Aug 25

FRM 2008 Episode #12: Operational Risk C (Basel II)

by David Harper, CFA, FRM, CIPM

FRM |

history_basel 

In this issue

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Every week I publish short (< 10 min) screencasts to give you a financial learning boost. Get your daily fix! In the last two weeks, I reviewed the numbers behind VaR Mapping (Jorion Chapter 11) and Foreign Exchange Risk (Saunders FX reading):

About Episode #12 (Operational Risk C - Basel II)

We just published the latest screencast episode (Operational Risk C). This is the third screencast in the Operational Risk discipline. This screencast episode has a 112-page PowerPoint you can download in two parts (part 1= hour plus part 2 = 50 minutes). We continue to follow the sequence of GARP's 2008 FRM Study Guide. Please find links to the eleven previous episodes (#1 to #11) at the end of this note.

Here are some additional Basel II resources:

Three pillars

threepillars

Basel II isn't a single approach. Sort of like everything that entered Noah's Ark in pairs, everything seems to enter Basel II in triplets (yikes, what a lame metaphor!):

  • The framework has three pillars; the first pillar contains the rules for calculating regulatory capital.
  • Regulatory capital must be held against all three major risk categories: credit risk (was in the original Accord), market risk (added in the 1996 Amendment and largely continuing in Basel II) and operational risk (new to Basel II and, to some degree, offsets the anticipated reduction in the credit risk capital charge)
  • In this way, the first pillar contains the rules that determine the regulatory capital to be held against credit, market and operational risks. Within each risk type, there are two/three approaches: a basic/standardized approach (which may have an additional variation; e.g., operational risk has an alternative standardized approach) and an advanced/internal approach.

Regulatory capital

capital_reg

Both the original Accord and Basel II reduce to a capital ratio: regulatory capital must be at least (>=) 8% of risk-weighted assets (RWA; the market risk and operational charge are multiplied by 1/8% so they can be added to RWA in credit). With minor differences, the regulatory capital (which has a broader definition than equity capital) is essentially the same as under the original Accord:

  • Tier 1 (core capital): equity and equity-like. Core buffer
  • Tier 2 (supplementary capital)
  • Tier 3 can only cover market risk

Credit Risk

b_credit

For credit risk, banks will use a Standardized Approach unless they can earn into a Foundation/Advanced Internal ratings based (IRB) approach:

  • The Standardized Approach uses a lookup table: the type of asset and its credit quality (based on rating) determine its risk weight
  • The IRB Approaches uses a variation of the essential credit risk function we study in Credit Risk (M. Ong): EL = EAD * PD * LGD
  • The key difference between Foundation and Advanced IRB is: under Foundation, except for PD which is internally figured, the supervisor provides the inputs (e.g., LGD is 45%/75% even if the bank has a different view); under Advanced IRB, the bank gets to employ internal methods to figure PD, EAD, LGD, and M. That's pretty loose, you say? Yes, but the bank must meet a truckload of quantitative and qualitative criteria in order to employ the Advanced IRB. That's the quid pro quo: meet tougher criteria and, in return, you get to use internal methods that should lower the capital charge.

Market Risk

b_market

Market risk has two broad approaches: standardized or internal models approach (IMA). Read more here. Under standardized (a.k.a., building block), charges are applied to each position and then simply summed. The charges are parsed into:

  • a general market risk charge, and
  • a specific risk charge

This ignores diversification benefits, and the standardized approach to market risk has taken a beating by critics.

For those banks that qualify to use internal models approach (IMA), they develop the market risk charge based on daily value at risk (VaR). The market risk charge must use VaR but Basel does not insist on a particular VaR model. Minimum standards include:

  • Daily VaR assuming a 99th percentile confidence
  • Ten-day time horizon. That is, the price shock over ten trading day; i.e., typically we scale 1-day VaR to 10-day VaR by multiplying by the square root of ten ["square root rule"]
  • The historical observation period must be at least one year
  • Banks must update their datasets at least quarterly
  • No particular VaR model is specified. Banks can use variance-covariance, historical simulation or Monte Carlo simulation

The market risk charge (MRC) is the higher of:

  • The previous day's VaR, or
  • Average VaR over the last sixty (60) business days multiplied by a multiplicative factor (k), which is at least three (k >=3.0)

Read more about the market risk charge here.

