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17.2 presentation slides
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  • 1. Managing Credit Risk Under The Basel III Framework, 2nd ed Copyright 2014 CapitaLogic Limited This presentation file is prepared in accordance with Chapter 17 of the text book “Managing Credit Risk Under The Basel III Framework, 2nd ed” Website : https://sites.google.com/site/crmbasel E-mail : crmbasel@gmail.com Chapter 17 Basel Accord and Standardized Approach
  • 2. Copyright 2014 CapitaLogic Limited 2 Declaration Copyright © 2014 CapitaLogic Limited. All rights reserved. No part of this presentation file may be reproduced, in any form or by any means, without written permission from CapitaLogic Limited. Authored by Dr. LAM Yat-fai (林日林日林日林日辉辉辉辉 博士博士博士博士), Doctor of Business Administration (Finance), CFA, CAIA, FRM, PRM, MCSE, MCNE.
  • 3. Copyright 2014 CapitaLogic Limited 3 Outline Basel I framework Basel III framework Standardized approach Regulatory capital Appendices
  • 4. Copyright 2014 CapitaLogic Limited 4 Pre-Basel I Banks were regulated using balance sheet measures Total equity > Total assets × 5% Accounting definition of equity and assets vary from country to country Enforcement of regulations vary from country to country During 1980’s Derivatives trading expanding Third world debt emerging
  • 5. Copyright 2014 CapitaLogic Limited 5 Basel I Basel Committee on Banking Supervision (BCBS) An organization established by G10 bank regulators from North America, Europe and Japan Set out by the BCBS in 1988 Adopted by over 100 bank regulators
  • 6. Copyright 2014 CapitaLogic Limited 6 Principle of regulatory capital A sufficient amount of (i) regulatory capital is mandated to match (ii) a prudent estimate of UL (capital charge), both calculated by unified regulatory rules across all countries Higher expected return => higher risk => higher capital charge => more regulatory capital Regulatory capital Total capital charge≥
  • 7. Copyright 2014 CapitaLogic Limited 7 Capital charge A capital charge ratio is applied to each debt to arrive at a prudent estimate of the UL 0% to residential mortgages of higher quality and OECD country debts 1.6% to debts from OECD banks and FSEs 4% to residential mortgages of lower quality 8% to other debts Capital charge = A prudent estimate of UL = Principal × Capital charge ratio Example 17.1
  • 8. Copyright 2014 CapitaLogic Limited 8 Vulnerabilities of Basel I Capital charge ratios lack risk differentiability Loan to Microsoft (AAA) – 8% Loan to Tencent (BBB) – 8% Debt issued by Greece (CCC) – 0% Capital arbitrage Encourage highest return/highest risk/lowest capital charge investments through loopholes in the regulatory rules Fail to recognize credit risk mitigation Exclude Market risk, e.g, equity market crises 1987 Operational risk, e.g. the 911 event Liquidity risk, e.g. financial tsunami 2008
  • 9. Copyright 2014 CapitaLogic Limited 9 Outline Basel I framework Basel III framework Standardized approach Regulatory capital Appendices
  • 10. Copyright 2014 CapitaLogic Limited 10 4 (=3+1) pillars of Basel III Basel III Minimum capital requirements Public disclosure Supervisory review process Liquidity sufficiency Basel II
  • 11. Copyright 2014 CapitaLogic Limited 11 Minimum capital requirements Minimum capital requirements Credit risk Operational risk Debt exposures Securitization exposures Basic approach Standardized approach* Advanced measurement approach* Market risk Internal model method* Standardized method Standardized approach Internal ratings based approach* Standardized approach Ratings based approach* Supervisory formula approach* * Regulatory approval required
  • 12. Copyright 2014 CapitaLogic Limited 12 Supervisory review process A bank should have a process in place to assess its overall capital adequacy in relation to its risk profile and a strategy to maintain its level of capital A regulator should review and evaluate a bank’s internal capital adequacy assessments and strategies, as well as the bank’s ability to monitor and ensure compliance with capital sufficiency. A regulator should take appropriate supervisory action if it is not satisfied with the result of a bank’s process A regulator should expect a bank to operate above the minimum regulatory capital sufficiency and should be able to request a bank to hold additional regulatory capital A regulator should seek to intervene at an early stage to prevent a bank’s regulatory capital from falling below the minimum levels and mandate a bank to take rapid remedial action if the regulatory capital is not maintained or restored
  • 13. Copyright 2014 CapitaLogic Limited 13 Public disclosure The organization structure of a banking group, the entities to which the Basel III framework is applicable and the entities to which the Basel III framework is irrelevant The terms and conditions of the major features of the financial instruments which are qualified as regulatory capital The list of financial instruments qualified as common equity and additional tier one capitals The total amount of tier two capital The capital charges arising from the credit, market and operational risks General information of other risks to which a bank is exposed and the relevant methods that the bank has applied in managing these risks The structure and operations of the bank’s risk management function
  • 14. Copyright 2014 CapitaLogic Limited 14 Liquidity sufficiency Liquidity ratios Liquidity coverage ratio Net stable funding ratio Supervisory monitoring tools Contractual maturity mis-match Concentration of funding Available unencumbered assets Financial market monitoring tools
