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Market Risk Part I

2014, Frankfurt am Main


Prof. Dr. Martin Hellmich

Akademische Programme
Berufsbegleitende Programme
Seminare
Executive Education
Unternehmensprogramme & Services
Forschung
Internationale Beratung
FrankfurtSchool.de

The faboulus Fab


More and more leverage in the system, the whole building is about to
collapse anytime now Only potential survivor, the fabulous Fab standing
in the middle of all these complex, highly leveraged, exotic trades he created
without necessarily understanding all of the implications of those
monstruosities !!!

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and his famous transaction

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and the leveraged financial system


International Herald
Tribune, December
2008

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The Gordon Gekko perspective on things..


They got all these fancy names for trillions
of dollars for credit, CMO, CDO, SIV, ABS. You
know I honestly think there are only 75
people in the world that knows what they
are

MtM-Losses

Cumulated
Losses

Asset
Pool

Source: BIS-Working Paper No. 251

Beared

ABCP

By
Capital Notes

But MtM of ABCB


are falling
(reduced Subordination)

Capital
Notes

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and the response of regulators

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and the response of regulators


(Source: Moodys Analytics)

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Agenda

1.
2.
3.
4.
5.

Overview about relevant national and international regulatory requirements


Basics of Risk Management
Objectives and Structure of CRR/ CAD IV (Basel III)
Introduction to Market Risk
Trading Book: The market value of counterparty credit risk

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Overview of regulatory requirements


Global vs. European vs. German (as of 15th of August 2014)
Law
1.
Global

Parliament (time consuming)


2.

Directive

EU

22

SolvV

EBA ITS/ BTA

11

German Banking Act (KWG)


25a(1) 25a(5)
7,
8,
10,
24

Public administr.

25(1)

25a(1)

25b-h

LiqV
Gro
MikV
Ma
SAN

Crisis
Directive

Renumeratio
nD

CRD IV - ImplementationL

BCBS\ Large
exposures
FSB\ Resol.
BCBS\
Renumerat.
BCBS\
Governance
Basel 2\ S2,
Sound
principles
BCBS1\ Know
Your
Customer
(KYC)

Capital Requirement
Regulation (CRR)

EBA\Report
(FIN-, COREP)

10

Capital Adequacy
Directive IV (CAD IV)

Basel 2 + 3\
Pillar 3\ Discl

Circular letter

German Banking Regulation

Recommend.
Basel 2+3\
Pillar 1\ CR

Public administration
3.

Finance Ministry (FM)

FM

FM

Notification
Directive
(AnzV)

BaFin

FinanzinformatD
(Monthly
Report D.)

BaFin

Minimum
Requirements
RiskMgt
(MaRisk)
Anti-Money
Laundry Law
BaFin

Interior
Ministry

1) BCBS : Basel Committee On Banking Supervision


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Overview of regulatory requirements


Global vs. European vs. German (as of 15th of August 2014)
Law
1.
Global

Parliament (time consuming)


2.
EU

Circular letter

Public administr.

German Banking Act (KWG)


Basel 2 & 3:\ Pillar 1:
11
25a(1)
25(1)
25a(1)
25b-h
Core10
Equity
Tier 122
- ratio:
(4.5%25a(5)
+x%)*12.5 *7,
Risk-weighted
assets Core
Equity Tier
1
8,
Tier 1 capital - ratio: (6% +x%)*12.5 * Risk-weighted
assets Tier 1 capital
10,
Total capital - ratio: (8% +x%)*12.5 * Risk-weighted assets Total capital
24
Leverage ratio: 3% * (Total Assets + m% * Off-balance
sheet items) Tier 1 capital
Liquidity Coverage Ratio: 100% * (Outflows Inflows) Highly quality liquid assets
Net Stable
LiqVFunding Ratio: 100% * (Required stable funding) Available stable funding
Basel 2 & 3:\ Pillar 3: Qualitative and quantitative disclosure of risk
Gro
Non-Basel elements:
Large exposures, Single rule book,
MikV
SolvV

EBA ITS/ BTA

Ma
SAN

Crisis
Directive
CRD IV - ImplementationL

BCBS\ Large
exposures
FSB\ Resol.
BCBS\
Renumerat.
BCBS\
Governance
Basel 2\ S2,
Sound
principles
BCBS1\ Know
Your
Customer
(KYC)

Capital Requirement
Regulation (CRR)

EBA\Report
(FIN-, COREP)

Capital Adequacy
Directive IV (CAD IV)

Basel 2 + 3\
Pillar 3\ Discl

Public administration
3.

