Question:
Assume a loan of $40 million to an unrated (non-financial) company.
(i) If 70% of the loan ($28 million) is secured by a AA rated bank loan, under the STANDARDIZED approach, what is the capital charge given the mitigation (CRM)?
(ii) If loan is secured by an unrated bank loan in the full amount ($40 million), what is the capital charge under the COMPREHENSIVE approach (given the mitigation)?
(iii) If the loan is secured by a $30 million unrated bank loan plus $10 million in a cash deposit collateral , what is the capital charge under the COMPREHENSIVE APPROACH?
Answer:
Please note this question is more difficult than you will find on the exam. It is only meant to illustrate the conceptual approach to mitigation (CRM) under standardized Basel II.
Click here for spreadsheet of scenarios.
First note that the capital charge for the unsecured non-rated corporate loan =
$40 million * 100% (risk weight) * 8% = $3.20. As that’s unsecured, all of the secured scenarios below improve by requiring less capital.
Notice, by the way, that an unrated corporate loan (controversially) has a lower risk weight than a corporate loan rated B- or lower (150%).
(i)
Under the SIMPLE standardized approach, the risk weight is substituted.
As the collateral has a risk weight of 20%, the risk weight is lowered to:
($28 MM collateral)(20%) + ($40 - $28)(100%) = $17.60 MM.
Capital charge = 8% * 17.60 = $1.41 MM; i.e., lower than the unsecured loan
Note only the secured portion enjoys the lower risk weight; the unsecured portion remains weighted at 100%.
(ii)
Under the standardized COMPREHENSIVE approach (i.e., not IRB), the exposure is adjusted by haircuts.
Assume 6% haircuts (haircut for unrated bank bond with maturity from 1 to 5 years)
Net exposure = (40 * 106%) - (40 * 94%) = 4.8 MM
Capital charge = $4.8 MM * 100% (risk weight) * 8% = $384,000
Notice the 6% haircut increases the loan and decreases the collateral; i.e., that represents the “worst case” movement.
Notice this difference between SIMPLE & COMPREHENSIVE Standardized:
In the simple, the risk weight of the collateral is substituted but the exposure ($40 million in this case) in unchanged.
In the comprehensive, the exposure was reduced by the collateral but not entirely due to haircuts (i.e., net exposure > 40 - 40)
(iii)
Cash has a 0% haircut. So the net exposure is given by:
($40 * 106%) - (30*94%) - (10 * 100%; i.e., no haircut) = $4.2 MM
Capital charge = $4.2 * 100% (risk weight) * 8% = $336,000
