FRM schweser part 2 book 3 2013 (2 of 2)

Cross Reference to GARP Assigned Reading—Basel Committee oil Banking Supervision The Three Pillarsof the Basel IIAccord BaselII recognizesthree pillars of sound bank managementthatdeal w

Topic 45 Cross Reference to CARP AssignedReading—Senior Supervisors Group

• LSufficientfundingis providedtodevelop ITsystemsfor the purposeof internal risk

reporting;they competeequallywith proposalsthatare revenuegenerating,forexample,

• AssessingITinfrastructureandcapacity prior toapprovingnewproducts,

* Post-implementationreviewsofITsystems performed anywhere from6-18months

afterwardas acheck that thesystems meet the riskpersonnel’sneeds

• The levelofgovernanceforoutsourcedIT activities isthesame asif theyweredone

in-house.Thereare noimpediments toimplementationor access todata due to

outsourcing

* Theexistenceof effective projectmanagementoffices (PMOs)to ensure thattimelines

anddeliverablesare met.Specifically,onepersonis inchargeof thePMO,whichseems

toresultinstrongercoordinationand communication hetween project staff

• Thereis adata administratoraswellas adataowner, andthedataowner must ensure

asufficiendy highlevelof data accuracy, integrity, andavailability.Thishelpsto ensure

that IT projectsaremeetingdie users' needs

• The boardisabletoimplementrelevant internalauditprograms toallowforperiodic

reviewsofdatamaintenance processesand functions.The monitoringcouldhe

continuousorspecific to a productor business line Thiswouldallowfor thequick

correctionof any weaknesses detectedbyinternalaudit

infrastructureat anorganization

Therearelive major factors to consider with regard topoor orfragmentedIT

infrastructures,

1 Nocommon understandingoflong-termbusiness strategy between business lines and IT

management Thisfactor often resultsduetointernal competitionfor funding, thereby

notpermittingimportant ITinfrastructureprojects tobecompleted,

2. Managementonlymakesdecisions basedonshort-termprofits.As a resultof this factor,

many ITinfrastructure projectsarescaledback,delayed,oreliminated

3 Significantturnover inimportantIT roleswithin thefirm.Thisfactorhas resultedin

delaysincompletingFT projects

4 Insufficientdata governance andinsufficientdata managementplanwithin thefirm.This

factorresults in inconsistencyacrossbusinesslines inhow to upgradesystems; this is

costly ifdiesystemsend upbeingincompatiblebecauseof theinconsistencies.

5 Mergerandacquisitionactivities.Thisfactor resultsinmultiplesystemsrunning

simultaneouslywithin the reoendymergedfirm Data aggregationacrossproductsand

businesslines becomesasignificant challenge,

Cross Reference to CARP AssignedReading—Senior Supervisors Group

DATA AGGREGATION BEST PRACTICES

anorganization

Theexistenceof severalITsystemsbeingoperatedsimultaneously withinafirm results in

alack of integrated ITsystems.This,in turn, requiresasignificantamountof manualdata

entry toallowforproperaggregation of risk data Best practices relatedtodata aggregation

at anorganizationareexplainedasfollows:

• Toincreaseefficiency andaccuracy, minimize the amountof manual intervention and

manual datamanipulation (i.e.,spreadsheets) by automatingtheriskdata aggregationprocess

* Aggregated risk data needstobeaccurate, timely, andcomprehensiveinorder tohave

value Therefore, theremust bestandards,cutofftimes,and timelinesregardingthe

production of internal riskreports.

• Single platformcentralized datahaseswithsingleidentifiersand/orconsistentnaming

conventionscould allowforthe timely retrieval of multiple records of risk dataacrossthefirm They also permitdata segmentation when required toproduce specific data

(fie., riskconcentrations}.

• Createdata warehouses that will take information from varioussubsystemsandstore

diemin awarehouse.The dataisdien filteredandreorganizedsothat customized reports can becreated using specificdatafrom the warehouse

• Automated reconciliationwill reduce dieriskof manualerrorsandincomplete

information Forexample,off-balance sheetdata shouldnot be omitted

• Periodicreconciliationof risk and financialdatawillensuretheaccuracyandproperoperadon of the ITsystem.

* Formergerandacquisitiontransactions,ensuringdrat legacy ITsystems areintegrated

into tire chosenITsystem assoon aspossible

* When obtainingapprovalsfornewITpurchases,involve the appropriate technical staff

to ensure that the existingsystems canprocessandaggregatedatafrom thesenew items.

©2013Kaplan,Inc.

Page15fi

Cross Ref ere DM to GARP Assigned Reading-Senior Supervisors Group

KEY CONCEPTS

AIM45.1

Ariskappetiteframework(RAF) setsin placea clear, future-orientedperspectiveof the

firm’starget risk profilein anumberof differentscenariosandmapsout astrategyfor

achieving that riskprofile.An RAFshouldstartwitharisk appetitestatement thatis

essentiallya mission statementfroma risk perspective.Benefitsofawell-developed RAF

includeassistingfirmsin preparingfor theunexpectedandgreatlyimprovingafirm’s

strategicplanningand tacticaldecision-making

AIM45.2

The chief risk officer (CRO) shouldbeeasily available tothe hoard ofdirectors(hoard) and

there should heastrongalliancebetween theCRO and die chief financial officer (CFO).

The chiefexecutiveofficer (CEO)shouldstronglysupporttheRAFandgivetheCRO the

final wordon risk decisions

Thehoard should:hewillingto challengemanagement to operate thefirmconsistent

with theRAF,actively work withsenior management tocontinuallyrevise theRAF,have

sufficient technical and business understandingof the risks feeing thefirm,be proactivein

stating thenatureandfrequencyof the information they need,andsetupa reputational

riskcommittee.

AIM45.3

TheRAF helpsto ensure that each businessline’sstrategiesare congruentwith the firm’s

desiredrisk profile.Italsoconsiders the integratednatureof thebusinesslineswithin die

firm

AIM45.4

Manymetrics can he monitoredas partofaneffective RAF.Risk metricsshouldhedivided

intoclasses,dependingonwhoisreceivingthe information within the firm

AIM45.5

Arobust data infrastructureresultsin management heingahletomake proper decisions

regardingafirm’sstrategy,riskappetite,and riskmanagement.Additionally,itallows for the

abilitytosufficiendydocumentand convey the firm’s risk reportingrequirements

Keyelementsofaneffective ITrisk management policyinclude!clearlydefined standards

andinternalriskreporting requirements,sufficientfundingto develop ITsystems,

assessing IT infrastructure and capacity prior toapprovingnew products, timelypost¬

implementation reviewsof ITsystems,and sufficientgovernance for outsourced IT

activities.

Cross Reference to GASP Assigned Reading—Senior Supervisors Group

AIM45.6

Poororfragmen red IT infrastructures resultfrom alack ofcommonunderstanding oflong¬

term businessstrategiesbetween businesslines and IT management,managers dunking

onlyaboutshort-termprofits, significant turnover in IT roles, insufficientdatagovernance,

and merger andacquisition acdvities.

AIM45.7

The lackof integrated ITsystems is themajorchallenge relatedto data aggregations

Manybest practicesregardingdataaggregationsexistincluding: minimizingtheamountof

manualdata processes, using single platformcentralizeddatahases,creatingdatawarehouses,

automatedand periodicdatareconciliations,and timely integrationof legacy ITsystems.

©2013Kaplan,Inc.

Page158

A. The RAFrepresentsdie firm'scoreriskstrategy.

B TheRAFshouldbeamended totake advantage of all profitableopportunities

C. The RAFfocuseson which risks diefirmiswillingto takeandunder what

condidons

D The RAFbeginswith die risk appetitestatementthat contains many elements,

includingexamining thecomposidonof theincome statement.

Asa bestpraedee,which of diefollowingmembers ofsenior managemencshould

have thefinal wordonsignificantrisk decisionsat afirm?

A Chiefexecutive officer,

B Chief financial officer

C. Chief operating officer

D Chiefriskofficer

1.

2

Whichof diefollowingstatementsregardingdie roleofarisk appetite framework

(RAF) in managing the riskofindividual business lineswithin afirmiscorrect?

A. Individual businesslines maycollectivelycause the firm’s RAF todrift when

marketcondidons change

B Sensitivityanalysisis a robust toolto assist senior managementand/or the board

todetermine consistency with theRAF.

C Eachindividual husinessline's risk appetiteallotmentaccordingtotheRAFis

independent of the odiers to ensureobjectivityin theprocess

D The business line managerssubmitlong-term businessplansto senior

managementand/orthe board todetermine if theyare consistentwith theRAF

Whichof thefollowingstatements is incorrectregardingdiekeyelementsofan

effective IT riskmanagementpolicy?

A. Havingasinglepersoninchargeof die project managemencoffice

B Comparable fundingfor IT projectsand revenue-generatingprojects

C Post-implementation reviews of ITsystems at least24monthsafter

A. IntegratinglegacyITsystems into thenewITsystem immediately

B Theuseofone masterspreadsheet to accumulateall of die datainoneplace

C. Periodicmanualreconciliationsto reducethe riskoferrorsandincomplete

information

D Allowing individualdepartmentsasmuch time as dieyrequireto produce

internalreportsthatare accurate, timely,andcomprehensive

Foradditional Book3, Topic45practicequestionssee:

3

4

5

Self-TestQuestions:#7(page273)

Cross Reference to GARP AssignedReading—Senior Supervisors Group

CONCEPT CHECKER ANSWERS

1L A The RAF represents the firms core risk strategy, The RAF docs not necessarily need to be

amended every time there is aprofitableopportunity; doing sowouldcause the RAF to lose

its value The RAF also focuses on which risks the firm is unwilling to take The risk appetite statement would notlikelyinclude an examination of the composition of the income

statement; it would more likely be the balance sheer fi.e., debt, equity),

2 D Thewillingnessof the CFO to give the CRO the final word on many risk decisions is a best

practice, which hasstrengthenedthe importance of the risk management function.

3, A Individual business lines maycollectivelycause the firm's RAF to drift when market

conditions change Sensitivityanalysisonly examines one change in a variable ar a time.

Vforc robust tools would be stress tests and scenarioanalyses,for example Each business

line’s risk appetite allotment according to the RAF may he amendedifanother business line

encounters an opportunity that requires more capita! The business line managers submit

medium-term businessplansto senior management and/or the hoard.

4 C Post-implementation reviews should beperformedfi—1 H months afterimplementation;

24 months or more wouldlikelyhe toolong.Having one person inchargeof the project

management office seems to have resulted in strongercoordination and communication between project staff.

5- A For merger and acquisition transactions, it is best thatlegacyITsystemsate integrated

into the chosen IT system as soon aspossible Spreadsheetsate a form of manual data manipulation and, becausetheyarc not automated, they would not be a best practice Automated reconciliations should beperformed,not manual One of the key points about internal risk reports is that they should beproducedon atimelybasis, therefore, there must

be standards, cutoff times, and timelines regarding their production.

©211 13 Kaplan,fnc.

