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IV. OPERATIONAL AND INTEGRATED RISK

IV. 1. EXTENDING VAR TO OPERATIONAL RISK .......................................................................... 4 Operational Risk ................................................................................................................................4 Top-Down Approaches .......................................................................................................................4 Bottom-up Approaches ......................................................................................................................6 Top-Down Models .............................................................................................................................7 Bottom-Up Models ............................................................................................................................8 Catastrophic Loss ...............................................................................................................................9 Catastrophe Options and Catastrophe Bonds .................................................................................... 10 Limitations to Operational Risk Hedging ........................................................................................... 11

IV. 2. CAPITAL ALLOCATION AND PERFORMANCE MEASUREMENT .................................. 12 Economic and Regulatory Capital ..................................................................................................... 12 Economic Capital and Risk-Adjusted Return on Capital (RAROC) ........................................................ 13 Attribution of Capital ....................................................................................................................... 14 Capital Charge ................................................................................................................................. 14 Allocation of Economic Capital ......................................................................................................... 16 Drawback of RAROC Approach ......................................................................................................... 16 Adjusted RAROC .............................................................................................................................. 16

IV. 3. LIQUIDITY RISK - CULP ........................................................................................................... 17 Definitions ....................................................................................................................................... 17 Funding Liquidity Risk and Market Liquidity Risk ............................................................................... 17 Measuring Liquidity Risk .................................................................................................................. 18 Cash Flow at Risk (CFaR) ................................................................................................................... 20 Liquidity-adjusted VAR (LVAR) .......................................................................................................... 20 Monitoring Liquidity Risk ................................................................................................................. 21 Metallgesellschaft Case .................................................................................................................... 21

IV. 4. AMA APPROACH TO OPERATIONAL RISK ........................................................................ 22 Severity distributions ....................................................................................................................... 22 Frequency distributions.................................................................................................................... 23 Business-line diversification (correlation) ......................................................................................... 26

IV. 5. REGULATION .............................................................................................................................. 29 History ............................................................................................................................................. 29 Regulation ....................................................................................................................................... 29 1988 Basel Accord ............................................................................................................................ 30 Basel II Accord ................................................................................................................................. 31

IV. 6. MODEL RISK ............................................................................................................................... 34 Model Risk ....................................................................................................................................... 34 Quantifying Model Risk .................................................................................................................... 35 Managing Model Risk ....................................................................................................................... 36 Quantification .................................................................................................................................. 36 Institutional Methods ...................................................................................................................... 37 Definition ........................................................................................................................................ 37 Efficient Market Hypothesis (EMH) ................................................................................................... 38 Role of Model Risk Manager............................................................................................................. 39

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IV. 7. CASE STUDIES ............................................................................................................................ 40 Financial Crisis at Metallgesellschaft ................................................................................................. 40 Stack-And-Roll Hedging Strategy ...................................................................................................... 40 Losses at Sumitomo ......................................................................................................................... 41 Collapse of Long-Term Capital Management (LTCM) ......................................................................... 41 Bankruptcy of Barings ...................................................................................................................... 42 Risk Management Measures ............................................................................................................ 42

IV. 8. OPERATIONAL RISK ................................................................................................................. 43 Approaches to estimating operational risk under Basel II .................................................................. 47

IV. 9. FINANCIAL CONGLOMERATES .............................................................................................. 52 Aggregating Risk .............................................................................................................................. 52 Silo Approach to Capital Regulation .................................................................................................. 52 Regulatory Debate ........................................................................................................................... 53 Capital Management of a Financial Conglomerate ............................................................................ 54 Economic Capital as a Common Currency for Risk ............................................................................. 54 Risk Aggregation: The Building Block Approach ................................................................................. 55 Diversification Benefits from Risk Aggregation .................................................................................. 55 Diversification Benefits at Each Aggregation Level ............................................................................ 56 Current Industry Practices ................................................................................................................ 56 3+1 Pillars ........................................................................................................................................ 57

IV. 10. ERM ............................................................................................................................................. 58 Total Risk = Systematic risk + non-diversifiable risk ........................................................................... 58

