Risk Management: Challenge anh Opportunity pptx

Analogue to the current methodology, the required amount of capital to cover a claim on the banking book is calculated by: exposure at default EAD • risk weight RW • 8% risk weighted ass

Second Revised and Enlarged Edition

Michael Frenkel ´ Ulrich Hommel

Risk Management Challenge and Opportunity

Second Revised and Enlarged Edition

With 100 Figures

and 125 Tables

1 2

Professor Dr Markus Rudolf

Professor Dr Ulrich Hommel

EUROPEAN BUSINESS SCHOOL International UniversityStiftungslehrstuhl

Unternehmensfinanzierung und Kapitalmårkte

Schloss Reichartshausen

65375 Oestrich-Winkel

ulrich.hommel@ebs.de

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In my "Word of Greeting" of the first edition of this book which was dedicated to Günter Dufey, I pointed out that I appreciate Günter Dufey as someone who builds bridges between Germany and the United States Meanwhile, almost 5 years have gone by Günter Dufey's significance as an academic intermediary between the continents has even increased since then Due to his efforts, the cooperation be-tween high ranked U.S business schools and the WHU - Otto Beisheim Hochschule in Germany have been intensified The joint summer MBA program

on the WHU campus is attended by 45 U.S students every year This number is still growing Moreover, since the issue of the first edition, Günter Dufey has enlarged his activity spectrum also to Asia In 2002 until 2003 Günter Dufey joined the Singapore Office of the firm as Senior Advisor, supporting the Corpo-rate Governance Practice of the firm in the Region Since then he was appointed

as Professor of Banking and Finance at the Nanyang Business School - Nanyang Technological University and as Principal of the Pacific International Business Associates Last but not least, he is now an ordinary member of the Singapore In-stitute of Directors

It is impressive to see the energy and the enthusiasm with which Günter Dufey travels restlessly around the world, once eastwards, another time westwards Without any doubt, it is quite unusual that a Festschrift sells out The first edition

of this book has been written by a global selection of financial experts They wanted to act as a sign of friendship by honoring Günter Dufey's 60th birthday I

am very happy, that the first edition was so successful because this indicates also the importance of the book' content

Much has been changed in the field of risk management since then Probably most significantly, there has been an intensive discussion between financial insti-tutions dealing with modified rules of determining the adequate amount of equity capital for risks The committee of banking supervision located at the Bank of In-ternational Settlement in Basel, Switzerland, has initiated several proposals known under the short form "Basel II" One of the core questions in the context of these capital adequacy rules is the capital requirement for credit risks According to Basel II, in the future this will be closer related to the rating of transaction coun-terparties enhancing the role of the rating process and the rating industry Another important risk category which is addressed by Basel II for the first time is opera-tive risk The terror attack on the World Trade Center on 11 September 2001 showed drastically how significant external and unpredictable events can be on the operations of any company, particularly of banks Moreover, risks form internal processes, people, or systems contribute to the success or to the failure of the business All these risks are summarized as new risk type in Basel II, namely as

operative risk Operative risk is much more difficult to measure than credit and market risks But they nevertheless affect the performance of financial institutions The deadline for implementing Basel II in national laws is year-end 2006 It is obvious that this development is intensively covered in the second edition of the book I hope that this book will help to understand the complex and new aspects of risk management better And I am happy that such an instructional content is asso-ciated to the name of my former student in Würzburg, Günter Dufey

Otmar Issing

Michael Frenkel, Ulrich Hommel, Markus Rudolf

The success of the first edition of this book encouraged us to update and extend this volume in order to provide an up-to-date and comprehensive survey of the major areas of risk management issues Since the first edition of this book, a num-ber of changes in the area of risk management took place Some of them are re-flected in the discussions on the “Basel II” rules The new edition takes these new developments into account Given the wider scope of the new edition, we decided

to structure the book according to the type of risk management the various aspects are most narrowly related to More specifically, we distinguish four broader top-ics Part 1 focuses on bank risk management, part 2 on insurance risk manage-ment, part 3 on corporate risk management, and part 4 on systemic issues of risk management In the following, a very brief outline of the papers is presented Part 1 begins with the analysis by Thomas Hartmann-Wendels, Peter Grundke and Wolfgang Spörk of the Basel II rules and their consequences on bank lending Then, Ingo Walter looks at conflicts of interest involving financial services firms

He shows the conditions that can cause or limit exploitation of conflicts of interest and argues that external regulation and market discipline can be both complements and substitutes A normative theory or risk management in banks is the subject of the contribution of Gerhard Schröck and Manfred Steiner Then, Claudia Holtorf, Matthias Muck and Markus Rudolf present a case study that analyses the new Basel capital accord requirements by applying the RiskMetricsTM Value at Risk

is the core of several papers in part 1 Alois Paul Knobloch surveys applications of this concept for risk measurement purposes; John Bilson uses to concept to review fixed income portfolios, Robert Härtl and Lutz Johanning examine risk budgeting, and Jack Wahl and Udo Broll examine the implications of Value at Risk for the optimum equity level of a bank Wolfgang Drobetz and Daniel Hoechle compare alternative estimates of conditional return expectations Subsequently, Ludger Overbeck surveys modelling of credit risk portfolios A critical evaluation of credit risk models is the topic of the paper by Hergen Frerichs and Mark Wahren-burg Related to this type of risk is the analysis of Stefan Huschens, Konstantin Vogl, and Robet Wania, who look at possibilities to estimate default probabilities and default correlations The subsequent two papers examine operational risk in the context of Basel II While Carol Alexander gives an overview of the different dimensions of this risk type, Wilhelm Kross addresses practical issues for man-agement dealing with such risk In the last paper of this part, Christoph Kaserer, Niklas Wagner and Ann-Kristin Achleitner investigate possibilities to measure private equity returns under conditions of illiquidity

Part 2 focuses on insurance risk management Martin Nell and Andreas Richter discuss three issues related to the management of catastrophic risk which stem from the terror attacks of September 11, 2001 Subsequently, Christopher Culp surveys products and solutions that represent the convergence or integration of

capital markets and traditional insurance Such products are referred to as tive risk transfer Ulrich Hommel and Mischa Ritter address a similar area of risk management They analyze the main forces behind the securitization of catastro-phic insurance risk and derive conclusions as to how other forms of insurance can

alterna-be transferred to financial markets In recent years, demographic changes in a number of advanced economies have been discussed intensely The paper of Petra Riemer-Hommel and Thomas Trauth addresses this issue by analyzing possibili-ties of managing longevity risk associated with pension, annuity and long-term care products Particularly in the German market, another problem of life insur-ance companies generate from unknown capital market developments and the si-multaneously issued interest rate guarantees of traditional life insurance products Peter Albrecht and Carsten Weber investigate the implications of this constellation

