Bank Regulation and Basel I, II, III Chapter 7 Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Why regulate bank capital Goal: to provide reliable banking system where bank failures are rare and depositors are protected Crash of 1929/FDIC/Glass-Steagall Act The ability of a bank to absorb unexpected losses dependent on equity and other forms of capital Capital should cover the difference between expected losses and “worst-case losses” Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

The Model used by Regulators (Figure 7.1, page 166) Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Why regulate bank capital Competition: insurance/banks/securities firms – regulatory arbitrage CRD – EU Capital Requirements Directive Is bank regulation unnecessary? Sistemic risk – “ripple effect” Deposit insurance – moral hazard? Therefore: necessary to combine deposit insurance with regulations on the capital banks must hold Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

History of Bank Regulation Pre-1988 1988: BIS Accord (Basel I) 1995: netting 1996: Amendment to BIS Accord 1999: Basel II first proposed 2006: Basel II 2009: Basel 2.5 2010: Basel III Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Pre-1988 Banks were regulated using balance sheet measures such as capital : assets (capital to total assets) Definitions of capital and required ratios varied from country to country (posibility for “regulatory arbitrage”) Enforcement of regulations varied from country to country Bank transactions became more complicated. Bank leverage increased in 1980s. Off-balance sheet derivatives trading increased Total assets was no longer a good indicator of the total risk being taken. Basel Committee on Bank Supervision set up Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

1988: BIS Accord – Basel I First standard: Assets/Capital must be less than 20. Assets includes off-balance sheet items that are direct credit substitutes such as letters of credit and guarantees Second standard: Cooke Ratio: Capital must be 8% of risk weighted assets. At least 50% of capital must be Tier 1. Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Basel I: Risk Weights Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Risk-Weighted Capital A risk weight is applied to each on-balance- sheet asset according to its risk (e.g. 0% to cash and govt bonds; 20% to claims on OECD banks; 50% to residential mortgages; 100% to corporate loans, corporate bonds, etc.) N - number of on-balance-sheet items, Li – principal amount of the ith item, ωi – risk weight Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Risk-Weighted Capital For each off-balance-sheet item we first calculate a credit equivalent amount and then apply a risk weight Risk weighted amount (RWA) consists of sum of risk weight times asset amount for on-balance sheet items Sum of risk weight times credit equivalent amount for off-balance sheet items Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Credit Equivalent Amount The credit equivalent amount is calculated as the current replacement cost (if positive) plus an add on factor The add on amount varies from instrument to instrument (e.g. 0.5% for a 1-5 year swap; 5.0% for a 1-5 year foreign currency swap) Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Add-on Factors (% of Principal) Table 7.2, page171 Remaining Maturity (yrs) Interest rate Exch Rate and Gold Equity Precious Metals except gold Other Commodities <1 0.0 1.0 6.0 7.0 10.0 1 to 5 0.5 5.0 8.0 12.0 >5 1.5 7.5 15.0 Example: A $100 million swap with 3 years to maturity worth $5 million would have a credit equivalent amount of $5.5 million Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

The Math On-balance sheet items: principal times risk weight Off-balance sheet items: credit equivalent amount times risk weight For a derivative Cj = max(Vj,0)+ajLj where Vj is value, Lj is principal and aj is add-on factor Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Risk-weighted assets For on-ballance-sheet items, Example 7.1 For off-balance-sheet items we use credit equivalent amount (Cj). For an OTC derivative, (Cj) is: Example 7.2 Total risk-weighted assets for a bank with N on-balance-sheet and M off-balance sheet items Example 7.3 Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Types of Capital (page 172) Tier 1 Capital: common equity, non-cumulative perpetual preferred shares, less goodwill Tier 2 Capital: cumulative perpetual preferred stock, certain types of 99-year debentures, subordinated debt with an original life of more than 5 years Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

G-30 Policy Recommendations (page 172-3) Influential publication from derivatives dealers, end users, academics, accountants, and lawyers 20 recommendations published in 1993 Report itself is not a regulatory document but has been very influential in the development of risk managment practices. Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Netting (page 174-5) Netting refers to a clause in derivatives contracts that states that if a company defaults on one contract it must default on all contracts In 1995 the 1988 accord was modified to allow banks to reduce their credit equivalent totals when bilateral netting agreements were in place Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Netting Calculations Without netting exposure is With netting exposure is Net replacement ratio Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Netting Calculations continued Credit equivalent amount modified from To Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

1996 Amendment (page 176) Implemented in 1998 Distinguishes between bank’s trading book and banking book Requires banks to measure and hold capital for market risk for all instruments in the trading book including those off balance sheet (This is in addition to the BIS Accord credit risk capital) Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

The Market Risk Capital Standardized approach Internal Model Based Approach – IMBA VaR Benefit of diversification Total capital = 0,08 x (Credit risk RWA + Market risk RWA) Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

The Market Risk Capital The capital requirement is Where k is a multiplicative factor chosen by regulators (at least 3), VaR is the 99% 10-day value at risk, and SRC is the specific risk charge (primarily for debt securities held in trading book) Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Basel II Implemented in 2007 Three pillars New minimum capital requirements for credit and operational risk Supervisory review: more thorough and uniform Market discipline: more disclosure Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