Page160

The following i* i review of (fie Operational and IniteratedRisk Management principled designed to address

the AIM statements set forth hy GART® This topic is also covered in:

Topic 46

EXAM FOCUS

This topicfocuses on the use of batik stress testing todetermine if liquidityand capital are

adequate.Thediscussion focuses primarilyon capital adequacy but notes than the issuesare

similar with respect toliquidity For theexam,understand diederailsof the2009Supervisory

Capital Assessment Program (SCAR), the first stress testing required after the 2007—20(5 K

financialcrisis.Also, be abletoexplain theissueof coherencein stresstesting and describethe

challengeswith modeling the balancesheet usingstress tests in diecontext of the stress test

horizon Finally, understand the differences in disclosure between U.S.and European stress

tests and the way diat stress test methodologiesanddisclosure have changedsince the 2009

SCAR

STRESS TESTING

In diewakeof the2007-2008financialcrisis, regulatorsandodierpolicymakers realized

that.standard approachestorisk assessment,such asregulatorycapitalratiorequirements,

were not sufficient.At that point, supervisorystress testing becameapopular tool for

measuring bank risk Therewas a"pop-quiz”quality to thepost-hnancialcrisis stress tests.

Theyweredifficultto manipulatebecausedieyweresprungonbanksatshortnotice.Asa

result, dieinformation provided bythestress tests to regulatorsandthe market wastruly

new.This allowed financial marketstobetter understandbank risks and, as a result, regaina

leveloftrust in die bankingsector.

The goal ofstress testing, aswellascapital/liquidity and “economiccapitalfliquidity*

(i.e., internal,bank-specific) models,is to assesshow muchcapitalandliquidityafinancial

institution needs to support its business(i.e., risktaking) activities.Itisrelativelyeasyfor

banks toswapoutoflower risk assetsandinto higherrisk assets Stress testing provides

clarityabout thetrue riskand soundnessof hanks

Stress testingis anold tool thatbanks andotiier firms have used to examinerisk.Itasks

thequestion"what is the institutionsresiliencetodeterioratingconditions?*and simulates

financialresultsgiven various adversescenarios Stresses aregenerallyoftwobasictypes:

scenarios or sensitivities.Anexample ofa scenario is a severe recession.Anexample

of sensitivityis asignificantincrease in interest rates. Risk managerscan stress test the

sensitivity ofasingle positionorloanor an entireportfolio

Cross Reference to GARP AssignedReading-Schuermann

SUPERVISORYCAPITAL ASSESSMENT PROGRAM (SCAP)

andafter the SupervisoryCapitalAssessmentProgram (SCAP)

In the wake of the financialcrisis, therewasmuch uncertainty about thesoundnessof

theU.S.bankingsystem. Regulators neededto assess thecapitalstrengthof financial

institutions.If therewas agap between whatabank neededin termsofcapitaland whatit

had, regulatorshad tofindacredihleway to“fill the hole.”The2009 U.S.hankstress test,

knownas dieSupervisoryCapitalAssessmentProgram (LSCAP), was meant to serve that

purpose It wasdie firstmacro-prudentialstress testafter the2007-200K financialcrisis.

Macro-prudential reguladon focuseson diesoundnessof die hankingsystem as awhole

(i.e.,focusesonsystematic risks) whilemicro-prudential regulationfocuseson thesafety

and soundnessof theindividual institution

Atthis point the Federal governmentplanned toinfuseequity capitalinto hanks diat

were undercapitalized hasedon stress tesdng The Treasury intended toborrowmoney

and'‘downstream”it asequityin banksvia the Treasury’sCapitalAssistanceProgram

(CAP).If hankscould not convince investors tofill the hole(i.e.,infuse bankswithneeded

equitycapital),current investorswouldbedilutedbythegovernment’s equity investment

In die end,19SCAPbanks wererequired to raise$75 hillion withinsix months The

undercapitalized hanks raised $77 billion ofTier 1 commonequityand did not needto

drawon theCAPfunds

Prior to 2009, stress testingwas relatively simple Figure1summarizes thedifferencesin

stress testing preÿSCAPand post-LSCARFigure1:Comparison ofStressTestingPre-SCAPandPost-SCAP

Primarilyassessedexposure tosingle-shocks Considersbroad macro-scenarios and market-wide [c.g.,volatilityincreases OR interest rate

increases OR increasingunemployment)

stresses with multiplefactors occurring/changingat

once, as evidenced in the 2007-2008 financial crisis.

Focusedonspecifichank products or

business units(c.g., lendingor trust).

Focuses on the whole firm, a morecomprehensive

look at the effect of the stress scenarios on the

institution.

Typicallyfocusedon earnings shocks (i.c., losses) but not on capital adequacy

Explicidyfocuses on capitaladequacy.Considersthe

post-stress common equity threshold to ensure that

a bank remains viable.

Focusedexclusivelyon losses Focuses on revenues, costs, andprojectedlosses.

Stress testing is now dynamic and pathdependent

Stress testing was static in nature.

©2013 Kaplan,Inc.

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Topic 46 Cross Reference to CARPAssignedReading—Schuermann

AJM46.2:Describe the problem of coherencein modelingriskfactorsduringthe

stresstesting of banks

Oneof the challenges ofdesigning usefulstress tests is coherence The sensitivitiesand

scenarios must heextremehutmustalsobe reasonableorpossible (i.e.,coherent) Problems

areinherentlymulti-factored, makingitmoredifficult todesigna coherentstress test.For

example,an increase involatilitycanlead tocredit marketsfreezing High unemployment

andfallingequity prices often go hand-in-hand Itis notsufficient tospecifyonepotential

problem (i.e.,riskfactor) because the otiters donot remain fixed Thesupervisor’skey

challengeis tospecify dte jointoutcomesof all relevant riskfactors.

Additionally, noteverythinggoes badat once. Forexample, ifsomecurrenciesare

depreciating, othersmustbeappreciating Ifthereis a"flighttoquality/ theremustalso

besafe haven assets in dtestressmodel.Sowhileit isimportantto lookat, forexample,

whathappens ifU.S.Treasurydebtbecomes riskier and is nolonger asafe haven, themodel

wouldatthesame timehaveto identify the ‘‘risk-free*asset (s) in which capitalwouldflee

under those circumstances

Theproblem is even greaterwhendesigningstress scenariosformarked-to-market

portfolios oftradedsecuritiesandderivatives Riskisgenerally managedwidtavalueat risk

(VaR)system. Hundredsofthousandsof positionsin the trading bookmust be mapped to

thousandsof risk factors,trackedon adailybasis The data thatresultsis usedto estimate

volatility and correlationparameters.Itisverydifficultto find coherentoutcomesinsucha

complex, multi-dimensional universe.

The2009SCAPtested rathersimplescenarioswith three variables:growth in CDP,

unemployment, and thehousepriceindex (HFI).Historicalexperience wasusedfor the

market risk scenario (i.e.,dte financialcrisis—aperiod of"flight tosafety,”the failureof

Lehman, andhigher riskpremia).While the market riskscenariodid not testforsomediing

new, the overall framework achievedcoherenceof financial and otherstressesof the time

period

One tilingto note is that prior to 2011 all supervisorystress testsimposed the same

scenarios onall banks(i.e., aone-size-fits-all approach to stresstesting) Inrecognitionof

the problem, the 2011and2012ComprehensiveCapital Analysis andReview (CCAR)

asked hanks tosubmit resultsfrom their own stress scenarios inaddition tothe supervisory

stress scenarioinan attempt toreveal bank-specificvulnerabilities.Thiswas animportant

stepforwardfrom the2009SCAP as itgavesupervisorsa senseof what banks thinkare

thehighrisk scenarios.This providesregulatorswithnot only bank-specific(i.e.,

mkro-prudential) insight but alsoimproves macro-prudentialsupervision as ithiglilightscommon

risksacrossbanks that mayhavebeen underemphasizedorunnoticed before

Cross Reference to GASP Assigned Reading-Schuermann

factorstospecificintermediate riskfactorsin modelinglosses

Currentstress tests arebasedon macro-scenarios(e.g., unemployment,GDPgrowth, the

HPI).Oneconcern ishowto translate the macro-riskfactors employedinstresstesting

into micro(he.,bank-specific)outcomesrelatedto revenuesand losses Supervisors need to

map from macro-factorsinto intermediate riskfactors that drive lossesinspecific productsandgeographicareas.Althoughnotlimited to these products,geographic differencesare

especiallyimportantin modeling lossesin bothcommercial and residential realestate

lending

Creditcard lossesareparticnlarlysensitive tounemploymentfigures.Forexample,unemploymentwas12.9%in Nevada inJuly2011,3.3%in North Dakota, andthenational unemployment rate was9.1%.Creditcard lossrates varieddramaticallyfrom

region to regionduringthis period The geographic diversity withrespect tomacro-factors

makesa“one-size-fits-alTstresstesting regime lessmeaningful

GeographyLsnot theonlydifference supervisorsmust contend with Risksaffect different

assetclassesindifferentways Forexample, duringrecessions peoplebuyfewer automohiles

overall.However,ifa person needsa car duringa recession,heis morelikely tobuya used

car.Thus,ifdefault rates increase,loss givendefault(LCD) (i.e., loss severity) maynot

increase as much

The business cycle also affects differentindustriesatdifferent times.Consider the airlineindustryversus the healthcareindustry duringa recession.Airplanesarecollateralfor loans

toairlines.If the airline industryisdepressed, the bankgetsstuck with collateralthat isvery

difficulttosellexcept atextremely depressed prices.Healdicareissomewhat recession-proof

but that doesn't mean the bankcantransformanairplaneit Lsstuck withinto ahospital.Thesefactorsincrease the difficulty ofmappingbroadermacro-factors to bank-specificstress

results

CHALLENGESWITH BALANCE SHEET MODELING

AIM46.4:Explainthechallengesin modelinga banks balance sheetover a stress

test horizonperiod.

The typicalstress test horizonis twoyears Overthisperiod,both the income statement

and balance sheetmuse be modeledto determine ifcapital Lsadequatepost-stress.Generally

speaking,capital Ls measuredas a ratioof capitalto assets.Therearedifferent typesof

capital (e.g.,Tier 1andTier 2) but ingeneral(andfor die sake ofsimplicity), capitalcanbe

definedas commonequity Risk-weightedassets (RWA) arecomputed basedon theBasel II

riskweight definitions Forexample,agency securities havea lowerrisk weight thancredit

card loans

Ina stressmodel, diebeginning balance sheetgeneratesthe firstquarters incomeand Joss

from thestressedscenario,whichin turndetermines thequarter-end balance sheet.Acdiat

Topic 46 Cross Reference to CARPAssignedReading—Schuermann

point, theperson modelingthe riskmustconsiderifanyassetswill be soldororiginated,

ifcapitalisdepleteddue to otheractionssuchasacquisitions orconservedas die resultof

aspin-off, if therearechangesmadetodividend payments,if shares will he repurchasedor

issued(e.g.,employeestockor stockoption programs),andso on Thesedecisionsmake

modelingthe balance sheet over thestresshorizon quitedifficult.Thestress modeldoesn’t

determineifitwould beagood time tosellasubsidiaryorlower dividend payments.