on the asset allocation decision

Part 3 includes papers that discuss a variety of issues of corporate risk ment In the first paper, Fred Kaen addresses the relationship between risk man-agement and corporate governance and makes the point that risk management not only helps a firm to survive but also serves broader policy objectives In the next paper, Christian Laux examines how corporate risk management can be integrated into the objective of maximizing firm value Subsequently, Ulrich Hommel inves-tigates the more fundamental question why the management of corporate risk should be managed at all and why it should be managed on the firm rather than the investor level Focusing on a German regulation requiring firms to implement risk management systems, Jürgen Weber and Arnim Liekweg discuss critical imple-mentation issues for non-financial firms How risk analysis and risk aggregation enters value-based corporate risk management is the topic of the paper by Werner Gleißner A more macroeconomic focus of risk is presented by Lars Oxelheim and Clas Wihlborg who emphasize the importance of exchange rates, interest rates and inflation rates in estimating corporate risk This issue is taken one step further in the paper of Matthias Much and Markus Rudolf as they include international is-sues of corporate risk management They use the case study of three airlines to emphasize commodity and exchange rate risk and show the effects on corporate risk by applying the “Earnings at Risk” concept A consequence of corporate risk

manage-is the use of financial derivatives in rmanage-isk management In thmanage-is context, real options represent alternatives to financial hedging The paper of Alexander Triantis uses a specific example to discuss the implications of these alternatives Operational and managerial flexibility in international supply chains also contribute to real options Arnd Huchzermeier uses a case study to illustrate the value of such flexibility for risk management In the international context, exchange rate exposure represents a major risk, when cross-border acquisitions are considered Stefan Hloch, Ulrich Hommel, and Karoline Jung-Senssfelder show that this risk stems from consider-able time lags between the acquisition decision and its implementation due to, e.g., the process of regulatory clearance by the antitrust authorities In the following paper, Christian Geyer and Werner Seifert describe electricity derivatives as new risk classes to organized exchanges and explain why the German Stock Exchange (Deutsche Börse) intends to establish an exchange for energy derivatives Foreign exchange risk is more closely examined in two contributions While Martin Glaum

presents an empirical study on the measuring and management of foreign change risk in large German non-financial corporations, Kathryn Dewenter, Robert Higgins and Timothy Simin show that, contrary to many studies presented earlier in the literature, there is a negative influence of the value of the dollar and stock returns of U.S multinational firms The subsequent paper by Wolfgang Breuer and Olaf Stotz addresses the problem of securing the real value rather than the nominal value of assets in risk management The last paper of part 3 focuses

ex-on capacity optiex-ons Stefan Spinler and Arnd Huchzermeier explain how optiex-ons

on capacity can be used in capital intensive industries for risk management Part 4 focuses on more systemic risk aspects with which firms have to deal in the national and the international environment Adrian Tschoegl argues in his con-tribution that financial debacles in the mid-1990s are the result of management failures and suggests that risk management has to take into account that such er-rors are the result of human nature While this emphasizes a microeconomic ele-ment of risk management, Michael Frenkel and Paul McCracken show that a cur-rency union as represented by the European Monetary Union exerts several additional risks which firms operating in this area have to recognize Whether risk management itself makes financial markets riskier is discussed in the paper by Ian Harper, Joachim Keller and Christian Pfeil The authors argue that both on theo-retical and empirical grounds there are indications that this is indeed possible In the same direction, Torben Lütje and Lukas Menkhoff analyze risk management

of institutional investors may lead to the behaviour of rational herding A final look at systemic risk aspects is presented by Mitsuru Misawa He looks at the Japanese experience in the 1990s when financial markets suffered significant damage due to the burst of the asset price bubble and evaluates Japan’s big bang financial reform

Although this book covers a variety of diverse aspects of risk management, no book on this broad and complex issue can cover all aspects Therefore, we were forced to be selective in certain areas In addition, new topics may come up in the future, as further risk categories may continue to evolve and both risk manage-ment and policies will also further develop

Such a volume cannot be completed without the help of many individuals We thank all authors and those that have given us suggestions for the new edition We are very grateful to Kerstin Frank who showed enormous commitment and pa-tience in preparing the manuscript We are also thankful to Gudrun Fehler for proofreading a number of papers of this volume and to Martina Bihn representing the publisher for her support and patience in making this new edition possible

A Word of Greeting V

Preface VII Part 1: Bank Risk Management

Thomas Hartmann-Wendels, Peter Grundke and Wolfgang Spörk

Conflicts of Interest and Market Discipline in Financial Services Firms 25

Ingo Walter

Gerhard Schröck and Manfred Steiner

Claudia Holtorf, Matthias Muck, and Markus Rudolf

Value at Risk:

Regulatory and Other Applications, Methods, and Criticism 99

Alois Paul Knobloch

Parsimonious Value at Risk for Fixed Income Portfolios 125

John F O Bilson

Robert Härtl and Lutz Johanning

Jack E Wahl and Udo Broll

Parametric and Nonparametric Estimation of Conditional

Wolfgang Drobetz and Daniel Hoechle

Ludger Overbeck

Hergen Frerichs and Mark Wahrenburg

Estimation of Default Probabilities and Default Correlations 239

Stefan Huschens, Konstantin Vogl, and Robert Wania

Managing Investment Risks of Institutional Private

Christoph Kaserer, Niklas Wagner and Ann-Kristin Achleitner

Assessment of Operational Risk Capital 279 Carol Alexander

Wilhelm Kross

Part 2: Insurance Risk Management

Catastrophic Events as Threats to Society:

Martin Nell and Andreas Richter

New Approaches to Managing Catastrophic Insurance Risk 341 Ulrich Hommel and Mischa Ritter

Christopher L Culp

Petra Riemer-Hommel and Thomas Trauth

Asset/Liability Management of German Life Insurance Companies:

A Value-at-Risk Approach in the Presence of Interest Rate Guarantees 407 Peter Albrecht and Carsten Weber

Part 3: Corporate Risk Management

Risk Management, Corporate Governance and the Public Corporation 423 Fred R Kaen

Statutory Regulation of the Risk Management Function in Germany:

Implementation Issues for the Non-Financial Sector 495 Jürgen Weber and Arnim Liekweg

A Comprehensive Approach to the Measurement of

Lars Oxelheim and Clas Wihlborg

Foreign-Exchange-Risk Management in German

Non-Financial Corporations: An Empirical Analysis 537 Martin Glaum

Estimating the Exchange Rate Exposure of US Multinational Firms:

Kathryn L Dewenter, Robert C Higgins and Timothy T Simin

International Corporate Risk Management:

Matthias Muck and Markus Rudolf

Corporate Risk Management: Real Options and Financial Hedging 591 Alexander J Triantis

The Real Option Value of Operational and Managerial Flexibility

Arnd Huchzermeier

Managing Acquisition-Related Currency Risk Exposures:

Stefan Hloch, Ulrich Hommel, and Karoline Jung-Senssfelder

Introducing New Risk Classes to Organized Exchanges:

