Temp_store

LO 59.7: Describe the mechanics of contingent convertible bonds (CoCos) and explain the motivations for banks to issue them.
Contingent convertible bonds (CoCos), unlike traditional convertible bonds, convert to equity automatically when certain conditions are met. These bonds typically convert to equity when the company or bank is experiencing financial strains. The motivation for banks to issue CoCos is that during normal financial periods, the bonds are debt and thus do not drag down return on equity (ROE). However, in periods of financial stress, the bonds convert to equity, providing a cushion against loss, which helps prevent insolvency. The needed capital is provided by private sector bondholders rather than the government, allowing the bank to avoid a bailout.
Potential triggers that activate conversion are: The ratio of Tier 1 equity capital to risk-weighted assets. For example, Credit Suisse

issued CoCos in 2011. Conversion is triggered if Tier 1 equity capital to risk-weighted assets falls below 7%. Supervisors judgment about the issuing banks solvency prospects. For example, the Credit Suisse CoCos automatically convert if bank supervisors determine that the bank needs public sector aid (i.e., equity capital) to avoid insolvency.
A minimum ratio of a banks market capitalization to its assets. Market value triggers
may reduce balance sheet manipulations (as one might see if the ratio of capital to risk-weighted assets is used as a trigger) but might instead introduce stock price manipulation.
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Because of the increased pressure on banks to maintain higher capital levels under Basel III, it is estimated that more than $1 trillion of CoCos will be issued between 2010 and 2020.
D o d d – F r a n k W a l
l S t r e e t R e f o r m

LO 59.6: 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.
In the wake of the 20072009 financial crisis, one of the primary goals of Basel III is to improve liquidity risk management in financial institutions. Basel III specifies a minimum leverage ratio (capital / total exposure) of 3%. As of the 2010 Basel III publication date, the type of capital required to calculate the ratio was not decided. Total exposure includes all items on the balance sheet, in their entirety (i.e., not risk-weighted). It also includes some off-balance sheet items such as loan commitments.
Banks often finance long-term obligations with short-term funds such as commercial paper or repurchase agreements. This is fine during normal economic periods. However,
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in times of financial stress, this mismatched financing gives rise to liquidity risk. Banks find it difficult to roll over the short-term financing when they have, or are perceived to have, financial problems. During the 2007-2009 financial crisis, liquidity risk, not a lack of capital, was the real problem for many banks (e.g., Lehman Brothers). Basel III requires banks to meet the following two liquidity ratios: (1) liquidity coverage ratio and (2) net stable funding ratio.
Liquidity Coverage Ratio (LCR): The LCR focuses on the banks ability to weather a 30- day period of reduced/disrupted liquidity. The severe stress considered could be a three- notch downgrade (e.g., AA to A), a loss of deposits, a complete loss of wholesale funding, a devaluation of the value of collateral for funding agreements like repurchase agreements (i.e., increased haircuts), and potential drawdowns on lines of credit. The ratio is computed as:
high quality liquid assets / net cash outflows in a 30-day period > 100%
Liquid assets need to be at least as great as potential net cash outflows such that the bank can withstand one or more of the pressures described earlier.
Net Stable Funding Ratio (NSFR): The NSFR focuses on the banks ability to manage liquidity over a period of one year. The ratio is computed as:
amount of available stable binding / amount of required stable funding > 100%
To calculate the numerator, each source of funding (such as retail deposits, repurchase agreements, capital, and so on) is multiplied by a factor that reflects the relative stability of the funding source. See Figure 5 for the available stable funding (ASF) factors and types of funding available.
Figure 5: ASF Factors in NSFR
ASF Factor
100%
90%
80%
50%
0%
Category
Tier 1 and Tier 2 capital, preferred stock, debt with remaining maturity greater than one year. Stable demand and term deposits from individuals and small businesses with maturities less than one year. Less stable demand and term deposits from individuals and small businesses with maturities less than one year. Wholesale funding (demand and term deposits) from nonfinancial corporations, sovereigns, central banks, multi-lateral development banks, and public sector entities with maturities less than one year. All other liability and equity categories.
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To calculate the denominator, each required amount of stable funding is multiplied by a factor that reflects the relative permanence of the funding required. See Figure 6 for the required stable funding (RSF) factors and the types of assets requiring the funding.