The challenges of balance sheet modelingexist under bothstaticand dynamic modeling

assumptions The hank must maintain itscapital (andliquidity) ratiosduringall quartetsof

thestress testhorizon.At the endof thestresshorizon the hank must estimate the reserves

needed to coverlossesonloans and leasesfor die nextyear.Thismeansthata two-year

horizon stress test isactuallya threeyearstress test(he,,aT-yearstress testrequires the bank

to estimate required reserves to coverlossesforT+l years)

STRESS TEST COMPARISONS

2012 CCARjandthe2011EBAIrishand EBAEuropeanstress testsintheir

Disclosurewas asignificantfeatureof the 2009SCAP It disclosedprojectedlossesfor each

of the 19 participating banks for eightasset classes.It alsodisclosedresources the bank

hadtoabsorblossesother dian capital (e.g.,pre-provision nee revenueandreservereleases

ifavailable).This high level of disclosure created transparency. IL allowedinvestorsand

themarket cocheck dieseverityofstress testsand tocomprehendstress test outcomes at

theindividualbank level Before die2009SCAP, banksonlyreported realized losses, not

forecasted losses (i.e.,possible losses given the stress scenario).

The2011 CGAHrequired onlythat macro-scenarioresults be published, nothank level

results.This differeddramaticallyfrom the2009SCAPrequirements The market hadto

figureoutwhetherabankhadpassed die test or not(i.e,,market participantshadto"do

the math*themselves).Forexample, ifahank increased itsdividend,it wasassumedbythe

market tohave"passed'1 thestress test However, the2012 CCAR disclosedvirtuallythe

same amount anddetailof bank levelstressdataas die 2009SCAP(i.e.,bank level loss rates

and lossesbymajorassetclasses) The regulatoryassetclassesare:

1 First andsecondlien mortgages.

2. Commercial andindustrial (C&I)loans

3 Commercial real estateloans

4 Credit card lending

5 Other consumer loans

6. Other loans

Cross Reference to CARP AssignedReading-Schuermann

Oneof die key contributions of theCCARwas thatin both2011 and 2012 theCCAR

required banks to submitthe resultsof dieirown scenarios,both baseline andstress, not

justsupervisorystress testresults*The Fed alsoreported dollar pre-provision net revenue

(PPNR),gainsand Jossesonavailable-for-sale and held-to-mattuitysecurities,and trading

andcounterpartylosses for thesixinstitutions with dielargest trading portfolios*These

firmswererequired toconduct the tradingbookstress test.The numbers thatwere reported

weresupervisoryestimates, notbankestimates,of losses under thestress scenario.

Incontrast,die2011 European Banking Authority(EBA) Irish and2011 EBAEuropean¬

widestress tests,both disclosedafter the CCAR,containedconsiderable detail*In the Irish

ca*se,thereportcontainedacomparisonof hank and diird partyestimates of losses The

EBAdata wasavailable inelectronic, downloadable form*Ireland neededcredibility,having

passed theCommitteeof European BankSupervisors (CEBS)stress testin July2010only

to needconsiderable aidfour months later*Ingeneral, die faithinEuropean supervisorswas

harmedandonly bydisclosing detailedinformationonbank-by-bank,as*set-class,country,

andmaturitybucket basiscould the marketinterpret die data anddrawits ownconclusions

about individual bankrisks. Figure2summarizesdie differencesamongthe variousstress test regimes

©2013Kaplan,Inc*

Page 166

Topic 46 Cross Reference to GARP Assigned Reading—Schuermann

Figure2:Comparisonof Majcro-prudeiiLia]StressTests

Methodologies Disclosure Findings

(TIPI).Historicalexperience rates.

was used for the market risk

scenario (i.e., the financial

crisis— aperiodof“'flight

to safety.” the failure of

Lehman, and higherrisk

premia) A “qne-sÿBB-fits-all*

approach

1 9 SCAP banks were

bank levelprojected required to raise losses and asset/ £/5 billion within

productlevel loss six months The

undcrcapitalized banks actually raised

£77hi Hi on of Tier I

common equity and

none of the banks

were forced to use

year end were

included.

the Treasury’s Capital

AssistanceProgram

hinds.

COAR (2011) In recognition of “one-size- Only

macro-fits-a.ll” stress testing, CCAR scenario results asked banks to submit

results from their own

baseline and stress scenarios.

published.

were

CCAR (2012) were again asked TO

submit their own baseline and stress test results.

Ranks Similar in detail no

SCAP2009—bank level and asset/

productlevel loss

Trish sovereign and

individual bank debt.

Specifiedeight macro-factors Bank level

projectedJosses.

the Committee of unemployment,commercial Comparisons of

European Bank and residential real estate exposures by asset

.Supervisors (CEBS)l price indices, short and class andgeography

90European banks long-term government rates, Data is electronic

were stress tested and stock prices) for each

of 21 countries.Specified

over 70 risk factors for the trading book Tt also

imposedsovereign haircuts

across seven maturity buckets.

Eight banks were

required to raiseE2.5

Cross Reference to CARP Assigned Reading—Sckuermaiin

The key benefit ofgreaterdisclosureis transparency.Transparencyisespeciallyimportant

in timesof financial distress.However, during “normal1'times, thecostsofdisclosuremay

outweigh diebenefits Forexample, banks may‘Svindow dress17 portfolios, makingpoor

long-terminvestmentdecisionsto increasethe likelihood of passing thetest Tradersmay

place too muchweighton diepuhlicinformation includedin stress testdisclosure and be

disincentivized toproduceprivateinformation about financial institutions Thisharms

the informationcontentof market prices and makes prices less usefultoregulatorsmaking

policydecisions

One thingto note isthat prior to the CCAR 2011requirements, all supervisorystress tests

imposed thesame scenarios on all hanks(i.e., aone-size-fits-all approach to stress testing)

In recognition of the problem, the2011and2012 CCAR asked bankstosubmitresults

from theirown scenariosin addition tothesupervisorystress scenarioinan attempt to

reveal hank-specificvulnerabilities

©2013Kaplan,Inc.

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Topic 46 Gross Reference to GAJtPAssignedReading—Schuermann

AIM46.1

After die2007-2008financialcrisis, it wasclear that traditionalrisk measuressuchas

regulatorycapital ratios wereinsufficient.Supervisorystress-testing hecameanimportant

risk-assessmenttool at diat point

The goal ofstress testingis to assess howmuchcapital andliquidityafinancialinstitution

needsto support itsbusiness(Le., risktaking}activities.

The2009U.S. bankstress test, knownasthe SupervisoryCapitalAssessmentProgram

(SCAT),was the firstmacro-prudentialstress test after the 2007-2008 financialcrisis.

AIM46.2

Oneof the challengesregulatorsfaceisdesigning coherentstress tests.Thesensitivities

andscenarios mustheextreme hut mustalso be reasonable andpossible(i.e.,coherent)

Problemsareinherentlymulti-factor, makingitmoredifficulttodesignacoherentstress

test.

AIM46.3

Currentstress tests arebasedon macro-scenarios (i.e., unemployment,GDPgrowth, the

HPI).One concern is howtotranslate the macro-riskfactorsemployedin stress tests into

micro (i.e.,hank specific) outcomesrelatedto revenuesand losses.Supervisorsmusthe

abletomap from macro-factorsinto intermediate riskfactors that drive losses inspecific

productsandgeographicareas.

AIM46.4

Ina stressmodel, die scarring balance sheer generates the firstquarter’sincomeandloss

from the stressedscenario,whichin turndetermines the quarter-end balance sheet The

hankmust maintain itscapital (andliquidity) ratiosduringallquarters of thestress test

horizon, typicallytwoyears

AIM46.5

Disclosurewas asignificantfeature of the2009SCAR Thishighlevelof disclosure lead to

transparency andallowedinvestorsandthe market the ability tocheck dieseverityof die

stress testsandtheoutcomesof thestress at theindividualhank level

In201 1, CCAR required only macro-scenario resultsbe published,not hank level results,

differing significandy from the 2009SCAR requirements.The2012 CGAR disclosed

virtuallythesame amountand detailof bank levelstressdataasthe 2009SCARTheEBA

Irish and the EBAEuroperequiredsignificant disclosuresaswell Thedisclosureswere

needed to increase trust in theEuropean hankingsystem.

Cross Reference to GARP Assigned Reading-Scbuermann

CONCEPT CHECKERS

Whichof the following changesin stress testingwas not theresultof the2009

SupervisoryCapitalAssessment Program(SGAP)?

A Banksare nowrequired toprovide theresultsof theirown scenario stress tests.

B Stressscenarios are nowbroaderin nature.

C Stress testing nowfocuseson the whole firm

D Stress testing nowfocuseson revenues, costs,and losses

PiperHook, a bankexaminer, istryingto makesenseofstress testsdone byoneof

thebanks sheexamines.Thestress rests aremulti-factored and complex The bank

is using multipleextreme scenarios to testcapital adequacy, makingit difficultfor

Hook tointerpret the results.One of the keystress testdesigncliallongesdiat Hook

mustdeal withinherexamination ofstress tests is:

A. multiplicity

B efficiency

C coherence

D efficacy

Greg Nugent,a regulator with the Office of the Comptroller of dieCurrency,

is presentingresearch on stress tests to agroupofregulators Heisexplainingthat macro-variablestress testingcan bemisleading forsomebanks becauseof

geographicaldifferencesin macro riskfactors He gives theexampleof die wide

rangeof unemploymentrates acrosstheU.S.followingthe2007-2008financial

crisis.Which typeof loan did Nugentmost likely identifyashavinglosses tied to

unemploymentrates?

A Residential realestateloans

B Creditcardloans

C Commercialrealestateloans

D Industrialterm loans

1.

2.

3

4 A riskmodeler has tomake assumptionsaboutacquisitionsandspinoffs, ifdividend

paymentswillchange,and if the bank will buy back stockor issuestockoptionsto

employees.Thesefactorsmakeitespecially challengingto:

A getaCAMELSrating of2 orbetter

B determineifthe bank hasenoughliquidity to meet itsobligations

C meettheTier1 equitycapitaltorisk-weighted assets ratio.

D modelabank’s balance sheetover a stress test horizon

Oneof the keydifferences between the 2011 CCAR stress test and the2011EBA

Irishstress test isthat:

A. theCCARdidnot requirebanks to provide resultsfrom their own stress

scenarios.

B theEBAIrish didnotfindanybanksinviolationof capital adequacy

requirements

C theCCAR requireddisclosure ofmacro-level,not hank level, scenario results

D theEBAIrish allowedfor1-year stresshorizons

5

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Topic 46 Cross Reference to CARPAssignedReading—Schuennann

CONCEPT CHECKER ANSWERS

1 A The200?U.S hank stress test, known as the SupervisoryCapitalAssessmentProgram

(SCAP), was the firstmacro-prudentialstress test after the2007—2008financial crisis.

The 201 1 CCAR, not the 2003SCARrequiredthat hanksprovideresults of their own stress

scenariosalongwith supervisory stress scenarios.

2 C One of thechallengesofdesigninguseful stress tests is coherence The sensitivities and

scenarios must he extreme but must also he reasonable orpossible(i.c., cohdcnt) Problems

areinherentlymulti-factored,makingit more difficult todesigna coherent stress test Hook

isdealingwith thepossiblyincoherent results of the banks stress tests.

3 B Credit cardJossesareparticularlysensitive tounemployment figures.Forexample,

unemploymentwas 12.9% in Nevada in July 2011, 3.3% in North Dakota, and the national

unemploymentrate was9.1% Credit card loss rates varied dramatically from region to

region duringthisperiod.Residential mortgages arc affectedby unemploymentas well hut

people aregenerallymorelikelyto quit paying credit card bills before mortgages.