Christian Geyer and Werner G Seifert

Was Enron’s Business Model Fundamentally Flawed? 671 Ehud I Ronn

“Real” Risk Management:

Opportunities and Limits of Consumption-based Strategies 679 Wolfgang Breuer and Olaf Stotz

Capacity Options: Convergence of Supply Chain Management

Stefan Spinler and Arnd Huchzermeier

Part 4: Systemic Issues of Risk Management

Adrian E Tschoegl

Michael Frenkel and Paul McCracken

Does Risk Management Make Financial Markets Riskier? 765 Ian R Harper, Joachim G Keller, and Christian M Pfeil

Risk Management, Rational Herding and Institutional Investors:

Torben Lütje and Lukas Menkhoff

Revitalization of Japanese Banks – Japan’s Big Bang Reform 801 Mitsuru Misawa

A Word of Greeting V

Preface VII Part 1: Bank Risk Management

Thomas Hartmann-Wendels, Peter Grundke and Wolfgang Spörk

1.1 Why Do We Need a More Sophisticated Banking Supervision? 5

3.1 The IRB Approach for the Corporate Asset Class 9

3.1.1 Basic Structure of the IRB Approach for the Corporate Asset

3.2 The IRB Approach for the Retail Asset Class 17

Conflicts of Interest and Market Discipline in Financial Services Firms 25

Ingo Walter

1.1 Conflicts of Interest in Wholesale Financial Markets 28

1.2 Conflicts of Interest in Retail Financial Services 31

2 Conflicts of Interest and Strategic Profiles of Financial Firms 36

2.1 Potential Conflicts of Interest in Multifunctional Client

Gerhard Schröck and Manfred Steiner

2 Necessity for a Framework on Risk Management in Banks

3.1 Evolution of Capital Budgeting Rules in Banks 60

5 Implications of the New Approaches on Risk Management

5.1 Implications for Risk Management Decisions 68

5.2 Implications on Capital Budgeting Decisions 71

5.3 Implications on Capital Structure Decisions 71

6 Foundations for a Normative Theory for Risk Management in Banks 72

Claudia Holtorf, Matthias Muck, and Markus Rudolf

3 Regulatory Reporting, VaR, and Capital Requirement 89

Value at Risk:

Regulatory and Other Applications, Methods, and Criticism 99

Alois Paul Knobloch

1 The Concept of Value at Risk and its Role in

1.1 Value at Risk: Definition and Risks of Concern 100

2 Calculating Value at Risk: Methods and Inherent

2.2 Simulation Methods: Historical and Monte Carlo Simulation 107

3 Risk Reduction and Capital Allocation Within a Value at Risk

Framework 109

4 Shortcomings of Value at Risk as a Measure of Risk 114

1.3 The Level, Slope, and Curvature (LSC) Model 133

Robert Härtl and Lutz Johanning

4 Adjusting Risk Limits for Time Horizons and

5 Incorporating Asset Correlations Into Risk Budgets 150

Jack E Wahl and Udo Broll

2.5 Bandwidth Selection for Nonparametric Regression Estimators 182

Hergen Frerichs and Mark Wahrenburg

2 Backtests Based on the Frequency of Tail Losses 221

4 Forecast Evaluation Approaches to Backtesting 231

3.2 Estimation in a General Bernoulli Mixture Model 250

Managing Investment Risks of Institutional Private

Christoph Kaserer, Niklas Wagner and Ann-Kristin Achleitner

2.4 Cash Flow Based Returns 267

Carol Alexander

1.1 Frequency, Severity and the Loss Distribution 283

2.1 Choosing the Functional Form of the Loss Model 289

Wilhelm Kross

1.3 Inefficiencies in AMA Compliance Management 310 1.4 Desirable Side-Effects in OpRisk Management 311 1.5 Priorities and Maximized Value in OpRisk Management 313 1.6 Generic Roadmap towards Effective OpRisk Management 315

Part 2: Insurance Risk Management

Catastrophic Events as Threats to Society:

Martin Nell and Andreas Richter

4 Problems with Catastrophe Insurance Demand 335

New Approaches to Managing Catastrophic Insurance Risk 341 Ulrich Hommel and Mischa Ritter

5 Risk Management Strategies Using CAT-Linked Securities 352

5.1 Ex-Post Capital Provision and Funding Cost Reduction with

Petra Riemer-Hommel and Thomas Trauth

2 Establishing the Relevance of Longevity Risk to the Insurance Industry 392

3 Economic Reasons for the (Re)Insurance Gap 396 3.1 Difficulties in Forecasting Longevity Trends 397

3.4 Absence of Diversification and Hedging Opportunities 400

4 Possible Solutions for Longevity Risk (Re)Insurance 401

Asset/Liability Management of German Life Insurance Companies:

A Value-at-Risk Approach in the Presence of Interest Rate Guarantees 407 Peter Albrecht and Carsten Weber

3 The Case of German Life Insurance Companies 411

5 Book Values of Assets 413

10 Appendix C: Conversion of Market Values into Book Values 419 Part 3: Corporate Risk Management

Risk Management, Corporate Governance and the Public Corporation 423 Fred R Kaen

2 “Scientific” Theoretical Perspective on Risk Management 424

3 From Theory to Practice: Why Firms Should Manage Risk 426

3.2 Reducing Financial Distress and Bankruptcy Costs 427 3.3 Using Risk Management to Encourage and Protect

3.4 Using Risk Management to Monitor and Control Managers 430 3.5 Using Risk Management to Improve Decision Making

Christian Laux

5 Interactions Between Risk Management, Financial Structure,

7 Risk Management and Managerial Incentive Problems 449 Value-Based Motives for Corporate Risk Management 455 Ulrich Hommel

2 The Irrelevance Theorem of Modigliani-Miller (MM) 456

3 Value Based Motives for Corporate Risk Management 458 3.1 Raising the Efficiency of Financial Contracting 459

3.3.1 Transaction Cost of Financial Distress 468

3.5 Coordinating Financial and Investment Policies 471

Value-based Corporate Risk Management 479 Werner Gleißner

2.3 Aggregating Risks: Definition of Total Risk Volume 484

2.5 Designing Risk Management Systems and Monitoring 486

3 Risk, Cost of Capital and Shareholder Value 487 3.1 Introducing Considerations, the Shareholder Value 487 3.2 Enterprise Value and Capital Costs in Efficient Markets 488

3.4 Deriving Realistic Cost of Capital Rates 490 3.5 Further Consequences of Inefficient Capital Markets 491

Statutory Regulation of the Risk Management Function in Germany:

Implementation Issues for the Non-Financial Sector 495 Jürgen Weber and Arnim Liekweg