IV. 11. TECHNOLOGY AND OTHER OPERATIONAL RISKS ...................................................... 63 Definitions ....................................................................................................................................... 63 Risks of Implementing Technological Innovation ............................................................................... 63 Technology and Economies of Scale/Scope ....................................................................................... 63 Average Cost Curve in Banking ......................................................................................................... 63 Economies of Scope ......................................................................................................................... 64 Empirical Findings ............................................................................................................................ 64 Daylight Overdraft Risk .................................................................................................................... 64

IV. 12. A. INVESTORS AND RISK MANAGEMENT........................................................................ 65 Covariance/Correlation of Returns between Securities ..................................................................... 65 Diversification, Asset Allocation, and Expected Returns .................................................................... 66 The Capital Asset Pricing Model (CAPM) ........................................................................................... 67 Diversification and Risk Management ............................................................................................... 67 Capital Market Line (CML) ................................................................................................................ 68 CAPM .............................................................................................................................................. 68 Probability Distribution of Returns ................................................................................................... 70 Expected Return of a Portfolio.......................................................................................................... 72 Strategies for Diversifiable Risk ........................................................................................................ 72 Strategies and Policies to Reduce Systemic Risk ................................................................................ 72 Effect of Hedging on Firm Value........................................................................................................ 73 Risk Management Irrelevance Proposition ........................................................................................ 73

IV. 12. B. CREATING VALUE WITH RISK MANAGEMENT ........................................................ 74 Risk Management Irrelevance Proposition ........................................................................................ 74

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Bankruptcy and Distress Costs .......................................................................................................... 74 Taxes ............................................................................................................................................... 75 Optimal Capital Structure ................................................................................................................. 75 Large Undiversified Shareholders ..................................................................................................... 76 Manager Incentives.......................................................................................................................... 76 Debt Overhang ................................................................................................................................ 77 Information Asymmetries and Agency Costs of Managerial Discretion ............................................... 77

IV. 13. REPORT OF COUNTERPARTY RISK .................................................................................. 78 Risk Management and Risk-Related Disclosure Practices ................................................................... 80 1. Improving Transparency and Counterparty Credit Assessments ................................................... 80 2. Improving Risk Measurement, Management and Reporting ......................................................... 80 3. Prime Brokerage ......................................................................................................................... 81 Financial Infrastructure .................................................................................................................... 82 1. Documentation Policies and Practices ......................................................................................... 82 2. Operational Efficiency and Integrity ............................................................................................ 82 3. Netting, Close-out and Related Issues ......................................................................................... 83 Complex Financial Products .............................................................................................................. 83 4. Credit Derivatives ....................................................................................................................... 83 1. Governance-Related Guiding Principles ......................................................................................... 84 2. Intermediary/Client Relationship ................................................................................................ 85 3. Risk Management and Monitoring .............................................................................................. 86 4. Enhanced Transparency .............................................................................................................. 87 Emerging Issues ............................................................................................................................... 88 1. Sale of Complex Products to Retail Investors ............................................................................... 88 2. Conflict Management ................................................................................................................. 89 3. Risk Management for Institutional Fiduciaries ............................................................................. 89 4. Official Oversight of Hedge Funds ............................................................................................... 90 Supervisory Challenges .................................................................................................................... 91

IV. 14. BASEL II CORE READINGS .................................................................................................... 92 Basel II Objectives ............................................................................................................................ 93 Scope .............................................................................................................................................. 94 Capital Requirements ....................................................................................................................... 95 Risk-Weighted Assets (RWA) ............................................................................................................ 97 First Pillar: Credit Risk ...................................................................................................................... 98 CRM Techniques ............................................................................................................................ 110 Asset Securitization ........................................................................................................................ 111 Supervisory Backtesting Framework ............................................................................................... 113 Three-Zone Supervisory Framework ............................................................................................... 113 Operational Risk under the Basel II Accord ..................................................................................... 114 Four Principles of the Basel II Accord’s Second Pillar ....................................................................... 115 Issues to be focused in Second Pillar ............................................................................................... 116 Purpose of the Third Pillar .............................................................................................................. 116 Potential problems with risk analytics ............................................................................................ 117

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IV. 1. Extending VaR to Operational Risk LO 57.1: Compare and contrast top-down and bottom-up approaches to measuring operational risk