German Banking Regulation

Recommend.
Basel 2+3\
Pillar 1\ CR

Directive

Renumeratio
nD

Notification Requirements on internal risk


Directive measurement and management
(AnzV)
Basel 2 & 3:\ Pillar 2:
FinanzRisk-bearing
capacity
- capital buffers [conservation,
informatD
(Risikotragfhigkeit)
anticyclical, systemic]: x% (x1+x2+x3)
(Monthly
Report D.)
Minimum
Non-Basel elements:
Requirements
- renumeration
RiskMgt
- transparency
(MaRisk)
Anti-Money

- sanctions
- EU Banking pass

Finance Ministry (FM)

Laundry Law
FM

FM

BaFin

BaFin

BaFin

Interior
Ministry

1) BCBS : Basel Committee On Banking Supervision


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Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative
1. Remuner.
Directive

2014

2015

2016

2017

Mid-term

Description
2012
Advisory board: responsible for compensation of board
Must be aligned to strategy, no incentives of excessive risk
taking
- Bank-internal caps
- Sustainable: delayed payout across several years
- Disclosure: qualitative and quantitative aspects
- Required details on delay, bonus reduction/ deletion
- System-relevant banks (>10 bn total assets):
compensation control committee and additional disclosure
overruled by CAD IV: boni fixed salary,
with shareholder consensus: boni 2*fixed salary

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2018

2019
Longterm

Implications
Bonus caps:
Move towards fixed salaries
Need for compensation/ HRconsultants

11

Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative
2. EMIR

2014

2015

2016

2017

Mid-term

Description

2018

2019
Longterm

Implications

Mandatory CCP-clearing for (1) standardized derivatives AND


(2) if both contract partners are financials or NFC+
(corporates exceeding notional derivative thresholds): Q1
2015
More electronic process steps in post-trading : 2013
(confirmation, portfolio reconciliation, .)
Reporting of every derivative to regulator: Feb 2014
(inception, change, maturity, interbank + NFC+: daily
prices)

New revenues: offering


indirect clearing
(large banks for their banking
segment)
Additional collateral
requirements
Collateral is the new capital
(Capital replaced by collat.)

3.Extended
FinRep

IFRS-banks, group level:


Balance sheet & P&L, quarterly, 30/9/2014

Separation of margin and


mismatch income

4. Basel III/
CoRep

31/3/2014
Quarterly: capital ratios, components, leverage ratio, NSFR,
Monthly: large exposures, LCR

Process: Integrate Solvency


and Liquidity (Solvidity)
Methods:
- internal estimates for
selected LCR-positions,
- Ratio forecasts/ planning

(European
Market
Infrastructu.
Regulation,
27/7/2013)

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Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative

2014

2015

2016

2017

Mid-term

Description

2018

2019
Longterm

Implications

5. ECB =
regulator

Nov 2014
Total assets > 30 bn EUR or
(Total assets > 5 bn EUR AND Total assets > 20% GDP) or
Top 3 bank of each country or
Has large cross-border activities or
The bank receives, or has applied for being bailed out
About 150 banks

Pillar 1: harmonized
Pillar 2: ECB-interpretation
English will become working
and project language for all
SSM-banks

6. Asset
encumbr
ance

30.6.2014 (quarterly reports)


31.12.2014 (semi-annual reports)
EBA-initiative
Report percentage of encumbered assets and conditionally
encumbered (in stress scenario)
Encumbrance structure

Will upward shift senior


unsecured curves
Systems:
implement encumbrance
reports

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Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative
7. Liikanen
report

2014

2015

2016

2017

Mid-term

Description

2018

2019
Longterm

Implications

1.7. 2015
Outsourcing of (prop) trading activities and lending to highly
leveraged entities in unit that is legally separated from
deposit-taking unit if (i) trading volume >100 bn EUR or (ii)
trading volume > 20% of total assets and total assets of last
3 years > 90 bn EUR

Low risk assets in trading


portfolios (liquidity buffer,
sovereign bonds)
ALM-hedges (IR, FX) used to
hedge lending/ deposit
mismatches

8. Margining
for OTCderivativ.

VM: 1.1.2015, IM: 1.12.2015-19 (different asset classes)


Mandatory margining (IM0 and VMt) for OTC-derivatives if
the 2 contract partners are banks and/ or systematically
relevant Non-financials
IM0 is a major challenge as new, gross and restricted re-use
Sophisticated internal margin models or (very) conservative
regulatory margins

Models:
Develop internal margin model
Process:
Enhance collateral
management
Collateral is the new capital
(Capital replaced by collat.)
Integrating liquidity- into
collateral management

9. Internal
audit

2015
Pillar 2, 15 principles/ requirements of Internal Audit
1 principle IA
Supervisor
Supervisory assessment of IA

Regulatory affairs becomes


unit of internal audit

(17/5/2013)

(06/2012)

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2. Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative

