Applied Business Statistics Case studies Basel II - Introduction

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Applied Business StatisticsCase studiesBasel
II - Introduction

• Mauro Bufano
• Risk Management Banca Mediolanum Spa

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Basel II motivations

• In a market economy, every company is free to
  determine its own capital, basing on
  shareholders preferences
• This is not true for banks! Financial
  institutions have minimum capital requirements
  imposed by regulators. Why?
• Centrality of banks in the overall economy
• Contagion effect a banks default can affect the
  entire economic system (see Lehman Brothers 2008)
• In banks liabilities we have families savings
  (in many cases, with a State guarantee within a
  limit)
• How much does it cost to save banks from default?

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Basel I agreement-1988

• The first international agreement on banks
  capital was made in 1988 by the Basel committee
  its an international institution
  established in 1974 by the G10 countries. It
  reports directly to the Central Banks of G10
• The main reasons of this agreement were
• To prevent banks crisis, avoiding excessive risk
  taking
• To harmonize different capital requirements in
  developed countries, that could have caused
  distortions in the market
• To ensure financial stability of the banks,
  impacting directly on consolidated balance sheet

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Basel I agreement-1988

• The first agreement regulated only capital
  requirements on credit risk, by applying the rule
  of 8
• The regulatory capital had to be at least 8 of
  the risk weighted assets
• Regulatory capital constituted by
• Tier I capital share capital, disclosed
  reserves, general provisions, innovative capital
  instruments
• Tier II capital undisclosed and revaluation
  reserves, hybrid capital instruments and
  subordinated debt
• Tier III capital (from 1996) short term
  subordinated debt covers only market
  risk, was not present in the first agreement

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Basel I agreement-1988

• The 1988 agreement had some weights in order to
  determine risk weighted assets
• wi 0 for cash and exposure vs central
  governments, central banks and EU
• wi 20 for exposures vs banks and public sector
• wi 50 for mortgage loans
• wi 100 for private sector exposures, equities,
  subordinated loans, hybrid instruments
• Problems
• There was few or no differentiation of exposures
  at all
• It encouraged regulatory arbitrages
• It didnt take into account many other risks
  present in banks business (market risk,
  operational risk and so on)

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Basel II agreement - 2004

• Basel II agreements in 2004 is a more complex one
  than its parent in 1988
• Its based on 3 pillars
• Pillar I Minimum capital requirements
• Pillar II Internal Capital Adequacy Assessment
  Process (ICAAP) Supervisory Review Process
  (SREP)
• Pillar III Market discipline
• Its aims are
• New rules for capital requirements (
  differentiations, risk factors)
• Supervision of banks by regulators (e.g. Bank of
  Italy)
• information to the market on the capital
  adequacy (and risk bearing) of a bank
• Possibility to use (after validation by the
  regulator) internal capital models
• From single exposure approach portfolio
  approach

towards
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Basel II Pillar I

• The first pillar of Basel II is also the most
  important, because it states minimum mandatory
  capital requirements for banks
• In Pillar I three types of risks are considered
• Credit risk
• Market risk
• Operational risk
• Minimum capital requirements can either be
  determined by
• Standardized risk weights
• Internal models they have to be validated
  by the regulator they need an internal complex
  process and IT sources
• For this reason only major banks can use internal
  models for capital requirements purposes.
  Smaller banks can use for Pillar I the
  standardized approach

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Pillar I Credit risk

• Even in the standardized approach, credit risk
  estimation has advanced a lot from 1988 agreement
• Risk weights are no more based only on the nature
  of exposure, but also on the credit worthiness,
  stated by the agency ratings (Moodys, SP, Fitch
  etc.)

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Pillar I Credit risk

• Internal models a bank can estimate its internal
  capital via internal model (Internal Rating Based
  IRB). In this case for each exposure its
  necessary to estimate.
• Probability of default (PD)
• Loss given default (LGD)
• Exposure at default (EAD)
• Maturity (M)
• In order to ensure that not only biggest banks
  adopt internal models, there are two approaches
• Foundation only the PD is estimated by the bank.
  LGD, EAD and M are given by the regulator
• Advanced the bank estimate all of the 4
  parameters given above

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Pillar I Credit risk

• Once the single exposure parameters are
  estimated, we can determine expected losses and
  unexpected losses.
• Expected losses EL EADPDLGD Expected losses
  have to be budgeted in the profit and loss
  account
• Unexpected losses these losses represent a tail
  event in the loss distribution. Given a
  confidence level of 99.9 (as stated by Basel II
  for Credit risk), we have that minimum capital
  requirement (for exposure i) is

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Pillar I Credit risk

• The IRB formula represent the unexpected loss
  (i.e. the 99.9 loss quantile), calculated under
  the Vasicek-Gordy model (2000)
• Its assumptions are
• An infinitely granular portfolio
• One common risk factor
• Normal distribution of the unique risk factor
• The correlation with the risk factor is modelled
  via a Gaussian copula function
• The correlation factor ? is not estimated by the
  bank, but given by the regulator (its generally
  a decreasing function of the PD)