LO 57.2: List and describe examples of top-down models for measuring operational risk

LO 57.3: List and describe examples of bottom-up models for measuring operational risk

LO 57.4: List and describe ways a firm can hedge against catastrophic operational losses

LO 57.5: Describe the characteristics of catastrophe options and catastrophe bonds

LO 57.6: Discuss limitations to operational risk hedging

Operational Risk

Operational risk (as defined by Kingsley et al, 1998) is the “risk of loss caused by failure in operational

processes or the systems that support them, including those adversely affecting reputational, legal

enforcement of contracts and claims.” Operational risk includes strategic risk and business risk, and

can arise from breakdowns of people, processes, and systems with the organization.

Operational risk events divided into:

High frequency/low severity (HFLS): occur regularly, but low-level losses

Low frequency/high severity (LFHS): rare but devastating

In this chart, losses are shown left of the mean (i.e., where negatives = loss) but

Top-Down Approaches LO 57.1 Compare and contrast top-down and bottom-up approaches to measuring operational risk

The traditional approach is top-down: an overall cost of operational risk is determined for the firm. The

bottom-up approach is generally more advanced: operational risk is determined at the business unit (or

SBU, strategic business unit) level.

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Features of Top-Down Approach

Top-Down

Approaches

Assesses overall, firm-wide cost of operational risk

Is typically a function of a target (macro) variable or variance in target variable; e.g., revenue, earnings

Does not distinguish between HFLS and low frequency high severity (LFHS) operational risk events

Advantages Disadvantage

SIMPLE

LOW DATA requirements

(not data-intensive)

Little help or utility with regard to

designing/modifying procedures that

mitigate risk; does not really help with

prevention

Because top-down approach both (i)

aggregates risk (note: may “over-

aggregate”) and (ii) is backward-

looking, it is a poor diagnostic tool.

Note the tendency to over-aggregate.

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Bottom-up Approaches Bottom-up approaches target specific operational risk problems. Importantly, they can distinguish

between high-frequency, low-severity (HFLS) events and low-frequency, high-severity (LFHS) event.

Features of Bottom-up Approaches

Bottom-up

Approaches

Analyzes risk from the perspective of individual business activities

Maps processes (activities) and procedures to risk factors & loss events to generate future scenario outcomes

Distinguishes between HFLS and LFHS

Advantages Disadvantage

DIAGNOSTIC: Useful because it can

help employees correct weaknesses

PROSPECTIVE: Forward-looking

DIFFERENTIATES between HFLS and

LFHS

High data requirements

By overly disaggregating risk from

different business units/segments,

may omit interdependencies and

therefore correlations. Note the

tendency to under-aggregate (or

overly disaggregate)

Although a bottom-up approach has disadvantages (i.e., data-intensive and may under-

aggregate), generally the bottom-up approache is superior, according to the reading.

Keep in mind that bottom up is required to distinguish between high-frequency, low-

severity (HFLS) and low frequency, high severity (LFHS) loss events.

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Top-Down Models LO 57.2 List and describe examples of top-down models for measuring operational risk

The six common top-down models are:

1. Multi-factor models

2. Income-based models

3. Expense-based models

4. Operating leverage models

5. Scenario analysis

6. Risk profiling models

Multi-Factor Models

Stock returns (as the dependent variable) are regressed against multiple factors. This is a multiple

regression where Iit are the external risk factors and the betas are the sensitivity (of each firm) to the

external risk factors:

1 1 2 2it i i t i t itR I I <IV. 1. 1>

The risk factors external to the firm; e.g., interest rates, GDP. Also, note the multi-factor model cannot

help model low-frequency, high-severity loss (LFHS) events.

Please note the characteristics of a multi-factor model. The mult-factor model based on

a multiple regression has several applications in the FRM. It has an intercept ( ). After

the intercept, it has several terms. Each term contains an external risk factor (I) and a

sensitivity to the risk factor (beta ). Finally, it has an error term or residual ( ).

Income-Based Models (aka, Earnings at Risk Models)

These are also called Earning at Risk (EaR) models. Income or revenue (as the dependent variable) is

regressed against credit risk factor(s) and market risk factor(s). The residual, or unexplained, volatility

component is deemed to be the measure of operational risk.