2014

2015

2016

2017

Mid-term

Description

2018

2019
Longterm

Implications

10. Financial
Transact.
Tax

2015
Lowered on political agenda
France: introduced
Germany: wont introduce it alone
Concerns: no level playing field if not globally implemented

Lowered on political agenda


France: introduced
Germany: not alone
Concerns: no level playing
field if not globally
implemented

11. Sound
capital
planning

2015
Best practise overview on capital planning process
(internal control and governance, capital policy and risk
capture, forward-looking view, management framework)
No binding elements

---(as based on survey of large


banks, they should have this
already in place)

12. Recovery
and
resolution
Directive

2015
Requirements to hypothesize resolution stress and to
draft a resolution plan/ good will
(fight against too big/ interconnected to fail)

Setup, submit and review


resolution plan/ good will

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Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative
13. LCRdisclosure

14. Funding
plans

2014

2015

2016
Mid-term

Description
Quarterly, 1.1.2015,
1. Quantitative:
Average LCR in quarter
based on daily LCR (<1/1/ 17: monthly LCR)
1.1 HQLA [EUR}
1.2 Outflows of 13 categories [EUR]
1.3 Inflows of 3 categories [EUR]
2. Qualitative:
2.1 Main drivers LCR
2.2 Composition HQLA
2.3
Feb 2015
EBA-initiative
Report:
plan balance sheets, P&L, LCR and NSFRs
report funding gaps, how planned to close and how much
the closing cost

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2017

2018

2019
Longterm

Implications
Systems and processes:
>2017: daily LCR

Need NSFR & LCR forecast


Need sound planning process

16

Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative
15.
Effective
risk data
aggregation and
risk
reporting

2014

2015

2016
Mid-term

Description
1.1.2016
A. Governance and Infrastructure
1. Governance
2. Data architecture and IT-infrastructure
B. Risk Data Aggregation
3. Accuracy and integrity
-R isk data as sound as accounting data
- Measure data quality
4. Completeness
5. Timeliness
6. Adaptability
C. Risk reporting
7. Accuracy
- Forward-looking elements
8. Comprehensiveness
9. Clarity and usefulness
10. Frequency
11. Distribution

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2017

2018

2019
Longterm

Implications
Risk data volume multiplies
for on-demand analysis by 10
(daily risk data generation: 5
20 terabytes)
Development of data quality
models
(backtesting, sensitivity
analyses)
Augment risk analysis by
forward-looking elements
(e.g. expert judgement,
volatility adjustments, ...)

17

Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative
16. Pillar 3
reports,
Phase 1

17. Capital
requ.
against
CCP
(17/5/2013)

2014

2015

2016
Mid-term

Description
1.4.2016
A. Reporting format:
- separate document
B. Scope, frequency, timing:
- capital requirements: quarterly
- other quantitative metrics: financial reporting
- qualitative information: annual
C. Consistency & Comparability:
- Use templates
D. Link to accounting data:
- Explicit mapping to line items
E. Periodic review of templates (by regulator)
F. Assurance of Pillar 3 reports:
- Board attest and internal control structure
1.1.2017
Capital 2%*[trade exposure posted collateral + posted
collateral + default funds]
Non-qualifying CCPs: risk weight = 1.250 %

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2017

2018

2019
Longterm

Implications
Policy:
need board-approved
disclosure policy
Systems:
adjust reporting systems
Process:
Monitor key Pillar 3-metrics

Capital relief compared to


time where position was
uncollateralized

18

Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative

2014

2015

2016

2017

Mid-term

Description

2018

2019
Longterm

Implications

18. Stded
approach
for CCRexposure

1.1.2017
Same structure:
Exposure = 1.4*(replacement cost + potential future
exposure)
Recognizes margined transaction, hedging sets and market
volatility and still being a pre-calibrated standardized
approach

Systems:
implement exposure method
Processes:
monitor change in capital
charge between old and new
method

19. Fundam.
review of
trading
book
(Sept
2013, 2nd
Consult.
Version)

2017
Regulatory tading book definition : trading-evidence based
All banks affected:
model banks: modified internal models + calculation of
standardised approach
Sted banks: new sted approach
New internal model: regulatory correlations, market
liquidity haircuts, desk-level model approval and withdrawal
VaR => Expected shortfall (backtesting still on VaR)
New sted approach: diversification effects, still bucketing
approaches (but not the same buckets as currently)

More capital required


Profitability of internal
model to be revised
(Do capital savings still justify
model investments?)
Model banks need
infrastructure to compute
standardised approach
(instrument logic)
All banks: NEW std approach

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Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative

2014

2015

2016

2017

Mid-term

Description

2018

2019
Longterm

Implications

20. MiFID II

2017
MiFID: 2004
MiFID II (proposal status): multilateral and organized trading
platform, algorithmic trading, position limits for commodity
derivatives, regulated markets must weekly disclose
positions of commodity derivatives and issuance
certificates, individual positions of market participants
=> only to regulators

