LO 59.3: Describe the comprehensive risk measure (CRM) for positions that are

LO 59.3: Describe the comprehensive risk measure (CRM) for positions that are sensitive to correlations between default risks.
The comprehensive risk measure (CRM) is a single capital charge for correlation- dependent instruments that replaces the specific risk charge (SRC) and the IRC. The measure accounts for risks in the correlation book. Instruments that are sensitive to the correlation between the default risks of different assets include asset-backed securities (ABS)
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Topic 59 Cross Reference to GARP Assigned Reading – Hull, Chapter 16
and collateralized debt obligations (CDOs). In normal periods, there is little risk of loss for highly rated tranches of these instruments. However, in times of stress, as in the 20072009 financial crisis, correlations with other instruments increase and even the highest-rated tranches can be vulnerable to loss.
The committee has specified a standardized approach for rated instruments. Due to the experience of the financial crisis, resecuritizations, such as CDOs of ABSs, have higher capital requirements than normal securitizations such as mortgage-backed securities.
Figure 1: Standardized Capital Charge for Correlation-Dependent Instruments
Type o f Instrument
Securitization Resecuritization
AAA to AA- 1.6% 3.2%
A+ to A – 4% 8%
BBB+ to BBB- 8% 18%
BB+ to B B – 28% 52%
Below BB or
Unrated Deduction Deduction
For unrated instruments or instruments rated below BB, the bank must deduct the principal amount of the exposure from capital. This is equivalent to a 100% capital charge; banks must hold dollar-for-dollar capital against the tranche. For unrated tranches banks are allowed, with supervisory approval, to use an internal model to calculate the CRM. If a bank is allowed to use an internal model, it must routinely perform rigorous stress tests. Internal models must be sophisticated and capture the cumulative effects of several factors including: Credit spread risk. Multiple defaults. The volatility of implied correlations. The relationship between implied correlations and credit spreads. The costs of rebalancing hedges. The volatility of recovery rates. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) does not allow ratings to be used in setting capital requirements. As such, the United States is trying to devise its own CRM rules that do not use ratings.
Professors Note: For unrated and low rated (below BB-) instruments or tranches, the deduction o f the principal amount o f the exposure from capital is in essence assigning a 1250% risk weight to the asset class. Think about a $100 corporate loan that has a 100% risk weight. The capital charge is $8, or $100 x 100% x 0.08 (the asset value times the risk weight times the capital requirement). I f instead you have a $100 unrated ABS CDO, the capital charge is $100. Another way to look at it is $100 x 1250% x 0.08. This lets you see the difference in the way that these low or unrated correlation dependent instruments are treated in terms o f capital requirements, com pared to traditional assets like loans.
2018 Kaplan, Inc.
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Topic 59 Cross Reference to GARP Assigned Reading – Hull, Chapter 16
B a s e l III C a p i t a l R e q u i r e m e n t s

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