1 Introduction: Statutory Regulations as Cause of a

2 Entrepreneurial Risk and Risk Management: A Holistic Approach 497

2.3 The Process of Entrepreneurial Chance and Risk Management 499

2.4 The Process-External Monitoring and Revision Function 508

3 Summary: The Critical Factors for the Implementation of the

A Comprehensive Approach to the Measurement of

Lars Oxelheim and Clas Wihlborg

4 The Choice of Independent Variables and Time Horizon 519

6 Results, Interpretations and the Use of Coefficients 524

6.3 Exposure Under Pegged Versus Flexible Exchange Rates 527 6.4 What Has Financial Exposure Management Achieved? 528 6.5 Financial Structure as a Hedge Against Macroeconomic Exposure 529

7 Using Estimated Coefficients for Future Periods 530

8 Concluding Remarks and the Use of MUST Analysis in External Reporting 533

Foreign-Exchange-Risk Management in German

Non-Financial Corporations: An Empirical Analysis 537

Martin Glaum

2 Theoretical Framework: Measurement and Management of Foreign-

4.3 The Use of Foreign-Exchange-Rate Forecasts 549

4.4 Organization of Exchange-Rate Management 550

4.5 Further Arguments and Hypotheses on Exchange-Risk Management 551

Estimating the Exchange Rate Exposure of US Multinational Firms:

Kathryn L Dewenter, Robert C Higgins and Timothy T Simin

2 Sample Selection and Event Study Methodology 560

3 Event Study Measures of Exchange Rate Exposure 562

International Corporate Risk Management:

Matthias Muck and Markus Rudolf

Alexander J Triantis

1 Identification and Classification of Risks 592

3 Using Derivatives and Other Contracts to Manage Risk 597

4 Using Real Options to Hedge and Exploit Risk 599

5 Using Real versus Financial Options for Hedging 601

6 Creating an Integrated Risk Management Strategy 603

The Real Option Value of Operational and Managerial Flexibility

Arnd Huchzermeier

2.2.1 The Two-stage Supply Chain Network Model Formulation 612 2.2.2 The International Two-stage Supply Chain Network Model 613

3 The Option Value of Managerial Flexibility 617

3.1.1 Stochastic or Scenario Programming Formulation with Recourse 618 3.1.2 The Option Value of Managerial Flexibility under Demand Risk 619

3.2.4 The Option Value of Managerial Flexibility under Demand Risk

Managing Acquisition-Related Currency Risk Exposures:

Stefan Hloch, Ulrich Hommel, and Karoline Jung-Senssfelder

2 Currency Risk Exposures in Cross-Border Acquisitions 633

3 Introducing an Acquisition-Related Approach to Managing

Introducing New Risk Classes to Organized Exchanges:

Christian Geyer and Werner G Seifert

2.1 The Integration of the Markets is Accelerating 653 2.2 Consolidation of European Market Infrastructures 654 2.3 A New Understanding of Roles, New Technologies, and

New Abilities Need a Different Form of Capitalization 657

3.1 Challenges and Opportunities in the Emerging Power Market 659

3.3 Opportunities Offered by an Electricity Exchange 661

3.5 Determinants of Power Prices and Related Risks 662 3.6 Limitations of Black/Scholes With Respect to Electricity 663

4 Price Discovery: Reshaping the Power Industry 664

4.2 Price Discovery in Bilateral and Exchange Markets 666 4.3 Reshaping of the Energy Industry has Begun 667 4.4 The Creation of the European Energy Exchange 667

5.1 The Future of Deutsche Börse: Developer and Operator of Markets for

Was Enron’s Business Model Fundamentally Flawed? 671 Ehud I Ronn

2 Causes for Market-Value Losses Known Prior to Oct 16, 2001 671

3 Corporate Governance and the Slide towards Bankruptcy:

Business Practices Brought to Light Subsequent to Oct 16, 2001 672

4 The Aftermath of Enron for Merchant Energy 674

5 The Economic Role of Markets: Price Discovery, Risk Management

6 Was Enron’s Business Model Fundamentally Flawed? 676

“Real” Risk Management:

Opportunities and Limits of Consumption-Based Strategies 679 Wolfgang Breuer and Olaf Stotz

4 Consumption Oriented Utility and International Invitations for Tenders 684

4.4.1 Active Risk Management Only at t = 1 690 4.4.2 Active Risk Management Only at t = 0 692

Capacity Options: Convergence of Supply Chain Management

Stefan Spinler and Arnd Huchzermeier

2 Supply Contracting: Emergence of Forward Buying,

2.2 Long-Term Investment vs Short-Term Flexibility 701

3.3 Trading Opportunities for Flexibility Contracts 713

Part 4: Systemic Issues of Risk Management

Michael Frenkel and Paul McCracken

2 Risks Stemming from Excessive Government Borrowing 743

3 Risks of High Adjustment Costs Stemming from European Labor Markets 750

Does Risk Management Make Financial Markets Riskier? 765 Ian R Harper, Joachim G Keller, and Christian M Pfeil

3.1 Some Comments on Different Approaches to VaR 768

4 Some Empirical Results on Volatility in Major Stock Markets 772

Risk Management, Rational Herding and Institutional Investors:

Torben Lütje and Lukas Menkhoff

2 Incentives towards Rational Herding of Institutional Investors 787

4.1 Evidence of Herding Among Institutional Investors 790

4.2 Relation between the Perception of Herding and the

Institutional Investors' Characteristics 792

4.3 Perception of Herding and the Sources of Information 794

5 Consequences for the Management of Macro Risks 796

Revitalization of Japanese Banks – Japan’s Big Bang Reform 801

Mitsuru Misawa

2 Demise of the High Growth Period and Birth of the Bubble Economy 803

3 The Japanese Big Bang (Financial Overhaul) 805

4.1 Shift toward the “Business-Category Subsidiary” System 807

4.2 Legalization of Financial Holding Companies 808

5 Revitalization through Coordination and Consolidation 810

6 Risk Management by Deferred Tax Accounting 815

7 A Case of Major Bank’s Default – Risk Avoiding by Nationalization 817

8 Future of Japan’s Big Bang Financial Reform 819

Authors 821

PART 1 Bank Risk Management

Thomas Hartmann-Wendels, Peter Grundke and Wolfgang Spörk1

1University of Cologne, Department of Banking, Albertus-Magnus-Platz,

50923 Cologne, Germany

Abstract: Basel II will dramatically change the allocation of regulatory equity capital to credit risk positions Instead of an uniform 8 % capital charge regula-tory equity capital will depend on the size of the credit risk, measured either by ex-ternal or by internal rating systems This will lead to a dramatic change in the bank-debtor relation Credit spreads will widen and for high risk borrowers it may become difficult to get new loans The major Basel II rules are surveyed and their consequences for bank lending are discussed.*

* The survey on the Basel II rules is based on the information released by the Basel

Com-mittee on Banking Supervision until the submission deadline of this contribution in tober 2003