1 1 2 2it it t t t t itE C M <IV. 1. 2>

Expense-Based Models

Operational risk is measured as fluctuations in historical expenses. This is the easiest approach but

ignores operational risks that are unrelated to expenses; further, a risk-reducing initiative that happened

to increase expenses (because it involved a cost) would be mischaracterized.

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Operating Leverage Models

This is a model that measures the relationship between variable costs and total assets. Operating

leverage is the change in variable costs for a given change in total assets.

Scenario Analysis

In this context, this is a generic label referring to an attempt to “imagine” various scenarios that contain

catastrophic shocks. By definition, scenario analysis attempts to anticipate low frequency high severity

(LFHS) risk events – but doing this generally is a subjective exercise.

Risk-Profiling Models

Refers to a system that directly monitors either performance indicators and/or control indicators.

Performance indicators track operational efficiency; e.g., number of failed trades, system downtime,

percentage of staff vacancies. Control indicators track the effectiveness of controls; e.g., number of

audit exceptions.

Bottom-Up Models LO 57.3 List and describe examples of bottom-up models for measuring operational risk

There are three types of bottom-up approaches: process, actuarial and proprietary.

1. Process Models

The process approach attempts to identify root causes of risk; because it seeks to understand cause-

and-effect, in should be able to help diagnose and prevent operational losses.

Scorecards or Causal Networks

The scorecard breaks down complex processes (or systems) into component parts. Data are matched to

the component steps in order to identify lapses or breakdowns. Scorecards are process-intensive and

require deep knowledge of the business processes. The outcome is a process map.

Connectivity Models

Connectivity models are similar to scorecards but they focus on cause-and-effect. Examples of

connectivity models include fishbone analysis and fault tree analysis.

Reliability Models

Reliability models emphasize statistical techniques rather than root causes. They focus on the

likelihood that a risk event will occur. The typical metric is the event failure rate, which is the time

between events.

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2. Actuarial Models

Empirical Loss Distributions

Internal and external data on operational losses are plotted in a histogram in order to draw the

empirical loss distribution. Basically, it is assumed that the historical distribution will apply going

forward. As such, no specification or model is required (i.e., Monte Carlo simulation can fill in the gaps).

Parametric Loss Distributions

This approaches attempts to describe the operational loss distribution with a parametric distribution. A

common distribution for operational risk events is a Poisson distribution.

Extreme Value Theory (EVT)

This approach is not mutually exclusive to the empirical and parametric approaches. EVT conducts

additional analyses on the extreme tail of the operational loss distribution. For LFHS events, a common

distribution is the Generalized Pareto Distribution (GPD). Extreme value theory (EVT) implies the use of a

distribution that has fat-tails (leptokurtosis or kurtosis > 3) relative to the normal distribution.

3. Proprietary Operational Risk Models

Proprietary models include, for example, OpVar offered by OpVantage. A proprietary model implies the

vendor has their own database of event losses that can be used to help fit distributions.

Catastrophic Loss LO 57.4 List and describe ways a firm can hedge against catastrophic operational losses

Three ways a firm can hedge against catastrophic operational loss include:

1. Insurance

2. Self-insurance

3. Derivatives

Insurance

Includes fidelity insurance (covers against employee fraud); electronic computer crime insurance,

professional indemnity (liabilities to third parties caused by employee negligence); directors’ and

officers’ insurance (D&O, covers lawsuits against Board and executives related to bread of their fiduciary

duty to shareholders); legal expense insurance; and stockbrokers’ indemnity (covers stockbroker losses

arising from the regular course of business).

Insurance contracts transfer risk to the insurance company, which can absorb the company-specific

(aka, non-systemic or unique) risk because they can diversify this risk among of pool of customers. In

theory, diversification can minimize/eliminate the company-specific risk.

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However, insurance contracts create a moral hazard problem: the policy creates an incentive for the

policy-holder to engage in risky behavior. Two other disadvantages: insurance policies limit coverage

(“limitation of policy coverage) and Hoffman claims “only 10 to 30% of possible operational losses are

covered” by insurance policies. In short, they rarely provide total coverage and never provide coverage

of all possible operational losses.