4 D In a stress model, the starting balance sheet generates the first quarters income and loss from

the stressed scenario, which in turndeterminesthe quarter-end balance sheet At that point

the person modelingthe risk must considerifany assets will be sold or originated,if capital

isdepicteddue to other actions such as acquisitions or conserved as the result of a spin¬

off if them arcchanges made to dividend payments, if shares will berepurchasedor issued

(c.g., employee stock or stock option programs), and so on This makes itchallengingto

model the balance sheet over the stress horizon,

5 C The 201 1 CCARrequiredbanks toprovideresults from their awn stress scenarios but the

EBA Irishdidnot After the 201 1 EBA Irish tests, €24 billion wasrequiredto inciea.se the

capitalof several banks The 2011 CCAR, unlike the SCAP and the 2012 CCAR,only

required the disclosure of macrn-icvcl scenario results The EBA Irish did notchangethe

stress horizon from two years to one year,

die AIM siitemeriLS set furth by GARI"8 This topic Ls also covered in:

STANDARDS

Topic47

EXAM FOCUS

In chis topic, iin overview of Basel IIis presented.For theexam, you should understand the

basic frameworkof the Basel IIAccord andhowitdiffersfrom theoriginal Accord.Youshould

know the threepillarsand thetiercapitaldefinitionsandunderstand theconceptualdifferences

betweenthe standardizedapproachand the internalratings-hased (IRB)approach.Also, have

a basicgrasp of how operational riskisaddressedinBaselII.Thistopic providesabigpicture

approach to die assigned material GARB has emphasized diat candidates are not expected

to memorize specific details from the Basel material.However, wedoencourageyou to lookthrough the assigned reading, in addition to our review, and study recent exam questionsrelated todiis material inthe hackof this book Youshould expect to see Basel questionson

Regulation refers to theoversightprovided byan external partywidi theability toinfluence

thelegalandoperatingstructureof theindustry Implicitin the decision to regulate isdie

tradeoffbetween diecostsand benefitsof regulation.Widiin thebanking industry,die

necessity ofregulationissuhject todebate Whilesomeargue thathanksandfinancial

institudonsshouldhetreated nodifferendy from firmsinother industries (i.e.,allowed

tofail), most believe diat the potentialcostsof hankfailureare solargethat regulationis

necessary.Thescopeof regulationcanvarysignificantlyfromsystematic(i.e., ensureglobalbanking stability)tomicro-level (i.e., protect consumersand investors)

Fourreasons have beenadvancedto justify theexistenceofbankingregulation:

1 Protectbankdepositor fromlossin bankruptcy.Thestructureof thebankingsystem is onewhere the individual depositorsatesmall andanonymous toeach other These

characteristicsdonot provide the incentive todireedymonitorhank management

or investincostly monitoring of hank activities.Therefore,individualsneedexternal

assurances or guaranteesof the recoverabilityof theirdepositsin caseofbankruptcy

2. Providestabilityfortransactions.Thefunctioningofasmooth economydependson

thetransaction servicesbanksprovideinadditiontotradidonal loanorigination.It

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isimportant that currency availability,payment processing, andsettlementfunctions

remain uninterrupted

3 Avoidcontagioneffectsin thebankingindustry Thegreatestfear ofan unregulated

bankingsystem is that failure ofoneInstitution will leadto thefailureof others

chat, in turn,will lead to the failureof still others This domino effectismademore

likelyby thereputation effects ofonehank failureonotherinstitutionsandby the

interconnected natureoftransactions withother institutions.Ultimately, the Federal

Reservewillinterveneifitfeels the potentialimpactof collapse will impact the overall

economy

4 Maintainstabilityin theeconomy.Banksin distress canseverely impactlocal and

regionaleconomies.Itisimportant that other banksfillthevoidquickly.In the absence

ofregulation, other banksmayrefrainfrom supporting the distressed hank basedon

differentialinformation regardingthecauseof theproblem

Deposit Insurance

Depositinsurance through Federal Deposit Insurance Corporation (FDIC)guarantees

the returnofdeposits (with importantlimitations) in dieextreme caseof hank insolvency

orfailure While thissystem reduces die risk of depositors,italso hasanegadve effectin

thatitreducesdieincentivesof thosesamedepositorsto monitor die financialstrengdi

of the bank Depositors dien haveasafety netfromdepositinsuranceand will provide

lessoversightthantheywould in theabsenceofdepositinsurance*The bank alsofacesa

moral hazard problem,as the depositinsurance system can increase itsrisk-takingbehavior

The hank hasan increased incentive to takeon more risk dianwithout deposit insurance

becausedie bank doesnotfully bear thecost(higher required interest ondeposits) fromits

decisions.Inshort,depositinsurance reduces the incentivesof depositorsto monitor hank

activities since theirfundsareguaranteed,and banks willincreasetheir risk profilessince

lossesareeffectivelysubsidizedby theFDIG*

Largefirmson the brinkofinsolvencywillarguablycreate acontagioneffectif theyare

allowedto fail When this threatislarge, thegovernment isinclinedto preventthe collapse

fromhappeningin aneffort to reduce dieprojected contagionrisk Thisaction isbasedon

the too-big-to-fhil policy.In theeventof failure, thegovernmentwouldhe forced topick

up thepieces; therefore,offering liquidityto preventdiis fromoccurringis abetteroption

Theinterventionbythe governmentcreates amoralhazard issuewherelarge businesses

have areduced incentive to monitorbehavior.Arecentexample ofacompanydeemed

toobigto foilwas dieAmericanInternational Group(AIG).

BASELI

Theintentof the 1988BaselAccord(Basel I) was tostrengthenandstandardize theglobal

hankingsystem.Theexpectationwas chatindividualcountrieswould implement the

basicframeworkof the Accord andmodify appropriatelyfor their respective markets The

primarycontribution of the1988Accordwas theestablishmentof standardizedcapital

Cross Reference to GARP AssignedReading—Basel Committee on BankingSupervision

levelshuilt upon a risk-based definitionofcapital (i.e., notallassetshave thesame risk)

Accordingly,assets weresortedintofourcategories(buckets) basedon their riskexposure

OrganizationforEconomicCo-operation andDevelopment(OECD) sovereigns(30

developedcountries)wereconsideredleast risky, whilecorporateobligations carried the

greatest risk.The riskier theobligation,diemorecapital the bankwasrequired tobold The

Accordstipulatedthat the Cooke ratio(capital/risk-weighted assets} mustexceed 8% Basel

Iwaslater amended totakeaccountof differencesin market riskandtoallow the useof

internal models to measuremarket risk This allowed bettermeasurement of riskandmore

efficient allocadonofcapitalsincebankscould boldless capitalorlendmorebasedon a

givenlevelofcapital

"While BaselI, parricularly the risk-based capital approach,was asignificantimprovement

in thesophisticationandstandardizationof riskmeasurement,severalimportantissues were

leftunaddressed:

* Therewas noclear rationalefor the 8%capital requirement

• Theriskbucketswerehomogenous.Forexample, all corporate bondsfaced diesame

capitalcharge regardlessof(important) differencesin maturity and seniority

* The Cookeratio was toosimple totrulyevaluatesolvency levels

• Potentially risk-reducing diversification inthe loan portfolio wasignored

* Useofoff-balancesheetactivities tomitigate risk exposureswas not

recognized-Professor’sNote:BaselI (1988)wasoriginally developedto covercredit risk

capitalrequirements Itwasamendedin1996toalso include market riskcapital

requirements.Basel17wasintroducedin2Q()4and addressednotonlycredit and

market riskcapitalbut alsooperationalriskcapital

|jÿ)

The Basel II Accordisaimed atlargeinternational banksandall subsidiaries, holding

companies,andsecurityfirms operating under theparentfirm Theprimarygoal ofBasel

IIis to providemoreprecise classifications of risk levels hetween banks.Sincebanksgready

variedinsophistication and creditexposures,the bucket approach of Basel Iwasdeemedboth simplisticandineffective In addition, theCommitteesoughta systemflexible enough

toaccommodate therapidchangesand innovations infinancial marketsaswellasrisk

management practices thatwerelacking under BaselI.Accordingly, theCommittee went

to greatlengthsto secure industry input and to incorporatecommon practicesso diat the

changes couldbereasonablyimplemented Ultimately, BaselII established threeoptionsforthe calculationofcredit riskcapitalrequirements

1 Standardizedapproach.This approachisessentiallythesame as underthe original Basel

Accord, butthe riskweightingsarebasedondiecharacteristicsof each borrower and

provided by external credit ratingsources,suchasStandard&Poor's Corporation

2. Internal ratings-based(1RB)foundation approach.TheIRBfoundationapproachis a

hybridofinternaland externalestimates.Typically,die bank usesinternalestimatesof

default probabilitiesbut usesexternal sources for ocher model inputs, suchasloss given

default(LGD).Regulators often provide the latter information

3 Internalratings-based(IRB)advancedapproach. Under this approach, the hankgeneratesall of theestimates usedin itsmodels

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Cross Reference to GARP Assigned Reading—Basel Committee oil Banking Supervision

The Three Pillarsof the Basel IIAccord

BaselII recognizesthree pillars of sound bank managementthatdeal with capital

requirements, supervisory review byregulators,and market disciplinebasedon better

disclosureof risks to the financialcommunity

The first pillar, Pillar1, is a highlyquantitativeassessmentof the capitalrequirementsfor

the batik.Aldiough diemain focus of thispillariscredit risk,operadonalrisk(new in Basel

TI) is also animportantfactorindetermining capital adequacy

Pillar 2 envisions aformal rolefor regulatorsin an effort toidentifyandstem potential

problems The regulator will provideacredible checkfor theinputs usedin thebank’s

models anddetect risksnot covered in Pillar1.In addition, thefrequent monitoringallows

forinterventionearlier radier dianlaterifcorrective action isneeded.Also, under Pillar2,

regulatorscan setthe requirementhigher than the 8% of Basel I

Pillar 3 focusesonthe capital markets asexternal monitorsof the bank Theinstitution

mustsubmitrequireddisclosures toqualifyforregulatorycapital treatment.These

disclosuresalsoprovide the financial community information on the bank's risk exposures

and capital adequacy

Whilethe actual calculationsfor computing the capital requirementsarequite involved

under either method(standardizedor IRB),thefollowing discussionisqualitativein order

to providea clearunderstandingof die conceptual differencesinmediods

totalcapital

basicrisk-basedcapital calculation=

totalrisk-weighted assets

UnderBasel I, die risk weightingswerebasedon credit risk only Under BaselII, assets are

riskweighted for credit risk, market risk,andoperationalrisk.Thisrevised ratio isknownas

the capitalratio orcapital adequacyratio.

Asmentioned, total risk-weightedassets are broken downintocredit risk, market risk,

and operational risk.Accordingto BaselII, abank’s capitalratio mustexceed 8%.This

mandated8% capital requirement Is used todetermine thecapitalchargefor agiven risk

Forexample, diecapital chargefor credit riskiscomputedas8%of therisk-weightedassets

for credit risk

In order to computetotalrisk-weightedassets, we startwithrisk-weightedassetsforcredit

riskThe calculation ofrisk-weightedassets forcreditrisk issimply thesumofcreditrisky

assetsmultiplied by correspondingriskweights.Wethen add thecapitalchargesfor market

and operational risk(methodsforcalculatingcapitalchargesaredemonstratedshortly)

Since weneed todetermine the risk-weightedassetsfor market andoperadonalriskweneed

todividediecapital chargeamountsby 8%(oralternatively multiply by12.5).In other

words, ifwealready knowdiecapital charge for market and/oroperational risk,we know

thatit must beequal to atleast 8% ofrisk-weightedassetsforagivenrisk

Forexample,supposethat die sum ofrisk-weightedassetsfor credit risk totals$1,500.