Oc-The New Basel Capital AccordPILLAR I

• review of the institution´s capital adequacy

• review of the institution´s internal assessment process

PILLAR IIImarket discipline

• enhancing transparency through rigorous disclosure rules

The New Basel Capital AccordPILLAR I

• review of the institution´s capital adequacy

• review of the institution´s internal assessment process

PILLAR IIImarket discipline

• enhancing transparency through rigorous disclosure rules

Fig 1.1 Overview on the New Basel Capital Accord

In the first pillar the rules for quantifying the necessary amount of capital to cover the risk exposure of the various risk types are specified Besides the already (ex-plicitly) regulated credit and market risk positions, operational risk is included as a new risk type Operational risk is defined as “the risk of loss resulting from inade-quate or failed internal processes, people and systems or from external events” (Basel Committee 2003b, p 2) As the methodologies to capture market risk re-main nearly unchanged compared to the 1996 update on the Basel Accord (Basel Committee 1996), the most far-reaching changes in this pillar stem from credit risk The consequences of the refined measurement framework and risk coverage for the banking business are in the focus of the following discussion

Although pillars II and III have not been to the same extend controversially cussed in the public, they have enormous consequences for the banking industry, especially in the credit area The proposals of pillar II display a strong qualitative element of supervision in opposite to the current regulation, in which a nearly sole quantitative regulation approach can be observed For example, banks are encour-aged to develop – based on a supervisory catalogue of qualitative criteria – own methods to measure credit and operational risk Besides for an internal use (for risk management), these can also be used for regulatory purposes, when the super-visor testifies the compliance with the criteria catalogue This fundamentally new way of supervision will lead to a merger of internal and regulatory risk manage-ment systems The widened disclosure requirements, especially concerning the used risk management systems that are proposed in the third pillar, will enhance the transparency and thereby allow a deeper insight into an institute’s risk profile

dis-Due to the increased transparency market participants may be able to evaluate the individual risk profile and the corresponding capital coverage of an institute more rigorously and sanction it adequately This market discipline effect will lead to an additional banking supervision through the market participants and will transfer some of the supervisory duties to the markets

At early stages of negotiating an internationally accepted update of the 1988 Capital Accord, it was planned to implement Basel II in 2004 But the ambitious goal to integrate different cultures, varying structural models and the complexity

of public policy and existing regulation led to the need for an intensive discussion process This need for aligning the original proposals was also raised by various Quantitative Impact Studies (Basel Committee 2001b, 2002, 2003c,d), which showed that the aim of a lower capital requirement for more ambitious approaches

in measuring the various risks was not met Moreover, the public pressure and the lobbying work of organizations representing small and medium sized enterprises (SME) resulted in an integration of political ideas in an originally economical concept Currently it is planned that the Basel Committee will publish the final version of the New Basel Capital Accord by no later than midyear 2004 There is hope that Basel II will be implemented by various national bank supervisors by the end of 2006

 9J[&Q9G0GGFC/QTG5QRJKUVKECVGF$CPMKPI5WRGTXKUKQP!

By integrating operational risks in the new regulatory framework and increasing the transparency, some of the systematic weaknesses of the 1988 Capital Accord can be reduced But the most obvious changes of the revised Capital Accord are related to the area of credit risks or, to be more precise, to the credit risks of the banking book The by far largest positions in the banking book are traded and non-traded claims on sovereigns, banks and other customers As the potential loss from these positions is determined by the amount outstanding and the creditworthiness

of the borrower, the capital charge under the current regulation results from the product of both parameters multiplied with the solvability coefficient of 8% The creditworthiness of each borrower is quantified by a system of standardized risk weights For sovereigns the risk factor is 0% or 20%, for banks 20% and for all other borrowers – independent from their individual creditworthiness – 100%

It is quite obvious that a flat risk weight of 100% for all banks (and sovereigns) can not catch adequately the individual credit quality One reason for such an undifferentiated regulation approach may be found in the trade-off be-tween the complexity of implementation of a regulation and the degree of accu-racy in assessing the individual creditworthiness Another argument in favor of such a simple risk measurement system stems from the hope that the flat risk weights may not reflect a proper measurement for an individual borrower, but on average (over all claims in the banking book) the total credit risk is captured at least approximately correct From the point of view of a bank supervisor it is satis-fying that the total amount of credit risk of the whole banking book is covered

non-Unfortunately, many banks (ab)used the undifferentiated risk measurement tem for regulatory arbitrage For example they sold their “good” claims of the banking book (usually via asset backed transactions; ABS) This resulted in a situation in which more “bad” claims than on average remained in the banking book for which an average risk weight is obviously not high enough Moreover, an increasing divergence of economic and regulatory capital was observable

sys-Another consequence of the undifferentiated way of assessing the credit quality

of borrowers can be seen in the lending margins As the banks have to apply the same risk weight for all non-banks, independent of their real credit quality, they have to cover different risk exposures with the same amount of regulatory capital This divergence of economic and regulatory capital leads to a subsidization of

“bad” borrowers by “good” borrowers, i.e good borrowers pay too much for their loans

To overcome the weaknesses of the current regulation, banks can use in the ture one of the three following approaches to measure the credit risk of their bank-ing book In the standardized approach the risk weights are derived from credit assessments from qualified rating agencies (see Basel Committee 2003a, pp 14-15 for an catalogue of eligibility criteria), whereas in the internal ratings based ap-proaches (IRB) the risk weights are estimated by the institute itself Banks can choose between a foundation and an advanced IRB approach These three ap-proaches will be introduced in the next chapters

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The standardized approach is merely a modification of the current regulatory framework Analogue to the current methodology, the required amount of capital

to cover a claim on the banking book is calculated by:

exposure at default (EAD) • risk weight (RW) • 8%

risk weighted asset

exposure at default (EAD) • risk weight (RW) • 8%

risk weighted assetAlthough the structure of the formula is equivalent to the approach in the current version of the Capital Accord and the solvability coefficient is unchanged, there are some differences in the definitions of the components which enter the calcula-tion of the risk weighted assets This is due to the fact, that implicitly all “other risks” have been covered with the amount of capital for credit risks under the cur-rent regulation As most of the risks formerly known as “other risks” are captured now explicitly as operational risks, but the total capital requirement to cover all risks should remain unchanged, the definition of the credit exposure is changed by recognizing credit risk mitigations as a mean to lower the exposure

Quite similar to the current regulation, the claims in the banking book are gorized in claims on sovereigns and on banks The former group of “non-banks” is

cate-split into a category of corporate claims and a “regulatory retail portfolio” All claims on private customers and on SMEs with a total exposure of less than € 1 million belong to this new group In addition to the current categories, ABS are treated as a separate category

In opposite to the 1988 Capital Accord, different risk weights are applied to the exposures in each of the categories The individual risk weight is determined by the credit assessment of an external rating agency To all not-rated borrowers a standardized risk weight is applied This risk weight is in most cases higher in comparison to the current regulation (see table 1.1 for details)