New Capital Requirements Risk weights will be based on on either external credit rating (standardized approach) or a bank’s own internal credit ratings (IRB approach) Recognition of credit risk mitigants Separate capital charge for operational risk Total capital = 0,08 x (Credit risk RWA + Market risk RWA + Operational risk RWA) Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

USA vs European Implementation In US Basel II will apply only to large international banks Small regional banks required to implement “Basel 1A’’ (similar to Basel I), rather than Basel II European Union requires Basel II to be implemented by securities companies as well as banks Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Basel II Credit Risk Standardized Approach Foundation IRB Advanced IRB Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

New Capital Requirements Standardized Approach, Table 7.4, page 180 Banks counterparties are treated similarly to corporations. Under Basel I corporations are assumed to be substantially less creditworthy Rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB- B+ to B- Below B- Unrated Country 0% 20% 50% 100% 150% Banks Corporates Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Adjustments for Collateral Two approaches Simple approach: risk weight of counterparty replaced by risk weight of collateral Comprehensive approach: exposure adjusted upwards to allow to possible increases; value of collateral adjusted downward to allow for possible decreases; new exposure equals excess of adjusted exposure over adjusted collateral; counterparty risk weight applied to the new exposure Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

New Capital Requirements IRB Approach for corporate, banks and sovereign exposures Basel II provides a formula for translating PD (probability of default), LGD (loss given default), EAD (exposure at default), and M (effective maturity) into a risk weight Under the Advanced IRB approach banks estimate PD, LGD, EAD, and M Under the Foundation IRB approach banks estimate only PD and the Basel II guidelines determine the other variables for the formula Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Key Model (Gaussian Copula) The 99.9% worst case default rate is Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Numerical Results for WCDR Table 7.5, page 183 PD=0.1% PD=0.5% PD=1% PD=1.5% PD=2% r=0.0 0.1% 0.5% 1.0% 1.5% 2.0% r=0.2 2.8% 9.1% 14.6% 18.9% 22.6% r=0.4 7.1% 21.1% 31.6% 39.0% 44.9% r=0.6 13.5% 38.7% 54.2% 63.8% 70.5% r=0.8 23.3% 66.3% 83.6% 90.8% 94.4% Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

for the individal loans IRB approach In a general portfolio of loans, there is a 99,9% chance that the total loss will be less than the sum of for the individal loans Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Corporate, Sovereign and Bank Exposures Capital required: EAD x LGD x (WCDR – PD) x MA MA – Maturity adjustment is designed to allow for the fact if an instrument lasts longer than one year, there is a one-year credit exposure arising from a possible decline in the creditworthiness of the counterparty RWA = 12.5 x EAD x LGD x (WCDR – PD) x MA Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Retail Exposures Capital required: EAD x LGD x (WCDR – PD) RWA = 12.5 x EAD x LGD x (WCDR – PD) Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Credit Risk Mitigants Credit risk mitigants (CRMs) include collateral, guarantees, netting, the use of credit derivatives, etc The benefits of CRMs increase as a bank moves from the standardized approach to the foundation IRB approach to the advanced IRB approach Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Guarantees Traditionally the Basel Committee has used the credit substitution approach (where the credit rating of the guarantor is substituted for that of the borrower) However this overstates the credit risk because both the guarantor and the borrower must default for money to be lost Alternative proposed by Basel Committee: capital equals the capital required without the guarantee multiplied by 0.15+160×PDg where PDg is probability of default of guarantor Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Operational Risk Capital Basic Indicator Approach: 15% of gross income Standardized Approach: different multiplicative factor for gross income arising from each business line Internal Measurement Approach: assess 99.9% worst case loss over one year. Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

PILLAR II: Supervisory Review Banks should have a process for assesing their overall capital adequacy in relation to their risk profile Supervisors should review and evaluate bank’s internal capital adequacy assesments and strategies Supervisors should have the ability to require banks to hold capital in excess of minimum regulatory requirement Similar amount of thoroughness in different countries Local regulators can adjust parameters to suit local conditions Importance of early intervention stressed Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

PILLAR II: particular attention Interest rate risk in the banking book Credit risk stress tests used, default definitions used, credit risk concentration, risks associated with the use of colateral, guarantees, and credit derivatives Operational risk Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

PILLAR III: Market Discipline To encourage banks to increase disclosure of risk assessment procedures and capital adequacy Banks will be required to disclose Scope and application of Basel framework within the banking group Nature and components of capital (Tier 1, 2, 3) Capital requirements for credit, market, op. risk Nature of institution’s risk exposures Structure of the risk management function and how it operates Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Basel III : Capital Quality – min 4,5% equity Capital loss absorption at the point of non-viability Capital conservation buffer – 2,5% equity Countercyclical buffer – up to 2,5% Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Basel III: Risk Coverage Securitization Trading book Counterparty credit risk Bank exposure to central counterparties (CCPs) SIFIs: progressive Common Equity Tier 1 capital 1% - 2,5% Leverage ratio Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

Basel III: Liquidity Liquidity coverage ratio (LCR): sufficient high liquidity to sustain 30 day stress scenario Net stable funding ration (NSFR): longer term structural ratio designed to address liquidity mismatches. Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006