basel iii - training deck v1.11
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Copyright © 2011 Tata Consultancy ServicesLimited
Introduction to Basel III
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Agenda
Background
Liquidity Risk Management
Capital & Leverage
Counterparty Credit Risk
Market risk
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• The objective of WBT (web based training) on “Introduction to Basel III”is to provide high level overview of Basel III
• Prior knowledge / experience in Basel II is mandatory for this WBT
Objective
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Basel III – Highlights
Basel III
Capital
Market Risk
Pillar 2 &
Pillar 3**Securitisation
Liquidity
Risk
Counterparty
Credit Risk
Stress calibration of CCR measures New risk measure – CVA for MTM losses
CVA Capital Charge – Adv & Std
Pillar 1 RWA for Specific Wrong Way Risk
AVC multiplier for exposures to FI
Increased margin period & collateral haircuts
Incentives to move to CCP
Increased MR Specific Risk Charge for
equities, credit derivatives
Enhanced VaR modeling, MR stress
testing guidelines
New risk measures - Incremental Risk
Charge, Stressed VaR
Enhanced Pillar 2 guidelines for
Securitisation, illiquid positions, wrong wayrisk, Model Validation, Back Testing, Credit
Rating Agencies
Enhanced disclosures for Securitisation
exposures in Trading Book, Market Risk,
Counterparty Credit Risk (incl. Wrong Way
Risk)
Higher risk weights for resecuritisations
Banks not permitted to use “Ratingsresulting from self-guarantees”
Increased CCF for Liquidity facilities
Specific Risk Charge alignment across
Banking Book & Trading Book
New measure “CRM” for Correlation
Trading Portfolio
Increase in quality and quantity of capital
New Capital deductions from CET1 (DTA)
Increase in minimum capital ratios Capital buffers, Leverage Ratio , Capital
Surcharge (SIFI)
Liquidity Coverage Ratio (LCR) – High
quality liquid assets to sustain a significant
30-day stress scenario
Net Stable Funding Ratio (NSFR) - stable
sources of funding ( 1 year horizon)
Monitoring metrics - Contractual maturity
mismatch, Concentration of funding,
Available unencumbered Assets, Market-
related monitoring tools** Not in scope
for this WBT
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Key Timelines – Basel III
Source : BCBS Basel III Timelines
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Liquidity Risk Management
Fundamental Principles of LRM as per BCBS
LRM Basel III Key Changes
LRM Functional View
LRM Data Sources
LRM Liquidity Risk Measures
LRM Capital & Liquidity Gap under Basel III – An
example
LRM Introduction
LRM Monitoring
LRM Stress Test
LRM Governance - Principles & Supervision
LRM Public Disclosures
LRM Summary
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Liquidity Risk Management (LRM) - Genesis
In 2008 & 2009, BCBS published “Principles for Sound Liquidity Risk Management & Supervision” & a
consultative document, proposing new measures to strengthen liquidity regulations in the banking sector. The BIS guidelines for LRM published under BCBS144*, 165* & 188* require all banks to significantly enhance
their liquidity risk infrastructure & functionality in providing granular liquidity-related data, in-depth analysis &
reporting
The two key metrics introduced under Basel III- LRM are
– Liquidity Coverage Ratio (LCR)
– Net Stable Funding Ratio (NSFR)
There are other monitoring tools which includes Contractual Maturity Mismatch, Concentration of Funding,
Instruments & Currencies & tracking of Available Unencumbered Assets.
A strong Governance Model should be put in place to develop , review & approve strategies, policies &
practices related to management of liquidity effectively
BCBS *LRM
Papers
Assessment
Impact AnalysisImplementation Observation Liquidity Reporting
2008 - 2010 2010 - 20112011 -
2012
2013 -
20152015 - 2018
*BCBS - 165 International Framework for Liquidity Risk Measurement, Standards & Monitoring
*BCBS - 144 Principles for Sound Liquidity Risk Management & Supervision
*BCBS 188 - International framework for liquidity risk measurement, standards & monitoring
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Liquidity Risk – Introduction (1/4)
“One of the main reasons the economic and financial crisis became so severe was thatthe banking sectors of many countries had built up excessive on- and off-balance sheetleverage.
This was accompanied by a gradual erosion of the level and quality of the capital base.
At the same time, many banks were holding insufficient liquidity buffers.
The banking system therefore was not able to absorb the resulting systemic trading andcredit losses nor could it cope with the re-intermediation of large off-balance sheetexposures that had built up in the shadow banking system.
The crisis was further amplified by a procyclical deleveraging process and by the
interconnectedness of systemic institutions through an array of complex transactions”
Basel Comm it tee, Strengthening the resi l ience of the banking sector -
cons ul tat ive document
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Liquidity Risk – Introduction (2/4)
Asset and liability mismatch generates not only interest rate
risk liquidity risk
Different meaning of “liquidity”:
Secur i ty ease with which it can be cashed back or traded, evenin large amounts, on a secondary market
Market
liquidity of the securities traded in the market
different proxies of liquidity (e.g. bid-ask spread, volume)
Affected by many factors: n. market participants, size & frequency of trades, degree ofinformational asymmetry, time needed to carry out a trade
Function of tightness (market’s ability to match supply and demand at low cost) and depth(ability to absorb large trades without significant price impact)
Financ ial inst i tut ion ability to fund increases in assets andmeet obligations as they come due, without incurring high losses
Generally proxied by the difference between the average liquidity of assets and that ofliabilities
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Liquidity Risk – Introduction……..(3/4)
Selling assets
at a price belowtheir market
value
transformationof
short-termdeposits into
long-term loans
Prepayment of loans
UnforeseenUsage of
Credit lines
Inability to
paybackliabilities
Eventsleading to
Liquidity Risk
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LRM Introduction…………..(4/4)
TransactionalLiquidity
Risk
Market
liquidity risk
Tradability
risk
Long-termfunding risk
Party A fails to fulfill
liquidity to execute
transaction
Other counterparties
Subsequently lack liquidity,
creating trust issues
in the market
Uncertain, lower-quality
assets are no longer
accepted for trade or
collateral against liquidity
Market refrains
from providing
liquidity
Part of banks’ existing
liquidity buffer – de facto –
becomes illiquid
Banks compete for
increasingly smaller pool
of liquidity
Accrued difficulty to fund
ongoing bank activity on
the interbank market
Difficulty providing sufficient
and timely assets for
transactions increases
1
2
3
45
6
7
8
Liquidity Risk – Vicious Cycle
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Fundamental Principles of LRM as per BCBS
Fundamental principle
1.A bank needs to establish a robust liquidity risk management framework
Governance of liquidity risk management
2.A bank should clearly articulate a LR tolerance appropriate for its business strategy and role
3.Senior management needs to be actively involved in LRM
4.Liquidity costs need to be factored into internal transfer pricing, so that LR is considered adequately
Measurement & management of liquidity risk
5.A bank should have sound a process for identifying, measuring, monitoring and controlling LR
6.A bank should actively monitor and control LR exposures throughout the group and take into account legal, regulatory and
operational limitations to the transferability of liquidity7.A bank should establish a funding strategy for effective diversification of sources / tenor of funding
8.A bank should actively manage its intraday liquidity positions and risks
9.A bank should actively manage its collateral positions
10.A bank should conduct stress tests regularly and use the results to adapt strategy / positions
11.A bank should have a formal contingency funding plan
12.A bank should maintain a cushion of high quality liquid assets as insurance against a range of liquidity stress
scenarios (see International framework for LRM)
Public Disclosure
13.A bank should issue regular public disclosure on LRM and positions
Role of supervisors
14.Comprehensive assessment of liquidity risk management framework
15.Monitoring of internal reports, prudential reports & market information
16.Effective and timely intervention (New)
17.Communication with other supervisors and public authorities
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LRM Basel III - Key Changes
# Basel III - LRM 2010 BCBS Guidelines
* ALM Guidelines
^ LCR – Liquidity Coverage Ratio
% NSFR – Net Stable Funding Ratio
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LRM Functional View
Cash Flow DataTransaction
DataHistorical DataPosition Data
Reference
DataALM Data
Pricing /
Valuation
Bank’s Assets and Liabilities
Governance & Liquidity Policies Regulatory Requirements
LRM Components Cash Flow Engine
Cash Inflow
Cash Outflow
Monitoring Tools
Maturity Mismatch
Funding Concentration
Market Monitoring
Unencumbered Assets
LCR by Currency
Public Disclosures
Daily Cash Flow Reports
Enhanced Mismatch Reports
Local Regulators(OSFI,APRA ..)
