P2.T7. Operational & Integrated Risk Management John Hull, Risk Management and Financial Institutions Basel I, II, and Solvency II Bionic Turtle FRM Video Tutorials By David Harper, CFA FRM Basel I, II, and Solvency II • Explain the motivations for introducing the Basel regulations, including key risk exposures addressed and explain the reasons for revisions to Basel regulations over time. • Explain the calculation of risk-weighted assets and the capital requirement per the original Basel I guidelines. • Describe and contrast the major elements—including a description of the risks covered—of the two options available for the calculation of market risk: Standardized Measurement Method & Internal Models Approach • Calculate VaR and the capital charge using the internal models approach, and explain the guidelines for backtesting VaR. • Describe and contrast the major elements of the three options available for the calculation of credit risk: Standardized Approach, Foundation IRB Approach & Advanced IRB Approach - Continued on next slide - Page 2 Basel I, II, and Solvency II • Describe and contract the major elements of the three options available for the calculation of operational risk: basic indicator approach, standardized approach, and the Advanced Measurement Approach. • Describe the key elements of the three pillars of Basel II: minimum capital requirements, supervisory review, and market discipline. • Define in the context of Basel II and calculate where appropriate: Probability of default (PD), Loss given default (LGD), Exposure at default (EAD) & Worst- case probability of default • Differentiate between solvency capital requirements (SCR) and minimum capital requirements (MCR) in the Solvency II framework, and describe the repercussions to an insurance company for breaching the SCR and MCR. • Compare the standardized approach and the internal models approach for calculating the SCR in Solvency II. Page 3 Explain the motivations for introducing the Basel regulations, including key risk exposures addressed and explain the reasons for revisions to Basel regulations over time. The primary motivation for bank regulation is to ensure that a bank holds enough capital for the risks it assumes. It is impossible to eliminate the possibility of a bank failure, but governments want to maximize confidence in the banking system by minimizing the default probability of banks. Deposit Insurance: Governments provide deposit insurance programs to protect depositors. Without deposit insurance, banks who take excessive risks relative to their capital base would find it difficult to attract deposits. Governments do not want to create a deposit insurance program that results in banks taking more risks. So, deposit insurance is accompanied by regulation concerned with capital requirements. Page 4 Explain the motivations for introducing the Basel regulations, including key risk exposures addressed and explain the reasons for revisions to Basel regulations over time (continued) Systemic risk is the risk that a failure by a large bank will lead to failures by other large banks and a collapse of the financial system. When a bank or other large financial institution experiences financial difficulties, governments have a dilemma. • If they allow the institution to fail, they create a systemic risk • But if they “bail out” the institution, they March 2008: Fed begins bailouts engender moral hazard Sep 2008: Lehman Brothers During the 2007-08 crisis, many large financial institutions were bailed out, rather than being allowed to fail, because governments were concerned about systemic risk. But the U.S. government allowed Lehman Brothers to fail in September 2008 to make it clear to the market that bailouts for large financial institutions were not automatic. Hull notes this decision to let Lehman Brothers fail arguably made the credit crisis worse. Page 5 Explain the motivations for introducing the Basel regulations, including key risk exposures addressed and explain the reasons for revisions to Basel regulations over time (continued) The Basel Committee formed in 1974 met regularly in Basel, Switzerland, under the patronage of the Bank for International Settlements. The first major result of these meetings was a document titled “International Convergence of Capital Measurement and Capital Standards”, and referred to as the 1988 BIS Accord; aka, “Basel I.” Before the formation of Basel I guidelines, banks maintained a pre-set minimum ratio of capital to their total assets, but there was lack of standardization in defining the capital as well as the banks’ assets. Each country had its own definitions for deriving the capital-assets ratio which gave undue advantages to the banks belonging to the countries with liberal guidelines on the