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P2 Focus Review: 6th of 8 (Basel)

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
P2 Focus Review 6th of 8: Basel
Concepts:
  • Basel has Three Pillars
  • Minimum capital requirements (Numerator)
  • Credit Risk
  • Market Risk
  • Operational Risk
  • Basel III
Basel has Three Pillars
Pillar One deserves the majority of your time (see next). It's a good idea to read the beginning of the Basel II framework (after all, Basel III remains largely built on the Basel II foundation) and grasp the evolution of Basel (i.e., credit risk, then market risk, then finally operational risk was added), the scope, the basic ratio (see next), and the roles of the three pillars. Please be fluent in the basic (standardized) and advanced (internal) approaches under each of the three risk categories. Know the definition of operational risk, such that you are aware of risks not covered by Basel.

Please have memorized the three VaR calibrations under Basel:
  • Credit VaR: 99.9% confidence over a one-year horizon
  • Market VaR: 99.0% confidence over a 10-day horizon; be ready to translate an x-day (1-day) 95% VaR into 10-day 99%.0% VaR. Very common question.
  • Operation VaR: 99.9% confidence over a one-year horizon
In regard to Supervisory Review (Pillar Two), I probably would memorize the high-level principles, just in case they are tested. I would be familiar with the role of Pillar Two; e.g., why is Pillar Two called the "load-bearing Pillar?" In regard to Market Discipline (Pillar Three), it's hard to say, so; it's not prominent in the historical exam sample. I can't say that it is really high priority.

Minimum capital requirements (Numerator)
Keep in mind we are in regulatory capital now, as opposed to (internal) economic capital. The key formula has been, and probably will continue to be, the basic Basel II+ requirement for regulatory capital:
  • Minimum regulator capital requirement = 8.0% > Total risk charge (TRC)/Risk Weighted Assets (RWA); which is equivalent to:
  • Total regulatory capital > credit risk charge (CRC) + market risk charge (MRC) + operational risk charge (ORC)
The GARP 2012 sample exam includes a mere three Basel references, but I think question 12 is most typical:
Question 12: "Using approved approaches, Barlop Bank has calculated the following values:
  • Risk-weighted assets for credit risk, RWA(c) = USD 47 million
  • Market risk capital requirement, CR(m) = USD 3.2 million
  • Operational risk capital requirement, CR(o) = USD 2.8 million
Assuming Tier 3 capital is USD 0, in which scenario below does Barlop Bank meet the Basel II minimum capital requirement?"


So you need to quickly determine that total risk weighed assets (RWA) = 47 + 12.5 * (3.2 + 2.8) = 122.0 million; and that regulatory capital (Tier 1 + Tier 2 - Deductions) must be equal to or greater than (at least) 8.0% of the total RWA. Please notice that, by simply adding the three RWAs, Basel is implicitly giving ZERO high-level diversification benefit across the high-level risk categories (credit, market and operational risk), despite the bank's ability to achieve such benefits WITHIN each category under internal (advanced) approaches.

Historically (as in the Question 12 above) the FRM seems to like to quiz your knowledge that Tier 2 cannot exceed Tier 1; i.e., Total regulatory capital must be 8.0%, where total capital = Tier 1 + Tier 2, and Tier 1 needs to be at least 4.0%.

