In the case of financial collateral, for large exposure purposes, with the exception of institutions using the FCSM, institutions have to use the FCCM according to Article 401(2) CRR, regardless of the method used for calculating the own funds requirements for credit risk. In relation to SFTs, Article 401(2) CRR permits the institutions allowed to use the methods referred to in Section 4 of Chapter 4 of Title II of Part Three CRR (among others master netting agreements in accordance with Articles 220 and 221 CRR) and Section 6 of Chapter 6 of Title II of Part Three CRR (i.e. internal model methods –IMM- for counterparty credit risk) to apply those methods for calculating the exposure values of such transactions. According to Article 401(4) CRR, when an institution reduces an exposure to a client, the institution, in the manner set out in Article 403 CRR, shall treat the portion of the exposure by which the exposure to the client has been reduced as having been incurred for the protection provider rather than for the client. Then, Article 403(1)(b) CRR describes how the mandatory substitution applies in the case of financial collateral: an institution has to treat the portion of the exposure collateralised by the market value of recognised collateral as exposure to the third party (collateral issuer) rather than to the client, provided that the exposure is secured by collateral and provided that the collateralised portion of the exposure would be assigned a risk weight that is equal to or lower than the risk weight of the unsecured exposure to the client under Chapter 2 of Title II of Part Three CRR. However, it is not clear how the substitution has to be applied when an institution uses the FCCM, the IMM (for SFTs) or master netting agreements, since the wording of Article 403(1)(b) CRRII and the third subparagraph of Article 403(1) CRRII seems to be still tailored to the FCSM: - The condition to apply the substitution approach as set out in Article 403(1)(b) CRR (“provided that the collateralised portion of the exposure would be assigned a risk weight that is equal to or lower than the risk weight of the unsecured exposure to the client under Chapter 2 of Title II of Part Three”) is clearly tailored for the FCSM. Indeed, applying this condition to the FCCM would mean that the substitution is no longer mandatory when the risk weight of the collateral issuer is higher than the risk weight of the client, which does not make sense from a prudential point of view. - In Article 403(1)(b) CRR, the amount of the exposure to be assigned to the collateral issuer is the market value of the collateral, which is the value of the collateral used in the FCSM according to Article 222(2) CRR. The amount of the collateral used in the FCCM is the volatility-adjusted value of the collateral defined in Article 223(2) CRR. - The third subparagraph of Article 403(1)(b) CRR II still restricts the scope of substitution to where an institution uses the FCSM since, except in two applicable cases (for more details, see EBA Q&A 2014_793) where partial application is permitted, an institution is required to opt for either the FCCM or the treatment set out in Article 403(1)(b) of the CRR. And yet, Article 401(4) CRR refers to Article 403 CRR (the substitution approach), in such a manner, that an institution, when it reduces an exposure to a client using an eligible credit risk mitigation technique in accordance with Article 399(1) CRR shall treat the part of the exposure by which the exposure to the client has been reduced as having been incurred for the protection provider rather than for the client. Therefore, it is not clear from the wording of Article 401(4) CRR, referring to Article 403 CRR (“in the manner set out in Article 403”), together with the wording of Article 403(1)(b) CRR (which is clearly tailored for the FCSM) if the substitution approach is mandatory in the case of an institution using the FCCM or using the IMM (in the case of SFTs), or using master netting agreements together with FCCM, or using IMM for master netting agreements (in the case of SFTs), and whether it is necessary to reassign the secured part of the exposure towards the client as exposure towards the protection provider/collateral issuer. Can you clarify the situation, since the Basel text is however clear at least for the FCCM: the substitution approach shall apply to banks using the FCCM, according to the third bullet point of paragraph 42. Regarding IMM for SFTs, it should be noted that there is no exposure reduction via an eligible credit risk mitigation technique as referred to in Article 401(4) CRR. IMM is a method to directly calculate the exposure. There is no separate calculation of the amount to be deducted from the exposure when recognizing the collateral. However, collaterals are used. So the question arises, shall the substitution approach apply in this case? If yes, which amount shall the institution assign to the collateral issuer? A further question arises when a bank applies master netting agreements in the case of SFTs, using either the fully adjusted exposure value determined in accordance with Article 220 CRR (FCCM) or in accordance with Article 221 CRR (IMM). Does the substitution approach have to be applied to all collateral in a netting set or only to the net position if this is secured by collateral? Netting is one eligible form of credit risk mitigation regulated in Part Three, Title II, Chapter 4. However, one feature distinguishing netting from conventional credit risk mitigation techniques is the offsetting of positions that cancel each other out. In conventional credit risk mitigation techniques, the default risk of an exposure to a counterparty is reduced by financial collateral or a guarantee provided by a third party. The institution nevertheless retains an open position of the original value vis-à-vis the counterparty. In netting, by contrast, opposite positions of the bank and a counterparty are set off against one another. After that, only one position (the net position) remains. This means that the offsetting of positions which occurs in netting does not result in the default risk of the netted position being fully or partially replaced by the default risk of a third party. Does this mean that a substitution has not taken place as the secured amount is efficiently reduced and no additional exposure stemming from the CRM technique arises? Two questions remain: According to Article 399(1) CRR, an institution shall use a credit risk mitigation technique in the calculation of an exposure where it has used that technique to calculate capital requirements for credit risk in accordance with Title II of Part Three. Does this sentence mean that, under the large exposure framework, an institution cannot renounce to a credit risk mitigation technique it has used under the solvency framework? And what about the other way around? Is it allowed that an institution uses collateral to reduce the exposure amount only for the purposes of large exposures but not for calculating its capital requirements? Has the substitution approach according to Article 403 CRR to be applied in such cases?