ratio. The situation worsened with the increase in international exposure of the banks. Page 6 Explain the motivations for introducing the Basel regulations, including key risk exposures addressed and explain the reasons for revisions to Basel regulations over time (continued) Huge exposures created by loans from international banks to less developed countries (LDCs), and the accounting games used to cover those exposures including debt rescheduling raised questions about the adequacy of capital levels. • Banks started booking various unregulated (over-the-counter) derivative deals such as interest rate swaps, currency swaps, and foreign exchange options giving rise to complexity in bank transactions and exposing them to substantial credit risk. • Banks started booking over-the-counter derivatives as “off-balance sheet” transactions which lessened the pressure on banks’ balance sheet as the assets in their balance sheet remained unaffected due to the derivative contracts. As a result, banks required to keep lesser capital vis-à-vis their assets while ignoring the off-balance sheet transactions. Page 7 Explain the motivations for introducing the Basel regulations, including key risk exposures addressed and explain the reasons for revisions to Basel regulations over time (continued) In June 1999, the Basel Committee proposed new rules that have become known as Basel II which were revised in January 2001 and April 2003. A final set of rules agreed to by all members of the Basel Committee was published in June 2004. This was updated in November 2005. Implementation of the rules began in 2007 after a Quantitative Impact Studies (QIS). Page 8 Explain the calculation of risk-weighted assets and the capital requirement per the original Basel I guidelines. The Basel I Accord This accord was the first outcome of the efforts of Basel committee to design uniform banking risk management standards to ensure capital adequacy in banks. The accord was readily accepted for implementation by all 12 members. The accord put forth 2 mandatory conditions that banks had to necessarily fulfill: • Banks to keep capital equal to at least 8.0% of the risk-weighted assets. • Cooke Ratio as a primary regulatory requirement. Page 9 Explain the calculation of risk-weighted assets and the capital requirement per the original Basel I guidelines (continued) Cooke Ratio (= 8.0%) The Cooke ratio was used to compute minimum capital that a bank was required to keep vis-à-vis the risk associated to its on and off-balance sheet assets called risk- weighted assets (RWA), a measure of the bank’s total credit exposure. Let us understand the derivation of risk-weighted assets of a bank in detail on the next slide. Page 10 Explain the calculation of risk-weighted assets and the capital requirement per the original Basel I guidelines (continued) Risk Weighted Assets for On-Balance Sheet Items In Basel I accord, for each type of on-balance sheet asset, a specific risk-weight was assigned signifying the risk associated with the asset type. The table below shows a snapshot of such assignment from the accord: Risk Weights for On-Balance-Sheet Items Risk Weight (%) Asset Category 0 Cash, gold bullion, claims on OECD governments such as Treasury bonds or insured residential mortgages 20 Claims on (loans to) OECD banks and OECD public sector entities such as securities issued by U.S. government agencies or claims on municipalities 50 Uninsured residential mortgage loans 100 All other claims such as corporate bonds and less- developed country debt, claims on non-OECD banks Page 11 Explain the calculation of risk-weighted assets and the capital requirement per the original Basel I guidelines (continued) The total risk weight for a bank’s on-balance sheet assets portfolio is simply the sum of risk-weighted assets, as shown in the formula below: Total on-balance sheet RWA = ∑ th where is the principal amount of the item and is the corresponding risk weight. Example: The assets of a bank consist of $100.0 million of corporate loans, $10.0 million of OECD government bonds, and $50.0 million of residential mortgages. Compute the total risk-weighted assets. Total RWA = 100% x 100 + 0% x 10 + 50% x 50 = 125 or $125 million. Page 12 Explain the calculation of risk-weighted assets and the capital requirement per the original Basel I guidelines (continued) Risk Weighted Assets for Off-balance Sheet Items The off-balance sheet items include bankers’ acceptances, guarantees, and loan commitments. For deriving RWA they are converted into their credit equivalent amount. Conversion into credit equivalent amount leads to derivation of a loan principal amount having same credit risk. For non-derivative items such as trade financing products, note issuance facilities etc., a specific