Figure 6: RSF Factors in NSFR
RSF Factor
Category
0%
5%
20%
50% 65% 85%
100%
Cash and short-term instruments, securities, and loans to financial entities with residual maturities of less than one year. Marketable securities with maturities of greater than one year, if claim is on a sovereign with 0% risk weight (e.g., U.S. Treasury securities). Corporate bonds with rating of AA- or higher and residual maturity greater than one year. Claims on sovereigns or similar bodies with risk-weight of 20%. Gold, equities, bonds rated A+ Residential mortgages. Loans to small businesses or retail customers with remaining maturities less than one year. All other assets.
to A-.
Example: Calculating the NSFR
Bank of the Bluegrass has the following balance sheet:
Retail deposits (less stable) Wholesale deposits Tier 2 capital Tier 1 capital Cash (coins and banknotes) Central bank reserves Treasury bonds (> 1 yr) Mortgages Retail loans (< 1 yr) Small business loans (< 1 yr) Fixed assets Total assets Using the information in Figures 5 and 6 to find the corresponding ASF and RSF factors, calculate the banks net stable funding ratio. 10 10 10 30 30 90 15 195 100 75 2 18 Total liabilities and equity 195 Page 298 2018 Kaplan, Inc. Topic 59 Cross Reference to GARP Assigned Reading - Hull, Chapter 16 Answer: ASF = (100 x 0.8) + (75 x 0.5) + (2 x 1.0) + (18 x 1.0) = $137.50 RSF = (10 x 0) + (10 x 0) + (10 x 0.05) + (30 x 0.65) + (30 x 0.85) + (90 x 0.85) + (15 x 1.0) = $137.00 NSFR= 137.50 / 137.00 = 1.0036 = 100.36% With an NSFR greater than 100%, Bank of the Bluegrass satisfies the new liquidity requirement. These new rules represent a significant change for banks and will impact bank balance sheets. The LCR is scheduled to be implemented January 1, 2015, and the NSFR is scheduled to be implemented January 1, 2018. C o n t i n g e n t C o n v e r t i b l e B o n d s

LO 59.5: Describe the motivations for and calculate the capital conservation buffer and the countercyclical buffer introduced in Basel III.
The capital conservation buffer is meant to protect banks in times of financial distress. Banks are required to build up a buffer of Tier 1 equity capital equal to 2.5% of risk- weighted assets in normal times, which will then be used to cover losses in stress periods. This means that in normal times a bank should have a minimum 7% Tier 1 equity capital ratio (i.e., 4.5% + 2.5% = 7.0%). Total Tier 1 capital must be 8.5% of risk-weighted assets and Tier 1 plus Tier 2 capital must be 10.5% of risk-weighted assets in normal periods. Banks need an extra cushion against loss during stress periods. The idea behind the buffer is that it is easier for banks to raise equity capital in normal periods than in periods of financial stress. The buffer will be phased in between January 1, 2016, and January 1, 2019.
Dividend payments are constrained when the buffer is wholly or partially used up. For example, if a banks Tier 1 equity capital ratio is 6%, the bank must retain a minimum of 60% earnings, thus dividends cannot exceed 40% of earnings. See Figure 3 for the restrictions on dividend payments as they relate to the capital conservation buffer.
Figure 3: Dividend Restrictions Resulting from the Capital Conservation Buffer
Tier 1 Equity Capital Ratio
Minimum Percentage o f Retained Earnings 7.0% 4.000% to 5.125% 5.125% to 5.750% 5.75% to 6.375% 6.375% to 7.000% > 7.0%
100% 80% 60% 40% 0%
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Professors Note: While the buffer requires the ratios to be 7% (Tier 1 equity), 8.5% (Total Tier 1 capital), and 10.5% (total capital) o f risk-weighted assets, the ratios are expected to decline in times o f market stress due to losses. At that point, the ratio requirements described in LO 59.4 are in force (i. e., 4.5%, 6.0%, and 8.0%, respectively). However, once fin an cial markets stabilize, banks w ill fa ce pressure to increase the ratios again. Given the higher equity requirements under Basel III, it w ill likely be difficult fo r banks to achieve the high returns on equity (ROE) that they enjoyed in the 15 years leading up to the fin an cial crisis (i. e., 1990 2006).
While left to the discretion of individual country supervisors, Basel III also recommends that banks have a capital buffer to protect against the cyclicality of bank earnings, called the countercyclical buffer. The countercyclical buffer can range from 0% to 2.5% of risk- weighted assets. Like the capital conservation buffer, it must be met with Tier 1 equity capital. The buffer will be phased in between January 1, 2016, and January 1, 2019.
