LO 60.3: Explain proposed modifications to Basel regulations in the following

LO 60.3: Explain proposed modifications to Basel regulations in the following areas: Classification of positions in the trading book compared to the banking book Treatment of credit spread and jump-to-default risk, including the incremental
default risk charge
The FRTB also addressed regulatory modifications. One modification is to clarify if a risk asset should be considered part of the trading book or the banking book. Historically, the trading book consisted of risk assets that the bank intended to trade. Trading book assets have been periodically marked-to-market. The banking book has consisted of assets that are intended to be held until maturity, and they are held on the books at cost. Banking book assets are subject to more stringent credit risk capital rules, while trading book assets are subject to market risk capital rules. Using different rules has enabled a form of regulatory arbitrage where banks will hold credit-dependent assets in the trading book to relax capital requirements.
In an attempt to mitigate this regulatory arbitrage, the FRTB makes a specific distinction between assets held in the trading book and those held in the banking book. To be allocated to the trading book, the bank must prove more than an intent to trade. They must meet dual criteria of: (1) being able to trade the asset, and (2) physically managing the associated risks of the underlying asset on the trading desk. If these two criteria are met, then an asset can be allocated to the trading book, but the day-to-day price fluctuations must also affect the banks equity position and pose a risk to bank solvency.
.Another important distinction was made in terms of reclassification between a banking book asset and a trading book asset. Once an asset has been acquired and initially assigned to either the trading book or the banking book, it cannot be reclassified except for extraordinary circumstances. This roadblock has been established to minimize the act of switching between categories at will, based on how capital requirements are calculated.
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Topic 60 Cross Reference to GARP Assigned Reading – Hull, Chapter 17
An example of an extraordinary circumstance is if the bank changes accounting practices that is a firm-wide shift. Another caveat is that any benefit derived from calculating capital requirements under a post-shift category is disallowed. The capital requirement of the original method must be retained.
Basel II. 5 also introduced the incremental risk charge (IRC) to further mitigate this regulatory arbitrage. The IRC recognizes two different types of risk created by credit- dependent risk assets: (1) credit spread risk, and (2) jump-to-default risk.
Credit spread risk is the risk that a credit risk assets credit spread might change and thus cause the mark-to-market value of the asset to change. This risk can be addressed by using the expected shortfall calculation process discussed earlier. The IRC process allows banks to assume a constant level of risk. This means that it is assumed that positions that deteriorate are replaced with other risk assets. For example, if a bank has an A-rated bond with a three- month liquidity horizon that suffers a credit-related loss, then it is assumed that the bank replaces this risk asset with another A-rated bond at the end of the three-month liquidity horizon. This is clearly a simplifying assumption, which is being replaced with incremental marking-to-market without assuming replacement under the FRTB proposals.
Jump-to-default risk is the risk that there will be a default by the issuing company of the risk asset. A default would lead to an immediate and potentially significant loss for the bank that holds the defaulted issuers risk asset. This risk is subject to an incremental default risk (IDR) charge. The IDR calculation applies to all risk assets (including equities) that are subject to default. It is calculated based on a 99.9% VaR with a one-year time horizon.
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K e y C o n c e p t s
LO 60.1 The Fundamental Review of the Trading Book (FRTB) is changing the historical reliance on 10-day value at risk (VaR) with a 99% confidence interval combined with a 250-day stressed VaR. The new calculation will require the use of expected shortfall with a 97.5% confidence interval. This switch will better capture the value of capital at risk below a certain confidence interval.
LO 60.2 The FRTB is establishing various liquidity horizons, which are the length of time required to execute transactions that extinguish an exposure to a risk factor, without moving the price of the hedging instruments, in stressed market conditions. The expected shortfall will then be calculated by structuring risk assets into categories and solving for an overall value of expected shortfall for a banks risk assets.
LO 60.3 Some banks have engaged in regulatory arbitrage by actively switching assets between the trading book and the banking book depending on which category would show their capital requirements in a more favorable light. The FRTB is mitigating this arbitrage opportunity by deploying a rules-based standard for classification into these categories and a roadblock for easily switching between them.
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C o n c e p t C h e c k e r s
1.
2.
3.
4.
5.