  • 15. Copyright 2014 CapitaLogic Limited 15 Outline Basel I framework Basel III framework Standardized approach Regulatory capital Appendices
  • 16. Copyright 2014 CapitaLogic Limited 16 Standardized approach Generic approach For banks with less quantitative expertise Capital charge calculated on individual debt basis Risk factors EAD Capital charge ratio = Function(LGD) for retail = Function(PD) for institution RM Capital charge = EAD × Capital charge ratio
  • 17. Copyright 2014 CapitaLogic Limited 17 Exposure at default On balance sheet debt Term loan, mortgage, bond EAD = Principal - Specific provision Commitment A promise to lend up to a certain amount Credit card, card line EAD = Drawdown amount - Specific provision + (Credit limit - Drawdown amount) × CCF
  • 18. Copyright 2014 CapitaLogic Limited 18 Credit conversion factor 20/50Other commitments10. 0Commitments that are unconditionally cancellable without prior notice9. 75Note issuance and revolving underwriting facilities8. 100Forward forward deposits placed7. 100Partly paid-up securities6. 100Forward asset purchases5. 100Asset sales with recourse4. 20Trade related contingencies3. 50Transaction related contingencies2. 100Direct credit substitutes1. CCF (%)Type of commitment
  • 19. Copyright 2014 CapitaLogic Limited 19 Retail exposures 6%Other retail exposure 6% Qualifying revolving retail exposure 2.8%Residential mortgage Capital charge ratioExposure
  • 20. Copyright 2014 CapitaLogic Limited 20 Institution exposures 841.68Unrated 12CCC to C 88412B 8848BB 441.68BBB 1.641.64A 01.61.61.6AAA, AA > 3 months< 3 months Rating Country (%) Bank (%) Corporation (%) Example 17.2
  • 21. Copyright 2014 CapitaLogic Limited 21 Recognized credit ratings Issued by ECAIs recognized by bank regulators 3 global credit rating agencies Domestic credit rating agencies Split rating Several different credit ratings from different credit rating agencies Larger of two capital charge ratios Second lowest of more than two capital charge ratios
  • 22. Copyright 2014 CapitaLogic Limited 22 Credit risk mitigation Reduction of EAD On balance sheet netting Financial collaterals Reduction of CCR Default insurance Credit guarantee CDS
  • 23. Copyright 2014 CapitaLogic Limited 23 On balance sheet netting Bilateral netting agreement ( ) Lending EAD - Borrowing principal Net EAD = Max 1 - Curreny haircut , 0              
  • 24. Copyright 2014 CapitaLogic Limited 24 Financial collaterals A lender may sell collaterals to recover part of the EAD ( ) Effective EAD EAD 1 + Supervisory add-on 1 - Collateral haircut = Max - Collateral value , - Curreny haircut 0                
  • 25. Copyright 2014 CapitaLogic Limited 25 Financial collaterals The largest haircut among the investment componentsMutual fund 100Others 25 Not a constituent of major equity indices 15 Constituent of a major equity indexEquity of a listed company 15BB 612Longer than 5 years 36From 1 to 5 years 12Up to 1 year A and BBB 48Longer than 5 years 24From 1 to 5 years 0.51Up to 1 year AAA and AA Debt Country (%)Corporation and bank (%) Constituent / residual maturity Collateral and credit rating
  • 26. Copyright 2014 CapitaLogic Limited 26 Default insurance Credit guarantor/protection independent of debt issuer Credit guarantor/protection seller with credit quality higher than debt issuer CCR of credit guarantor/protection seller to replace that of debt issuer
  • 27. Copyright 2014 CapitaLogic Limited 27 Currency and maturity mis-matches Currency mis-match Protected part reduced by 8% Maturity mis-match Protected part reduced to RM > 0.25 RM < 0.25 No default protection Example 17.3 Example 17.4 ( ) ( ) EAD of the protected part without maturity mis-match Min Protection period of credit risk control, 5 - 0.25 × Min RM of debt, 5 - 0.25
  • 28. Copyright 2014 CapitaLogic Limited 28 Outline Basel I framework Basel III framework Standardized approach Regulatory capital Appendices
  • 29. Copyright 2014 CapitaLogic Limited 29 Regulatory capital Long term funding from investors Retain earnings (capitalized profits) Common shares Preferred shares Subordinated debts with long initial maturity Calculated in accordance with regulatory rules
  • 30. Copyright 2014 CapitaLogic Limited 30 Regulatory capital Common equity tier one capital Retained earnings Common shares Additional tier one capital Non-cumulative perpetual preferred shares Tier two capital Cumulative perpetual preferred shares Subordinated debts with initial maturity longer than 5 years Minimum regulatory capital Regulatory capital Total CC Common equity tier one capital Total CC × 75% + Additional tier one capial Common equity tier one capital Total CC × 56.25% ≥   ≥    ≥
  • 31. Copyright 2014 CapitaLogic Limited 31 Outline Basel I framework Basel III framework Standardized approach Regulatory capital Appendices
  • 32. Copyright 2014 CapitaLogic Limited 32 Risk weight and risk-weighted amount Risk weight Risk weighted amount Risk weight = Capital charge ratio × 12.5 Risk weighted amount = Capital charge × 12.5 = EAD × Capital charge ratio × 12.5
  • 33. Copyright 2014 CapitaLogic Limited 33 Capital adequacy ratio (CAR) Minimum CAR 8% Regulatory capital CAR = Total risk weighted amount Regulatory capital = Total capital charge × 12.5 Regulatory capital 1 = × Total capital charge 12.5 1 × 8% 8% ≥ ≥
  • 34. Copyright 2014 CapitaLogic Limited 34 Capital adequacy with RWA Regulatory capital Total RWA 8% Common equity tier one capital Total RWA 6% + Additional tier one capial Common equity tier one capital Total RWA 4.5% ≥ ×   ≥ ×    ≥ ×

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