Historically, also, the full definitions of Tier 1, Tier 2 and Tier 3 regulatory capital have been testable; but they are generally not easy to memorize. However, if we want to be pragmatic, I see these at slightly less testable in the current transition-environment to Basel III. Importantly, Tier 3 is eliminated in Basel III. And Tier 1 is "tightened" to essentially core equity; such that, frankly, I think it's conceivable that the current test may not go too far beyond "Tier 1 is core equity and equity-like" and Tier 2 is the rest, just due to the differences between Basel II and Basel III. If you don't have a lot of time, I think it might be enough to know:
  • Basel III: Tier 1 capital ~= common shares + retained earnings + additional going-concern capital minus (-) regulatory adjustments, and
  • Basel III: Total regulatory capital = Tier 1 (going concern capital) + Tier 2 (gone-concern capital) - deductions
Credit Risk
Historically, Pillar One Credit Risk has been highly testable, as you might expect (the original Basel Accord started with this category only). The essential (bare minimum) concepts include:
  • Calculation of the credit risk charge (CRC) under the standardized approach. For example: the CRC for a $100.0 MM A-rated corporate exposure = 50% * $100 MM * 8.0% = $4.0 million; the CRC for a $10.0 AA-rated bank loan = 20% * $10.0 MM * 8.0% = $160,000.
  • A conceptual grasp of the internal ratings-based (FIRB and AIRB) function. An actual calculation is beyond exam scope, but please don't let that fool you into skipping the IRB approaches; this is among the most tested historically. Very popular is a question on the key difference between AIRB and FIRB; i.e., who supplies the estimates in each for EAD, PD, LGD, maturity (M) and correlation? Best is to understand exactly how this IRB is a function which calibrates the capital requirement (K) to equal the unexpected loss (UL) where UL = CVaR(confidence) - EL. Also GARP likes to quiz the underlying (and unrealistic) theory of portfolio invariance.
  • The following document, An Explanatory Not on the Basel II IRB Risk Weight Functions, was previously included in the FRM syllabus, but was recently dropped. However, I strongly recommend this excellent summary on the IRB as the first few pages refer to some material that has been often tested in the FRM, it may be more useful to you than some of the assigned Basel pages: An Explanatory Note on the Basel II IRB Risk Weight Functions.
Market Risk
Pillar One Market Risk has appeared, to my knowledge, on every single exam. Highly testable. Please make sure you have a confident grasp of, at a minimum:
  • With respect to the Market Risk standardized approach, I predict a continuation of recent low testability: I would prioritize IMA VaR and backtest over this (see next)
  • The key quantitative parameter: Basel II/III IMA Market Risk VaR must be a 10-day VaR with 99.0% confidence. Be facile with conversion from other confidences/horizon. For example, GARP 2010 sample exam supplies an assumption that bank's trading portfolio has a 1-day, 95% VaR of $40,000; and then expects you to translate this into a Basel IMA VaR: 10-day, 99% VaR with $40,000*SQRT(10)*2.33/1.645. I can almost guarantee you will need to perform this sort of re-scaling of VaR.
  • Maybe because Basel IMA prescribes no specific model, GARP likes to quiz the high-level IMA requirement function where MRC = MAX[most recent VaR, k*60-day average VaR] + SRC.
  • I would probably memorize the quantitative (including above 10-day, 99.0% confidence of course) and qualitative (e.g., must backtest, must stress test) parameters
  • Backtest: if you worked our questions, you will be totally ready for this. At the end of the day, this is a hypothesis test of a binomial distribution and the green/yellow/red zones are a way to cope with the unavoidable Type I vs. Type II trade-off. Study of the backtest is exam-profitable because you are employing several concepts.
  • Stressed VaR: GARP has liked testing this, by giving you the most recent SVaR and 60-day average SVaR, and looking for you to apply the function: MAX(recent SVaR, k*60-day average SVaR); i.e., memorize the formula
Operational Risk
As the third major category, also highly testable. Please note that you should require very little time to size up the BIA and SA approaches: for our purposes, these are pretty straightforward.
  • BIA OpRisk charge is fixed 15% of gross income (GI) over prior three years. Negatives excluded. As this is easy to test, be ready.
  • SA OpRisk charge is a blended 12% to 18%, based on business line mix, of GI. Negatives are included as a zero.
  • For AMA, I would memorize the qualitative and quantitative parameters, including OpRisk VaR at one-year horizon and 99.9% confidence
Also, I would definitely be fluent in the business-line/event-type operational (BL-ET) loss matrix. Especially, I would be familiar with the operation loss event types.