Insurance is a critical component of risk management. Remember the positives (risk

transfer to the insurance company; insurance company absorbs company-specific risk

via portfolio diversification) and the negatives (moral hazard, limitation of policy

coverage, lack of coverage for all operational loss events)

Self-Insurance

This is when the company holds (its own) capital as a buffer against operational losses. Holding capital

is expensive—firm can use liquid assets or line of credit. Some firms self-insure through a wholly-owned

insurance subsidiary.

Derivatives

Swaps, forward and options can all transfer operational risk. But derivatives do not necessarily hedge

against operational risk. It depends. Specifically, derivatives hedge if and when the derivative hedges a

risk (e.g., credit or market risk) that itself is correlated to operational risk.

Catastrophe Options and Catastrophe Bonds LO 57.5 Describe the characteristics of catastrophe options and catastrophe bonds

Catastrophe Options

Catastrophe options (“cat options”) were introduced by the Chicago Board of Trade (CBOT). The CBOT

cat option is linked to the Property and Claims Service Office (PCS) national index of catastrophic loss; it

trades like a call spread (i.e., a long call is combined with a short call at a higher strike price). The “cat

option” has a payoff linked to an index of underwriting losses written on a pool of insurance policies.

Technically, it is a spread option. But unlike a typical option, the payoff does not have unlimited upside.

Cat options are useful because they have essentially no correlation to the S&P.

The weather derivative is a particular type of cat option. Its value derives from a weather-based index.

The most common are daily heating degree day (HDD) and cooling degree day (CDD).

11 / 119

Cat Bonds

These are bonds with embedded options, where the embedded option is triggered by a catastrophe;

e.g., hurricane. The borrower pays a higher rate (i.e., the cost of the embedded catastrophic risk hedge)

in exchange for some type of debt relief; the most common is relief of both debt and principal. There

are three types of catastrophe bonds:

Indemnified notes: triggered by events inside the firm; i.e., debt relief is granted if the internal event happens. But these require detailed analysis and are especially subject to the moral hazard problem

Indexed notes: triggered by industry-wide losses are reflected by an independent index (external to the company). There has been a trend away from indemnified and toward indexed notes because indexed notes are not subject to moral hazards (i.e., they link to external, index-based loss events not internal, company-specific loss events)

Parametric notes: like an indexed note, linked to an external event. However, cash flow is based on a predetermined formula; e.g., some multiple of Richter scale for earthquakes

Limitations to Operational Risk Hedging LO 57.6 Discuss limitations to operational risk hedging

Operational risk is embedded in the firm—assessing it is subjective. It is very difficult to quantify cross-

correlations. Additionally, influences like the incentive scheme produce subtle, complex outcomes.

There are at least four limitation to operational risk hedging:

1. It can be difficult to identify and define the specific operational risk

2. Measurement of operational risks is often subjective

3. It is difficult to foresee unanticipated correlations between/among various operational risks

4. Data is often not available and/or reliable

Two normal means of benchmark are peer comparisons and extrapolation from history into the future.

However, both of these can be problematic when applied to the measurement of operational risk. As

firm cultures vary, peer comparisons may be misleading. Further, catastrophic events are “once in a

lifetime,” and therefore do not lend themselves to extrapolation.

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IV. 2. Capital Allocation and Performance Measurement LO 65.1: Distinguish between economic and regulatory capital.

LO 65.2: Describe the relationship between economic capital and risk-adjusted return on capital.

LO 65.3: Compute the RAROC for a loan.

LO 65.4: Explain how capital is attributed to market, credit, and operational risk and calculate the

capital charge for market risk and credit risk.

LO 65.5: Describe how economic capital is allocated for non-loan types of bank products.

LO 65.6: Explain why the RAROC approach may lead to incorrect economic capital allocation

decisions and how the second-generation RAROC approach addresses this issue, and calculate

a project’s adjusted RAROC to determine whether the project should be accepted.

Economic and Regulatory Capital LO 65.1 Distinguish between economic and regulatory capital

Economic capital absorbs unexpected losses, up to a certain point, depending on the desired confidence

level. The confidence level is a policy decision that should be set by senior management and endorsed

by the board. Economic capital is most relevant to shareholders. First set aside reserves for expected

losses; e.g., such losses are priced into higher yields. Economic capital does not cover expected losses;

economic capital is meant to absorb unexpected losses.