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Pillar I - Market risk

• Also for market risk we have a standardized and
  an advanced approach
• Standardized approach it consists in weights and
  haircuts based on
• The maturity of the security
• Its duration
• The credit worthiness of the issuer
• Compensation for netting long/short positions
• Internal model its based on the concept of
  Value at Risk (VaR)

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Pillar I - Market risk

• The VaR must have the following characteristics
• A confidence level of (at least) 99
• A time horizon of (at least) 10 working days
• Historical sample for volatility at least 1 year
• Update of volatility and correlation at least
  quarterly
• Total VaR obtained by summing VaR of different
  risk factors (correlations equal to 1 among risk
  factors)
• Reflect non-linear risk profile of option
  contracts
• Calculated on a daily basis
• The factor F is a number between 3 and 4, it
  reflects the quality of internal model
• Default risk must be calculated with the model
  adopted for credit risk (IRB)

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Pillar II

• Pillar II consists in two different aspects
• ICAAP its a process internal in the bank
  itself. Its aim is to determine the capital
  adequacy for unexpected losses
• SREP its a review of the risk measurement
  process carried out by the individual banks,
  requiring, if necessary, a further capital buffer
  in addition to the one of ICAAP
• The final goal of Pillar II is to determine an
  internal capital to tackle different risks. There
  is no regulatory requirement, but the banks are
  free to choose the models to adopt in order to
  correctly estimate risks
• The capital amount necessary to cover all risks
  is named economic capital

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Pillar II

• Pillar II requires the quantification of several
  risks not embedded in Pillar I or too much
  simplified. Among these
• Concentration risk its part of the credit risk.
  It derives from the fact that loan portfolios are
  not perfectly granular but some exposures are
  particularly heavy (therefore their defaults
  could result in a huge loss for the bank) The
  IRB formula needs to be augmented of a buffer
  (Granularity adjustment, GA), calculated with the
  Herfindahl Index (H)

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Pillar II

• Interest rate risk on banking book its the risk
  of a mismatch between asset and liabilities in a
  bank. Like concentration risk, it has a capital
  requirement
• Among other risks, not having a capital
  requirement, we find
• Liquidity risk
• Residual risk
• Reputation risk
• Compliance risk

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Pillar II stress tests

• A fundamental requirement of Pillar II is the
  stress testing of all Basel II risks (included
  Pillar I risks) it consists in conditioning the
  risk factors to particularly bad events (stress
  test scenarios) and working out the capital
  adequacy that the bank would need in those
  scenarios
• Also for stress tests, the final goal is to
  determine a stressed economic capital and take
  actions (when needed) in order to manage those
  risks

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Example of stress tests

• Market risk an example of a stress test could
  consists in a parallel shift of the yield curve
  of 200 bps
• For every shift, we must calculate the
  theoretical value of the portfolio and the
  eventual loss associated to each scenario

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Example of stress tests

• Credit risk considering the time series of
  default of Italian families (last 20 years), we
  could take as an extreme event the worst rate
  registered (source, Bank of Italy)
• Conditioned on the highest default rate, we could
  work out the additional capital requirement
  basing on the IRB formula

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Pillar III - market discipline

• The third pillar of Basel II consists in the
  transparency of banks risks and its reporting
  to the market (included customers). Information
  provided include
• Size and composition of capital and risky assets
• Distribution of credit exposure and default rates
• Risk measurement and control systems
• Accounting practices in use
• Capital allocation criteria within the banks

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Advantages and limitations of Basel II

• Advantages
• More flexibility of capital ratios
• Takes into account portfolio diversification
• Extends the rules of the supervisors and of the
  market
• space for risk management techniques
• Internal models as source of competitive
  advantage
• Limitations
• Procyclicality the regulatory requirements could
  decrease capital in booms and increase capital in
  recessions the parameters should be
  calibrated on a long time horizon
• Excessive dependency on agency ratings
• Complexity?

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What next?

• 2008-09 global recession has shown many
  limitations of Basel II agreements
• Moving towards Basel III?
• Anyway, capital adequacy agreements are
  developing also in other industries, basing on
  Basel II risk factors (e.g. Solvency II for
  insurance companies)

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References

• Resti, A. and Sironi, A., Risk Management and
  Shareholders Value in Banking
• Basel II International Convergence of Capital
  Measurement and Capital Standards www.bis.org
• Circolare 263/2006 Banca dItalia
  www.bancaditalia.it/vigilanza/banche/normativa/dis
  posizioni/vigprud
• Vasicek, O. A., Credit Valuation, KMV
  Corporation
• Gordy, M. B., (2000b), A comparative analysis of
  credit risk models, Journal of Financial and
  Quantitative Analysis,12, 541-522