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P2.T7.515. Basel I guidelines and 1996 Amendment (Hull's Financial Institutions)

Nicole Seaman

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Learning outcomes: Explain the calculation of risk-weighted assets and the capital requirement per the original Basel I guidelines. Describe and contrast the major elements—including a description of the risks covered—of the two options available for the calculation of market risk: Standardised Measurement Method; Internal Models Approach

Questions:
(Source: John Hull, Risk Management and Financial Institutions, 5th Edition (New York: John Wiley & Sons, 2018))

515.1. About the original Basel guidelines, Hull writes "The 1988 BIS Accord was the first attempt to set international risk-based standards for capital adequacy. It has been subject to much criticism as being too simple and somewhat arbitrary. In fact, the Accord was a huge achievement. It was signed by all 12 members of the Basel Committee and paved the way for significant increases in the resources banks devote to measuring, understanding, and managing risks. The key innovation in the 1988 Accord was the Cooke ratio." (Source: John Hull, Risk Management and Financial Institutions, 5th Edition (New York: John Wiley & Sons, 2018))

The Cooke ratio, named after Peter Cooke from the Bank of England, required banks to keep (regulatory) capital equal to at least 8.0% of risk-weighted assets. Assume a bank entered into an over-the-counter (OTC) interest rate swap with a counterparty. The notional principal is $100.0 million and the swap had a current value of -$3.0 million (i.e., negative three million) to the bank. How is the risk-weighted asset (RWA) determined for the swap?

a. The swap's RWA is zero (0) because the original Basel I guidelines failed to include off-balance-sheet items and over-the-counter derivatives
b. The swap's RWA equals the negative value of three million
c. The swap's RWA equals the product of the notional of $100.0 million, an add-on factor based on the swap's maturity, and the risk-weight of the counterparty
d. The swap's RWA equals the product of the notional of $100.0 million and an add-on factor based on the swap's maturity minus $3.0 million due to the negative current value of the swap


515.2. About Basel's original approach to regulatory capital held for market risk, Hull writes "In 1995, the Basel Committee issued a consultative proposal to amend the 1988 Accord. This became known as the '1996 Amendment.' It was implemented in 1998 and was then sometimes referred to as 'BIS 98.' The amendment involves keeping capital for the market risks associated with trading activities." (Source: John Hull, Risk Management and Financial Institutions, 5th Edition (New York: John Wiley & Sons, 2018))

The 1996 Amendment distinguishes between the banking book and the trading book. About these books, each of the following is true EXCEPT which is false?

a. The trading book consists of instruments that are actively traded and marked to market daily; the banking book consists primarily of loans that are held to maturity and not marked to market daily
b. The 1996 Amendment introduced a capital charge for the market risk associated with all items in the trading book
c. Under the 1996 Amendment, the credit risk capital charge in the 1988 Accord continued to apply to all on-balance-sheet and off-balance-sheet items in the trading and banking book, except positions in the trading book that consisted of (i) debt and equity traded securities and/or (i) positions in commodities and foreign exchange
d. The 1996 Amendment eliminated the Standardised Measurement Method for the calculation of market risk and abolished the distinction between the banking/trading books due to widespread regulatory arbitrage between the trading and banking books


515.3. About the calculation of market risk under the 1996 Amendment, each of the following is true EXCEPT which is false?

a. The standardized approach assigns capital separately to each of debt securities, equity securities, foreign exchange risk, commodities risk, and options; but no account is taken for correlations between different types of instruments
b. if a bank elects to use the historical simulation (HS) approach to calculating its value-at-risk (VaR), then a backtest is not required because an HS is effectively already a backtest
c. In the internal model-based approach (IMA), the value-at-risk (VaR) measure used is calculated with a 10-day time horizon and a 99.0% confidence level
d. Most large banks preferred to use the internal model-based approach because it better reflected the benefits of diversification and led to lower capital requirements.

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