRE22: Standardised approach: credit risk mitigation, paras 22.7, 22.9, 22.10–22.13, 22.19, 22.33, 22.46, 22.49, 22.52, 22.57, 22.59, 22.68–22.71, 22.75–22.76 and 22.79, version effective 1 January 2023, bis.org.
Basel Committee on Banking Supervision, CRE32: IRB approach: risk components, paras 32.6, 32.10–32.11 and 32.24–32.26, bis.org.
Regulation (EU) No 575/2013 as it applies in the UK, Article 239, legislation.gov.uk; Prudential Regulation Authority, PS1/26, para 1.23, January 2026.
KPMG AG Wirtschaftsprüfungsgesellschaft, EU-Bankenpaket und CRR III: Diese regulatorischen Neuerungen erwarten Institute im IRB-Ansatz, 2024.
12 CFR 217.36 and 217.37, law.cornell.edu.

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