Risk. The accord set a minimum level of risk capital expressed as a ratio of the total risk weighted assets. Banks have ... that are held short term for resale and marked to market ... short term subordinated debt with a maturity of at least 3 years.
The Basle Accord Following P. Jorion, Financial Risk Management Chapter 31
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Introduction The first Basle Accord concluded on July 15, 1988, instituted the minimum levels of capital to be held by international against financial risks. The latest accord issued in 2001 allow more flexibility as well as greater reliance on the bank's internal methodologies Summary broad overview of Basle Accord Original Basle capital requirements with emphasis on credit risk Application example to JP Morgan Major drawbacks of the original accord Main components of the new accord Basle accord for market risk Daniel HERLEMONT
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The Original Basle Accord 1988 Application in 1992 Risk Based Capital Charge roughly attempted to create greater penalty for riskier assets Initially, the 1988 Basle accord only covered Credit Risk The accord set a minimum level of risk capital expressed as a ratio of the total risk weighted assets Banks have to hold capital that covers 8% of their risk-weighted assets.
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1996 Amendment In 1996 the accord is amended to incorporate Market Risk, came into force in 1997 banks are allowed to use a standard approach or an Internal Model Approach based on their own risk management system.
Bank's asset in 2 categories Trading Book: bank portfolio with financial instruments that are held short term for resale and marked to market Banking Book consists of other instruments, typically loans
The 1996 amendment adds a capital charge for the market risk of trading books the currency and commodity risk of the banking book Daniel HERLEMONT
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The New Basle Accord New accord in January 2001, Expected implementation date: by the end of 2006 Based on 3 pillars Pillar 1: Minimum Capital Requirement to cover credit, market, and operational risks relative to 1998 accord, bank have a wider choice of models dfor computing the risk charge Pillar 2: Supervisory review process to ensure that banks have in place a process for accessing the overall capital in relation to risks banks indeed operates the minimum regulatory ratios corrective actions is taken as soon as possible
Pillar 3: Market Discipline disclosure, transparency, ... Daniel HERLEMONT
The New Basle Accord TotalCapital = Bank ' s Capital Ratio > 8% CreditRIsk + MarketRisk + OperationaRisk
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The New Basle Accord - The Menu
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Basle Accord - summary of methods
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The 1988 Basle Accord - the 3 Tiers Capital Capital shall be at least 8% of its total risk weighted assets Capital has a broader interpretation than the book value. The Basle Accord recognizes 3 forms of capital Tier 1 Capital: the buffer of high quality capital equity disclosed reserves
Tier 2 Capital: or supplementary capital Undisclosed reserves (or hidden reserves) Asset reevaluation reserves General provisions/loan loss reserves Hybrid debt captial instruments Subordinated term debt
Tier 3 Capital, for market risk only short term subordinated debt with a maturity of at least 3 years.
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The 1988 Basle Accord - the 3 Tiers Capital Of the 8% capital charge 50% must be covered by Tier 1 the amount of Tier 3 is limited to 250% of Tier 1
For Credit Risk Charge (CRC) constraint
Market Risk Charge (MRC) constraint
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On Balance Risk Charges
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Off Balance Risk Charges The Basle Accord computes a credit exposure through credit conversion factors. Instruments that substitute for a loan Transaction related contingencies Short term self liquidating traded related liabilities Commitments with maturity greater than a year Other derivatives such as swaps, forwards and options on currency, interest rates, equity and commodity products are given special treatment
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Total Risk Charge
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Illustration
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The New Basle Accord The Basle Accord has been successful in raising banking capital (tier 1 ratio) Issues with the 1988 accord regulatory arbitrage (lending pattern to in the direction of more credit risk) inadequate differentiation between credit risks Securitization Non recognition of credit risk mitigation techniques Non recognition of diversification of credit risk
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Issue in 1988 Accord - an illustration
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The New Basle Accord - Credit Risk Charges Banck can choose between 3 approaches Standardized approach, based on external credit rating institutions Foundation Internal Rating Based (IRB) Approach bank estimates the probability of default supervisors provide other inputs
Advanced Internal Rating Based Approach banks can provide other intputs Loss Given Default (LGD) Exposure At Default (EAD)
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Standardized approach
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Securitization and Credit Risk Mitigation Securitization charges
Collateral credit exposures
Guarantees and Credit Derivatives
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Operational Risk Charges (ORC) Basle Committee expects that ORC will represent about 20% of the Total Risk Charge on average 3 Approaches proposed the Basic Indicator Approach the Standardized Approach the Internal Measurement Approach the most sophisticated, based on internal bank data, the bank then provides: the probability of loss event (PE) the loss given that event (LGE) the expected loss (EL)
The measurement of ORC is the least advanced component of the Basle Accord ... mucch work to be done on the calibration of models (if any ...) Daniel HERLEMONT
Market risk is defined via Maturity Bands ... 4. Page 4. Daniel HERLEMONT. Example. Daniel HERLEMONT. Example ... different types of risk i on each day t.
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Transition period for data requirements under the IRB approach for corporate, ...... production and analysis of reports on the outputs of the bank's internal rating.