asean risk workshop capital treatment of credit risk · pdf fileasean risk workshop –...

Jinu Chandrasekhar

Head, Portfolio Risk Review, Global Portfolio Risk

Standard Chartered Bank

13 May 2015

ASEAN Risk workshop

Capital Treatment of Credit

Risk under Basel III

ASEAN Risk workshop – Capital treatment of credit risk under Basel III

Training Agenda

Agenda

2

1 Evolution of the capital adequacy framework 3

5 Basel III major credit items overview 7

6 Asset Value Correlation 8

7 Credit Valuation Adjustment 9

8 Specific Wrong Way Risk 10

Central Counterparty 12

3 Risk Weighted Assets – Standardised Approach 5

Key Takeaway 13

2 Three approaches to credit risk 4

9 Calibration of capital charge to stressed period 11

11

4 Risk Weighted Assets – AIRB Calculation 6

10

3

Production of a sound minimum standard of capital adequacy for internationally active banks as well as smaller institutions

Well-understood measure of capital adequacy that is comparable across banks and over time

Providing a reasonable level playing field between banks

Taking into account the effects of capital requirements on banks’ risk-taking incentives

Promoting improved risk measurement and management within banks

…towards the primary aim of the capital adequacy framework


Evolution of the capital adequacy framework

Key milestones of the Basel accord

Risk-based capital requirements already existed in some jurisdictions. However, there were also other jurisdictions still then using leverage ratios or other

simple non risk-based metrics to regulate bank capital.

The 1988 Basel Capital Accord – “one size fits all” approach. Credit risk only was considered.

- A level playing field for all internationally active banks

- Eligible capital with a tiering structure acknowledging that not all capital has equal loss-absorbing capacity

- A set of simple asset risk weights prescribed - in recognition of varying risks of loss across different asset classes, including off balance sheet exposures

The Amendment to the capital accord to incorporate market risk

- Allowed, for the first time, to use internal models (value-at-risk) in the regulatory framework, subject to supervisory approval

Basel II: the New Capital Framework

- Motivated by the evolution of modelling approaches / designed to improve the incentives provided by the risk-based capital framework

- Introduction of three-pillars: Minimum Capital Requirements / Supervisory Review Process / Disclosure and Market Discipline

- Introduction of an explicit capital requirement for operational risk

Basel III: Strengthening of the regulatory capital requirements

- Increased quality and quantity of capital

- Reduced leverage through introduction of backstop leverage ratio – Leverage Ratio

- Increased short-term liquidity coverage – Liquidity Coverage Ratio

- Increased stable long-term balance sheet funding – Net Stable Funding Ratio

- Strengthened risk capture, notably counterparty risk – Asset Value Correlation (“AVC”), Credit Valuation Adjustments (“CVA”) charge, Wrong-way risk

Breakout of financial crisis – need for stronger capital requirements emerged.

Prior to

1988

1988

1996

2004

2008

2010

4

Evolution in the calculation methodology for Risk Weighted Assets


Three approaches to credit risk

Three approaches for the calculation of Risk Weighted Assets

The capital regulations have grown in complexity in an effort to capture the risk sensitivity to the fullest extent where possible.

Advanced IRB

Internal models can be used for

determination of PD, EAD and

LGD

Collateral recognition allows

internal estimation, providing

differentiation for type of

guarantors, type of collaterals etc.

Foundation

Internal Ratings Based (“IRB”)

PD is allowed to be determined

using internal models

EAD and LGD are externally

provided by regulators

Supervisory treatment of collateral

and guarantees

Standardised Approach

Risk-based, yet relatively simple

Risk Weights based on external

ratings or asset class

Supervisory treatment of collateral

and guarantees

Advanced IRB reflects risk sensitivity to the fullest extent among the three approaches.

In general Basel framework designed to incentivise banks using AIRB through less capital requirements, compared to those

using Standardised approach. However, AIRB requires banks to be equipped with systems / granular historical data in order

for the internal models to be justified / approved.