Disclosures
Quantitative Analysis
Risk Models Simulations
Reconciliation
Scenario Analysis
Stress Testing
Extreme Stressed Scenario
Stressed Cash Flow
Limits Management
Behaviour Analysis
LCR NSFR
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LRM Data Sources
Source System Data
• Cash Flows
• Transaction Data
• Position Data
• Reference Data
• Market Data
• Security Data
• Historical Data• Internal Limits
Data Mapping / Business Rules / ReconciliationCategorize Data
• ON Balance Sheet / OFF Balance Sheet
• Banking Book / Trading Book
• Data Hierarchy / Liquidity Category
• Legal Entity / Business Units
• Reporting Lines
• Asset / Liability
• Transformation
• Source Target Data Check
• Data Validation / Integrity Check
• Data Reconciliation
• Defaulting / Enrichment / Aggregation / Limit
LRM Ready Data
• Analytics Data
• Stressed Data
• Ratio Calculation Data
• Forecasting Data
• Limits Data
• Reporting Data
• Exception Data
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LRM Liquidity Risk Measures (1/9)
Basel Committee has developed two standards to be used in
supervision of liquidity risk.
1.The Liquidity Coverage Ratio, addresses the sufficiency of a stock of
high quality liquid assets to meet short-term liquidity needs under a
specified acute stress scenario.
2.The Net Stable Funding Ratio, addresses longer term structural
liquidity mismatches.
Source: http://www.liquidity-coverage-ratio.com
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LRM Liquidity Risk Measures…..(2/9)
The liquidity coverage ratio identifies how much of unencumbered, high
quality liquid assets an institution needs to hold, which can be used to
offset the net cash outflows under an acute short-term stress scenario
specified by supervisors.
The scenario entails:
• a significant downgrade of the institution’s public credit rating;• a partial loss of deposits;
• a loss of unsecured wholesale funding;
• a significant increase in secured funding haircuts; and
• increases in derivative collateral calls and substantial calls on
contractual and non contractual off-balance sheet exposures, includingcommitted credit and liquidity facilities.
Source: http://www.liquidity-coverage-ratio.com
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LRM Liquidity Risk Measures…..(3/9)
Liquidity Coverage Ratio (LCR)
Aims to ensure adequate level of unencumbered high quality liquid assets which can be liquidated
during stress scenarios to endorse net cash outflow for the next 30 calendar days.
Stock of High quality liquid assets (HQLA)
LCR = --------------------------------------------------- ≥ 100%Net cash outflows over a 30-day time period
Liquidity Coverage Ratio
•Defines level of liquidity buffer to be held to cover short-term funding gaps under
severe liquidity stress
•Has a Cash flow perspective
•Predefined stress scenario
•Time horizon: 30 days
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LRM Liquidity Risk Measures…..(4/9)
High Quality Liquid Assets
There are two categories of assets that can be included in the stock
namely Level 1 & Level 2.
Level 1 assets can be included without limit while Level 2 assets
can only comprise 40% of the stock.
These Level 1 & Level 2 assets are considered to be high-quality
liquid assets (HQLA) if they can be easily and immediately converted
into cash at little or no loss of value.
The liquidity of an asset depends on the underlying stress scenario,
the volume to be monetised and the timeframe considered.
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LRM Liquidity Risk Measures…..(5/9)
Level 1 Assets
Level II Assets
Assets can comprise an unlimited share of pool, are held at market value and are not subject to haircut under LCR
Cash
Central Bank Reserve
– To the extent that can be drawn during stress times
Marketable Securities
– Representing claims guaranteed by sovereigns, central banks, PSEs, BIS ,
– IMF 0% risk weight according to Basel II Standardized Approach
Non 0%risk-weighted sovereigns
– Sovereign or central bank debt securities issued in domestic currencies by the sovereign or central bank in thecountry
– Domestic sovereign or central bank debt securities issued in foreign currencies,
Subject to the requirement that they comprise no more than 40% of overall stock after haircuts have been applied
Level I assets generated by secured funding transactions maturing within 30 days
Corporate Bonds and Covered Bonds
– Not issued by any financial institutions or bank itself or respective affiliated entities
– Rated AA- or higher by ECAI
Marketable securities
– Representing claims guaranteed by sovereigns, central banks, PSEs, BIS , IMF
– Maximum of 20% risk weight according Basel II Standardized Approach
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Portfolio’s should have least
correlation
Being listed increases assets
transparency.
Unencumbered Asset shouldn't be
pledged as a collateral except for
some exceptions
These assets tend to have higher
liquidity. Low credit and market risk
lowers duration, volatility, inflation
risk and foreign exchange risk
enhancing asset's liquidity.
Fundamental
Characteristic
of HQLA
Ease and
Certainty of
Valuation
Eligible for
Intraday
Liquidity Needs
Low
CorrelationWith Risky
Assets
Low Credit
And MarketRisk
Listed on
Recognized
Stock
Exchange
Unencumbered
Asset
Eligible by central bank for intraday liquidity
needs.
The asset price calculation formula of high-
quality assets should be simple and not
depend on strong assumptions.
LRM Liquidity Risk Measures…..(6/9)
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Asset should have active outright
sale or repurchase agreement
markets at all times
Quotes will most likely be available
for buying and/or selling a high-
quality liquid asset.
Diverse group of buyers and sellers
in an asset’s market increases the
reliability of its liquidity
Historically, the market has shown
tendencies to move into these
types of assets in a systemic crisis
LRM Liquidity Risk Measures…..(7/9)
HQLA Market
Characteristic
Active and
SizeableMarket
Flight toQuality
Presence
of Committed
Market
Makers
Low Market
Concentration
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LRM Liquidity Risk Measures…..(8/9)
Net stable Funding Ratio
Available Stable Funding (ASF)
= --------------------------------------------- ≥ 100%Required Stable Funding (RSF)
RSF Factor ASF Factor
Assets
Unencumbered
Assets
Consumer loans
Corporate Loans
Inter Bank Loans
0 % - 50 %
85 % - 100 %
50 % - 100 %
50 % - 100 %
LongTerm
Funding
Liabilities
Non Core Deposit
Core Deposit
Long Term Funding
Equity
70 %
85 % - 100 %
100 %
100 %
LongTerm
Funding
Short Term Funding 0 % - 50 %
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LRM Liquidity Risk Measures…..(9/9)
NSFR promotes medium to long-term funding thus reducing incentives forshort-term wholesale funding and supplements the LCR (by counterbalancing
“cliff -effects”)
•The stress scenario is defined differently from the one underlying the LCR –
idiosyncratic stress over 1 yr
•“Stable funding” is defined as those types of equity and liabilities expected to
be reliable sources of funds under an extended stress scenario of one year
•For determination of the required funding amount accounting and regulatory
treatment is irrelevant –required funding amount depends solely on the
respective instrument’s liquidity characteristics
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ABC Bank’s Capital & Liquidity Gap under Basel III..(1/2)
ABC bank faces material shortfalls of both tier 1 and tier 2 capital under Basel III
•The planned business growth leads to a potential material breach of the upcoming maximum leverage ratios
•Under the upcoming mandatory liquidity ratios, the bank would be obliged to hold at least 200m additional
liquid funds in order to sustain the LCR Funding test
•As a consequence, the bank’s plans need to be materially adapted in order to reflect the additional capital
and liquidity needs of Basel III
Basel III Impact 2011 2012 2013 2014 2015
RWA under Basel
III
RWA banking book 1600 1899 2282 2726 3270
RWA trading
book(x12.5)
938 1078 1240 1426 1640
Total RWA 2538 2977 3522 4152 4910
Required Tier I
capital under Basel
III
114 149 194 270 344
Required total
capital under BaselIII
228 268 370 436 516
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Basel III Impact 2011 2012 2013 2014 2015
Capital shortfallunder Basel III
Tier I Capital
shortfall
42 50 13 -42 -88
Total Capital
shortfall
10 23 -76 -103 -137
Leverage ratio
limitations
Leverage ratio
under Basel III
31X 29X 34X 37X 40X
Maximum leverage
3%
33X 33X 33X 33X 33X
Adjustment need 2X 4X -1X -4X -7X
Liquidity ratios
Basel III LCR
funding gap
0 0 0 0 -200
Basel III LTFR
(observation)
141% 137% 130% 126% 123%
ABC Bank’s Capital & Liquidity Gap under Basel III..(2/2)
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LRM Cash Flow (1/3)
Total Cash Outflows
Total expected cash outflows = Outstanding balances of various categories or types of liabilities and
off-balance sheet commitments * rates at which they are expected to run off or be drawn down.