For countries that require the countercyclical buffer, dividend restrictions may apply. See Figure 4 for the restrictions on dividend payments as they relate to the countercyclical buffer (when set to the maximum 2.5% of risk-weigh ted assets), keeping in mind that the ratios are higher because the capital conservation buffer is also included. In other words, Figure 4 is a revised Figure 3, taking the additional buffer into account.
Figure 4: Dividend Restrictions Resulting from the Capital Conservation Buffer and a
2.5% Countercyclical Buffer
Tier 1 Equity Capital Ratio
M inimum Percentage o f Retained Earnings 9.5% 4.50% to 5.75% 5.75% to 7.00% 7.00% to 8.25% 8.25% to 9.50% > 9.5%
100% 80% 60% 40% 0%
L i q u i d i t y R i s k M a n a g e m e n t

LO 59.4: Define in the context of Basel III and calculate where appropriate: Tier 1 capital and its components Tier 2 capital and its components Required Tier 1 equity capital, total Tier 1 capital, and total capital
Basel III increased capital for credit risk and tightened the definition of capital in response to the 20072009 financial crisis. The proposals were published in December 2010 and will be implemented gradually between 2013 and 2019. Basel III eliminated Tier 3 capital.
Tier 1 capital (or core capital) includes: Common equity including retained earnings (called Tier 1 equity capital or Tier 1
Non-cumulative perpetual preferred stock (additional Tier 1 capital, part of total Tier 1
common capital).
capital).
Tier 1 capital does not include: Goodwill. Deferred tax assets. Changes in retained earnings arising from securitized transactions. Changes in retained earnings arising from the banks credit risk, called debit (debt) value
adjustment (DVA).
Tier 1 capital is adjusted downward to reflect defined benefit pension plan deficits (but is not adjusted upward for surpluses). In addition, there are rules governing capital issued by consolidated subsidiaries and also for the inclusion of minority interests.
Some preferred stock, such as cumulative perpetual preferred. Tier 2 capital (or supplementary capital) includes: Debt subordinated to depositors with an original maturity of five years or more.
Common equity is known as going-concern capital. It absorbs losses when the bank has positive equity (i.e., is a going concern). Tier 2 capital is known as gone-concern capital. When the bank has negative capital and is no longer a going concern, Tier 2 capital absorbs losses. Depositors are ranked above Tier 2 capital in liquidation so theoretically, as long as Tier 2 capital is positive, depositors should be paid in full.
Capital requirements for each tier and for total capital are: Tier 1 equity capital must be 4.5% of risk-weighted assets at all times. Total Tier 1 capital (i.e., equity capital plus additional Tier 1 capital such as perpetual
preferred stock) must be 6% of risk-weighted assets at all times.
Total capital (Total Tier 1 capital plus Tier 2 capital) must be at least 8% of risk-
weighted assets at all times.
By comparison, under Basel I the equity capital requirement was 2% of risk-weighted assets and the total Tier 1 capital requirement was 4% of risk-weighted assets. The new requirements are significantly more rigorous both because the percentages are higher and because the definition of what qualifies as equity capital has been tightened. The 8%
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total capital requirement is the same as under Basel I and Basel II, but again, the stricter definition of equity capital applies under Basel III.
The timeline for implementation for new capital requirements is shown in Figure 2.
Figure 2: Implementation Dates for New Capital Requirements
Regulatory Change Tier 1 Equity Capital Tier 1 Total Capital New Capital Definitions
1/1/13 3.5% 4.5%
1/1/14 4.0% 5.5%
1/1/15 4.5% 6.0%
1/1/18 4.5% 6.0%
Phased in
Phased in
Phased in
New definitions fully in place
C a p i t a l C o n s e r v a t i o n B u f f e r a n d C o u n t e r c y c l
i c a l B u f f e r

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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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.
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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

LO 59.2: Explain the process of calculating the incremental risk capital charge for positions held in a banks trading book.
Prior to the financial crisis, the capital charge for exposures in the banks trading book (i.e., bonds, marketable equity securities, commodities, foreign currencies, and most derivatives that are held by the bank for the purpose of trading) was generally lower than the capital charge for exposures in the banking book (i.e., instruments the bank intends to hold for investment purposes including loans and some debt securities). A one-year, 99.9% confidence level VaR was required for calculating capital for the banking book while a multiplier was applied to a 10-day, 99% VaR for capital to back the trading book.