Regulatory capital is rule-based (e.g., BIS 88, BIS 98) with the intention to ensure enough capital is in the

banking system. Most financial institutions hold more capital than required by regulators.

0%

1%

2%

3%

4%Economic Capital (EC)

ExpectedLoss (EL) VAR

ES

EC( = VAR( ) - EL

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Economic Capital and Risk-Adjusted Return on Capital (RAROC) LO 65.2 Describe the relationship between economic capital and risk-adjusted return on capital (RAROC)

The denominator of risk-adjusted return on capital (RAROC) is risk-adjusted capital. This is the capital

required to absorb unexpected losses, which is the same as economic capital.

RAROC for a Loan

LO 65.3 Compute the RAROC for a loan

Revenue + ROC - interest exp.- operating exp.- Expected loss

economic capitalRAROC

For example, assume the following:

A loan portfolio of $1 billion pays an annual rate of 7%

Expected losses are 1%

Economic capital amounting to 5% is invested at a rate of 6%

The loan is funded with deposits that earn (a deposit charge of) 5%

The bank’s annual operating cost is 8%

$70 3 (47.5 8 ) 1015%

50

MM MM MM MM MMRAROC

MM

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

RAROC = Risk-adjusted Return / Economic Capital

ExpectedLoss (EL) VAR WCL

EC( = VAR( ) - EL

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Attribution of Capital LO 65.4 Explain how capital is attributed to market, credit, and operational risk…

In practice, banks manage risk according to three classifications: market, credit and operational risk. To

be successful, a RAROC process must be “integrated” into the overall risk management process and

therefore must incorporate all three of these classifications and with some consistency in methodology.

Capital for Market Risk

In RAROC, market risk capital is attributed as a function of the risk expressed in the VAR calculation.

Capital for Credit Risk

Credit risk capital is a function of exposure, probability of default (usually a function of risk rating (RR) or

via algorithm), and recovery rates. The capital factors (i.e., applied as a percentage of face value) vary

based on RR and tenor.

Capital for Operational Risk

RAROC for operational risk is a work in progress. One approach is to assign a RR (e.g., on a scale of 1 to

5) to each business based on operational risk factors defined in terms of a breakdown of people,

processes or technology.

Capital Charge LO 65.4 (continued) …and calculate the capital charge for market risk and credit risk

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The RAROC capital allocation for market risk requires a market risk (VAR) limit and the following

parameters:

F1 = a constant, to account for exceptional shocks, or to account for time required to liquidate position (this is a buffer really)

F2 = charge for unused portion of the limit

F3 = penalty charge for exceeding the VAR limit

MR 1

2 3

Charge = (F VaR)

(F Unused portion of limit) (F excess) <IV. 2. 1>

For example, assume the Value at Risk (VaR) limit is $1 million. Assume F1=2, F2=0.15,

and F3=3.0. Compute the capital charge (i) if VaR is $800,000 and (ii) if VaR is $1.2

million.

Regarding (i) VaR of $800,000: there is only an unused VaR and no excess. So, the F1 and F2 multipliers

apply. The charge is (a) $800,000 2 = $1.6 million (for the F1) plus (b) $200,000 (the “unused portion”)

0.15 = $30,000. The total charge is $1.6 million (F1) + $30,000 (F2) = $1.63 million.

Regarding (ii) VaR of $1.2 million: there is an excess VaR but no unused portion (note that either F2 or F3

apply, but not both). So, the F1 and F3 multipliers apply. The charge is (a) $1.2 million 2 = $2.4 million

(the F1 charge) plus (b) $200,000 3 = $600,00 (the F3 charge). The total charge $2.4 million (F1) +

$600,000 (F3) = $3 million.

Calculation of Charge for Credit Risk

A capital factor is expressed as a percentage of the market value of the position. Capital factors are

determined by a matrix:

• Tenor: longer tenor higher capital factor

• Credit quality: lower quality higher capital factor

Deriving the credit factors is a four step process:

1. Select a representative time period

2. Map risk ratings to the portfolio

3. Estimate expected and unexpected losses

4. Exercise judgment in assigning capital factors to adjust for imperfect data

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of market discipline.