Also assume that the market riskcapital charge(requirement)is$30and the operational

Cross Reference to GARP Assigned Reading—Basel Committee on Banking Supervision

risk capital charge Ls$50 Total risk-weightedassets arecalculated asfollows:$1,500 +

[($30 + $50) x 12.5] =$2,500.Thismeans that the hankmustholdatleast $200incapital

(i.e.j $2,500 x8%)inorder tosatisfytheminimumcapitalrequirement

Amoredetaileddiscussionof the calculation ofcreditriskcapitalrequirements and

correspondingcreditrisk-weightedassets isoutlinedin thefollowingsection as well as in

AIM47.4.

StandardizedApproach

The standardized approach under BaselII assignsa riskweight toeachassetbasedon its

credit risk(i.e., probabilityof default) An asset’sassignedriskweightcan rangefrom 0%

for high quality sovereigndebt to100%or moreforcorporatedehtbasedon itscreditrating.Since8%is the mandatedcapital requirement, dtlsserves asthe benchmarkfor

calculatingthecapitalcontributionfor eachasset.Asimple examplewill helpillustrate thispoint

Example: Standardized approach

SupposeFirst NationalBancorp hasa$100 million loan portfolio splitequallybetween

UK sovereign debt(rated AAA] and corporatedebt Calculate thecapital requirement for

First NationalBancorp if thecorporatedebt Is (1)AAA-ratedand(2) BBB-rated.Assume

the corporateriskweightingsare20% for AAA-rated debt and 100% forBBB-rated debt.

Answer:

Note thatthe riskweightingof UKsovereign debt Is0% dueto itsAAA rating

capital(basedon AAA rating) = ($50million)(0%)(8%)

+ ($50million)(20%)(8%) -$800,000

capital(based on BBBracing) = ($50million)(0%)(8%)

+ ($50million) (100%)(&%)-$4,000,000

An importantchangein Basel II relativetoBasel IIs that thepreviousdistinction between

OECDandnon-OECDsovereign debt is nolongervalid Previously,OECDsovereigns

wereassigneda riskweightingof 0%.UnderBasel II, the credit rating of die debtis

determinedon acase-by-<ase hasls

The TRBapproach has the potential toreduce the capital requirementfor banks because

their own estimatesof risk may be lower than those calculated usingthe ''cookiecutter”philosophy of the standardized approach.Someof the benefits ofswitchingfrom the

standard method may bedelayed because the capital requirement under IRBcannot beless than 90%of thecapital requirement theprevious yearorless than80%of the priorrequirement after twoyears

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Calculationofrisk-weightedassets (RWA) isbased on thepotential exposureatdefault

(EAD)andcapital requirement (K)asfollows:

risk-weightedassets =capital requirementx 12.5x exposureatdefault

Note that collateral is notdeductedfrom EAD under the IRBapproach hut is deducted

under diestandardizedapproach The calculation of the capitalrequirement (K)isitselfa

functionofloss given default(LCD), probabilityofdefault(PD),maturityadjustment

(M),andamaturity'adjustmentfactor, related to EAD (b).Theexact formulationis:

K= LCDx PD x f(M,h)

Nowthatwehavediscussedthehasics,eachinput in thecapital requirementisdescribedin

ahitmoredetail In particular,differences between thefoundation TRB and advanced IRB

approachesarehighlighted.Figure1 summarizes someof theLeyproperties

LCD is animportant factorin thecapitalcalculationsince it islinearlyrelated toK

(i.e., increases in LGDwillincreaseAby thesame percentageregardless of thesizeof the

default).Underthe foundation IRBapproach, LGD increaseswith the riskinessof the

claim.Therefore,(predetermined)senior recoveryrateswill be higher diansubordinated

recoveryrates.Collateralcan be usedtoreducetheLGDand hence thecapital charge

Under theadvancedIRBapproach, banksgenerate internalestimates ofLGD

Theprobabilityofdefaultcalculationexplicitlyincorporates the correlation ofthe

specificassetclass.Theresulting stressedprobabilityis concaveinshape (i.e.,diminishing

effect of PDon K) Asset returns are basedon asystematic factorand anidiosyncratic

(unsystematic) factor.Whilethe derivation iscomplex and basedonthe distributionsof die

factors, Basel computationsarebasedon a ‘'worse-case”systematic draw atthe99.9% level

(approximatelythreestandard deviationsfrom die mean)

The maturityadjustmenteffect differs between the foundation andadvancedIRB

approaches Under die foundation approach, die effectivematurityisassumed to be

2.5years, while the effective maturityiscalculated individuallybased on PD underdie

advanced IRB approach Under the latter approach, thematurityadjustment can have the

perverse effect ofcharging higher-qualityloans more than lower-qualityones Hence, the

maturity effectcan mitigate thegains(i.e., reducecapital requirements)from otherareasof

the

Cross Reference to CARP AssignedReading-Basel Committee on BankingSupervision

Figure1 :Comparison of Standardized and IRBApproaches

Standardized Foundation IRB Advanced IRB Factor

Credit Risk Mitigation andSecuritization

Banks diat employ thestandardizedapproachcanfurther adjust their capital requirements

toreflectthe reducedriskin [he loanportfolio from theuseofcollateral,guarantees,

hedges,swaps,andocherderivatives.The specificrules,asyoucanimagine,arequitedetailed,but the general principles ofcredit riskmitigation{CRM) arestraightforward,Highly liquidassets,suchascash,gold, high-gradedebt,andequitiesinindices, can

he considered collateral The hankmayalso he ableto useon-balance-sheet netting ifa

legal basisexistsandaccuratenettingvaluescan hedetermined.Thecriteriafor using

guaranteesand credit derivativestooffset capitalrequirementsare morestringentdueto

the complexity and specific conditions of thecontracts, timingof cashflows,and potentialasset-liability mismatches,

Securitization isconsideredan acceptablemethodforcreditrisk mitigation under bodi die

standardizedand IRB approaches.However, thecommitteemakesanimportantdistinction

between traditional andsyntheticsecuritization.The primary difference Is thattraditional securitizationdictatesthat theassets in thepoolare trulyseparatefrom the hank.Syndietics

can reducecapital requirementsif theunderlyingcreditderivatives meettheprevious

standardforCRM.

Under diestandardizedapproach, thesameweighLingscheme describedfor capitalrequirementdetermination is utilized Institutionsemploying IRBapproachescan compute

capital usingeitheraratings-basedapproach(RBA) or asupervisory formulaapproach

delineated bythe Basel committee.

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THE NEW BASEL II CAPITAL ACCOPO

+ Riskweightsand risk-weightedassets

Tier I capitalanditscomponents

Probability of default (PD)

Exposureatdefault (EAD)

* Maturity (M)

Stresstests

+ Concentration risk

+ Residual risk

Professor'sNote: The above two AIMs arediscussedthroughout thistopic

The Bank for InternationalSetdements(BIS)createdthe first Basel Accordin 1988.Since

thattime, variouschangeshave taken placeininternationalbankingmarkets drat have

requiredan update of dieoriginalagreement.The Basel I Accord of 1988cameunder

criticismwidriiia few years ofitsIssuance.That Accord hadfairlystringentguidelinesfor

calculating credit risk, whichdid notaccurately reflect the true risk tocapital.The1988

Accord also failedtoaddressnewandinnovative riskmanagementvehicles and methodsfor

managing credit risk.Finally, BaselIdid not includeany consideration ofoperationalrisk,

and thusfailedto capture animportantcomponent ofmostbanks’ risk profiles

Whiledie original Accord focusedoncredit riskandmarket risk, thenewAccord expands

thetreatmentof these riskstoincludeaspecific operationalriskcomponent in thebanks

capitalratio.Althoughthe minimumcapitalratio (totalcapital / total risk-weighted assets)

of 8%is thesame under thenewAccord,diese changesmayrequirea different levelof

capitalforsomehanks dian die first Accord.However, the overallobjectiveis to maintain

similaroverallcapital requirements (i.e., capitalcharges) and to ensure thosecapital

requirementsaremuch more sensitive tothe risk profileof the bank’s operations

Besides the general objective ofmaintaininga soundinternational financial system, the

specificobjectivesof the Basel IIAccordinclude thefollowing:

• Promotesafetyandsoundnessof the financialsystem.

* Enhance competitiveequality

* Createcapitaladequacyassessmentsandapproaches thatareappropriateto thedegreeof

risk involvedin a banks positions andactivities.

• FocusonInternationallyactive hanks while allowing the principlesto be flexible enough

tohaveapplication to awidevariety ofbankingoperations

Cross Reference to CARPAssigned Reading-Basel Committee on BankingSupervision

* Encouragecontinuousimprovementin abank's internal riskassessmentcapabilities

• Ensurethat riskis a primaryemphasisinsupervisorypractices

TheBasel II Accordconsistsof threepillars:

* Pillar1:Minimumcapital requirements.Banksshouldmaintain a minimumlevelof

capital to cover theircredit, market,andoperationalrisks

* Pillar 2:Supervisory reviewprocess.Banksshouldassess the adequacy of their capitalrelative totheir risk,andsupervisorsshouldreview and takecorrective actionifproblemsoccur

* Pillar 3: Marketdiscipline Risksshouldhe adequately disclosedinorder toallow

market participants to assess a hank’srisk profileand theadequacyofitscapital.Greater

disclosurewillincrease thedisciplineinthemarketplace,leadingtogreater financial

stability

TheBISbelievesthat these pillars taken together shouldincreasethesafetyand soundness

of die financialsystem.These pillarsrepresent a package,andaccording todie BIS,

implementationof the NewAccord should norheconsideredcomplete untilall diree pillars

arein place

© Professor’s Note: These three pillarsofsound bank managementwill be

discussedingreater detailinAIM47.1laterin thistopic

to.

The Basel II Accord isdesigned toapplytoall internationallyactivebanks The Accord

coversany holdingcompany that may be the parentof otherentitiesinvolvedin banking

activities,anditlooksattheentiregroupon aconsolidatedbasis Theideais toinclude the

risks heldatanylevelofa multilevelbankinggroupandto preventthedoublecountingofcapital

Banksubsidiariesare viewed as partof die wholebankinggroup.However, the Accord also

callsonsupervisorstoevaluate subsidiaries1 individual capital to assure thatdiedepositors

of eachsubsidiary(who may not haveaccess toodter parentcompanyassets) arefullyprotected

If partof the bankgroup'sorboldingcompany's operationsarein related businesses

(e.g.,insurance, securities), theseoperationsshould be consolidatedaswell, andthe capital

should beadjusted toappropriatelyreflect the riskof theseentities.

Therearethreetypesof capital available to coverbankrisks (credit, operational,and market

risks),and theyareclassifiedas Tier 1, Tier 2,andTier3.Tire Basel II Accord retains dierequirement that banksmaintaincapital ofatleast oftotal risk-weightedassets.