Beside the categories that are based solely on the status of the borrower, gages on residential property are treated with a risk weight of 35% For mortgages

mort-on nmort-on-residential property a flat risk weight of 100% has to be applied The signment of the risk weights to a claim outlined in Tab 1.1 can be changed in a more favorable way, if the claim’s credit risk is either transferred to a third party

as-or collateralized by qualified assets

Table 1.1 Risk weights in the standardized approach

risk weights (in %) banks

BB-100

350 B+ to B-

The standardized approach allows for a wider recognition of credit risk mitigants (CRM) for regulatory purposes than under the current regulation The three ways

to reduce the amount of risk weighted assets through CRM are presented in Fig 2.1 (based on Hartmann-Wendels 2003, p 39):

netting agreements financial collaterals

EAD is reduced to the

net amount owed to

the other party

comprehensive approach:

EAD is reduced by the adjusted value of the collaterals

simple approach:

RW of the claim is substituted by the risk weight of the collateral

RW of the claim is substituted by the

RW of the third party that buys or guarantees the risk

exposure at default (EAD)

risk weight (RW)

risk weighted assets

credit derivatives/guarantees netting agreements financial collaterals

EAD is reduced to the

net amount owed to

the other party

comprehensive approach:

EAD is reduced by the adjusted value of the collaterals

simple approach:

RW of the claim is substituted by the risk weight of the collateral

RW of the claim is substituted by the

RW of the third party that buys or guarantees the risk

exposure at default (EAD)

risk weight (RW)

risk weighted assets

credit derivatives/guarantees

Fig 2.1 The influence of CRM-techniques on the risk weighted assets

CRM techniques are recognized only under a restrictive set of requirements (see Basel Committee 2003a, pp 17ff for details) concerning the legal certainty in the case of a credit event Whereas netting agreements can only reduce the EAD and credit derivatives and guarantees lead to a situation in which a more favorable risk weight can be applied to the credit exposure, financial collaterals can influence each of the parameter of the risk weighted assets, depending on the used approach Financial collaterals are defined as highly liquid assets with a low volatility con-cerning their values (see Basel Committee 2003a, pp 22 ff for the list of eligible instruments)

Using the simple approach, banks may apply the more favorable risk weight of the collateral for the collateralized credit exposure If a bank decides for the com-prehensive approach, more financial assets are eligible, e.g equities that do not belong to a main index The market value of these collaterals has to be reduced by so-called “haircuts”, which should capture possible changes in value Only the ad-justed value of the collateral reduces the EAD of the collateralized credit expo-sure The collateralized exposure is calculated as follows:

E* = max {0, [E ⋅ (1+He) – C ⋅ (1 – Hc – Hfx)]} (1) where: E*= the exposure value after risk mitigation

E = the exposure value before risk mitigation

C = the current value of the collateral received

Hx = haircut appropriate to the exposure (x = e); for currency mismatch ween the collateral and exposure (x = fx); to the collateral (x = c)

bet-Banks have the choice between standard supervisory haircuts (see Basel tee 2003a, p 24 for details) and own estimations of potential changes in value of the various categories of eligible financial instruments When a bank decides for

Commit-an own model to estimate the haircuts, the use of this model is subject to the mission of the supervisory authorities

per-Summarizing, one can state that even with the standardized approach a more differentiated concept to measure the credit risks was designed, which overcomes some of the weaknesses of the current regulation Especially the revised definition

of the credit exposure (by recognizing CRM-techniques for regulatory purposes) leads to a more realistic risk measurement Moreover, the introduction of a new asset-category for ABS with very high risk weights for tranches rated BB+ and be-low, will give no more incentives for regulatory arbitrage Nevertheless, the stan-dardized approach is – at least for Germany and most of the European countries –

no suitable regulatory framework, because only a very low percentage of all panies (and by definition no private obligor) has a rating As a consequence, the number of applicable risk weights is similar to the current regulation, as for nearly all claims on the banking book the risk weights from the “non-rated” category have to be applied Therefore, this approach will be used only by a very small number of (especially smaller) institutes The bulk of banks will use an internal ratings-based approach (IRB), which will be introduced in the next chapter

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Beside the standardized approach, banks are also allowed to use an approach for determining the capital requirement for a given exposure that is based on their own internal assessment of the credit quality of an obligor After publication of the first consultative paper in 1999, this was a central demand of the European and especially the German supervisory authorities

If a bank uses the internal ratings-based (IRB) approach to credit risk, it has to categorize its banking book exposures into five broad asset classes These asset classes are corporate, sovereign, bank, retail, and equity The corporate asset class contains five sub-classes of specialized lending, and the retail asset class is com-pletely divided into three sub-classes Based on the information given in the third consultative paper (Basel Committee 2003a), we restrict ourselves in the follow-ing to the explanation and discussion of the proposals for the corporate asset class (without specialized lending), which are very similar to those one for the sover-eign and bank asset class, and the retail asset class

Once a bank uses the IRB approach partially, the bank will be expected to tend the use to all their asset classes and business units Hence, a cherry picking between the standardized and the IRB approach is not possible

to a supervisory value and the treatment of the effective maturity of an exposure The minimum requirements that must be met by a bank in order to be allowed to use the IRB approaches are the highest for the advanced IRB approach For the re-tail asset class, there is no distinction between a foundation and an advanced ap-proach (see section 3.2)

As in the standardized approach, the risk weighted assets for corporate sures under the IRB approach equal the product of the risk weight and the expo-sure at default (EAD) An important difference to the standardized approach is that the risk weight does not only depend on the obligor’s rating, but on several risk components In the foundation approach, the risk weight is a continuous func-tion of the one-year probability of default (PD) of the internal rating grade an ob-ligor belongs to, the loss given default (LGD), and, for exposures to small and medium enterprises (SME), the firm’s total annual sales (S) In the advanced ap-proach the risk weight additionally depends on the effective maturity of the expo-sure, whereas in the foundation approach an average maturity of 2.5 years is as-sumed Hence, characteristics of an exposure, which are relevant for its credit risk, are recognized in much more detail under the IRB approach than under the stan-dardized approach, which results in more differentiated capital requirements under the IRB approach Banks applying the foundation approach can only use their own internal estimate of the PD, but are required to use supervisory values for LGD and EAD, whereas the advanced approach completely relies on bank internal es-timates of all risk components

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Probability of Default

For both IRB approaches, a bank has to be able to estimate the one-year default probabilities of their internal rating grades, which are based on a supervisory ref-erence definition of default According to this reference definition, an obligor’s default has occurred when the obligor is past due more than 90 days on any mate-rial credit obligation or even when the bank considers that the obligor is unlikely

to pay its credit obligations in full An indication of unlikeliness to pay is for ample an account-specific provision, which the bank has made for the credit obli-gation due to a decline in the obligor’s credit quality

ex-Banks are allowed to use three different techniques to estimate the average PD for each of their internal rating grades First, a bank may use internal default data Second, a bank can map their internal rating grades to the scale used by an exter-nal credit assessment institution and then employ the corresponding default rates observed for the external institution’s grades for their own rating grades Of course, a bank using this method has to ensure that the rating criteria and the de-fault definition applied by the external institution are compatible with their own practices Third, a bank can use statistical default prediction models, with which it estimates the individual default probability of each obligor In this case, the PD of

a rating grade equals the average of the individual default probabilities tive of the applied method for the PD estimation, the underlying historical obser-vation period must cover at least five years (during a transition period of three