The Basel Committee proposed an incremental default risk charge (IDRC) in 2005 to correct the problem. The proposal required a 99.9% confidence level, one-year time horizon VaR for instruments in the trading book that are sensitive to default risk. This change had the affect of requiring roughly the same capital for trading book instruments as banking book instruments. However, because much of the 20072009 losses in the financial sector were due not to defaults but instead to downgrades, widening credit spreads, and losses of liquidity, the Basel Committee revised the IDRC to become an incremental risk charge (IRC). Instead of instruments sensitive to default, it is now credit-sensitive instruments. Banks must consider ratings change sensitivities in addition to default sensitivity. Banks are expected to rebalance the portfolio through the year to lessen default risk.
As part of the IRC calculation, banks are required to estimate a liquidity horizon for each instrument in the portfolio. For example, assume an AA-rated bond in the portfolio has a liquidity horizon of 6 months. If at the end of 6 months the bond has defaulted or has been downgraded, it is assumed that the bank will replace the bond with an AA-rated bond comparable to the one held at the start of the period. This rebalancing is assumed at the end of each six-month period (or three months, nine months, etc., depending on the estimated liquidity horizon). The Basel Committee set the minimum liquidity horizon at three months.
This assumption of rebalancing to the beginning of the period position is known as the constant level of risk assumption. Small losses occur as bonds are downgraded and the portfolio is rebalanced, but the likelihood of default is lessened. Generally this assumption reduces the one-year, 99.9% VaR. As discussed in the previous topic, the specific risk charge (SRC) captures changing credit spreads.
C o m p r e h e n s i v e R i s k M e a s u r e

LO 59.1: Describe and calculate the stressed VaR measure introduced in Basel 2.5, and calculate the market risk capital charge.
The implementation of Basel II coincided with the financial crisis of 2007-2009. Some people blamed Basel II because banks using the advanced internal ratings based (IRB) approach to calculate credit risk were allowed to use their own estimates of probability of default (PD), loss given default (LGD), and exposure at default (EAD). Some believed Basel II was a move toward self-regulation and allowed banks to underestimate risks. As a result, the Basel Committee on Banking Supervision implemented a series of changes to the calculation of market risk capital. These changes were part of Basel II.5, implemented December 31, 2011. There were three primary changes, including: 1. The calculation of a stressed value-at-risk (SVaR).
2. The implementation of a new incremental risk change (IRC).
3. A comprehensive risk measure (CRM) for instruments sensitive to correlations between
default risks of various instruments.
In the past, banks used the historical simulation method to calculate the VaR in order to find the market risk capital charge. The assumption in the historical simulation method
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is that percentage changes in market variables the next day are random samples of the percentage changes over the previous one to four years. Volatilities of most market variables were low in the pre-crisis period (i.e., 20032006). As such, market risk VaRs were also low during this period and continuing for a time following the start of the financial crisis. To remedy the problem of low VaRs, Basel II.5 required banks to calculate two VaRs, the usual VaR, using the historical simulation method, and a stressed VaR, using a 250-day period of stressed market conditions. Initially, regulators thought the year 2008 would be ideal for stressed market conditions. However, banks are now required to identify a one-year period when their actual portfolios performed poorly. This means the stressed period may be different across banks.
The total market risk capital charge is the sum of the usual bank VaR and the stressed VaR. The formula for the total capital charge is:
Example: Total market risk capital charge
Spartan State Bank has calculated a market risk VaR for the previous day equal to $15.6 million. The average VaR over the last 60 days is $4.8 million. The bank has calculated a stressed VaR for the previous day equal to $17.7 million and an average stressed VaR equal to $18.4 million. Spartan State Bank has an accurate risk measurement model and recorded only two exceptions while backtesting actual losses against the calculated VaR. As such, the multiplicative factors, both mc and ms are set to 3. Calculate the total market risk capital charge.
Answer:
total capital charge = $15.6 million + ($18.4 x 3) = $70.8 million
Professors Note: Because the stressed VaR w ill be equal to or\ more likely, greater than, VaR, the capital charge fo r market risk under Basel II.5 w ill be at least double the capital charge under Basel II.
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Page 291 previous days VaR, 10-day time horizon, 99% confidence levelmultiplicative factor, determined by supervisor, minimum value of threethe average stressed VaR over the past 60 days, 10-day time horizon, 99% = previous days VaR, 10-day time horizon, 99% confidence level the average VaR over the past 60 days, 10-day time horizon, 99% confidence = level = multiplicative factor, determined by supervisor, minimum value of three = previous days stressed VaR, 10-day time horizon, 99% confidence level = the average stressed VaR over the past 60 days, 10-day time horizon, 99% confidence level stressed VaR multiplicative factor, determined by supervisor, minimum of = three
VaRt – l SVaRavg
mS
m
max(VaRt l, mc x VaRavg) + max(SVaRt l , m$ x SVaRave)avg where: VaRt – l VaRavg
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I n c r e m e n t a l R i s k C a p i t a l C h a r g e

LO 58.10: Compare the standardized approach and the Internal Models Approach for calculating the SCR in Solvency II.