Total expected cash inflows = Outstanding balances of various categories of contractual receivables *
rates at which they are expected to flow in under the scenario up to an aggregate cap of 75% of total
expected cash outflows
Total Net Cash outflows over the next 30 calendar days = outflows - Min (Inflows; 75% of
outflows)
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LRM Cash Flow (2/3) – Cash Outflow Categorization
Retail
DepositRun offs
Secured
WholesaleFunding Run-offs
Unsecured
WholesaleFunding Run-offs
AdditionalRequirements
Deposits from anindividual
natural person
Secured Fundingcollateralized
by level 1 assets (run-offrate = 0%)
Provided by smallbusiness customers(5%, 10%, 15% and
higher)
Derivatives Payable(run-off rate = 100%)
Retail depositsSubjectto LCR include demand
deposits and termdeposits
Secured Fundingcollateralized
by level 2 assets (run-offrate = 15%)
Funding with
operational relationships(run-off rate = 25%)
Valuation change onposted collateral
securing derivativetransaction of non-Level 1
Asset (run-off rate = 20%)
Stable deposits(run-off rate = 5% or
higher)
Secured Funding withdomestic sovereigns,
central banks, or PSEs(run-off rate = 25%)
Treatment of deposits ininstitutional networks of
cooperative banks (run-offrate = 25%)
Liabilities related toderivative collateral callsrelated to a downgrade ofup to 3-notches.(run-off
rate = 100%)
Less stable deposits
(run-off rate = 10% or higher)
All other Secured
funding (run-off rate =100%)
Provided by Non-financial
corporate, sovereigns,central bank and PSEs(run-off rate = 75%)
Liabilities maturing within
30 calendar days(outflow rate = 100%)
Other Legal entitycustomers
(run-off rate = 100%)
Draw-downs on credit andliquidity facilities havedifferent run off rates
Other Contractual cashoutflows (outflow rate =
100%)
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LRM Cash Flow (3/3) – Cash Outflow categorization
Reverse Repo and
SecuritiesBorrowings
Other CashInflows Inflows byCounterparty OperationalDeposits
Level I assets if collateral not
used to covershort positions -0%
if collateral used
to cover shortpositions- 0%
DerivativesReceivable
(Inflow rate = 100%)
Retail and SmallBusiness
Inflow (inflow rate =50%)
Inflow rate is 0%since deposits heldat other institution
for operationalpurpose areassumed to
stay with institution
Credit or
Liquidity Facility
The draw-down rateis 0%
since Credit,liquidity, or any othercontingent fundingthat bank holds at
other institution forits own purpose areassumed to be
unable to be drawnin stress times.Level II assets
if collateral notused to covershort positions-15%
if collateral usedto cover short
positions – 0 %
For all the remainingcontractual
inflows,its inflowrate is
decided by thesupervisor
Other wholesaleInflow 100% inflows
from financialinstitutioncounterparties
50% inflow ratefor non- financial
wholesalecounter parties
Valuation changeson posted collateralsecuring derivative
transactions of non-Level 1 Assets (run-
off rate = 20%)
All other collateral if collateral not
used to covershort positions -100%
if collateral usedto cover shortpositions - 0%
Liabilities related toderivative collateral
calls related to adowngrade of up to3-notches.(run-off
rate = 100%)
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LRM Monitoring (1/4)
Contractual
Maturity
Mismatch
Funding
Concentration
Market
Monitoring
Unencumbered
Assets
Contractual maturity used as
behavior model Measures time to insolvency
No short-term funding is rolled
over
To monitor concentration of
Counterparty , Product andCurrency
Funding should be
diversified
Equity prices, debt markets,
Forex markets etc
Monitoring financial sector
Monitoring bank specific
(i) Eligible for collateral, or, (ii)
Eligible for central bank facilities
Amount , Currency denomination
Estimated market haircut
Location/Business unit
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LRM Monitoring (2/4) – Maturity Mismatch Report
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LRM Monitoring (3/4) - Funding Concentration Report
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LRM Monitoring (4/4) – Market Monitoring
$65,656,875
$7,471,425
$9,854,758
$5,869,854
$58,874,125
$25,852,541
$69,852,365
$58,744,523
Geography wise
North America
Latin America
Africa
EMEA
Asia
APAC
BRIC
AUSTRALIA
1.0000%
5.0000%
4.2000%
1.2000%
3.0000%4.2000%
1.2000%
3.0000%
1.0000%
5.0000%
4.2000%
Returns Quarterly
Information Technology
Banking & Finance
Aviation
Oil and Gas
Construction
Telecommunication
Food and Drinks
Mining
Transport
$6,502,521
$685,214
$85,241
$5,878,962$258,524
$6,985,425
$7,035,319
$25,874,152
Asset Type wise
Bonds
Forex *
Swaps*
Options*
Futures*
Forwards*
EquitiesMoney Market
$1,325,822
$14,568,752
$6,515,852
$5,236,517
$25,658,415
Portfolio wise
Emerging Markets
Blue Chips
Infrastructure
Energy & Utilities
Technology
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A bank should conduct stress tests on a regular basis for a variety of short-term and protracted
institution-specific and market-wide stress scenarios (individually and in combination) to identify sources
of potential liquidity strain and to ensure that current exposures remain in accordance with a bank’s
established liquidity risk tolerance.
A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and
positions and to develop effective contingency plans.
This stress test should be viewed as a minimum supervisory requirement for banks.
Banks are expected to conduct their own stress tests to assess the level of liquidity they should hold
beyond this minimum, and construct their own scenarios that could cause difficulties for their specific
business activities.
Such internal stress tests should incorporate longer time horizons than the one mandated by this
standard. Banks are expected to share the results of these additional stress tests with supervisors.
Refer Basel III: International framework for liquidity risk measurement , standards & monitoring Para 19
LRM Stress Test (1/2) - Guidelines
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LRM Stress Test (2/2) - Methodology
Erosion in value of
liquid assets
Additional collateral
requirements
Evaporation of
funding
Withdrawal of
deposits etc
External scenarios
Emerging markets
crisis,systemic shock
in maincentres of
business,market risk
Internal scenarios
Operational risk,
ratings Downgrade
Ad-hoc scenarios
e.g. Country/industry
specific
Step 1
Quantify liquidity
outflows in all scenarios
for each risk driver
Step 2
Identify cash inflows to
mitigate liquidity
shortfalls identified
Step 3
Determine net liquidity
position under each
scenario
Identify Liquidity
Risk Drivers
Design StressScenarios (and
Probabilities)
Model Stress
Tests
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LRM Governance Principles & Supervision
Key elements
Of robust
framework for
liquidity risk
management
Governance of
liquidity
Risk Management
Measurement
and
Management of
Liquidity risk
Public Disclosure The Role of
supervisors
Board and senior
management oversight
Establishment of
policies and risk
tolerance
Comprehensive cash
flow
forecasting
Limits and liquidity
scenario stress testing
Robuust and
multifaceted
contingency
funding plans
Maintenance of
sufficient
cushion of HQLA
Clearly articulate
liquidity risk tolerance
for
business strategy
Strategy policies
and practices in tandem
with risk tolerance
Incorporate
liquidity costs
Incorporate benefits and
risks ininternal pricing
performance measure
& new product
approval process
Identifying, measuring,
monitoring and
controlling liquidity risk
Projecting cash flows
from assets, liabilities
and off- B/S items
Actively manage Intra-
day liquidity positions
Actively manage
collateral positions
Conduct stress tests
on a regular basis
Contingency funding
plan that addressing
liquidity shortfalls
Disclose information
On regular basis
Market participants to
make an informed
judgment
regularly perform a
comprehensive
assessment
Monitoring combination
of internal , prudential
reports and mkt info
Communicate with other
supervisors and
public authorities
Key Highlights of Committee’s Proposal
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LRM Public Disclosures
A bank needs to disclose sufficient information regarding its liquidity risk management to enable
relevant stakeholders to make an informed judgment about the power of the bank to meet itsliquidity needs
These include quantitative & qualitative disclosures such as
Organizational structure and framework for the management of liquidity risk
The degree to which the treasury function and liquidity risk management is centralized or
decentralized
The aspects of liquidity risk to which the bank is exposed and that it monitors
Diversification of the bank's funding sources
Explanation of how stress testing is used
Description of the stress testing scenarios modeled
Regulatory restrictions on the transfer of liquidity among group entities.