Basel III (or Basel II+)
It is hard to estimate the relative importance of various topics in Basel III, given the flux and reading churn (for example, I noticed that GARP's 2012 Part 2 Question 14 references “Supervisory Guidance for Assessing Bank’s Financial Instrument Fair Value Practices," which is not even assigned in 2012!). I estimate the following are important:
  • The first B3 assignment (Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems) is easily the most relevant. Please note the Study Guide says December 2010, but you want the updated (June 2011) version at http://www.bis.org/publ/bcbs189.htm. The reason this is most useful is that it overview overviews the rest (e.g., liquidity ratios), and for most of these sub-topics, an overview is all you will need
  • Leverage ratio
  • Countercyclical buffers
  • Minimum liquidity ratio
  • Net stable funding ratio
 

vt2012

Member
Hi David,

2 questions:

1. BIA OpRisk= alpha*(GI1+GI2+GI3)/3 . If, say GI2<0 , then
OpRisk=alpha*(GI1+GI3)/3
or
OpRisk=alpha*(GI1+GI3)2 ?
and what if all GIs <0? 0/0?

2. "SA OpRisk charge is a blended 12% to 18%, based on business line mix, of GI. Negatives are included as a zero."
However, Jorion (HB, 6 edition, page 632, footnote 8), says OPC allows offsets for some negative GI numbers

Could you please clarify this?
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
Hi vt2012,

1. BIA: If GI2<0, then the negative year is excluded altogether, so correct is OpRisk=alpha*(GI1+GI3)/2
  • Source Basel (BII p 649, emphasis mine): "Banks using the Basic Indicator Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average."
  • BT Tier 3 members can see the calcs illustrated in XLS http://www.bionicturtle.com/how-to/spreadsheet/2011.7.c.5.-basel-oprisk-basic
  • Re: what if all GIs <0? Good question, I do not know.
2. SA OpRisk: under SA, GI for each business line (up to 8) is multiplied by a beta and these are summed for each business line; i.e., k = Σ [GI(i) * beta(i)], from i = 1 to 8. Jorion HB refers to the fact that negative business line GI(i) sums with positive GI(i) so "offsets" to produce a total sum. However, if the sum of these products, GI(i) * beta(i), is negative, a zero is included for the year, so SA expands to k = MAX(0, Σ [GI(i) * beta(i)]) for the single year and the final (k) charge is a three (3) year average of this max(.) function; so, my point was that under SA, a negative for the year translates into an INCLUDED ZERO into the 3-year average, unlike BIA which excludes the negative year altogether. I hope that explains, thanks
 

Linghan

Active Member
This is a really nice review summary sheet!! Thanks! Just wondering if it has been updated to include anything new (testable items) from recent years?
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
This is a really nice review summary sheet!! Thanks! Just wondering if it has been updated to include anything new (testable items) from recent years?
... we're currently working on updates of all the focus reviews/formulas sheets etc (because we are basically "caught up" with all core videos), but we're not committing to any particular timing. Thanks!
 

raghav159

New Member
Dear David,

Net Stable Funding Ratio
Are we expected to remember the ASF factors / the ranks of different factors for the NSFR ["Stable" demand & term deposits from individuals, "Less stable" demand and term deposits, Wholesale funding, etc.] ?
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
Dear David,
Net Stable Funding Ratio
Are we expected to remember the ASF factors / the ranks of different factors for the NSFR ["Stable" demand & term deposits from individuals, "Less stable" demand and term deposits, Wholesale funding, etc.] ?

@Nicole Seaman can we ask Lisa this question? it's a good question. On the one hand, certain PQs and the LOs suggest "yes," but on the other hand, it seems like much to expect. The relevant LO is found in P2.T7.R68 Hull Chapter 16. Basel II.5, Basel III, and Other Post-Crisis Changes [OR–23]:
  • Describe and calculate ratios intended to improve the management of liquidity risk, including the required leverage ratio, the liquidity coverage ratio, and the net stable funding ratio
 
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