The two approaches an insurance firm can use to calculate the SCR under Solvency II are: 1. Standardized approach.
Internal models approach. 2. Standardized Approach. Analogous to Basel II, the standardized approach to calculating SCR under Solvency II is intended for less sophisticated insurance firms that cannot or do not want to develop their own firm-specific risk measurement model. It is intended to capture the risk profile of the average firm and is more cost efficient for smaller firms with less fully developed risk management functions.
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Internal Models Approach. This approach is similar to the IRB approach under Pillar 1 of Basel II. A VaR is calculated with a one-year time horizon and a 99.5% confidence level. There is a capital charge for the following three types of risk: 1. Underwriting risk, divided into risks arising from life insurance, non-life insurance (such
as property and casualty insurance), and health insurance.
2.
Investment risk divided into market risk and credit risk.
3. Operational risk. Regulators have implemented quantitative impact studies (QISs) to examine whether capital is sufficient to weather significant market events. For example, QISs have considered large declines (i.e., 32%) in global stock markets, large declines (20%) in real estate prices, large increases (10%) or decreases (25%) in mortality rates, and so on.
Internal models developed by insurance companies must satisfy the following three tests: 1. Statistical quality test: This tests the quality of the data and the methodology the firm
uses to calculate VaR.
2. Calibration test: This tests whether risks are measured in agreement with an industry
wide SCR standard.
3. Use test: This test determines if the model is relevant and used by risk managers.
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K e y Co n c e pt s
LO 58.1 Prior to 1988, bank capital regulations were inconsistent across countries and ignored the riskiness of individual banks. In 1988, the Basel Committee put forth its first guidance to set international risk-based capital adequacy standards known as Basel I.
Basel I was originally developed to cover credit risk capital requirements. It was amended in 1996 to also include market risk capital requirements. Basel II was introduced in 2004 and addressed not only credit and market risk capital but also operational risk capital.
LO 58.2 Under Basel I, banks calculated risk-weighted assets for on- and off-balance sheet items. Capital was required as a percentage of risk-weighted assets. For example, cash and Treasury securities received a 0% risk weight while commercial loans received a 100% risk weight. Off-balance sheet items were expressed as credit equivalent amounts and were converted into risk-weighted assets. Capital could be Tier 1 or Tier 2 but at least half of the capital requirement (4%) had to be met with Tier 1 capital (equity and non-cumulative perpetual preferred).
LO 58.3 Banks were required to measure market risk in addition to credit risk under the 1996 Amendment to the 1988 Basel Accord. The 1996 Amendment proposed two methods for calculating market risk including the standardized measurement method and the internal model-based approach. The standardized method assigns a capital charge separately to each of the items in the trading book. This method ignores correlations between the instruments. The internal model-based approach uses a formula specified in the amendment to calculate a value at risk (VaR) measure used to determine the capital requirement. Capital charges are generally lower using this method because it considers correlations between the instruments.
LO 58.4 According to the 1996 Amendment, the market risk VaR is calculated with a 10-trading-day time horizon and a 99% confidence level. The capital requirement for market risk is:
max(VaRt_1, mc x VaRavg) + SRC
where: VaRt _ j = previous days VaR VaRavg = the average VaR over the past 60 days mc SRC = specific risk charge = = multiplicative factor, minimum value of three
The 1996 Amendment requires banks to backtest the one-day, 99% VaR over the previous 250 days. If the actual loss is greater than the estimated loss, an exception is recorded. The
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multiplicative factor (mc) is set based on the number of exceptions. If, over the previous 250 days, the number of exceptions is: Less than 5, mc is usually set equal to three.
Greater than 10, mc is set equal to four. The bank supervisor has discretion regarding the multiplier.
5, 6, 7, 8, or 9, mc is set equal to 3.4, 3.5, 3.65, 3.75, and 3.85, respectively.