The frequency and type of internal liquidity reporting
Regulatory reports like LCR, NSFR & Maturity mismatch Drilldown reports Portfolio wise, Fund concentration, Cash flows and Aggregate Reports
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LRM Summary
Background
The recent credit crisis compounded quickly into a major liquidity crunch leading to insolvency of majorfinancial institutions
Inadequate liquidity management in almost all banks
No dedicated liquidity buffer or liquidity portfolio in banks
BCBS Response
17 Principles for Sound Liquidity Risk Management and Supervision ( BCBS 144). Importance of managing liquidity contingency buffer similarly as capital
Maintaining High Quality liquidity portfolio that can hedge out liquidity outflows under stress scenarios
Improved Risk Policies, Procedures & Governance to be reviewed & implemented
Action on Banks
The Basel III Liquidity regulation imposes significant challenges to banks for enhancing existing liquidity
measurement and management methods Improved Governance Policies for Liquidity Risk ( Review, Modify)
Sophisticated scenario based approach ( Stressed Scenarios) for LRM
Completely Revamp their Liquidity Risk System to include Calculation of LCR, NSFR and Monitoring
Tools as per BCBS papers
Periodically inform Regulator about their LRM approach and get necessary guidance & approval
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Basel III - Capital Requirements
Composition of Capital
Capital Adjustment
Former deduction from capital
Capital Conservation Buffer
Counter Cyclical Buffer
Leverage Ratio
Summary
What changes in Basel III
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Why Basel II has changes
Raising the quality,
consistency and transparency
of the capital base
Reducing procyclicality and
promoting countercyclical
buffers
Supplementing the risk-
based capital requirement
with a leverage ratio
Basel II – key
weaknessBasel II –
key changes
Many regulatory adjustments
are not applied to common
equity, allowing to report highTier 1 ratios
No harmonized list of regulatory
adjustments
Hybrid capital proved to be lessvaluable in times of stress than
anticipated
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Composition of Common Equity Tier 1 Capital
Common shares issued by thebank that meet the criteria for
classification as common
shares for regulatory purposes(or the equivalent for non-joint
stock companies);
Stock surplus (sharepremium) resulting from the
issue of instruments includedCommon Equity Tier 1;
Retained earnings;
Accumulated othercomprehensive income andother disclosed reserves;
Common shares issued byconsolidated subsidiaries ofthe bank and held by third
parties (ie minority interest)that meet the criteria for
inclusion in Common Equity
Tier 1 capital.
Regulatory adjustmentsapplied in the calculation of
Common Equity Tier 1
CommonEquity Tier 1
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Composition of Additional Tier 1 Capital
Instruments issued by the bank thatmeet the criteria for inclusion inAdditional Tier 1 capital (and are notincluded in Common Equity Tier 1);
Stock surplus
(share premium)resulting from theissue of
instrumentsincluded in
Additional Tier 1capital;1;
Instruments issued by consolidatedsubsidiaries of the bank and held bythird parties that meet the criteria forinclusion in Additional Tier 1 capital
and are not included in CommonEquity Tier 1.
Regulatoryadjustmentsapplied in thecalculation of
Additional Tier 1Capital
AdditionalTier 1 Capital
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Composition of Common Equity Tier 1 Capital
Instruments issued by the
bank that meet the criteriafor inclusion in Tier 2 capital(and are not included in Tier1 capital)
Stock surplus (sharepremium) resulting fromthe issue of instrumentsincluded in Tier 2 capital
Instruments issued byconsolidated subsidiaries
of the bank and held bythird parties that meet the
criteria for inclusion inTier 2 capital and are notincluded in Tier 1 capital
Certain loan lossprovisions
Regulatory adjustments
applied in the calculationof Tier 2 Capital
Common
Equity Tier 1
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Capital adjustments
Goodwill and other
intangibles (except
mortgage servicing
rights)
Shortfall of the stock ofprovisions to expected
losses
Investments in own
shares (treasury stock)
Deferred tax assetsGain on sale related to
securitisation transactions
Reciprocal cross holdings
in the capital of banking,
financial and insurance
entities%)
Cash flow hedge reserve Defined benefit pensionfund assets and liabilities
Capital
Adjustment
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Former deductions from capital
Treatment
• The following items, which under Basel II were deducted 50% from Tier 1 and 50% from Tier 2 (or hadthe option of being deducted or risk weighted), will receive a 1250% risk weight:
Certain securitisation exposures;
Certain equity exposures under the PD/LGD approach;
Non-payment/delivery on non-DvP and non-PvP transactions;
Significant investments in commercial entities
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Capital Conservation Buffers
Background
• The capital conservation buffer, which is designed to ensure that banks build up capital buffers outsideperiods of stress which can be drawn down as losses are incurred.
Requirement
• A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above theregulatory minimum capital requirement
Restriction
• Mentioned below are the minimum capital conservation ratios a bank must maintain for various levels
of the Common Equity Tier 1 (CET1) capital ratios
• Common Equity Tier 1 Ratio is 4.5% - 5.125% then the MCCR (Minimum Capital Conservation
Ratios) to be maintained is 100%
• Common Equity Tier 1 Ratio is >5.125% - 5.75% then the MCCR to be maintained is 80%
• Common Equity Tier 1 Ratio is >5.75% - 6.375% then the MCCR to be maintained is 60%
• Common Equity Tier 1 Ratio is >6.375% - 7.0% then the MCCR to be maintained is 40%
• Common Equity Tier 1 Ratio is > 7.0% then the MCCR to be maintained is 0%
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Counter Cyclical Buffers
Background
• The countercyclical buffer regime consists of the following elements:
• National authorities will monitor credit growth and other indicators that may signal a build up of
system-wide risk and make assessments of whether credit growth is excessive and is leading to
the build up of system-wide risk
• Internationally active banks will look at the geographic location of their private sector credit
exposures and calculate their bank specific countercyclical capital buffer
Disclosure
• Public disclosure of how the bank is calculating the countercyclical buffers .
Restrictions
• Each Basel Committee member will identify an authority with the responsibility to make decisions on
the size of the countercyclical capital buffer
• This will vary between zero and 2.5% of risk weighted assets, depending on their judgment as to the
extent of the build up of system-wide risk
• If a bank's capital level falls into the extended buffer range, they would be given 12 months to get
their capital level within the acceptable range before restrictions on the distributions of their earnings
come into effect. Any decision to decrease Countercyclical Buffer will take effect immediately. The
Buffer decisions along with the actual Buffers will be announced on the BIS website
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Leverage Ratio
What is leverage ratio
• constrain the build-up of leverage in the banking sector, helping
avoid destabilising deleveraging processes which can damage
the broader financial system and the economy; and
• reinforce the risk based requirements with a simple, non-riskbased “backstop” measure.
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Calculation of Leverage Ratio
Leverage RatioTotal Capital
= ---------------------------------------------Total On and Off Balance Sheet Exposure
Capital measure
The capital measure for the leverage
ratio will be based on the new
definition of Tier 1 capital
Exposu re measure
On-balance sheet items
(a) Treatment of Repurchase agreements
and securities finance
(b) Treatment of Derivatives
General measurement principles
Items that are deducted completely
from capital do not contribute to
Leverage and will be deducted fromthe measure of exposure Off-balanc e sheet items
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Summary
Composition of Tier 1 capital and Tier 2 Capital.
Phasing out of Tier 3
Requirement of Capital Conservation Buffers
Restriction related to Capital Conservation Buffer
Requirement of Counter Cyclical Buffers
Restriction related to Counter Cyclical Buffer
Composition of Leverage Ratio
Parallel run for Leverage ratio
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Agenda
Counterparty Credit Risk (CCR) - Introduction
Changes in Basel III on CCR
Wrong Way Risk
Credit Valuation Adjustment (CVA)
Types of CVA Capital Charges
Types of Aggregation of CCR Capital Charges
Qualitative Criteria
Other measures
Summary
Other Changes
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Counterparty Credit Risk (CCR) - Introduction
What is CCR ?
The counterparty credit risk (CCR) is defined as the risk that the counterparty to a
transaction could default before the final settlement of the transaction’s cash flows.
In 2007,the financial crisis spread to financial market causing systematic risk, preparing
the context to analyze impact on derivatives and financial risk management on
counterparty credit risk (CCR).
CCR covers loans and repo transactions, and most importantly, the enormous volume of
over-the-counter (OTC) derivatives.