Increased risk sensitivity accompanies added complexity which is ever increasing – the Basel Committee issued a discussion

paper (BCBS258) in July 2013 on striking the right balance between risk sensitivity, simplicity and comparability.

The pursuit of increased risk sensitivity, at the cost of added complexity

5

The Standardised Approach


Risk Weighted Assets – The Standardised Approach

Risk weights prescribed for each exposure class to determine the credit risk RWA.

Simplicity – relatively straightforward to compare bank capital ratios under this regime.

Does not fully capture the different level of risk sensitivity (e.g. same risk weight on mortgage exposure with properties across different regions)

Exposure Class Remarks

Risk Weight

AAA to AA- A+ to A- BBB+ to

BBB- BB+ to BB- B+ to B- Below B- Unrated

Claims on Sovereigns 0% 20% 50% 100% 100% 150% 100%

Claims on the BIS, the IMF, the

ECB, the EC and the MDBs

The Bank for International Settlements

The International Monetary Fund

The European Central Bank

The European Community

Multilateral Development Banks (“MDBs”) qualifying

for 0% Risk Weight

0%

Claims on banks and securities

companies

Two options available – National supervisor to

choose one option to be applied 20% 50% 50% 100% 100% 150% 50%

Claims on corporates 20% 50% 100% 100% 150% 150% 100%

Claims on retail products Including credit card, overdraft, auto loans, personal

finance and small business 75%

Claims secured by residual

property 35% (depends on LTV)

Claims secured by commercial

real estate 100%

Overdue loans

(more than 90 days past due,

except qualifying residential

mortgage loans)

With specific provisions < 20% of the outstanding

amount 150%

With specific provisions ≥ 20% of the outstanding

amount 100%

With specific provisions ≥ 50% of the outstanding

amount AND supervisory discretion 50%

Other assets 100%

Risk Weights by exposure class and external ratings

6

IRB method - Key determinants of Risk Weighted Assets


Risk Weighted Assets – IRB Calculation

Regulatory formula of Risk Weight calculation in IRB method (Corp, Bank and Sov.)

Risk Weight (“RW”) is a function of probability of default (“PD”), loss given default (“LGD”), maturity and firm size.

PD

RWA EAD Risk Weight = X

LGD M S

f PD can be that of the primary obligor as well as the guarantor.

LGD is driven by multiple factors (e.g. counterparty type, country of

incorporation, collateralisation, nature of transaction etc).

M: Regulatory floor (1 year) and cap (5 year) exists in maturity calculation.

S: Firms with annual sales of EUR50m or less are entitled to smaller RWA.

06.15.12

5.11

5.21)999.0(

1)(

1

1

b

bMPDLGDG

R

RPDG

RNLGDRW

where:

N(x) = the cumulative distribution function for a standard normal random variable

G(Z) = the inverse cumulative distribution function for a standard normal random variable

R = the coefficient of correlation

b = the maturity adjustment factor

50

50

50

50

1

1124.0

1

112.0

e

e

e

eR

PDPD

2ln05478.011852.0 PDb

General provisions under IRB to cover Expected Loss

The original Basel II framework covers the risk of loss from a counterparty default. This loss is divided into two components, the expected loss

(“EL”) and the unexpected loss (“UL”), with the former covered by provisions and the latter covered by capital.

Under the AIRB approach, EL is calculated by the following formula:

Expected Loss = PD x EAD x LGD

7

Expansion within the Pillar 1 framework


Basel III major credit items overview

Primarily to address FI systemic risks and counterparty credit risk

The Basel Committee on Banking Supervision (“BCBS”), through Basel III, attempts to ensure full coverage of risks in the Pillar I

framework, increasing the capital requirements against risks that had not been adequately captured in the Basel II framework.