Irrespec-years starting on the date of the implementation of the New Accord shorter time periods are sufficient) In order to account for the uncertainty in the estimation process of the PD, a floor of 0.03% has been proposed The PD of a defaulted ob-ligor is set equal to 100%

If there is a recognized credit risk mitigation in the form of a guarantee or a credit derivative, a bank applying the foundation IRB approach has to split an ex-posure into a covered and into an uncovered portion For the covered portion the bank has to take the PD appropriate to the guarantor’s internal rating grade and the risk weight function appropriate to him, whereas the uncovered portion of the exposure gets the risk weight associated with the underlying obligor A bank using the advanced IRB approach can take into account guarantees or a credit deriva-tives either through adjusted PD values or through adjusted LGD estimates Under either approach, the effect of double default must not be recognized Despite the fact that (beside in the case of a perfect positive correlation) the joint probability

of a default of the protection provider and the underlying obligor is smaller than each of the individual default probabilities, the adjusted risk weight of the covered portion of an exposure must not be less than that of a comparable direct exposure

to the protection provider Under the foundation IRB approach the range of ble guarantors is the same as under the standardized approach, whereas under the advanced IRB approach there are no restrictions to the range of eligible guaran-tors, but minimum requirements with regard to the type of guarantee have to be satisfied

eligi-Loss Given Default

The loss given default equals the expected economic loss per unit exposure of fault a bank has to bear if a default occurs The economic loss includes discount effects and costs associated with collecting on the exposure As opposed to the

de-PD, the LGD can vary for different exposures to the same obligor, for example if the exposures exhibit a different seniority

Under the foundation approach, banks have to use for all senior corporate sures without recognized collateral a standardized supervisory LGD value of 45%, whereas all subordinated claims on corporates not secured by a recognized collat-eral are assigned a supervisory LGD value of 75% If there are recognized collat-erals, these supervisory LGD values can be reduced to collateral specific mini-mum LGD values The range of eligible collaterals consists of those financial collaterals that are also recognized in the standardized approach and, additionally, IRB specific collaterals, such as receivables or specified residential and commer-cial real estates Other physical collaterals may be recognized, too, but two basic requirements must be fulfilled in any case: Existence of a liquid market and exis-tence of publicly available market prices for the collateral

expo-Under the advanced IRB approach, a bank can use its own estimate of the LGD for each facility, but these must be based on a data observation period of at least seven years The range of eligible collaterals is not limited, but the collaterals have

to meet some qualitative requirements

Time to Maturity

Under the foundation IRB approach, an average time to maturity of 2.5 years is assumed, whereas under the advanced IRB approach, the risk weight explicitly depends on the facility’s effective time to maturity But there are two possible ex-ceptions: First, national supervisors can choose to require all banks to adjust risk weights for the effective time to maturity even under the foundation IRB ap-proach Second, national supervisors can decide to exclude facilities to small do-mestic obligors from the explicit maturity adjustment of the risk weights under the advanced IRB approach The prerequisite is that the obligor’s total annual sales as well as the total assets of the consolidated group of which the firm is a part are less than €500 million The effective maturity of a facility with a predetermined cash flow schedule is defined as M=Σn⋅CFn/ΣCFn where CFn denotes the cash flow (principal, interest, and fees) due at time n Options (e.g call privileges), which can cause a reduction of the remaining time to maturity, are not recognized

in this definition A cap of five years has been fixed for the time to maturity ing the risk weight formula under the advanced IRB approach The floor is one year, but there are exceptions for certain short-term exposures, which are defined

enter-by each supervisor on a national basis

Total Annual Sales

For exposures to SMEs with total annual sales of less than €50 million, there is a reduction of the risk weight: The lower the total annual sales, the lower the risk weight and, hence, the capital requirement The maximal reduction is reached for firms with total annual sales of €5 million If the total annual sales are no mean-ingful indicator of firm size and if the national supervisor agrees, the total annual sales can be substituted by the total assets as an indicator of the firm’s size Exposure at Default

In contrast to the standardized approach, the exposure at default is the amount gally owed to the bank, i.e gross of specific provisions or partial write-offs On-balance sheet netting of loans and deposits of an obligor are recognized subject to the same conditions as under the standardized approach The EAD of traditional off-balance sheet positions, such as commitments, is the committed but undrawn line multiplied by a product-specific credit conversion factor (CCF) Under the foundation IRB approach, only the use of standardized CCFs is allowed, whereas under the advanced approach, banks can use their own internal CCF estimates provided the exposure has not a supervisory CCF of 100% in the foundation ap-proach The internal CCF estimates must be based on a time period no shorter than seven years The EAD of innovative off-balance sheet positions, such as interest rate or equity derivatives, is calculated as under the current Basel Accord, i.e as the sum of replacement costs and potential future exposure add-ons, where the lat-ter depend on the product type and the maturity

The continuous function, which combines the risk components PD, LGD, S, and

M to a risk weight, is one of the key elements of the IRB approach proposed by the Basel Committee Irrespective of the asset class or its sub classes and irrespec-tive of the chosen approach (foundation versus advanced), the risk weight function always has the same basic structure (Hartmann-Wendels 2002):

of the sum of expected and unexpected losses per year being larger than the bank’s regulatory capital is smaller than 0.1% In order to interpret the term VaR actually

as a Value-at-Risk, a simplified version of the credit portfolio model rics™ has to be applied (Gordy 2001, Bluhm et al 2003, pp 83-94) The default

CreditMet-of an obligor is modeled as insufficient asset value return, which is below some critical level at the risk horizon It is assumed that the asset return of each obligor can be represented as the sum of one systematic and one firm-specific risk factor, which are both normally distributed Conditional on a realization of the systematic credit risk factor, the asset returns of all obligors and, hence, the default events are assumed to be stochastically independent Together with the assumed infinity of the portfolio (and on additional technical assumption making sure that in the limit the portfolio exhibits no dominating single exposure) this latter assumption en-sures that the (strong) law of large numbers can be applied Using the law of large numbers, it can be shown that the random variable which represents the percent-age portfolio loss equals almost surely the conditional (on a realization of the sys-tematic risk factor) default probability Important for the interpretation of the term VaR as a Value-at-Risk is finally the assumption that there is only one single sys-tematic risk factor driving the asset returns of all obligors and the monotony of the conditional default probability as a function of this single systematic risk factor Within the assumed credit portfolio model, the term VaR also corresponds to the obligors’ default probability conditional on an especially bad realization of the systematic risk factor