LO 68.18: Explain the negative bank behaviors that may result with the implementation of Basel II.

LO 68.19: Explain potential problems with the risk analytics of Basel II.

LO 68.20: Explain issues regarding the implementation of Pillar 2 (Supervision) and Pillar 3 (Market

Discipline) of Basel II.

Basel II Objectives Discuss the criticisms of the 1988 Basel I Accord and the objectives of the new Basel II Capital Accord

Criticisms of 1988 Basel I Accord:

Only addresses credit risk (the January 1996 Amendment addressed market risk)

Risks are not sufficiently differentiated; e.g., all corporate credit risk garnered 100% weighting

Maturities not sufficiently differentiated; i.e., generally long-term and short-term exposures treated the same

Portfolio benefits of diversification not incorporated

Does not fully recognize risk reduction benefits of credit risk mitigation (CRM) techniques; e.g., credit derivatives, collateral, guarantees, and netting arrangements

Many claimed that Basel I encouraged “regulatory arbitrage:” the reduction of regulatory capital

without an equivalent reduction in actual risk.

Objectives of Basel II Accord

The fundamental objective is “to develop a framework that would further strengthen the soundness and

stability of the international banking system while maintaining sufficient consistency that capital

adequacy regulation will not be a significant source of competitive inequality among internationally

active banks.”

Further, under Basel II, objectives sought by the Committee include:

To adjust capital requirements to more closely reflect actual risk; i.e., “to arrive at significantly more risk-sensitive capital requirements.”

To make greater use of banks’ internal systems as inputs to capital calculations.

To provide a range of options for determining capital requirements that are most appropriate for their operations and their market discretion.

To recognize innovative risk management financial instruments

To recognize that home country supervisors have an important role

To broadly maintain the aggregate level of capital minimum capital requirements, while also encouraging advanced, risk-sensitive approaches

Pillars of Basel II Accord

Describe the three pillars that are central to the Basel II Accord

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There are three pillars of the Basel II Accord are:

First Pillar: Minimum capital requirements

Second Pillar: Supervisory review process

Third Pillar: Market discipline

The pillars are interrelated: banks cannot simply meet the minimum capital requirements (first pillar).

Supervisors must review the implementation (second pillar) and the disclosures provided under the

third pillar “will be essential in ensuring that market discipline is an effective complement to the other

two pillars.”

As noted in the November 2005 update, “The Committee also wishes to highlight the need for banks and

supervisors to give appropriate attention to the second (supervisory review) and third (market

discipline) pillars of the revised Framework. It is critical that the minimum capital requirements of the

first pillar be accompanied by a robust implementation of the second, including efforts by banks to

assess their capital adequacy and by supervisors to review such assessments. In addition, the disclosures

provided under the third pillar of this Framework will be essential in ensuring that market discipline is an

effective complement to the other two pillars.” (paragraph 11)

Scope LO 68.1 Discuss the scope of the Basel II Accord and how it applies to various bank subsidiaries or business relationships

The framework is applied on a consolidated basis to internationally active banks. The framework applies

to all internationally active banks at every tier within a banking group, also on a fully consolidated basis.

95 / 119

The scope of application includes, on a fully consolidated basis, any holding company that is the parent

entity within a banking group. Banking groups are groups that engage predominantly in banking

activities and, in some countries, a banking group may be registered as a bank.

To the greatest extent possible, all banking and other relevant financial activities (both regulated and

unregulated) conducted within a group containing an internationally active bank will be captured

through consolidation.

Significant minority investments in banking, securities and other financial entities, where control does

not exist, will be excluded from the banking group’s capital by deduction of the equity and other

regulatory investments. Alternatively, such investments might be, under certain conditions,

consolidated on a pro rata basis.

Capital Requirements LO 68.2 Define the types of capital, and discuss how each type is used to meet capital requirements under Basel II

Credit Market Opr'l

Total capital8%

RWA + [MRC 12.5]+[ORC 12.5] <IV. 14. 1>

The total capital ratio must be no lower than 8%. Tier 2 capital is limited to 100% of Tier 1 capital. Total

risk weighted assets (RWA) are determined by multiplying the capital requirements for market risk and

operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting

figures to the sum of RWA for credit risk.