Unlike a firm’s exposure to credit risk through a loan, where the exposure to credit risk is
unilateral and only the lending bank faces the risk of loss, the counterparty credit risk
creates a bilateral risk of loss - the market value of the transaction can be positive or
negative to either counterparty to the transaction
Changes in Basel III on CCR
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Changes in Basel III on CCR
- 5 3 -
CCR Focus Areas
C r e d i t V a l u a t i o n A d j u s t m e n t
W r o n g W a y R i s k
C V A C a p i t a l C h a r g e
G
e n e r a l W r o n g W a y R i s k
S p
e c i f i c W r o n g W a y R i s k
O t h e r M e a s u r e s
A g g
r e g a t i o n o f C C R C a p i t a l
Q u a l i t a t i v e C r i t e r i a
Changes in Basel III on Counterparty Credit Risk (CCR)?
Basel III introduces measures to strengthen the capital requirements for Counterparty for
counterparty credit exposures arising from banks’ derivatives, repo and securities financingactivities. The building blocks as described in the diagram above are explained in later
slides.
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Other changes - CCR Reform Objectives
Why CCR reform ?
The Reform Objectives for Counterparty Credit Risks as in Basel III are as follows
– Determine capital requirement for counterparty credit risk using stressed inputs
– Introduce a capital charge for potential mark-to-market losses (ie credit valuation
adjustment - CVA - risk) associated with a deterioration in the credit worthiness of a
counterparty
– Apply longer margining periods as a basis for determining the regulatory capital
requirement
– Address the systemic risk arising from the interconnectedness of banks and other
financial institutions through the derivatives markets
– Address the treatment of so-called wrong-way risk, ie cases where the exposure
increases when the credit quality of the counterparty deteriorates
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other Changes - Counterparty Credit Risk (CCR) –
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Other Changes Counterparty Credit Risk (CCR)
Key Terms
What is Exposure?
A few Key Terms are Introduced below
– Counterparty exposure is the larger of zero and the market value of the portfolio of
derivative positions with a counterparty that would be lost if the counterparty were to
default and there were zero recovery. Counterparty exposures created by OTC
derivatives are usually only a small fraction of the total notional amount of trades with a
counterparty
– Expected positive exposure (EPE) is the average Expected Exposure EE(t) for t in a
certain interval (for example, for t during a given year).
– Potential future exposure (PFE) is the maximum amount of exposure expected to
occur on a future date with a high degree of statistical confidence.
W W Ri k
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Wrong Way Risk
Wrong-way risk is an unfavourable correlation between exposure and counterparty credit quality (i.e.
the exposure is high when the counterparty is more likely to default and vice versa).
Wrong-way risk is often difficult to define. For example, general empirical evidence supports a
clustering of U.S. corporate defaults during periods of falling interest rates.
If users of derivatives are hedging then they should generate right-way risk.
?
T f W W Ri k
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Types of Wrong Way Risk
The following are the Types of Wrong Way Risk
General Wrong-Way Risk arises when the probability of default of counterparties is positively
correlated with general market risk factors.
Specific Wrong-Way Risk arises when the exposure to a particular counterpart is positively correlated
With the probability of default of the counterparty due to the nature of the transactions with the
counterparty.
?
S ifi W W Ri k
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Specific Wrong Way Risk
A bank is exposed to “specific wrong-way risk” if future exposure to a specific counterparty is highly
correlated with the counterparty’s probability of default.
For example, a company writing put options on its own stock creates wrong way exposures for the
buyer that is specific to the counterparty.
A bank must have procedures in place to identify, monitor and control cases of specific wrong way risk,
beginning at the inception of a trade and continuing through the life of the trade.
?
For single-name credit default swaps , EAD equals the full expected loss in the remaining fair value of
the underlying instruments with the assumption that the underlying issue is in liquidation
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
G l W W Ri k
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General Wrong Way Risk
General Wrong-Way Risk arises when the probability of default of counterparties is positively
correlated with general market risk factors.
Stress testing and scenario analyses must be designed to identify risk factors that are positively
correlated with counterparty credit worthiness.
Banks should monitor general wrong way risk by product, by region, by industry, or by other categories
that are related to the business.
?Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
C dit V l ti Adj t t (CVA)
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Credit Valuation Adjustment (CVA)
Credit value adjustment (CVA) is the difference between the risk-free portfolio value
and the true portfolio value that takes into account the possibility of a counterparty’s default..
This adjustment can be either positive or negative, depending on which of the two counterparties
bears the larger burden to the other of exposure and of counterparty default likelihood
Example
For example, assume Party X is the Euro receiver in a Euro-US dollar currency swap, where the mid-
market valuation is 100. Assume this valuation already includes an effective market value of 2 for the
default risk to Party X, but the swap carries a net market value of default risk (to Party X) of 6. Then
the CVA is a downward adjustment of 4, leaving a fair market value of (to Party A) of 96
T f C dit V l ti Adj t t (CVA) C it l Ch
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Types of Credit Valuation Adjustment (CVA) Capital Charge
Types ofCVA Capital Charge
Banks with IMM approvaland Specific Interest Rate
Risk VaR model approval
for bonds -
Advanced CVA risk capital
charge
All other banks -standardised CVA risk
capital charge
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
A ti f CCR C it l Ch
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Aggregation of CCR Capital Charge
Types of Aggregationof
CCR Capital Charge
Banks with IMM approval
and market-risk internal-
models approval for the
specific interest-rate risk
of bonds
Banks with IMM approval
and without Specific Risk
VaR approval for bonds
All other banks
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Banks with IMM approval and Market-risk Internal
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Banks with IMM approval and Market-risk Internal
Further details :-
The total CCR capital charge for such a bank is determined as the sum of the following
components
– The higher of (a) the IMM capital charge based on current parameter calibrations forEAD and (b) the IMM capital charge based on stressed parameter calibrations for EAD.
– The advanced CVA risk capital charge
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Models approval for the Specific Interest-rate Risk of Bonds
Banks with IMM approval and without Specific Risk VaR
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approval for Bonds
Further details :-
The total CCR capital charge for such a bank is determined as the sum of the following
components
– The higher of (a) the IMM capital charge based on current parameter calibrations for
EAD and (b) the IMM capital charge based on stressed parameter calibrations for EAD.
– The standardised CVA risk capital charge
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
All Other Banks
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All Other Banks
Further details :-
The total CCR capital charge for such a bank is determined as the sum of the following
components
– The sum over all counterparties of the CEM or SM based capital charge (depending on
the bank’s CCR approach) with EAD
– The standardised CVA risk capital charge
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Qualitative requirements
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Qualitative requirements
Basel has prescribed certain qualitative measures to cover the inadequacies in banks’ margining
practices, backtesting and stress testing program
The banks using the Internal Model Methods (IMM) are required to follow these qualitative
requirements .
?
Other measures Enhanced Collateral Management Requirement
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Other measures Enhanced Collateral Management Requirement
Qualitative Criteria
• The Bank must have a collateral management unit that is responsible for calculating and
making margin calls, managing margin call disputes and reporting levels of independent
amounts, initial margins and variation margins accurately on a daily basis.
•The unit is required to track the extant of reuse of collateral and the concentration to
individual asset classes accepted by the bank.
•The enhanced collateral management process is to enable the bank more reliable data
which can be used in PFE and EPE calculations.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Enhanced requirements regarding re-use ofcollateral
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collateral
Qualitative Criteria
• The nature of collateral is consistent with the Bank’s liquidity strategy and enable the
bank’s ability to post or return collateral in time.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures Treatment of highly leveraged counterparties
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Other measures - Treatment of highly leveraged counterparties
Qualitative Criteria
• The Basel Committee prescribes qualitative requirement indicating that the PD estimates
for highly leveraged counterparties should reflect the performance of their assets based on a
stressed period.
•PD estimates for borrowers that are highly leveraged or for borrowers whose assets are
mostly traded assets must reflect the performance of the underlying assets based on
periods of stressed volatilities.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Requirements for stress testing of CCRmodels 1/3
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models 1/3
Qualitative Criteria
• Banks are required to have have a comprehensive stress testing program for counterparty
credit risk.
•The stress testing is required to include main the key elements:
•Banks must ensure complete trade capture and exposure aggregation across all forms
of counterparty credit risk
•For all counterparties, banks should produce, at least monthly, exposure stress testingof principal market risk factors to proactively identify, and when necessary, reduce
outsized concentrations to specific directional sensitivities.
•Banks should apply multifactor stress testing scenarios and assess material non-
directional risks (ie yield curve exposure, basis risks, etc) at least quarterly.