Tier 1capital,or corecapital, iscomprised of shareholders'equityanddisclosed reserves (i.e., retainedearnings) Equity includescommon stockoutstanding,aswellasany

outstanding preferred stock diatisnonredeemable and noncumillative

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Cross Reference to GARP Assigned Reading—Basel Committee on Banking Supervision Tier 2capital,orsupplementary capital,iscomprised of ocher assets orequity

(e.g., cumulativepreferredstock) thatmay beavailableto protectdepositors,but involve

a mandatorychargeagainstfutureincome orhavea limitedlife.Tier2capitalincludes

itemssuchas undisclosedreserves, revaluationreserves,general provisions/generalloan-lass

reserves, hybriddebtcapital instruments, andsubordinated termdebt*Obviously, these

sourcescouldbe used tooffsetlosses,hut theyare not as certain as Tier 1capitalsources.

Tier 3capital,orshort-termsubordinateddebt,canonly he usedLO meetcapital

requirements related to market risks To qualifyas Tier3 capital,short-term subordinated

debt musthe unsecured, notinarrears,andhavebeenissued with amaturityoftwoyears

or more.The debtmustalso havea covenantlimitinginterest or principal payments to

investorsifsuchpaymentswould impair thebank'sminimum capitalrequirement

There are nolimitationsonhowTier 1capitalis usedto meetcapitalrequirements.Tier 2

capitalislimitedto 100% ofTier 1capital.TheBaselII Accordrecommends that Tier2

andTier3 capital together be no greaterthan Tier1 capital,butleaves this decision up to

theregulatorsinthe banks' homecountry.

for the calculation of credit risk:

Foundation IRBApproach

Advanced IRBApproach

The StandardizedApproach incorporatesriskweights basedonexternal creditrating

assessments*Theideais toensureindependentexternal riskassessments in die calculation

of riskweightsandgiveissuers the incentive toseek thoseexternally generated risk

assessments*In general,greaterrisk exposures implyhigherriskweightings.Forsovereign

credits, creditscoresofexportcreditagenciesarerecommended Preferentialtreatment

ofshort-termcreditexposures isalso recommended Corporate credit riskweightsare

substantially expanded.TheCommitteerecommends that hankcredits never receive a

risk weight less than diat appliedtothe sovereignwithwhich the bankisincorporated

Ifnoexternalweightingisapplied to a certain risk exposure, theStandardizedApproach

mandatesariskweightingof100%.This means that thefiill8%capital requirementapplies

to thatexposure In addition,loans considered pastduearerequired toheweightedat

150% toreflect theirgreater riskprofile, unless the bank hasalreadyset asideprovisions for

that loan

UnderBasel I, afinancialInstitution’s risk categorization depended on whether it was in a

country that was anOrganizationforEconomicCo-operation andDevelopment(OECD)

member. Non-members had tohold morecapital againstacredit riskyposition than

members This createdan unfairadvantageforOECDbanks

Under the new proposed BaselII regulations, theamountof capital thatahank musthold

isspecific to die riskof theircreditriskyassets, die typeofinstitution theclaimis written

on,and, in thecaseof claimson banks,diematurityof thoseassets.Thesenewguidelines

areobviouslyarefinement relativetothe original Baselreguladons

Cross Reference to GARP Assigned Reading-Basel Committee onBankingSupervision

In diecaseof claimsonbanks, supervisors havetwooptions todetermine dieamountof

capital thatmustbe held.Inoption1, the riskweighting usedis one category less favorable

than for diat of the bank’scountry(forthehigher creditqualityassets).The riskweightsare

thesameforassetsof loweror unratedquality.Tn option2,the hankcan pickanexternal

creditradnganduse thistodetermineriskweightings Notethat shortermaturity (threemonthsor less)assetsgenerallyreceive moreiavorahle treatment (less capital is required to

beheld)

Giventhe below riskweightsforindividualcredit-riskyassets, the capital requirementunder

the StandardizedApproachiscalculatedas: assetvaluex riskweight x 8%

Figure2: MinimumRiskWeightsfor ClaimsonSovereignsand TheirCentral Banks

Credit Evaluation AAAtoAA— 4+ to A— BB3+ to BBB— BB+ to B— Below B- Unrated

Figure4:MinimumRisk Weights for Claimson Corporations

Credit Evaluation AAA to AA- A+ to A— BBB+ to EB— Below BB— Unrated

Theinternalraiings-based(IRB)approaches(foundadonandadvanced) lorcalculatingriskweightsare an attempt to recognizeanindividual hank’sriskprofilein diecalculation

ofcapitalrequirements The IRBapproaches use ahanksowninternalestimatesof

creditworthiness todetermine the risk weighdngsin thecapitalcalculation.The IRBapproachesare asignificant feature of the BaselII Accord,astheyare an attempt toallow

morecustomized (and hopefullymore accurate) riskprofiles.So Jar,however, diose banks

choosing the IRB approachareopting for the lower flexibility of thefoundationIRB, rather

than theadvancedIRB.As wasmentioned, the IRBapproach can he beneficialfor hanks

since it has thepotential to reduce thecapitalrequirement becauseabanksown estimatesof

riskmaybelower than thosecalculated using thestandardizedapproach

There aredireeissues toaddress in the IRB framework:

1. Riskcomponentsÿwhicharerisk parameter estimates,either developed internallyor

taken from supervisoryestimates.

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Cross Reference to CARP AssignedReading—Basel Committee on Banking Supervision

2. Risk weightfunctions,which taketheriskcomponentsandtranslate theminto

risk-weightedassets.

3 Minimum requirements, whicharestandards thatmusthe metbeforeabank iseligible

to use anIRBapproach

Thefoundationapproachis anTRB method withheavyrelianceonsupervisoryestimates.

The onlyparameterestimated by the hank isprobability of default (PD).Theadvanced

approach allows hanks to estimate notonlyPD, hutalso lossgivendefault(LGD),

exposureatdefault(EAD),andeffective maturity (M).Under either approach,the hank

must usetherisk weightfunctionstoderivecapitalrequirements

Asmentioned, under thefoundationTRBapproach,hanksestimateprobabilityofdefault

(PD).TheIRB riskweightsinturn dependon dtese defaultestimates.For example, when

consideringcorporateloans, the foundationIRBapproach produces the following risk

Whileit is unlikelythatyou will he tested on theseexactriskweightings,you should

understandthe correlation betweendefaultprobabilityandriskweight.Aswith the

StandardizedApproach,as probability of defaultincreases, sodoes the riskweight.

Regarding the advanced IRBapproach, thecapital chargeiscalculated by multiplyingrisk

weight byEADandthen multiplyingthatamounthv

BothIRB methodstreat corporate,hank,andsovereign riskssimilarly,huttreat retail,

project finance,andequity exposures inadifferentframework

Corporate,sovereign, and bank exposures The TRBmethodsofcalculatingrisk-weighted

assetsrely onfour keyquantitative inputs:

1. Probabilityofdefault{PD}.

2 Lossgivendefault(LGD).

3. Exposureat.default(EAD).

4 Maturity(M)of dieexposure

The IRBapproachallows the hank touseits own internal measuresof credit exposureto

ratespecific borrower default.APD isgeneratedto represent along-runaverage PD for

allborrowersinsimilar risk classes Unfortunately,PD doesnot fullyincorporate the risk

exposureto the hank.Recoveryracesalso playa roleinmeasuring the hanks exposureand

are incorporatedinto au LGD measurefor diecredit Theexposure to aparticular borrower

also playsa role and isincorporatedinto tlie EADestimate.

LGDand EADestimates inthe foundation IRBapproachare setbysupervisoryrules

However,banksareallowedto set LGDandEADestimationsusing the advanced IRB

approach if they meet rigorous requirements These requirements relatetodocumenting

how PDsaregeneratedandjustifyingtheiruse. Documentationof the processin PD

Cross Reference to CARP AssignedReading-Basel Committee on Banking Supervision

calculations moves thedecision making froma purelyquantitative process to a more

qualitative process

* Retail exposures TheCommitteeproposes the IRBapproachfor retail exposures

he distinctfrom thosepreviouslymentioned.Forretail exposures, thereisonlyone

advancedIRBapproach andnofoundation IRBalternative, meaningthat the PD, LGD, andEAD inputs thatgointo theretail exposure calculationare alldetermined

by the hank In general, abank isexpected tobemoreattunedto die risks associated

with the retail loans theymakethat have eitheraconsumeror businessfocus Banksare

expectedtomakeobjectivedefinitionsof retail exposuresbasedonborrowerand product

characteristics,whicharesegmentedalongsimilar risk characteristics The bankcanthen

make estimatesofriskexposureaccording to poolsof similar risks,ratherdian estimating

theexposurefor each individualasset.

Retail exposuresaredivided intodireemaincategories:(1)exposures securedbyresidential mortgages;(2) qualifyingrevolving retailexposures,whichincludemostcredit

cardassets;and(3)odier exposures thaLincludeloans made tosmall businesses

* Projectfinanceexposures.Theseriskweightingsare moreproblematic because

repaymentdependson performanceof theunderlyingproject The NewAccordallows

for two potential methods todetermineproject financeexposures.The firstis tosimply

usethesamemethodologyused for assessingcorporaterisk exposuresaspreviously

described-Ifthe bankcannot estimateall of the relevant data inputs,it canclassifytheexposureinto oneof five qualitygradeswhere dieriskweightingfor each gradeis

predetermined by the BaselCommittee.

* Equityexposures Riskweightingsfor equity exposuresaredifficult to generate,given

theirheterogeneous behavior Thereare twopotential methods diatcan heused to

determine equity risk exposure The firstis based on thePD/LGD corporateexposure

methodology, while thesecondallows banks to model their equity market risk over a

quarterlyholdingperiod

Under the IRBframework,banksneedto set upacredit risk controlfunctionwhichis

responsible foroverseeingtheselectionof internal ratings This credit riskcontrol function

should: (1) testand monitorinternal ratings, (2) preparereportswhich incorporate

historical default probabilities andratingsmigrations,(3) ensurethat ratingsareapplied ina consistentfashion, and (4) documentanychanges todieratingsprocess

In performingtheirowninternalestimatesof LGDandEAD,creditinstitutionsmust estimateaverageor expectedanimallosses basedonhistorical datarelating todefaults

Expected loss (EL) is a cost componentof credit business, and should becovered in the institutions regularcourseofbusiness,meaningitshould be coveredbyloan loss provisions

andwrite-offs.Economiccapital/reguWory capitalis usedfor unexpectedvariationsfromexpectedlosses calledunexpectedlosses(UL).An exampleofan “unexpected loss” iswhen

there is ageneraleconomicdownturn,and several borrowers simultaneouslydefault ondie

sameloan type.