Standardized

FoundationIRB

AdvancedIRB

Mo

re

Co

mp

lex

InternalRatingsBased(IRB)

Simple

Comprh.

Internal

Basic

Indicator

Standardized

AdvancedMeasurement

Approach(AMA)

Credit RiskOperational

Risk

Approach Ratings Mitigation Approach

Internal

ExternalStandardized

Internal

Market

Risk

96 / 119

Tier 1 Capital or “Core Capital”

This capital is “buffer of the highest quality.” It is equity capital: issued and fully paid common stock;

and non-cumulative preferred stock.

Tier 1 capital includes: Disclosed reserves, share premiums, retained earnings, and general reserves

Tier 2 Capital or “Supplementary Capital”

This capital gives some protection, but it is “imperfect buffer capital” because it ultimately will be

redeemed or charged against future income. Tier 2 capital includes:

Undisclosed (or hidden) reserves—in some countries, pass through earnings statement but remain unpublished

Asset revaluation reserves —e.g., securities carried at costS that have additional market value

General provisions or loan loss reserves—loan loss allowances taken against anticipated credit losses

Hybrid debt capital instruments—if unsecured, subordinated, and fully paid up; e.g., cumulative preference shares

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Tier 3 Capital – for Market Risk only

This capital is only for covering market risk.

Tier 3 capital includes short-term subordinated debt with maturity of at least two years

Please note: The Revised Framework issued in November 2005 says: “the Committee intends to

undertake additional work of a longer term nature is in relation to the definition of eligible capital. One

motivation for this is the fact that the changes in the treatment of expected and unexpected losses and

related changes in the treatment of provisions in the Framework set out here generally tend to reduce

Tier 1 capital requirements relative to total capital requirements. Moreover, converging on a uniform

international capital standard under this Framework will ultimately require the identification of an

agreed set of capital instruments that are available to absorb unanticipated losses on a going-concern

basis. [The Committee] will explore further issues surrounding the definition of regulatory capital, but

does not intend to propose changes as a result of this longer-term review prior to the implementation of

the revised Framework set out in this document.

Risk-Weighted Assets (RWA)

Similar to Basel I, the minimum ratio of capital to RWA is 8%

8%kk

Capital RWA

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The calculation of risk-weighted assets (RWA) can be done in one of the following ways:

Standardized approach

Internal ratings based approach: Foundation variant

Internal ratings based approach: Advanced variant

First Pillar: Credit Risk LO 68.3 Describe the Basel II Accord’s requirements for calculating risk-weights using both the standardized and internal ratings-based (IRB) approaches when accounting for credit risk

In regard to credit risk, banks can choose either a standardized approach (supported by external credit

ratings or “assessments”) or an internal ratings-based (IRB) approach. The IRB approach divides into

the more flexible Foundation IRB and the Advanced IRB.

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Standardized Approach

In the standardized approach for measuring credit risks, the risk weights applied to claims on sovereigns,

banks and corporations (including insurance companies) depend on the assessments made by external

credit assessment institutions recognized by supervisors.

Depending on the external risk score, rated claims are given a risk weight of 0%, 20%, 50%, 100% or

150%. Unrated claims are given a 100% risk weight.

Credit Assessments Credit Assessment

AAA to AA-

A+ to A- BBB+ to BBB-

BB+ to B-

Below B-

Unrated

Sovereign 0% 20% 50% 100% 150% 100%

Banks - Option 1 20% 50% 100% 100% 150% 100%

Banks - Option 2 20% 50% 50% 100% 150% 50%

Banks - Short-term claims under Option 2

20% 20% 20% 50% 150% 20%

Corporates 20% 50% 100% 150% 100%

Standardized Approach: Differences from Basel I

Use of external ratings: in Basel I, risk weightings were effectively 100%. However, Basel II allows for differentiation based on external credit assessments

Loans past due: a loan past due for more than 90 days requires a risk weight of 150% (i.e., when specific provisions are less than 20% of the outstanding amount)

Credit mitigants: Basel II recognizes an expanded range of credit risk mitigants

Retail exposures: risk weights for residential mortgage exposures are reduced relative to Basel I, as are other retail exposures

Pillar 1Capital

Requirements

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Advanced/Internal

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