# capital ratio

Discussion in 'P2.T7. Basel II & Regulatory' started by ajsa, Sep 18, 2009.

1. ### hsuwangMember

Hello David,

Thank you for the explanation!
So I might be wrong here but is this sort of in a sense similar to trying to literally understand the Black-Scholes formula?

also, if we view this the other way around, for a firm with high PD, it will be charged with higher capital requirement but then the rho and maturity adjustment will 'mitigate' its charges, so I guess without digging deeper into the Basel's formula, it'd be natural to think that the adjustment is there just because it is, not because it's going to have any impact on the charges? maybe I'll just let this one go for now and understand it in a broader sense?

Thanks!

2. ### David Harper CFA FRMDavid Harper CFA FRM (test)

HI Jack,

Re: "if we view this the other way around, for a firm with high PD, it will be charged with higher capital requirement but then the rho and maturity adjustment will ‘mitigate’ its charges" That's exactly correct...but I also agree that, for exam purposes:

* the two mitigants (i.e., high PD implies a lower rho input and a less maturity adjustment) are not important - they are nuances highly unlikely to appear in the exam
* the more important dynamic is illustrated by the "superficial" view of the IRB function where higher rho implies higher systemic risk (ASRF) implies higher charge; extreme illustration: if rho = 0, no charge.

David

Really interesting discussion here. I realized the K was for risk weight not risk capital too.

My gripe about IRB is it's one factor - shouldn't there be incentive for banks to seek out other orthogonal factors? I.e. even though the residual risk could be explainable by other factors, it doesn't give the benefit of diversification explained by those other factors. Another problem, say I worked at a regional bank somewhere that offered loans to anticyclic gold-miners, then I may not be very happy with the correlation constraints, even though I was so smart to get into something more anti-cyclic over something like homebuilders.

The other thing is, if I were an investor in a bank, I may want the bank to retain idiosyncratic risk only (and lever alpha) rather than lever just plain credit market risk: because if the alpha signal (of management) is overwhelmed by market risk/return, I might as well just sell CDS protection on a broad based credit index no? Puts a little constraint on the business model, but then JP Morgan and GS have other models to show regulators, so they can play it more credit-neutral I guess.

Hi asja,

Oh, okay, I think I see your point ... and note just after the sentence you quote, the IRB document says:
"The desire for portfolio invariance, however, makes recognition of institution-specific diversification effects within the framework difficult: diversification effects would depend on how well a new loan fits into an existing portfolio."
...which seems to support the statement

but, really, this just speaks to the imprecision of the statement: "IRB does not incorporate the risk-reducing role of diversification"
I can say, on the one hand, as i did above: false: by not counting idiosyncratic risk and assuming portfolio invariance, IRB gives full credit for benefits of diversification;
or we can say, per your aguments: true: IRB does not give insititution-specifid diversification benefits

and, finally, there is the issue of pillar 2 supervisory override, which is not IRB but does allow the supervisor to adjust for concentration (i.e., the lack of diversification)

...so I do see your point, I revise to suggest this depends on the how you interpret the question

David​