The unexpectedlosscalibrationhas tworesults.First,banksmustshowtheyhave

adequately reserved forEL .Second,banksdonot need to maintain reservesfor defaulted

loans Thissecond resultarisesbecause dieBasel risk modelemploysan LGD,whichis a

Cross Reference to GARP AssignedReading—Basel Committee on Banking LSupervmon

constant—defaulted,loansarecovered there.Tooffset thissecond result, theCommittee

recommends dratLGDestimates relyJM>ron historicaldefaultrates, buton more

conservative estimatesassumingeconomicdownturns

Creditinstitutionsmust now estimatedownturn LGD,whichis an estimateofprobable

lossesdueto an unexpectedeconomicdownturn.ThisdownturnLGD concept is relatively

new asitrelatestointernal riskmanagement.Comparisonswill need tobemadebetween

averageLGDand downturnLGD todeterminehow faraparttheestimates areandwhat

assetclassesare mostlikely affected

Ashas been noted,expected lossand unexpected lossarecoveredwith the bank's total

economic resources (i.e.,capital plusreserves).Under theJRB framework, banks must

useaconfidencelevelof 99.9%(over a 1-year time horizon) when calculating valueat

risk The confidence levelis setveryhighsinceitis thepercentchance that the bank will

remainsolventduringthenextyear From thelossdistribution in Figure5,youcan seethat

thedifferencebetween valueat risk and expected lossisthe bank’s unexpected loss(i.e.,

required capital) Youcanalsoseethat the probability ofexpectedlossevents is greaterthan

unexpectedlosseventsbut the severity of those expected lossesismuch less

Figure5:Valueat Risk (VaR)

VaR = lossat averyhigh

IRBRISK WEIGHT FUNCTION

Risk weightfunctionsare used to assess risk and determine capital adequacy The following

listcontains the necessary conditions for the IRB creditriskweight function Thecapital

requirementmodelis presented shortly withdetailedexplanations of thevariables

Conditionsfor the IRB credit riskweight function:

* Expectedlossesarecoveredbyprovisionsor revenue.

* Unexpectedlosseswillbecovered by bank capital

* Unexpectedlosseswill exceedcapitalat asmallpre-determined acceptable probability

(i.e.,abovedie chosenconfidencelevel)

Cross Reference to GARP AssignedReading-Basel Committee on BankingSupervision

* Riskweightsshouldheportfolio invariant (i.e., the calculationofloan risk is

independent of the portfolio).Anycorrelationwith other assetsin the portfoliois not

explicidyincluded inriskestimation.Tillssimplifiesdiecalculationofcapitalsince

eachloan isindependentof die portfoliothat it isbeingadded to.Difficulties including

diversification underthisassumption areoffset hycalibratingthe riskweight function for

awell diversified bank The supervisory process then adjuststhe requiredcapitalbased

on afirm specificassessmentof diversification

* Allsystematicrisksaremodeledbyasingleriskfactorjall idiosyncratic (unsystematic}risks tend tocancelouteach other

* Portfoliosarecomposed ofnumerousdiverseexposures

Thecapitalrequirement forcreditriskunderthe IRB frameworkiscomputedasfollows

This model isknownas anasymptoticsingleriskfactor (ASRF) model

capital requirement (K)-(conditionalEL-EL) x (maturityadjustment)

1

| downturn LGDxNf XG(PD)TJ xG(0,999)}—LGDxPD]x

* Conditional EL-EL:Conditional EL includes EL and UL,diedifference between

conditional EL and EL results in dienecessary capital for UL only.Regulatoryguidelines

requireELtobecovered byprovisionsandearningsandthereforshould notbe usedto

estimatecapital

* Conditional EL=downturn LGD x conditional PD

* LGD:Estimatesshould reflect lossesincurredduringan economicdownturn,effectively

a“downturnLGD.1'

* Conditional PD =N{...}:AveragePDsaretransformedintoconditionalPDsusing

a regulatorymappingfunctionincludingasinglesystematicriskfactorandasset

correlations.Alls the normaldistribution.The mapping function usesthe Merton

The conditional default threshold: The correlation weighted sumof thedefault

thresholdG(PD)and thesystematicriskfactorisused to calculate theconditional

PD G istheinverse normaldistribution

+ R:Assetcorrelation tothesinglesystematic risk factor.Highcorrelationisoften

associated with largecorporateloansas corporate returns areclosely related to

systematic conditions.Assetcorrelationsincreasewithfirmsize.Largerfirms

demonstratemoresystematic risk; this appliesto corporates, not hanksorsovereigns

An exampleoflowcorrelationassets areretail loans,astheydemonstratehighidiosyncraticrisk and lessassociation withthegeneral market orotherportfolio

exposures.Similarly,assetcorrelations decreasewithhigherPDsas higherPDs

suggest moreidiosyncraticrisk

+ 0.999:Systematicriskfactor,identicalfor allassets Thisimpliesaconfidence level

(CL)of99.9%or adefault dinesholdof0.1%.TheCL is sethighincaseof bank

parameter estimadon errors.

Cross Reference to CARP Assigned Reading—Basel Committee on Banking Supervision

* Maturityadjustment? Long-termcreditsare riskier chan shore-termcreditsand

therefore,capitalrequirementsshouldincreasewithmaturity; M ForM = 1, the

maturityadjustmentequalsone and dropsout, consistentwith thefoundation IRB

approach Thestandardmaturityis set at M-2.5years

b(PD): Maturity effectsareincreasedwithlow PDs because,intuitively,lowPDs

havemoreopportunity fordowngrades than higherPDs

CREDIT RISK MITIGATION

One intentof theBaselIIAccordis to increasesupervisoryrecognition of credit risk

mitigation practices.Oneway toaccomplish thisishy using collateral toreducedie capital

charge

Therearebasically twoapproaches:

1. Thesimpleapproach, where the riskweight of the collateralis usedinlieuof the

borrowerÿrisk weight for the secured portionoftheexposure

2. Thecomprehensive approach, where the valueof die collateralisadjusted periodically,

and diat valueisdeductedfrom theexposure

Creditriskmitigation techniques include:

• Financialandphysicalcollateral Forexample, adjustrisk exposure assigned by dievalue

of the collateral.Haircutsmaybe taken periodicallyto adjust for declineinvalueof

collateral

* Receivables.Capital chargecan bereduced bythe valueof thereceivables

• Guarantees and credit derivatives.Forexample, thesearerisk weighted byassigninga

reducedriskweightof the guarantor tothesecured portion of die loan

Usingthe foundation IRB Approach, collateral isaccountedfor throughareduedon in

LGD.Specifically, the loss given default isequal to currentloss given default

times thequantityofexposureafter riskmitigation divided hycurrent exposure Asan

expression:LGDRM = LGD x (ERMl E(,).

ASSET SECURITIZATION

Assetsecuridzation hasbecome apopular method for redistributing risks tootherparties.

Thesecuritization processessentially requiresoriginatorstolegallyandeconomically

transfer assets orobligations to a diird party, termedaspecial purposevehicle (SPVLThe

SPVthen issues securities thatareclaimson thepoolof transferredassets.Toreceivethe

appropriatetreatmentofcapital requirements, theissuinghankmust makeaMean break”

with theassets transferred and disclose all relevantquantitativeand qualitative information

associated widi theassets.

The LStandardized Approach toestimadngsecuritizationexposurestreats assets rated Baa3or

better similar toodier credit risks Riskierassetshavehigher riskweights applied, andifan

asset has noexternal rating, then diereis adirectdeductiontocapital (halfto corecapital

and halftoadditionalcapital)

The IRBapproachtoestimating securitizationexposures doesnotallowinternalestimates

ofPD, LGD, or other parameters.Therefore, there is no differencebetween thefoundation

Cross Reference to GARP AssignedReading-Basel Committee on BankingSupervision

IRB and advanced IRBas far as securitization riskisconcerned.Instead, the IRBapproach

allows three methods tocalculatethecapital requirement:

1 ExternalRatings-BasedApproach (RBA)* Thisapproachmust he used byany IRBhank that hasanexternal rating ofics risk assessment.The RBAapproachtreats

originators andinvestorsthesame*TheRBAdoes allowfor a rangeof riskweightsfor

each ratingcategory.

2 Supervisory Formula(SF).Theexposureisbasedon thecapital requirementfor theunderlyingassetshad they not beensecuritized.However,die bankisable toadjust

this exposure for credit enhancements andaweightedaverageLCD.The “thickness”

ofagivenexposureis the percentageofthe tranchedexposurewithin theentirepool of

exposures

3 InternalAssessmentApproach (IAA).Thisis permitted onlyinlimitedsituations

with specificpermissionof thesupervisoryauthority The bank calculatesitscapital

requirementhyapplyingits own internal riskassessment to die ratingsystem ofa major

externalrating agency.The hank dien uses theRBA to risk weight theexposures Both

the IAA andSFapproachescanbe usedon unrated exposures, andtheseapproachescan

reduce the negative effecton requiredcapitalarising from unratedsecurities.

The IRBapproach to riskweighted assetsecuritization issimilar toother IRB frameworks

Thegreatersensitivityto risk exhibited hy IRB-generatedweightsis maintainedin theasset

securitizationapplication* The risk weightsuseddependlargelyon theassetquality of dieunderlyingpoolandany credit enhancements diatareavailable toahsorh losses* For issuinghanks,akeycomponent isdie amountof capital die bankwouldhave been required to maintain onthe underlyingpoolofassets if theyhad notbeen securitized* The fullamount

of any first-loss posidon (losses the hank mustabsorb beforeothersecurity holders bearlosses) isdeductedfromregulatorycapital*

the risks covered—of thetwooptionsavailablefor the calculation of market risk:

* Standardised Measurement Method

* Internal ModelsApproach

Thereare twomethods used tocalculate market risk capital charges: thestandardized

mediodand die internalmodels approach (IMA).

Standardized Method

Thisapproachfirst determines thecapital chargesassociated withvarious market risk

exposures.These market risks include:equityrisk, interest raterisk,foreign exchange risk,

commodity risk,andopdonrisk* The market risk capital chargefor each market risk is

computedas8% ofitsmarket-riskyassets.The bank’s total riskcharges can then be found

hy summingdiecapital chargesof all marketrisks.

Sincethe market riskchargefrom thestandardized methodissimplya sumof all marketriskcharges,diver.silicadoneffectsareignored-Theinabilityto recognizediversification

benefitshasledmanyhanks to useinternal models*

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Internal ModelsApproach (IMA)

The IMAapproachallowsabankto use its own risk managementsystems todetermineits

market risk capitalcharge.Banks aremotivated to usethe internalmodelsapproachsince

itmay producea lowercapital charge than thestandardized method.However, inorder to

usethis approach, banks mustsatisfycertain requirementssetforth byregulators.These

requirementsinclude:internaloversight, backtestingofoutput, stress testing, andsetting

exposurelimits,

After these requirements aresatisfied, market riskchargescan becomputed.The market

riskcharge is set in oneof two ways? it is thehigherof(1) the previousday'sVaR, or (2)

theaverage VaRover the last60 businessdaysadjusted byamultiplicative factor (subject

to alloor of3).IfVaRiscontinuallyunderestimated,apenalty factor, calleda plusfactor,

isadded to this multiplier The muldplicative factors that includea penalty forexceptions

arediscussed shortly Themarket risk capitalcharge under this approach is thus average

VaR times amultiplicativefactor plusaspecific riskcharge thatcoversidiosyncratic

market risks

rfan institution isusingaVaRapproach tomodelitsmarket risk exposure, that model must

he backtested The bankmustbacktestdailyresultswhere thedailychangeinexposureis

compared tothe previousday'sVaRestimate.If thedayschangeinvalueexceeded theVaR

estimateof die previousday,anexception hasoccurred.ForaI-year period,therewould be

250 daystested

Theresultsof the backtest just describedareevaluated,andacumulative totalofexceptions

isdeterminedfor the250-davtesting period.Basedon thenumberofexceptions,die

hank’s exposureiscategorizedinto oneof threefollowingzonesand VaRisscaled upbythe

appropriatemultiplier,

* Green zone:0—4exceptions, increase inexposuremultiplieris 0.