LO 58.5 Basel II improves on Basel I in at least two ways. First, counterparty credit ratings are considered in calculating risk-weighted assets. Second, a model of default correlation is included. Basel II specifies three approaches banks can use to measure credit risk, including the standardized approach, the foundation internal ratings based (IRB) approach, and the advanced IRB approach. The standardized approach is the least complicated and the risk weighting approach is similar to Basel I, although some risk weights were changed. Under the IRB approach, the capital requirement is based on a VaR calculated over a one-year time horizon and a 99.9% confidence level. The foundation IRB approach and the advanced IRB approach are similar. The key difference is who supplies the input variables. Banks supply their own estimates of probability of default (PD), loss given default (LGD), exposure at default (EAD), and the maturity adjustment (M) if using the advanced approach. Under the foundation approach, banks supply PD estimates, while the Basel Committee supplies the estimates of LGD, EAD, and M.
LO 58.6 Basel II requires banks to maintain capital for operational risks. Operational risks include failures of the banks procedures that result in loss (e.g., fraud, losses due to improper trading activities). External events that result in loss, such as a fire that destroys bank assets or information, are also considered operational risks. Under Basel II, there are three approaches banks may use to calculate capital for operational risk including the basic indicator approach (the simplest), the standardized approach (similar to the basic indicator approach but with different multipliers applied to different lines of business), and the advanced measurement approach (the most complex). The capital requirement for operational risk under the advanced measurement approach is based on an operational risk loss calculated over a one-year time horizon and a 99.9% confidence level (i.e., VaR). The approach has an advantage in that it allows banks to consider risk mitigating factors such as insurance contracts.
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LO 58.7 Basel II is an international standard, governing internationally active banks. There are three pillars under Basel II as follows: 1. Minimum capital requirements. This pillar involves calculating capital based on the
riskiness of the bank, taking into consideration credit risk, market risk, and operational risk.
2. Supervisory review. A primary goal of Basel II is to achieve overall consistency in the
application of the capital requirements across countries while, at the same time, giving supervisors discretion to consider market conditions in their own countries.
3. Market discipline. Banks are required to disclose more information about the risks they take and the capital allocated to those risks. According to Basel II, if banks must share more information with shareholders (and potential shareholders), they will make better risk management decisions.
LO 58.8 In the context of Basel II, the worst case probability of default (WCDR) is the amount the bank can be 99.9% certain the loss will not exceed (from a specific counterparty) in the coming year. The one-year probability of default (PD) is the probability that an obligor, given a large number of obligors, will default. The exposure at default (EAD) is the dollar amount a counterparty is expected to owe if it defaults. The loss given default (LGD) is the proportion of the EAD that is expected to be lost in the event the counterparty defaults. For example, if the bank expected to collect 40% in the event of default by a counterparty, the LGD is 60%.
LO 58.9 In Europe, Solvency I establishes capital requirements for the underwriting risks of insurance companies. Solvency II is expected to replace Solvency I and will consider operational and investment risks in addition to underwriting risks. Pillar 1 of Solvency II specifies: Minimum capital requirement (MCR). The repercussions for breaching the MCR will
likely include a prohibition from taking new business. Regulators may also force the insurance company into liquidation and transfer the companys insurance policies to another firm. Solvency capital requirement (SCR). Repercussions for breaching the SCR are less severe than if the firm breaches the MCR. If the SCR falls below the required level, the insurance company will likely be required to submit a plan for restoring the capital to the required amount.

LO 58.10 There are two approaches an insurance firm can use to calculate the SCR under Solvency II. They are the standardized approach and the internal models approach. The standardized approach is least complicated and is meant to capture the risk of the average firm. The internal models approach is similar to the IRB approach under Basel II. It involves calculating a VaR with a one-year time horizon and a 99.5% confidence level.
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C o n c e pt C h e c k e r s
1.
Michigan One Bank and Trust has entered a $200 million interest rate swap with a corporation. The remaining maturity of the swap is six years. The current value of the swap is $3.5 million. Using the table below to find the add-on factor for the interest rate swap, the equivalent risk-weighted assets (RWA) under Basel I is closest to:
Add-on Factors as a Percentage of Principal for Derivatives year 15 years Remaining M aturity in Years < 1 year 1 to 5 years > 5 years
Interest Rate
0.0 0.5 1.5
Equity 6.0 8.0 10.0
A. $3,000,000. B. $3,250,000. C. $3,500,000. D. $6,500,000.
2.
3.
4.
Saugatuck National Bank uses the internal model-based approach to set market risk capital as prescribed by the 1996 Amendment to the 1988 Basel Accord. The bank has backtested its 99%, one-day VaRs against the actual losses over the last 250 trading days. Based on the results of the backtesting, the bank recorded 11 exceptions. Based on these results, the multiplicative factor (mc) in the model should be set: A. less than 3. B. equal to 3. C. between 3.1 and 3.9. D. equal to 4.
