Question about Bionic Turtle's 2009 FRM Program
07 Jan 2009
Sep
21
Friday’s Movie: Basel II (2007 FRM)
by David Harper, CFA, FRM, CIPM
For members, we published today a tutorial on Basel II. This includes twenty-seven learning outcomes (i.e., LO 67.1 thru 68.20) for FRM candidates. (non-members can sample the first ten minutes here)
Scope
The Basel II framework applies to "internationally active banks" on a consolidated basis. Bank subsidiaries are counted a part of a whole banking group.
Three pillars
Basel II has three pillars. The second pillar (supervisory review) and the third pillar (market discipline) play vital roles in Basel but 80%+ of an FRM candidate's focus is on the first pillar: the (technical) minimum capital requirements.
Basel II requires capital for all three risk buckets (credit, market & operational)
The new Accord aims to maintain the overall level of capital in the system. It anticipates a reduction in total capital for credit risks (not due to less credit risk, but rather more precise methods) to be offset by the controversial addition of the newest charge for operational risk. The new Accord did not change the 1996 (1998 implemented) rules for market risk.
Total capital held must be 8% of risk-weighted assets (RWA)
The first pillar says a bank must hold capital ("regulatory capital") equal to at least eight percent of risk-weighted assets (RWA). The 8% ("Cooke ratio") and the definition of capital do not change from the original Accord (except for a different treatment of general provisions or loan loss reserves. Under the internal-ratings based approach, if loan loss reserves are greater than expected losses, the difference can be included in Tier 2 capital [up to a limit of 0.6%]).
The bulk of the change from Basel I to Basel II, and the majority of the complexity, is in the denominator: risk-weighted assets (RWA). So, we have the same 8% ratio, where total capital is divided into the sum of risk-weighted assets, a market risk charge (MRC) and an operational risk charge (ORC). Note that MRC and ORC are multiplied by the reciprocal of 8% (12.5) simply so that the three risks can be blended together:
What is capital?
Equity capital (Tier 1) naturally is "buffer of the highest quality." Supplementary (Tier 2) capital is less certain buffer (e.g., cumulative preferred is Tier 2 whereas non-cumulative preferred is Tier 1), it probably could save the bank under an asset decline but not necessarily. The amount of Tier 2 cannot exceed the amount of Tier 1. Finally, Tier 3 is subordinated, short-term debt (but originally issued with at least two year maturity) but it only counts toward market risk.
Basic (standaridized) versus advanced (Internal) approaches
Basel II has an "evolutionary aspect" (LO 68.15). Among other things, that means the key risk elements can be approached in a basic or advanced way. Most banks will start with a basic approach and migrate to an advanced approach. In theory, advanced approaches will earn lower capital charges but they utilize more sophisticated approaches and they have rigorous requirements (including, don't forget, the supervisory review that is pillar two).
For example, credit risk has a standardized approach and an internal-rating based (IRB) approach. The standardized approach uses external credit ratings to translate an exposure into its risk-weighted asset (RWA) equivalent. Say the exposure is a $10 corporate loan. If the loan rates AAA, its RWA is $2 million (20% x $10 = $2) and the bank must hold $160,000 in capital against it ($2 x 8% = $160K). If the loan instead rates BB-, its RWA is $15 million (150% x $10 = $15) and the bank must hold $1.2 million against it ($15 million x 8% = 1.2 million)
But the IRB approaches instead use a more precise risk function, where the key parameters are probability of default (PD), exposure at default (EAD), loss given default (LGD) and maturity (M). Even with IRB, there is a foundation approach (supervisors supply EAD, LGD, and M) and an advanced IRB approach (bank estimates in own parameters--but they don't get to use their own function!).
Comments
Hi David,
Why does Basell call market risk charge (MRC) and an operational risk charge (ORC), instead of
market risk capital and operational risk capital?
thanks!
southsouth,
Interesting question. If the regs say why, I don’t know where. But my guess is they do this to distinguish between the concepts of capital, risk, and the link between the two (the charge). Put another way:
Capital = Charge for the Risk
There are three ideas there, although it’s easy to forget. If they said “operational risk capital,” it might confuse with capital in the numerator (Tier I, II, and III) which includes capital held for (against) operational risk but is really multi-purpose (Tier I capital is buffer for market, credit, operational risk).
Further, the use of “charge” succeeds in reminding me that it’s arbitrary (like sales tax charge is arbitrary). For BIA operational risk, the risk is measured by “operating income” and the charge is a % of that risk proxy. So, viewed that way, the logic is clean but flexible: some of the capital held (Tier I, II, or III) is to cover operational risk, which has been “charged” at x% (15%) of operational risk (proxy = operating income).
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