The proposal of the Basel Committee that capital for unexpected as well as for expected losses has to be hold for has caused much criticism shortly after the pub-lication of the second consultative paper, especially from the German supervisory authorities and banks It has been argued that expected losses are usually covered

by provisions and risk premiums paid by the obligor Partly, these arguments have been considered in the third consultative paper, e.g provisions made by a bank can reduce the capital charge for expected losses Meanwhile, it seems as if the US American supervisory authorities themselves, who originally favored capital re-

quirements for expected and unexpected losses, re-open the discussion whether capital requirements for the expected part of the credit losses are really necessary

As the term VaR corresponds to the Value-at-Risk of a portfolio of positions with a time to maturity of one year, but the foundation IRB approach assumes an average time to maturity of 2.5 years and the advanced IRB approach requires an explicit adjustment of the risk weight for the remaining time to maturity, the above general risk weight formula (2) additionally contains a maturity adjustment factor

MF, which is intended to control for the effect the exposures’ time to maturity has

Table 3.1 Factors VaR and MF in the general risk weight formula (2) for corporate sures under the foundation IRB approach

As table 3.1 shows, the asset return correlation, modeled by the joint dependency

on the systematic risk factor, of obligors with total annual sales over €50 million is assumed to be a monotonously decreasing function of the PD, where the minimal correlation value is 12% and the maximal value 24% This dampens the increase

of the risk weight function for increasing PD values Exposures to corporates where the reported total annual sales for the consolidated group of which the firm

is a part are less than €50 million are classified as exposures to SMEs and receive

a size dependent reduction of their risk weight This is achieved by reducing the asset return correlation parameter with decreasing sales S The maximal asset correlation reduction of 4% is reached for firms with total annual sales of €5 million; reported sales below €5 million are treated as if they were equal to €5 million For small PD and S values the reduction of the risk weight for an

small PD and S values the reduction of the risk weight for an exposure to a SME obligor can come to over 20% of the risk weight for a non-SME obligor

The empirical findings concerning the firm size- and PD-dependency of the set return correlation are partially contradictory and the reasons for these contra-dictions are still not clear Overall, it seems as if the proposed decrease of the asset return correlation with decreasing firm size can be empirically confirmed (Düll-man and Scheule 2003 and partially Dietsch and Petey 2003), but the results con-cerning the PD-dependency are ambiguous For example, Düllmann and Scheule

as-2003 rather find that the asset correlation is increasing with rising PD, especially for medium and large firms, whereas Lopez 2002 confirms the relationship as-sumed by the Basel Committee The specification of the corporate exposure risk weight function shown in table 3.1 is the result of several modifications (in com-parison to the second consultative paper), which were judged to be necessary after Quantitative Impact Studies (Basel Committee 2001b, 2002, 2003c,d) had shown that the capital requirements would overall increase and that there would be no in-centive to apply the more sophisticated IRB approaches The absolute level of the current risk weight function is lower and the function less steep than the originally proposed version (beside for small PD values) so that less regulatory capital per unit EAD is necessary and the increase of the capital requirements for more risky obligors is reduced The following Fig 3.1 shows the risk weights as a function of the PD for various total annual sales S

S≤5 S=27.5 S≥50

S≤5 S=27.5 S≥50

S≤5 S=27.5 S≥50

Fig 3.1 Risk weights under the foundation IRB approach as a function of the PD for ous total annual sales S (LGD=0.45)

vari-Calculation of the Risk Weight for Corporate Exposures Under the Advanced IRB Approach

Under the advanced IRB approach, the risk weight explicitly depends on the maining time to maturity of an exposure Table 3.2 shows the specifications of the

re-factors VaR and MF in the general risk weight formula (2) under the advanced IRB approach

Table 3.2 Factors VaR and MF in the general risk weight formula (2) for corporate sures under the advanced IRB approach

expo-VaR identical with the foundation IRB approach

in the maturity (see Fig 3.2) The proposed positive sensitivity ∆ of the risk weight to the time to maturity depends on the credit quality of the obligor: The higher the obligor’s PD, the lower is the sensitivity of the risk weight to the time

to maturity Hence, a variation of the time to maturity causes an up or down ing of the risk weight of the foundation IRB approach, which is smaller the lower the obligor’s credit quality

scal-Fig 3.2 Risk weights under the foundation and the advanced IRB approach as a function

of the time to maturity M (PD=0.01, LGD=0.45, S=5)

A sensitivity of the Value-at-Risk to the time to maturity of the positions in the portfolio can only be observed in so-called Mark-to-Market (MtM) models, but not in pure Default Mode (DM) models In a MtM model the value of a bond or a loan at the risk horizon depends on the future credit quality of the obligor For ex-ample in CreditMetrics™, the simulated asset return indicates in which rating

advanced IRB approach foundation IRB approach

class an obligor is at the risk horizon, and then the corresponding risk-adjusted forward rates, observed today, are used for discounting the future cash flows of the bond or the loan which are due beyond the risk horizon In contrast, DM mod-els, such as CreditRisk+™, only differentiate whether an obligor has defaulted un-til the risk horizon or not In the former case, the position’s value at the risk hori-zon equals a fraction of its face value, and in the latter case, the value is identical

to the face value Hence, for both credit quality states considered in DM models the remaining time to maturity beyond the risk horizon has no influence on the fu-ture position’s value If additionally the time to maturity is irrelevant for the obli-gor’s default probability until the risk horizon, the maturity has no influence at all

on the Value-at-Risk In a MtM model the sensitivity of the Value-at-Risk to the time to maturity decreases with worsening credit quality because the probability rises that the obligor defaults until the risk horizon and that the loan or the bond is set equal to a value, a fraction of its face value, which is independent from the re-maining time to maturity

The definition of retail exposures under the IRB approach is similar to that one under the standardized approach Eligible for retail treatment are loans to indi-viduals or small firms, where the exposure must be one of a large pool of loans, which are managed by a bank on a pooled basis This requirement is intended to guarantee a sufficient granularity of the retail portfolio Under the IRB approach, there is no explicitly stated upper percentage of the total exposures of the pool, which the single exposure must not exceed For loans to individuals, an upper ab-solute limit of the single exposure size is also not given, whereas loans to small firms can only qualify for the retail asset class if the total exposure to the firm is less than €1 million, which under the standardized approach is also the upper absolute limit for loans to individuals Furthermore, the bank has to treat the loan

to a small firm in its internal risk management system in the same manner as other retail exposures In contrast to the standardized approach, residential mortgage loans belong to the retail asset class regardless of the exposure size as long as the loan is given to an individual who is owner and occupier of the property

Under the IRB approach, the retail asset class is divided up into three classes:

sub-1 exposures secured by residential properties,

2 qualifying revolving exposures, and

3 all other retail exposures

In order to qualify for a retail treatment, a revolving exposure must be an cured and uncommitted exposure to an individual with a volume of less than

unse-€100,000 Furthermore, the future margin income must be high enough to cover the sum of expected losses and two standard deviations of the annualized loss rate

of the sub-class

For calculating the risk weight of a retail exposure, the proposals of the Basel Committee do not differ between a foundation and an advanced IRB approach