•Multiple-factor stress tests should, at a minimum, aim to address scenarios in which
•a) severe economic or market events have occurred;•b) broad market liquidity has decreased significantly; and
•c) the market impact of liquidating positions of a large financial intermediary.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Requirements for stress testing of CCRmodels 2/3
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Qualitative Requirements
•Stressed market movements have an impact not only on counterparty exposures, but also
on the credit quality of counterparties.
• At least quarterly, banks should conduct stress testing applying stressed conditions to the
joint movement of exposures and counterparty creditworthiness.
•Exposure stress testing (including single factor, multifactor and material non-directional
risks) and joint stressing of exposure and creditworthiness should be performed at the
counterparty-specific, counterparty group and aggregate bank-wide CCR levels.•Stress tests results should be integrated into regular reporting to senior management.
•The analysis should capture the largest counterparty-level impacts across the portfolio,
material concentrations within segments of the portfolio (within the same industry or region),
and relevant portfolio and counterparty specific trends.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
models 2/3
Other measures - Requirements for stress testing of CCRmodels 3/3
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Qualitative Requirements
• A The severity of factor shocks should be consistent with the purpose of the stress test.
•When evaluating solvency under stress, factor shocks should be severe enough to capture
historical extreme market environments and/or extreme but plausible stressed market
conditions.
•The impact of such shocks on capital resources should be evaluated, as well as the impact
on capital requirements and earnings. For the purpose of day-to-day portfolio monitoring,
hedging, and management of concentrations, banks should also consider scenarios of lesserseverity and higher probability.
•Banks should consider reverse stress tests to identify extreme, but plausible, scenarios that
could result in significant adverse outcomes.
•Senior management must take a lead role in the integration of stress testing into the risk
management framework and risk culture of the bank and ensure that the results are
meaningful and proactively used to manage counterparty credit risk.• At a minimum, the results of stress testing for significant exposures should be compared to
guidelines that express the bank’s risk appetite and elevated for discussion and action when
excessive or concentrated risks are present.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
models 3/3
Other measures - Back testing and model validation guidelines for
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CCR 1/3
Qualitative criteria
The Basel committee identified significant shortcomings in the bank’s ability to conduct back
testing and model validation and made recommendations. Only those banks in full
compliance with the qualitative criteria will be eligible for application of the minimum
multiplication factor. The qualitative criteria include:
•The bank must conduct a regular program of back testing, i.e. an ex-post comparison of the
risk measures45 generated by the model against realised risk measures, as well ascomparing hypothetical changes based on static positions with realised measures.
•The bank must carry out an initial validation and an on-going periodic review of its IMM
model and the risk measures generated by it. The validation and review must be
independent of the model developers.
•The board of directors and senior management should be actively involved in the risk
control process and must regard credit and counterparty credit risk control as an essentialaspect of the business to which significant resources need to be devoted. In this regard, the
daily reports prepared by the independent risk control unit must be reviewed by a level of
management with sufficient seniority and authority to enforce both reductions of positions
taken by individual traders and reductions in the bank’s overall risk exposure.
bank’s overall risk exposure.Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Back testing and model validation guidelines for
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CCR 2/3
Qualitative criteria
•The bank’s internal risk measurement exposure model must be closely integrated into the
day-to-day risk management process of the bank. Its output should accordingly be an
integral part of the process of planning, monitoring and controlling the bank’s counterparty
credit risk profile
•The risk measurement system should be used in conjunction with internal trading and
exposure limits. In this regard, exposure limits should be related to the bank’s riskmeasurement model in a manner that is consistent over time and that is well understood by
traders, the credit function and senior management.
•Banks should have a routine in place for ensuring compliance with a documented set of
internal policies, controls and procedures concerning the operation of the risk measurement
system. The bank’s risk measurement system must be well documented, for example,through a risk management manual that describes the basic principles of the risk
management system and that provides an explanation of the empirical techniques used to
measure counterparty credit risk.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Back testing and model validation guidelines for
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CCR 3/3
Qualitative criteria
• A review of the overall risk management process should take place at regular intervals
(ideally no less than once a year) and should specifically address, at a minimum:
•The adequacy of the documentation of the risk management system and process;
•The organisation of the risk control unit;
•The integration of counterparty credit risk measures into daily risk management;
•The approval process for counterparty credit risk models used in the calculation of
counterparty credit risk used by front office and back office personnel;•The validation of any significant change in the risk measurement process;
•The scope of counterparty credit risks captured by the risk measurement model;
•The integrity of the management information system;
•The accuracy and completeness of position data;
•The verification of the consistency, timeliness and reliability of data sources used to
run internal models, including the independence of such data sources;•The accuracy and appropriateness of volatility and correlation
assumptions;
•The accuracy of valuation and risk transformation calculations; and
•The verification of the model’s accuracy as described
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Increase margin period of risk for collateralised trades
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1/2
Other measures
Basel committee introduces indicators of when to compel the banks to extend the margin
period of risk is extended to 20 business days for netting sets where
(a) the number of trades exceeds 5,000 or
(b) the set contains illiquid collateral or OTC derivatives that can not be replaced in
the market place
Banks with a history of margin call disputes on a netting set which exceeds the margin
period of risk will be required to double the applicable margin period of risk for the affectednetting set.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Increase margin period of risk for collateralised trades
2/2
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Other measures
Product Minimum holding period
Transaction Type Minimum holding
period
Condition
Repo-style
transaction
5 business days Daily re-margining
Other capital market
transactions
5 business days Daily re-margining
Secured lending 20 business days Daily revaluation
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
2/2
Other measures - Capital charges for exposures to CCP
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Other measures Capital charges for exposures to CCP
Other measures
In order to prudently manage the systematic risks, the Basel Committee introduces
incentives to the banks to move the trades to central counterparty clearing house (CCP)
with exposure to CCPs assigned low risk weights.
The favorable treatment of exposures to CCPs applies only where the qualifying CCPs
complies with the standards set by
the Committee on Payment and Settlement System (CPSS) and
the International Organization of Securities commissions (IOSCO).
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Standard haircut for securitization collateral
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Other measures Standard haircut for securitization collateral
Other measures
Basel committee has introduced a new recalibrated supervisory haircuts (assuming mark-
to-market, daily re-margining and 10-buiness day holding period) expressed as a
percentage. Supervisory haircuts for collateral are as follows:
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Expected positive exposure(EPE)
l l d b d d i
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calculated based on stressed input
Other measures
Effective expected positive exposure (EEPE) is required to be calculated using a three-
year period of stress
IMM banks are required to calculate EAD using current market data and compare this
with the EAD using current parameters
Wherever stressed EEPE exceeds the EEPE calculated using current market data, the
former will be used for the portfolio-level capital charge.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Other measures - Changes in External Ratings
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Other measures Changes in External Ratings
Other measures
Banks are required to choose ECAI and use their rating consistently in order to eliminate “
Cherry picking” of assessments. In parallel, the use of unsolicited ratings is allowed subject
to certain conditions and supervisory control
The measures eliminates undesirable benefits where unrated exposures could have
received lower risk-weights than those of non-investment grade ratings
The requirement for eligible guarantors to be rated A- or better has been removed except
in the case of securitization exposures for Cliff effect.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
Summary
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Summary
The financial crisis necessitated reforms in Basel accord and Basel III came into being.
One of the key emphasis in the Basel III accord is the risk coverage of CounterpartyCredit Risk (CCR).
Credit Valuation adjustment(CVA) is introduced into a capital charge.
CVA capital charge differs based of approval status of the Bank and are of three types.
Aggregation of CCR and CVA charge is dependant on types of approval status of the
banks and are of two types.
Management of Wrong way risk is addressed in the Basel III.
Wrong way risk are of two types - Specific and general wrong way risk.
