Banks that are active in the credit derivative market are required to have in place internal limits on the gross amount of protection sold by them on a single entity as well as the aggregate of such individual gross positions. These limits shall be set in relation to the bank’s capital funds.
Banks shall also periodically assess the likely stress that these gross positions of protection sold, may pose on their liquidity position and their options/ability to raise funds, at short notice. Banks have to determine an appropriate liquidity reserve to be held against revaluation of these positions. This is important especially where the reference asset is illiquid like a loan.