Bank Macatawa has a $ 150 million exposure to Holland Metals Co. The exposure is secured by $125 million of collateral consisting of AA+-rated bonds. Holland Metals Co. is unrated. The collateral risk weight is 20%. Bank Macatawa assumes an adjustment to the exposure of + 15% to allow for possible increases in the exposure and allows for a 25% change in the value of the collateral. Risk-weighted assets for the exposure are closest to: A. $78.75 million. B. $93.75 million. C. $118.13 million. D. $172.50 million.
Which of the following accords first required banks to hold capital for operational risk? A. Basel I. B. The 1996 Amendment to Basel I. C. Basel II. D. Solvency II.
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5.
Which of the following statements is correct regarding capital requirements for insurance companies? A. Basel II includes the regulation of banks and insurance companies in the three
pillars.
B. The minimum capital requirement is likely to be higher than the solvency
capital requirement for insurance companies.
C. The repercussion for violating the solvency capital requirement is likely
liquidation and the transfer of company insurance policies to another firm.
D. The internal models approach to calculating the solvency capital requirement is similar to internal ratings based approach under Basel II in that the firm must calculate a VaR with a one-year time horizon.
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C o n c e pt C h e c k e r A n sw e r s
1. B The add-on factor is 1.5% of the interest rate swap principal for swaps with a maturity-
greater than five years.
credit equivalent amount = max(V,0) + a x L
where: V = current value of the derivative to the bank A = add-on factor L = principal amount
credit equivalent amount = $3.5 + (0.015 x $200) = $6,500,000
The risk-weight factor for a corporate counterparty under Basel I is 50% for derivatives and 100% for corporate loans. This means the risk-weighted assets (RWA) are:
RWA= 0.50 x $6,500,000 = $3,250,000
2. D Saugatuck National Bank must compare the VaR calculated using its current method
for each of the 250 trading days to the actual loss over the same period to determine the multiplicative factor. If the actual loss is greater than the estimated loss, an exception is recorded. If, over the previous 250 days, the number of exceptions is:
Greater than 10, mc is set equal to four.
Less than 5, mc is usually set equal to three. 5, 6, 7, 8, or 9, mc is set equal to 3.4, 3.5, 3.65, 3.75, and 3.85, respectively.
Therefore, with 11 exceptions recorded, mc should be set equal to four.
3. A Exposure = (1.15 x 150) – (0.75 x 125) = 172.5 – 93.75 = $78.75
The risk weight for an unrated corporate counterparty based on Figure 3 in the topic is 100%. Applying the 100% risk weight, risk-weighted assets are:
risk-weighted assets = 1.0 x 78.75 = $78.75 million
4. C Basel II requires banks to maintain capital for operational risks. Banks can use three methods
to measure operational risk. They are the basic indicator approach, the standardized approach, and the advanced measurement approach.
5. D Solvency II, not Basel II, establishes capital requirements for insurance companies. The
minimum capital requirement (MCR) is just that, a true floor and is thus likely to be lower than the solvency capital requirement (SCR). The repercussion for violating the MCR is likely the prohibition of taking new business and possible liquidation. The repercussion for violating the SCR is the requirement of a plan to remedy the situation and bring the capital back to the required level. The internal models approach is similar to the internal ratings based approach under Basel II in that the insurance company must calculate a one-year VaR with a 99.5% confidence level (versus 99.9% confidence for banks under Basel II).
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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:
Ba s e l II.5, Ba s e l III, a n d O t h e r Po s t -C r i s i s C h a n g e s
Topic 59
E x a m F o c u s
Following the 2007-2009 financial crisis, the Basel Committee on Banking Supervision implemented reforms to shore up bank capital. This topic describes the measures taken in Basel II.5 and Basel III to increase capital and tighten the definition of what constitutes capital in normal periods, create buffers to protect banks against loss in stress periods, and encourage banks to better manage liquidity risks by requiring banks to maintain liquidity coverage and net stable funding ratios. It also describes the major reforms in the Dodd- Frank Act that impact banks and bank regulation. For the exam, know the major changes to capital regulation, including the incremental risk charge, the comprehensive risk measure, the stressed VaR, the capital conservation buffer, and the countercyclical buffer. Understand why banks may use less mainstream funding sources, such as contingent convertible bonds, as a result of higher capital requirements. In addition, be able to calculate the leverage ratio, liquidity coverage ratio, and net stable funding ratio given a banks balance sheet. Finally, be able to recognize and describe major changes imposed on U.S. banks by Dodd-Frank, including the creation of the Financial Stability Oversight Council, the Office of Financial Research, and the Bureau of Financial Protection.