Asset Value

Correlation

(“AVC”)

Credit Valuation

Adjustment

(“CVA”)

Wrong Way Risk

(“WWR”)

Calibration of

capital charge to

stressed period

Capturing risks of

certain financial

institutions that are

highly correlated to

the financial system

via the IRB formula

Reflecting

experience from

past crisis events

such as the global

financial crisis in

2008

An additional capital

charge to cover the

risk of mark-to-

market losses on the

expected

counterparty risk to

OTC derivatives

Transactions with a

CCP are exempted

from this

requirement

Securities financing

transactions (“SFT”)

can also be

exempted, subject to

supervisory approval

Introduction of an

explicit Pillar 1

capital charge for

specific WWR

Banks are exposed

to specific WWR if

future exposure to a

specific

counterparty is

highly, positively

correlated with the

counterparty’s

probability of default

Calibration of

counterparty credit

risk modelling

approaches such as

Internal Model

Methods (“IMM”) to

stressed period

Determine capital

charges for CCR

using stressed

inputs, similar to the

approach used for

determining

stressed VaR for

market risk

Central

Counterparty

(“CCP”)

Enhancing

incentives for

clearing instruments

through CCPs by

applying lower own

funds requirements

relative to bilateral

OTC transactions

Also, the additional

CVA capital charge

does not apply to

exposures towards

eligible CCPs

8

Higher capital requirement due to higher correlation to financial systems


Asset Value Correlation

Application

Increasing the RW on exposures to certain financial institutions relative to the non-financial corporate sector in the IRB

approach.

Requiring additional capital for all unregulated financial institutions, and regulated financial institutions if they are large

enough to have a material influence on the overall financial systems in case of default.

Multiplier of 1.25 to the correlation coefficient in the IRB formula, effectively increasing the RW to a varying degree(depending

on probability to default).

Applied on exposures to large regulated financial firms (with assets of at least USD100bn) and to all unregulated financial

firms regardless of size.

Impact on the Risk Weight

Depending on the probability of default of an institution, the introduction of this multiplier increases the RW by approximately 10%

to 36%.

0%

10%

20%

30%

40%

0.03% 0.04% 0.05% 0.07% 0.09% 0.1% 0.2% 0.4% 0.5% 0.7% 0.9% 1.2% 1.5% 2.0% 2.7% 3.5% 4.6% 6.1% 8.0% 10.5% 13.8% 18.0% 24.6% 33.0%

Incremental RW (%)

Probability of Default

Impact of AVC charge application on the RW

Source: Standard Chartered

9

Capital charge on counterparty credit risk for derivatives


Credit Valuation Adjustment

What it is

Capturing the potential mark-to-market losses associated with deterioration in the creditworthiness of a counterparty.

Two methods are allowed: Advanced method (for banks with IMM approval) and Standardised method.

Under Standardised method, three key determinants are i) PD, ii) maturity and iii) collateralisation of exposure.

CVA charge can be mitigated through dealing with exempted counterparties or via hedging.

Exemption rules under EU regulation (“CRD IV”)

The following transactions are exempt from the CVA capital charge:

- Transactions in relation to a qualifying CCP

- Transactions with non-financial counterparties where those transactions do not exceed the clearing threshold as

specified in the EMIR (European Market Infrastructure Regulation)

- Intragroup transactions

- Transactions with pension scheme arrangements

- Transactions with central banks and debt management offices in EU and certain countries (including Japan and the US)

- Transactions with multilateral development banks and development organisations which qualify for zero per cent Risk

Weight

10


Specific Wrong Way Risk

Capturing high correlation between counterparty and underlying issuer

Specific Wrong Way Risk

Specific WWR manifest itself when there is a direct correlation between the nature of the trade and the counterparty:

- Self referencing (e.g. Bank ABC Securities sells protection on Bank ABC)

- Correlated credit

Banks must have procedures in place to identify, monitor and control cases of specific WWR, beginning at the inception of a

trade and continuing through the life of the trade.

Role of Stress Testing

Emphasis is on stress testing and scenario analysis practices to identify risk factors positively correlated with counterparty

credit worthiness.