There are qualitative criteria and other measures for management of CCR risk
Agenda
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Agenda
Basel II vs. Basel II.5
Summary of Market Risk updates
Correlation Trading Portfolios
Specific Risk Charges
Resecuritization
Stressed VaR (sVaR)
Incremental Risk Charges
Comprehensive Risk Measures (CRM)
Summary
Basel II vs. Basel 2.5
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Basel II vs. Basel 2.5
In July 2009 the Basel Committee on Banking Supervision published the revisions to the Basel II market risk framework
(also known as Basel 2.5) and Enhancements to the Basel II framework. Summary of the proposed revisions are stated
below
• Underestimation of losses under
normal market conditions
• Uncertainty about re-securitization
exposures
• Underestimation of exposure in
banks’ trading books to credit-risk
related products whose risk is not
reflected in VaR
• 20% CCF to short term eligible
liquidity facilities within thesecuritization framework
• 4% RW treatment for “liquid and
diversified” portfolios for specific
risk capital charge for equities
• Stressed VaR for banks using VaR
models in the trading book
• New Incremental Risk Capital
Charge for IRB banks
• Higher risk weights for re-
securitizations in the banking book
• The CCF for short-term eligible
liquidity facilities within the
securitization framework is changed
from 20% to 50%
• Removal of concessionary 4% RW
treatment for “liquid and diversified”
portfolios
Basel II Basel II.5
Summary of Market Risk updates
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Market Risk updates
Standardized Approach Internal Measurement Approach
Specif ic risk charge for correlation trading
portfolios
Specific risk charge for securitization
Specific risk charge for credit derivatives
Specific risk charge for equities
Risk weights for resecuritization
CCF for securitization liquidity facilities
Specification of Market risk factors
Amendment of qualitative standards
Stressed VaR
Specific risk charge for Interest rate sensitive
positions
Incremental Risk Charge (IRC)
Comprehensive Risk Measures (CRM)
y p
Correlation Trading Portfolios
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g
8
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
• Correlation trading portfolio is defined by Basel Committee to incorporate securitization
exposures and n-th-to-default credit derivatives that meet the following criteria• An n-th-to-default credit derivatives contract is the one where the derivative is triggered in theevent of a specified number (n) of defaults out of a pool of underlying assets
• The positions should not be re-securitization positions, nor derivatives of securitization
exposures that do not provide a pro-rate share in the proceeds of a securitization tranche• All reference entities are single-name products, including credit derivatives, for which a liquid
two-way market exists. It also includes traded indices based on these reference entities
• Hedges for these instruments are also included, provided they also meet the criteriamentioned above
Correlation Trading Portfolio
Correlation Trading Portfolio Criterion
In the past, banks did not hold sufficient capital for specific risk and that’s where large losses arose
from trading credit derivatives and securitization positions. So, in Basel II.5 major changes have
been introduced in relation to the calculation of specific risk
The correlation trading portfolio is for specific risk and is treated separately
Specific Risk Charge - for Correlation Portfolios
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Spec c s C a ge o Co e at o o t o os
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
The bank computes
(i) Total specific risk capital charges that would apply just to the net long positions from the net
long correlation trading exposures combined, and
(ii) Total specific risk capital charges that would apply just to the net short positions from the
net short correlation trading exposures combined.
The larger of these total amounts is then the specific risk capital charge for the correlation
trading portfolio. The risk weights are the same as for non-correlation securitization.
Under Internal Model Approach, the correlation trading portfolio is a limited exception that
applies to securitized products where banks may be allowed to apply a Comprehensive Risk
Measure (CRM). In broad terms, this will allow the bank to combine the measurement ofspecific risk and Incremental Risk Charge for these portfolios.
Standardized Approach
Internal Model Approach
Specific Risk Charge - for Securitization (1/2)
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p g ( )
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
Due to demand for yield by investors and desire of banks to move assets off their balance sheets to
free up the capital resulted in rapid growth in the credit derivatives. Banks’ share of the market for
credit securities exceed their share of any other market.
In order to eliminate the trading book/ banking book arbitrage the Basel Committee introduced
changes to specific risk charges for securitization in trading book
Under this approach the bank computes the specific risk of the securitization positions in the
trading book using the same method, used for such positions in banking book.
Table below gives the Securitization Risk Weights for Standardized Approach
Standardized Approach
Resecuritization exposures are subject to specific risk capital charges depending on whether
or not the exposure is senior
Specific Risk Charge - for Securitization (2/2)
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p g ( )
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
If the bank have an approval to use Internal Rating Based (IRB) Approach, in the banking booka more granular table of risk weights will be used for the securitization positions in the trading
book.
Table below shows the securitization risk weights for IRB Approach
Internal Rating Based Approach
Specific Risk Charge - for Credit Derivatives
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p g
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
First to default credit derivative
N-th-to-default credit derivative
Specific risk charge is set as lesser of the
• Sum of the specific risk charges for all of individual reference credit instruments in the basket,
and
• Maximum possible credit event payment under the contract.
Some offset is allowed if the reference entities hedge parts of the bank’s exposure
Specific risk charge is set as lesser of the
• Sum of the specific risk capital charge for the individual reference credit instrument but
disregarding (n-1) obligations with the lowest specific risk charges, and
• Maximum possible credit event payment under the contract.
No offset is allowed for these derivatives if it hedges a reference entity in trading book
Specific Risk Charge for Equities
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g
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
The capital charge for specific risk will be 8%, unless the portfolio is both liquid and
well-diversified, in which case the charge will be 4%. National authorities will have discretion to
determine the criteria for liquid and diversified portfolios.
The general market risk charge will be 8%.
The capital charge for specific risk and for general market risk will each be 8%
Basel II
Basel II.5
Resecuritization under Standardized Approach
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Source: Enhancements to the Basel II framework: BIS: July 2009
What is Resecuritization ?
Risk weights for resecuritization
A resecuritization exposure is a securitization exposure in which the risk associated with an underlying pool of
exposures is tranched and at least one of the underlying exposures is a securitization exposure.
Definition of resecuritization captures collateralized debt obligations (CDOs) of asset-backed securities (ABS)
including, for example, a CDO backed by residential mortgage-backed securities (RMBS).
Risk weights applicable for resecuritization exposures are added for Standardized approach
as well as IRB Approach, to reflect that they are riskier
Resecuritization under IRB Approach
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pp
Risk weights for resecuritization
• Banks using the internal ratings-based (IRB) approach to securitization will be required to apply higher risk
weights to resecuritization exposures
• The ratings-based approach risk weight tables were modified to add two additional columns for resecuritization
exposures as shown below.
Source: Enhancements to the Basel II framework: BIS: July 2009
CCF for Securitization liquidity facilities – SA
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Source: Enhancements to the Basel II framework: BIS: July 2009
The Standardized Approach of the Basel II framework applies a
• 20% CCF to commitments with a maturity under one year, and
• 50% CCF to commitments over one year
Eligible liquidity facilities under one year in the Standardized Approach securitization framework
receive a 20% CCF, while those over one year receive a 50% CCF
The CCF for short-term eligible liquidity facilities within the securitization framework is changed
from 20% to 50% to be consistent with the CCF applied to long-term eligible liquidity facilities
Basel II
Basel II.5
Specification of Market Risk Factors
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Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
An important part of a bank’s internal market risk measurement system is the specification of an
appropriate set of market risk factors, i.e. the market rates and prices that affect the value of the
bank’s trading positions.
Apart from the existing guidelines specified under Basel II, following addition guidelines are
prescribed.
Although banks will have some discretion in specifying the risk factors for their internal models, the
following guidelines should be fulfilled.
• Factors deemed relevant for the pricing of instruments should be incorporated as risk
factors in VaR model.
• The amendment re-emphasizes that the models must capture non-liner risk of options and
other relevant products (e.g. mortgage backed securities, tranched exposures or n-th-to-
default credit derivatives)• VaR models should also capture the correlation risk and basis risk of products (e.g.
between credit default swaps and bonds)
• Where proxies are used, a good track record for estimating the risk of the actual position
should exist
Additional Guidelines
Amendment of Quantitative Standards
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Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
Apart from existing quantitative standards specified under Basel II for the calculation of capital
charge using VaR models, following additional quantitative standards have been incorporated
• The regulatory capital requirement is based on estimating a 10-day 99% VaR figure. In
most implementations of VaR models this is achieved by following equation:
(1 day VaR)* Square root (10) = 10 Day VaR
Using the square root of time makes a number of implicit assumptions. In the newregulations the bank has to prove that there is no underestimation of the risk when using
this method
• Market data update period have been shorten to one month from three months, to ensure
that models adjust more quickly to market volatility
• The bank must also make provision to be able to update the data sets more frequently if
required
Additional Quantitative Standards
Stressed VaR (sVaR): Introduction
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Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
What is Stressed VaR ?
• It is VaR based on a one-year observation period relating to significant losses (additional to the VaR based onthe most recent one-year observation period)
• In terms of capital requirements, the capital estimate for sVaR is added to capital requirement for VaR
• sVaR estimate must be calculated at least on a weekly basis
Purpose of Stressed VaR ?• To reduce the pro-cyclicality of the minimum capital requirements for market risk and to increase the overall
level of capital
• It is intended to replicate VaR for the bank’s current portfolio if the relevant market factors were experiencing aperiod of stress
Why Stressed VaR ?