S t r e s s e d Va R

LO 58.9: Differentiate between solvency capital requirements (SCR) and minimum capital requirements (MCR) in the Solvency II framework, and describe the repercussions to an insurance company for breaching the SCR and MCR.
There are no international standards to regulate insurance companies. In Europe, Solvency I establishes capital requirements for the underwriting risks of insurance companies. Solvency II is expected to replace Solvency I and will consider operational and investment risks in addition to underwriting risks. While Solvency II was expected to be implemented in 2013, the date has been postponed. Solvency II has three pillars, analogous to Basel II.
Pillar 1 specifies a solvency capital requirement (SCR). The SCR may be calculated using the standardized approach or the internal models approach (discussed in the next LO). Repercussions for breaching the SCR are less severe than if the firm breaches a minimum capital requirement (MCR). If the SCR falls below the required level, the insurance company will likely be required to submit a plan for restoring the capital to the required amount. Specific measures, determined by regulators, may be required.
Pillar 1 also specifies a minimum capital requirement (MCR), which is an absolute minimum of capital. There are at least two methods for calculating the MCR under consideration. First, MCR may be set as a percentage of the SCR. A second possibility is to calculate MCR the same way as SCR, but with a lower confidence level. The repercussions for breaching the MCR are severe. If a firms capital falls below the MCR, regulators will likely prohibit the company from taking new business. Regulators can also force the insurance company into liquidation and transfer the companys insurance policies to another firm.

LO 58.7: Describe the key elements of the three pillars of Basel II: minimum capital requirements, supervisory review, and market discipline.
While Basel I improved the way capital requirements were determined for banks worldwide, it had some major limitations. First, all corporate loans were treated the same (i.e., a risk
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weight of 100%) regardless of the creditworthiness of the borrower. A firm with an AAA credit rating was treated the same as a borrower with a C rating. Basel I also ignored the benefits of diversification (i.e., there was no model of default correlation). Basel II, proposed in June 1999 and after multiple revisions was published in 2004 and implemented in 2007, corrected a number of the deficiencies in Basel I. The rules applied to internationally active banks and thus many small regional banks in the United States were not subject to the requirements but fell under Basel IA, similar to Basel I, instead. All European banks are regulated under Basel II.
There are three pillars under Basel II: (1) minimum capital requirements, (2) supervisory review, and (3) market discipline.
Pillar 1: Minimum Capital Requirements
The key element of Basel II regarding capital requirements is to consider the credit ratings of counterparties. Capital charges for market risk remained unchanged from the 1996 Amendment. Basel II added capital charges for operational risk. Banks must hold total capital equal to 8% of risk-weighted assets under Basel II, as under Basel I. Total capital under Basel II is calculated as:
total capital = 0.08 x (credit risk RWA + market risk RWA + operational risk RWA)
Pillar 2: Supervisory Review
Basel II is an international standard, governing internationally active banks across the world. A primary goal of Basel II is to achieve overall consistency in the application of capital requirements. However, Pillar 2 allows regulators from different countries some discretion in how they apply the rules. This allows regulatory authorities to consider local conditions when implementing rules. Supervisors must also encourage banks to develop better risk management functions and must evaluate bank risks that are outside the scope of Pillar 1, working with banks to identify and manage all types of risk.
Pillar 3: Market Discipline
The goal of Pillar 3 is to increase transparency. Banks are required to disclose more information about the risks they take and the capital allocated to these risks. The key idea behind Pillar 3 is that if banks must share more information with shareholders (and potential shareholders), they will make better risk management decisions. Banks have discretion in determining what is relevant and material and thus what should be disclosed. According to Basel II, banks should disclose: The entities (banks and other businesses such as securities firms in Europe) to which
A description of the characteristics, terms, and conditions of all the capital instruments
Basel II rules are applied.
held by the bank.
A list of the instruments comprising the banks Tier 1 capital. The amount of capital
provided by each instrument should also be disclosed.
A list of the instruments comprising the banks Tier 2 capital.
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The capital requirements for each type of risk covered under Basel II: credit, market, and
operational risks. Information about other bank risks. Information about the banks risk management function, how it is structured, and how it operates.

S o l v e n c y II F r a m e w o r k