Operational Risk

b_ops

Basel II allows three ways to calculate a capital charge for operational risk:

  • Basic indicator approach (BA). This is a simple top-down method (recall Linda Allen’s top-down versus bottom-up) and easy to criticize: the charge is a fixed percentage of the bank's three-year average gross income (negatives years excluded from the average). For example, 15% of average gross income.
  • Standardized approach (SA), including an Alternative Standardized approach (ASA): Very similar. Also top-down. Except it is an weighted average of gross income where the weighted average depends on the bank's business lines.
  • Advanced measurement approach (AMA): flexible but generally will be bottom-up and, for most banks, is likely to be the Loss Distribution Approach (LDA). We reviewed an actual example with Deutsche Bank's LDA at Work (an FRM assigned OpRisk reading).

Read more about operational risk here.

Internal ratings-based (IRB) function

b_irbfunction

In the FRM, we have studied distributions quite a bit. Your study of distributions reaches, hopefully, a payoff in the advanced Basel II approaches. What do the advanced approaches to credit risk (IRB), market risk (IMA) and operational risk (AMA) have in common? They all employ the value-at-risk (VaR) or capital-at-risk distributional concept: what is the worst likely loss with some confidence over some horizon (e.g., 99.9% one-year horizon for credit and operational risk, 99% ten-day horizon for market risk).

In this way, the IRB function (please read the excellent assigned reading - An Explanatory Note on Basel II IRB Risk Weight Functions) produces an unexpected loss (UL) using a single-factor model (ASRF) that may remind you of the Gaussian Copula Model that John Hull introduced in Credit Derivatives chapter.

Read more about the IRB function here.

Screencast Tutorial

Paid member access the screencast in the member section. In addition to the viewable screencast:

  • You can downloadable the underlying Power Point slides (in PDF format). For this episode, there is a single 112 page deck.
  • An ipod format (.m4v)
  • A downloadable version of the screencast in a .zip file. (Save to new directory on local and launch the .html file.)

Non-members can sample the start of the screencast tutorial here.

Practice Questions

As always, I wrote some engagement-type questions to provoke your thinking on the episode.

Question 1 (Credit Risk)

In the Standardized Approach to Credit Risk in the Basel II Accord, what is the regulatory capital charge for:

(i) $10 million AA rated corporate loan
(ii) Euro 100 million C rated corporate loan
(iii) $15 million UNRATED bank loan
(iv) AU 12 million AAA sovereign obligation

Question 2 (Credit)

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?

Question 3 (Market Risk)

In regard to the Basel Market Risk Charge:

(i) If the 1-day, 95% confidence RiskMetrics VaR is $2 million, what is the equivalent Basel VaR?
(ii) What do you think is the most important QUALITATIVE requirement for the internal models approach (IMA) to market risk in Basel II?
(iii) What is the rationale and role of the multiplicative factor (which equals 3.0)?
(iv) How is the backtesting framework an application of Type I/Type II trade-off?

Question 4 (Op Risk)

In the last three years, our bank recorded gross income = {-$10 million, +$8 million, +$13 million).

(i) If alpha = 15%, what is the required capital under the Basic Indicator Approach (BIA) to Oprisk in Basel II?
(ii) Without giving a numeric answer, explain how would this change under Standardized Approach.
(iii) Under the ASA? Why is there an ASA approach?
(iv) If the bank were to adopt an ADVANCED MEASUREMENT APPROACH (AMA), which criteria (requirement) do you think would be most difficult to meet?
(v) In quantitative terms (VaR confidence and holding period), how does the AMA approach require the bank to adequately cover extreme (tail) losses? How does this compare to market risk?

Question 5 (Pillars)

(i) How is Basel II evolutionary?
(ii) Why is the second pillar called "load-bearing?"
(iii) In accounting there is a debate about rules vs. principles. Is Basel II rules-based or principles-based?

My answers to these questions

Previous newsletters

Here are links to Episodes #1 through #6:

Thanks very much.

David Harper, CFA, FRM, CIPM
Founder
www.bionicturtle.com

David-Harper_100w

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