* Yellowzone:5-9exceptions, exposuremultiplierincreases asfollows:

Exceptions Increase inMultiplier

* Red zone: Greater than orequal to 10exceptions,multiplier increasesby1.

These plusfactorsareadded to the multiplicativefloorof3stated in the IMAapproach.So

lor250 days, ifVaR isexceeded10 or more timesdie multiplicativefactorfor theaverage

VaRamountwill be4 (= 3+ 1).Ifa bank’s model consistentlygenerates a high numberof

exceptions, thehankshould revisit the model andadjust it as needed,

Cross Reference to CARP Assigned Reading-Basel Committee on Banking Supervision

Professor's Note: You could alsofindthe numberofexceptionsifyou knowtheconfidence levelforVaRand the number ofdaysin a testingperiod. For

example, ifyouaregivena90% confidencelevel witha250-day testingperiod

the number ofexceptionswould be:(1 - 0.90} x 250 = 25 days In other

words> wewouldexpectVaRto be exceeded 25daysina250dayperiod.

for thecalculationofoperational risk:

+ BasicIndicatorApproach

+ StandardisedApproach

The BaselCommie teedecidedtoincorporaterisks other dian justcreditor market risks

in its suggestions forcalculating regulatory capital Thespecifictermfor theseother risks

isoperationalrisk,which dieBasel Committee definedexplicitlyas“the riskof director

indirectlossresultingfrom inadequateorfailedinternalprocesses, peopleandsystems or

from externalevents.31In itsbroadestterms,anyrisk that cannotbe classifiedas a market or

credit riskcan beclassifiedasoperational risk.However, it shouldbe noted that underBasel

II, reputational riskis notincluded in the definition ofoperationalrisk,

Operationalrisksare much moredifficulttoquantifycompared tocreditor market risks,

However,die BaselCommitteebelieves that including operational riskinabank’s capital

calculation willencourage thedevelopmentof methods to assessoperational risksand

ensurethat banksare holdingcapital that issufficient to coyerthose risks TheCommittee

proposeda continuumof approachestocalculating capitalrequirementsforoperationalrisk* This continuumisdefined alongthe levelofsophistication usedinquantifyingoperationalrisks:

* Basic IndicatorApproach(BIA),The B1Ameasures the capitalchargeon afirmwide

basis Banks will hold capital for operational risk equalto afixed percentageof rhe bank's

average annual grossincome overthe prior diree years Thisfixed percentage isalso

knownasthe alpha factor

operationalriskcharge(under BIA) =alpha factorx GI

The BaselCommittee hasproposed chat the alpha factor should be equalto15%

* StandardizedApproach (SA).SAbuildson the BIAby allowingbankstodivideactivities

along standardizedbusinesslines Within eachbusinessline,grossincomewillbe

multiplied byafixed percentage.The percentagediffersacrossbusiness lines Thecapital

chargeforoperational riskisthesumof each businessline's charges

The StandardizedApproachdivides bank activities intoeightbusiness lines Each

businessline’s grossincome ismultiplied byafixed percentage(knownasthe beta

factor)

operationalriskcharge(underSA) = £betafactor;xGIS

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The betafactors for die eightbusinesslinesare asfollows:

Tradingand sales

* AdvancedMeasurement Approach (AMA) ,Ifabankcan meet morerigorous

supervisory standards,itmayuse the AMA foroperational riskcapitalcalculations*

HieAMAissimilarto theIRBapproach for determiningcredit riskin thatbanks

usetheirown methodologies for assessingoperationalrisks The Basel requirements

for theAMAareextremely flexiblea*slongas the approachesarecomprehensivein

addressingoperationalrisksandsystematicintheirimplementation.Theguidelinesfor

implementingdieAMAareintentionallybroadinhope tiiaL banks will develop their

ownsophisticated mediods formeasuringoperational risk that will evolveover time.

Professor’sNote: UnderAMA, internal measures must be basedon a minimum of fiveyearsofdata However, when a bankfirstmoves to the

AMA onlythreeyearsofinternal data is needed

The capitalchargeforAMAiscalculated as thebank’s operationalvalueatrisk

(OpVaR)withaone-year horizonanda 99*9%confidence level.It should he noted that

havinginsurance can reducethis capitalchargebyas much as20% Recall from

Topic 42, that underAMA,firmsareencouragedto use die loss distributionapproach

(LDA) Other methods thatcouldbe used to capture “tailevents” includescenario

analysis and historical lossevents.

PILLAHSOFSOUND BANK MANAGEMENT

* Minimum capital requirements

* Supervisoryreview

* Market discipline

Pillar1:MinimumCapital Requirements

Pillar1,minimum capital requirements,ismainly concerned with measuring the risk

exposuresof individual creditsin which banksinvest.Recall thatthereare twofundamental

approachestoassessingthecapital requirementsaccordingtodie levelof risk associated

withcreditrisks The firstapproachistheStandardizedApproach,whichisdrivenhy

creditratings published byexternalcredit ratingagencies.The second approach is one that

Cross Reference to GARP AssignedReading-Basel Committee on BankingSupervision

allows banks to use anIRBapproach,where the individual lenderassessesvariablessuchas

creditworthiness, maturity,andconcentration associated withdefault,

Theevolutionaryaspect of Pillar ] relates to thedesireof theCommittee to seelending

institutions movefrom theStandardizedApproachtotheIRBapproach whenassessing

riskweightingsand measures,Within the IRBapproach, the Committeewould liketo

have hanksmovefrom the foundation approach to the advanced approach when settingregulatorycapital requirements In this way,it is hoped diat individual institutions will

formulatemoresophisticated risk managementprocedures that haveagreaterdegree of

accuracyinassessing riskexposures.Astheinternationalbanking industrycontinues co

changefasterdian die rules andregulationsthat govern theindustry,thehopeis that banks,usingtheirown riskmanagement models,will have riskassessmentcapabilities that willkeep up with thechangesin diemarketplace

Pillar2:SupervisoryReviewProcess

The SecondPillar of the New Accord relatesto howhankingsupervisors interactwith

hanking managers and dieir internal hankingmanagement procedures Themain purpose

ofPillar2is to ensureinternal processesappropriatelyassesscapitaladequacy.According

co theSecondPillar,bankingsupervisorsare responsible fordetermininghow well banks

areassessing their risksinrelation to die levelof capital required Capital adequacyis not a

substitutefor sound procedures.The Second Pillar includesnotonlythe assessmentof risks

(calculationof required capital), hut outlines howaninstitution identifiesdeficienciesinits

operationsandwhat actionswill be taken toreduceriskand restorecapitalon anongoingbasis Therearefourkey principlestothe SupervisoryReview Process(SRP):2

Principle1: Banks should have&process forassessingtheir overallcapitalin relationtotheir

riskprofileanda strategyformaintainingtheircapitallevels,

Thecapital adequacyassessment process should include:

• Policies and proceduresto ensurerelevant risksareidentified

• Proceduresforrelatingbankstrategiesandthe levelofcapitalfor risks undertaken

• Internal controls

• Reviewsandauditscoensureintegrityof the overallmanagiement system.

The responsibility of thisprocessrestswithbankmanagement, whonotonly need co

document their procedures,butmustalso be mindfulof theeconomiccyclein which

businesstransactions areundertaken Stresstests to identifyevents that mayadversely affect

theircapital positionshouldbe carriedout on anongoingbasis

Principle2: Supervisors shouldreviewand evaluate banks internalcapitaladequacy

assessmentsand strategies,aswellastheirabilityto monitorandensuretheir

compliancewith regulatorycapitalratios ,Supervisors should take appropriatesupervisoryaction iftheyare notsatisfiedwith the resultsofthisprocess.

The purposeof this principle is coguidesupervisors in carryingout theirsupervisoryroles.Specifically,supervisors should:

* Relatesensitivity analysesandstress tests to the bank’s capital

2 International Convergence ofCapital MeasurementandCapital Standards, Bank for InrcmationaJ Sctdcmcnts0unc2004): 39.

©2013 Kaplan,Inc.

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Topic 47 Cross Reference to GARP Assigned Reading—Basel Committee on Banking Supervision

• Evaluate howmanagementhas prepared for expectedandunexpected eventsand

their impactoncapital

• Appraisewhethertargetcapital levelsare properlymonitoredand reviewed hy

internal managementproceduresandsenior management officials

Principle3 : Supervisorsshould expect bankstooperate above theminimumregulatorycapital

ratiosand should have theabilitytorequire bankstoholdcapitalinexcessofthe

minimum.

Supervisory personnel shouldhavethe ability to ensure diat banksareoperatingwith

adequatelevelsofcapital.Setting triggersor targets forvariousoperationaldefinitionsis

encouraged Individualcountriesandtheirregulatorsmaywant to set ratioshigher than

those specified as theminimumin theNewAccord*

Principle4: Supervisorsshouldseekto intervene at anearlystage to preventcapital from

fallingbelow the minimumlevelsrequiredtosupport the risk characteristicsof

aparticularbank, andshouldrequirerapidremedialactionif capitalis not

maintainedor restored

To ensureminimal capital adequacy, theNewAccordsuggeststhatsupervisors:

• Increasethefrequencyandintensityof hank monitoringactivities.

• Restrictdividend payments.

• Require thehank toprepareandimplementacapitalrestoration plan*

• Require the bank to raiseadditionalcapitalimmediately

Asaconsequenceofincreasingthevalidity of banks'internalcontrol procedures, dieNew

Accordtreatsmarket risks likeinterest rate risk as afactor to beanalyzedandevaluated

under Pillar 2.Specifically,a bank's internal proceduresfor assessing interest rateriskare

incorporatedinto die overall procedures for risk assessment.Banksmust provide results of

sensitivity analysesor stress tests to indicate the levelof capital diat shouldbe maintainedin

theeventofanadversemovement ininterest rates(e*g., hanksmust provideananalysis of

the impact ofa 200basis point shocktotheircapitalposition)

Thesupervisors' duties,as a partof theSupervisoryReview Process,includethe following:

* Checkcompliancewith Pillars1and3,includinginternal risk management processes,

creditriskeasingor mitigation, and transparencyrequirements

* Assessriskswhich eitherare notincludedor are not properlycoveredinPillar1,

including legÿlrisks,documentationrisks,liquidity risks, creditconcentration risks,and

operational risks Legalrisk, documentation risk,andliquidity riskareresidual risks

that mayarisewhen credit risk mitigation (CRM) techniquesareapplied.Forexample,

the inabilityto securecollateral would bearesidual risk Recall diatCRM techniques

aredesignedtoreduce credit risks, however,ifcollateral is unableto be seized; the risk

reductionstrategywould provetobe ineffective

* Assesstheinternal capital managementmediods employed by thebank,including their

adequacyand whedieror not highercapital levelsarerequired

• Reviewinternal controlsystems.

Professor'sNote:Concentration risk needsto be assessedaspartofthe

Supervisory ReviewProcesssince it may not beproperly covered under Pillar1.

Thisrisk resultsfromadisproportionately largeexposureto asingle obligoror a

disproportionately largeexposureto a common sector