Which of the following statements regarding the differences between Basel I, Basel II. 5, and the Fundamental Review of the Trading Book (FRTB) for market risk capital calculations is incorrect? A. Both Basel I and Basel II. 5 require calculation of VaR with a 99% confidence
B. FRTB requires the calculation of expected shortfall with a 97.5% confidence
C. FRTB requires adding a stressed VaR measure to complement the expected
interval.
interval.
shortfall calculation.
D. The 10-day time horizon for market risk capital proposed under Basel I
incorporates a recent period of time, which typically ranges from one to four years.
What is the difference between using a 95% value at risk (VaR) and a 95% expected shortfall (ES) for a bond portfolio with $825 million in assets and a probability of default of 3%? A. Both measures will show the same result. B. The VaR shows a loss of $495 million while the expected shortfall shows no loss. C. The VaR shows no loss while the expected shortfall shows a $495 million loss. D. The VaR shows no loss while the expected shortfall shows a $395 million loss.
Which of the following statements best describe how the internal models-based approach (IMA) incorporates various liquidity horizons into the expected shortfall calculation? A. A rolling 10-day approach is used over a 250-day window of time. B. Smaller time periods are used to extrapolate into larger time periods. C. A series of weights are applied to the various liquidity horizons along with a
correlation factor determined by the Basel Committee.
D. The expected shortfall is based on a waterfall of the liquidity horizon categories and is then scaled to the square root of the difference in the horizon lengths of the nested risk factors.
Which of the following statements represents a criteria for classifying an asset into the trading book? I. The bank must be able to physically trade the asset. II. The risk of the asset must be managed by the banks trading desk. A. I only. B. II only. C. Both I and II. D. Neither I nor II.
Which of the following risks is specifically recognized by the incremental risk charge (IRC)? A. Expected shortfall risk, because it is important to understand the amount of loss
B. Jump-to-default risk, as measured by 99% VaR, because a default could cause a
potential in the tail.
significant loss for the bank.
C. Equity price risk, because a change in market prices could materially impact
mark-to-market accounting for risk.
D. Interest rate risk, as measured by 97.5% expected shortfall, because an increase
in interest rates could cause a significant loss for the bank.
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Topic 60 Cross Reference to GARP Assigned Reading – Hull, Chapter 17
C o n c e pt C h e c k e r An s w e r s
1. C Basel I and Basel II. 5 use VaR with a 99% confidence interval and the FRTB uses the
expected shortfall with a 97.5% confidence interval. Basel I market risk capital requirements produced a very current result because the 10-day horizon incorporated a recent period of time. The FRTB does not require adding a stressed VaR to the expected shortfall calculation. It was Basel II.5 that required the addition of a stressed VaR.
2. C The VaR measure would show a $0 loss because the probability of default is less than 5%. Having a 3% probability means that three out of five times, in the tail, the portfolio will experience a total loss. The potential loss is $495 million (=3/5 x $825 million).
3. D The expected shortfall is based on a waterfall of the liquidity horizon categories and is then scaled to the square root of the difference in the horizon lengths of the nested risk factors.
4. C The criteria for classification as a trading book asset are: (1) the bank must be able to
physically trade the asset, and (2) the bank must manage the associated risks on the trading desk.
5. B The two types of risk recognized by the incremental risk charge are: (1) credit spread risk,
and (2) jump-to-default risk. Jump-to-default risk is measured by 99% VaR and not 97.5% expected shortfall.
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
So u n d Ma n a g e me n t o f Ri s k s Re l a t e d t o M o n e y La u n d e r i n g a n d Fi n a n c i n g o f Te r r o r i s m
Topic 61
E x a m F o c u s
This topic focuses on the Basel Committees recommendations for identifying, assessing, and managing the risks associated with money laundering and the financing of terrorism (ML/FT) through banks. The concept of customer due diligence (CDD) is important and focuses on the precautionary steps a bank must take to ensure it knows the true identities of the customers with which it is dealing. Because many of the higher risk situations arise out of international, cross-border transactions, much of the recommendations focus on the risks associated with these activities. For the exam, understand who bears the ultimate responsibility for customer identification and verification, even if a third party is hired to carry out CDD. Also, know the responsibilities of both the correspondent and respondent banks in a correspondent banking relationship.
B e s t P r a c t
i c e s

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