How does it affect RWA – via increase in EAD

Single-name credit default swaps (“CDS”): the 100% notional of the CDS is to be used as the EAD of the counterparty, where

there exists a legal connection between the counterparty and the underlying issuer.

Equity derivatives referencing a single company: the EAD equals the full expected loss in the remaining fair value of the

underlying instruments assuming the underlying issuer is in liquidation, where there is a legal connection between the

counterparty and the underlying company.

11

IMM measure to reflect stressed period


Calibration of capital charge to stressed period

Conservative approach to capital charge under IMM, in consideration of stressed period

Effective Expected Positive Exposure (“EPE”) as the basis for determining EAD for trading counterparties is retained under Basel

III but with parameters, such as volatility and correlation, using data from a stressed period.

Stressed EPE is to be based on model parameters calibrated over a three-year period that includes the one-year stressed

period used for Stressed VaR for credit assets.

Banks should calculate EAD using current market data and compare that data with the EAD derived using the stressed

parameters. Then, banks should use the higher of:

1) the portfolio-level capital charge based on Effective EPE using current market data; and

2) the portfolio-level capital charge based on Effective EPE using the three-year period that includes the one-year stressed

period (used for the Stressed VaR calculation).

Effective EPE under IMM

Expected Exposure (“EE”): the probability-weighted average

exposure estimated to exist on a future date.

EPE: the time-weighted average of individual EE’s estimated

for a given forecasting horizons (e.g. one year).

Effective EE: the maximum in the path of individual EE profile

for a given forecasting horizons.

Effective EPE: the average of Effective EE profile for a given

forecasting horizons. 0 0.25 0.5 0.75 1

Exp

os

ure

Time (years)

CCR Effective EE profile & Effective EPE

EE

EPE

Effective EE

Effective EPE

12


Central Counterparty

Background

Capital requirements under Basel III for CCP exposures

Lessons learnt from Global Financial Crisis:

- The G20 commitment implemented a set of reforms designed for i) mandatory clearing of standardised OTC contracts, and

ii) increased capital costs on non-cleared derivatives contracts.

Basel III enhanced incentives for clearing instruments through CCPs:

- Potential reduction in Credit RWA, compared to bilateral trades

- Exemption from CVA capital charge for qualifying CCP related transactions

- Avoidance of punitive rules on margin requirements being imposed on OTC non-cleared trades

Key feature of CCP defence mechanism – CCP Default Waterfall

- Loss mutualisation among clearing members: contribution from clearing members of CCP via placement of default fund

- CCP’s skin in the game: a tranche of CCP’s capital to be used before default funds of non-defaulting clearing members

Trade exposure: when a bank is a clearing member of a CCP or acts as an agent / broker for its client’s trades

Margin exposure: when collaterals (margins) are posted directly to a CCP or its clearing member instead of a bankruptcy-remote

custodian

Default fund exposure: when a bank is a clearing member, it has to hold capital against the funded and/or unfunded

contributions that it has made to the CCP’s Default Fund pool

13


Key Takeaway

Strengthening capital requirements under Basel III with a focus to CCR

AVC capital charge to capture higher systemic risks within large regulated FIs and/or unregulated FIs

CVA capital charge to cover potential mark-to-market losses arising from deterioration in creditworthiness of

counterparties

Explicit Pillar I capital charge for specific WWR to dis-incentivise trades where there exists high correlation between

counterparty and underlying issuer / company

Calibration of CCR exposure calculation under the IMM approach to a stressed period

Incentivise clearing through CCPs via reduction in capital charge

Objectives of the Basel III capital treatment of credit risk

To strengthen global capital regulations with the goal of promoting a more resilient banking sector

To improve the banking sector’s ability to absorb shocks arising from financial and economic stress, which, in turn,

would reduce the risk of a spillover from the financial sector to the real economy

To raise capital buffers for systemic banks / derivatives and inter-financial exposures

To provide additional incentives to move OTC derivative contracts to CCPs and exchanges

asean risk workshop capital treatment of credit risk · pdf fileasean risk workshop –...

Documents