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

2. 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

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

4. 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

5. 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

6. 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

7. 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

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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. Netting Calculations Without netting exposure is
With netting exposure is
Net replacement ratio
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19. Netting Calculations continued
Credit equivalent amount modified from To
Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

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

27. 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

28. 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

29. 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

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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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 ×PDg where PDg is probability of default of guarantor
Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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