• Losses in most banks’ trading books during the financial crisis were significantly higher than the minimumcapital requirements under the Basel II Pillar 1 market risk rules.
• The Basel Committee therefore requires banks to calculate a stressed value-at-risk taking into account a one-
year observation period relating to significant losses
Stressed VaR: Guidelines
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Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
Key Guidelines
• No particular model is prescribed for the calculation of sVaR, so long as each model used captures all thematerial risks run by the bank
• On a daily basis, a bank must meet the capital requirement (c) given by the expression:
• The multiplication factors mc and ms will be set by individual supervisory authorities on the basis of their
assessment of the quality of the bank’s risk management system, subject to an absolute minimum of 3 for mc
and an absolute minimum of 3 for ms
• Data sets update every month and reassess whenever a material change in market prices takes place
Maximum of its
• Previous day’s value-at-risk number
(VaRt-1); and
• Average of the daily value-at-risk
measures on each of the preceding
sixty business days (VaRavg), multiplied
by a multiplication factor (mc)
Maximum of its
• Latest available stressed-value-at-risk
number (sVaRt-1); and
• Average of the stressed value-at-risknumbers over the preceding sixty business
days (sVaRavg), multiplied by a multiplication
factor (ms)
Treatment of Specific Risk: Interest Rate Positions
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Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
Key Guidelines
Banks are allowed to include specific risk for equity and interest rate risk positions in their VaR
model.
For interest rate risk positions, the bank will not be required to subject these positions to the
standardized capital charge for specific risk, if following conditions are met
• The bank has a value-at-risk measure that incorporates specific risk and the supervisor has
determined that the bank meets all the qualitative and quantitative requirements for general
market risk models
• The supervisor is satisfied that the bank’s internally developed approach adequately captures
incremental default and migration risks for positions subject to specific interest rate risk
• The specific risk VaR model must include all the material components of price risk and be
sensitive to changes in market conditions and portfolio composition. The model should
• explain the historical price variation in the portfolio
• capture concentrations (magnitude and changes in composition)
• be robust to an adverse environment
• capture name-related basis risk
• capture event risk
• be validated through back-testing
Incremental Risk Charge (IRC): Introduction
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Source: Guidelines for computing capital for incremental risk in the trading book : BIS: July 2009
Why IRC was introduced ?
• During the financial crisis a number of major banking organizations experienced large losses, most of whichwere sustained in banks’ trading books.
• Most of these looses were not captured in the 99%, 10-day VaR since the losses had not arisen from actualdefaults but rather from credit migrations combined with widening of credit spreads and the loss of liquidity
Purpose of IRC ?
• To address the shortcoming of regulatory capital model
• To produce an estimate of default and credit migration risks of unsecuritized credit products over a year capitalhorizon at 99.9 % confidence level
What is IRC ?
• Incremental Risk Charge (IRC) is an additional charge to the trading book meant to capture Default risk and
Credit Migration Risk. It measures losses “due to default and migration” for unsecuritized credit products, at the99.9% percent confidence interval over a capital horizon of one year
• Default Risk is the potential for direct loss due to obligor’s default, as well as the potential for indirect loss that
may arise from a default event
• Credit Migration Risk is the potential for direct loss due to internal/ external rating downgrade or upgrade as
well as the as the potential for indirect loss that may arise from a credit migration event
IRC: Estimation & Coverage
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Source: Guidelines for computing capital for incremental risk in the trading book : BIS: July 2009
Estimation of IRC
• IRC only applies to banks adopting the internal model approach and that seek to model specific risk in the
trading book
• Capital charge for IRC will be estimated as, C= max (IRCt-1, mc *IRCavg)
• IRC will be measured at least on a weekly basis
Maximum of its
• Previous day’s Incremental Risk measure (IRCt-1); and
• Average of the Incremental Risk Charge measures over 12 weeks
(IRCavg), multiplied by a multiplication factor (mc)
Positions covered under IRC
• IRC will be calculated on all positions that are subjected to a capital charge for specific interest rate risk according to
Internal Models Approach to specific market risk, but that are not subject to treatment outlined for unrated securities
under Basel II framework
• With supervisory approval, the bank may choose to include all listed equity and derivative positions, based on the listed
equity of a company, in its incremental risk model when the inclusion is consistent with how the bank internally measures
and manages this risk at the trading desk level
• Securitization positions are excluded from IRC, even when they are viewed as hedging underlying credit instruments
held in the trading account
IRC: Supervisory Requirements
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Source: Guidelines for computing capital for incremental risk in the trading book : BIS: July 2009
Key Supervisory parameters for IRC
• Soundness standard: IRC must adhere to a soundness standard comparable to IRB approaches in the banking book
• Constant level of risk over one-year capital horizon: This measure must take into account the liquidity horizons
applicable to individual trading positions. Trading positions are rebalanced at the end of their liquidity horizons to achieve
a constant level of risk
• Liquidity horizon: The liquidity horizon must be measured under conservative assumptions and should be sufficiently
long that the act of selling or hedging, in itself, does not materially affect market prices. The liquidity horizon for a position
or set of positions has a floor of three months
• Correlation: IRC should include correlations between defaults and migrations, which are caused by economic and
financial dependence among obligors. The correlations between default and migration risks and other market factors in
the VaR model are excluded and no diversification is allowed when capital is calculated
• Concentration: IRC should reflect issuer and market concentrations. Considering , other things being equal, a
concentrated portfolio should attract a higher capital charge than a more granular portfolio
• Risk mitigation and diversification effects: Netting of exposures is only allowed if the instruments are exactly the
same. IRC model should take significant basis risk into account. IRC must include the impact of potential risks that could
occur during the interval between the maturity of the instrument and the liquidity horizon
• Optionality: IRC model must reflect the impact of optionality. This should include the nonlinear impact of options and
other positions with material nonlinear behavior with respect to price changes. The bank should have an understanding
of the model risk associated with estimation of price risks
IRC: Modelling
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Modelling the IRC
• Modelling the IRC is a complex task, two models have been implemented by the banks to do
this
• Jump diffusion model
• Merton model
• Jump Diffusion Model: In this model, in addition to a Brownian Motion term, the price process
of the underlying is allowed to have jumps. The risk of these jumps is assumed to not be
priced. This model is not very popular due to issues such as problems with calibration of the
jumps to actual migration or default probabilities
• Merton Model: It is a simulation based model used by majority of the banks for assessing the
default risk.
• In deriving data to use in the IRC model one should use market estimates for estimating
probabilities of default and hence implied migration probabilities
• The market data from products such as CDS strips can be used to determine forward defaultprobabilities
• The effect of seniority or other instrument specific characteristics must be incorporated within
the estimates for loss given default
Source: Guidelines for computing capital for incremental risk in the trading book : BIS: July 2009
Comprehensive Risk Measures (CRM)
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What is CRM ?
• Under Internal Model Approach, for correlation trading portfolio the banks may be allowed toapply a Comprehensive Risk Measure (CRM). This will allow the bank to combine the
measurement of specific risk and Incremental Risk Charge for correlation trading portfolios
Estimation of CRM
• CRM applies to banks adopting the internal model approach and that seek to model specific
risk and IRC for correlation trading portfolio
• Capital charge for CRM will be estimated as, C= max (CRMt-1, mc *CRMavg)
• Capital charges for CRM and IRC are calculated separately and added. There is no
adjustment for double counting between the CRM and any other risk measure
• CRM estimates will be calculated at least on a weekly basis
Maximum of its
• Previous day’s Comprehensive risk measures (CRMt-1); and
• Average of the Comprehensive risk measures over 12 weeks (CRMavg),
multiplied by a multiplication factor (mc)
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
CRM: Modelling
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Modelling CRM
• Modelling CRM must ensure that following are captured in the model
• Cumulative risk arising from multiple defaults, including defaults in tranched products;
• Credit spread risk, including gamma and cross-gamma effects;
• Volatility of correlations, including the cross effect between spreads and correlation;
• Basis risk between indices and constituents or bespoke portfolios;
• Recovery rate volatility; and
• Hedging slippage and cost of rebalancing
• On an overall basis CRM must comply with all requirements for the IRC
• In addition, the banks will be required to design stress testing scenarios for correlation trading
portfolios and examine the effect of these scenarios on default rates, recovery rates, credit
spreads and correlations
• These tests must be applied weekly and the results submitted to the regulator
• The regulator may apply a supplementary capital charge if deemed necessary
• A floor on this measure was introduced , being 8 % of the measurement under the
standardized measurement method ( published in the press release of 18th June 2010)
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
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Thank You