LO 49.2: Describe the BIS recommendations that supervisors should consider to

LO 49.2: Describe the BIS recommendations that supervisors should consider to make effective use of internal risk measures, such as economic capital, that are not designed for regulatory purposes.
There are ten Bank for International Settlements (BIS) recommendations to consider: 1. Use of economic capital models in assessing capital adequacy. The bank should show
how such models are used in the corporate decision-making process so as to assess the models impact on which risks the bank chooses to accept. In addition, the board should have a basic understanding of the difference between gross (stand alone) and net (diversified) enterprise-wide risk in assessing the banks net risk tolerance.
2. Senior management. The economic capital processes absolutely require a significant
commitment from senior management. They should understand its importance in the corporate planning process and should ensure that there is a strong infrastructure in place to support the processes.
3. Transparency and integration into decision-making. Economic capital results need to be easy to trace and understand in order to be useful. Careful attention must be given to obtaining reliable estimates on an absolute basis in addition to developing the flexibility to conduct firm-wide stress testing.
4. Risk identification. This is the crucial starting point in risk measurement. The risk measurement process must be very thorough to ensure that the proper risk drivers, positions, and exposures are taken into account in measuring economic capital. That will ensure that there is little variance between inherent (actual) and measured risk. For example, risks that are difficult to quantify should be considered through sensitivity analysis, stress testing, or scenario analysis.
3. Risk measures. No given risk measure is perfect, and a bank must understand the
strengths and weaknesses of its chosen risk measures. No one risk measure for economic capital is universally preferred.
6. Risk aggregation. The reliability of the aggregation process is determined by the
quality of the measurement risk components, plus the interrelationships between such risks. The aggregation process usually requires consistency in the risk measurement parameters. The aggregation methodologies used should mirror the banks business composition and risk profile.
7. Validation. The validation process for economic capital models must be thorough and corroborating evidence from various tests must show that the model works as intended. In other words, within an agreed upon confidence interval and time period, the capital level determined must be enough to absorb the (unexpected) losses.
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Topic 49 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
8. Dependency modeling in credit risk. Banks must consider the appropriateness of the
dependency structures used within their credit portfolio. Specifically, credit models need to be assessed for their limitations, and such limitations need to be dealt with via appropriate supplementary risk management approaches, such as sensitivity or scenario analysis.
9. Counterparty credit risk. There are trade-offs to be considered in deciding between
the available methods of measuring counterparty credit risk. Additional methods, such as stress testing need to be used to help cover all exposures. Measuring such risk is complicated and challenging. Specifically, the aggregation process needs to be vetted prior to a bank having a big picture perspective of counterparty credit risk.
10. Interest rate risk in the banking book. Specifically, financial instruments with
embedded options need to be examined closely in order to control risk levels. Certainly, there are trade-offs between using earnings-based versus economic value-based models to measuring interest rate risk. For example, the former has aggregation problems because other risks are measured using economic value. Also, using economic value- based models could be inconsistent with business practices.
E c o n o m i c C a p i t a l C o n s t r a i n t s a n d O p p o r t u n i t
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