Systems:
reporting systems in
relevant entities

21. Revised
stded
model for
credit
risk

2017
Obligor specific risk-weights:
- Sovereigns: rwnew = rwold
- Banks: rwnew = f(T1-capital ratio, Asset quality)
- Corporates: rwnew = f(turnover, leverage)
- Retail, unsecured: rwnew = f(qualitative criteria)
- Retail, mortgages: rwnew = f(L2V, Debt servicing capacity)

Affects all banks (also IRBA)


Compliance:
Likely to require more capital
=> capital pressure
Systems:
data should be available as
factors are standard in
scorecard/ rating models
Simplification

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Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013

2014

2015

Short-term

Initiative

2016
Mid-term

Description

2017

2018

2019
Longterm

Implications

22. Securitis.
framework

2018
Securitisations:
- Internal rating based
- External rating
- Standardised approach
- 1.250%
Re-securitisations:
- new standardised approach
- 1.250%

Development of internal rating


models for securitisations
because sted approach is
prohibitively expensive

23. Large
exposures
(BCBS,
246,
3/2013)

1/1/2019
Enhances RWA-framework assuming infinitely granul. PFs
Borrower units (control rights, economic dependence)
Report:
Borrower units 10% of total regulatory capital
Report and rectify:
Borrower units 25% of total regulatory capital
Report largest 10 borrower units
Only standardised approach (SA-CCR, BCBS 279) for
counterparty credit risk (CCR) allowed.

Compliance:
More capital (if not
collateralised)
Methods:
Models to identify economic
dependencies
Process: monitor exposures

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Overview of regulatory requirements


Initiatives to come: short-,middle-., long-term
2012

2013
Short-term

Initiative

2014

2015

2016

2017

Mid-term

Description

2018

2019
Longterm

Implications

24. Pillar 3
reports,
Phase 2

A.
B.
C.
D.
E.

2019
Interest rate in the banking book
(unchanged in Phase 1)
Operational risk
(unchanged in Phase 1)
New securitisation framework
(unchanged in Phase 1)
New market risk framework
(unchanged in Phase 1)
Mandatory computation and disclosure of standard
credit risk approach for all banks (e.g. also for IRBA-banks)
F. Regulatory dash board

Systems:
- IRBA-banks to implement
standardised approach for
credit risk (trading- and
banking book)
- Implement regulatory dash
board
Process: monitor dash board

25. IRRBB

Higher capital charge under


Pillar 1
Increased capital pressure
Risk-adjusted return metrics

2019
Likely to become Pillar 1 charge
(all other market risks are also Pillar 1 charges)
Standardised approach (details expected for Sept. 2014)

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Objectives and Structure of CRR/ CAD IV (Basel III)


Publications of the Basel Committee:1
Basel 2.5, Basel III and Others
Publications

Content

Phase In
Implementation
Reporting
Final
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

CCR
3 Capial definition

B3-Monitoring

Permanent

Basel III

Non-B3
Initiat.

1)
3)

Framework for
Consermore resilient 6 vation C-cyclical
banks and
G-SIB
banking system 5
Leverage
(189)
LCR
NFSR
7
Monitoring tools2
C01
Own funds
1-4 Capital adequacy
CoRep
06
Group solvency
(stand-alone 07Credit risk
14
and group)
1617 Operational risk
18Market risk
25
FinRep
(IFRS-banks,
group)

CE only
CE only
CE only
B3-Monitoring
B3-Monitoring
B3-Monitoring
Observation metrics

B3-Monitoring

I
BS & P&L
II Geograph. Exp.
III Off-BS, particip.
IV Group structure,..

31/3/2014
31/3/2014*
31/3/2014
Not finalised3

31/3/2014

30/9/2014
31/12/2014
31/12/2014

As of November 16th, 2013, 2) Maturity ladders, funding concentration, funding spreads, funding roll-over,
13/8/2013: end of consultation phase, EBA => commission Jan 1st 2014, 4) Significant currency: 5% of debt

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Objectives and Structure of CRR/ CAD IV (Basel III)


Publications of the Basel Committee:1
Basel 2.5, Basel III and Others
Publications

Non-B3
Initiat.

Large
Exposures

Losses from
mortgages

1)

Content
LE

LE Limits

LE1
LE5

CPs, TB, BB,


Individual clients,
Maturityx buckets

C15

Exposure and
losses from
mortgages

Phase In
Implementation
Reporting
Final
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

31/3/2014

30/6/2014

As of November 16th, 2013,

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24

Agenda

1.
2.
3.
4.
5.

Overview about relevant national and international regulatory requirements


Basics of Risk Management
Objectives and Structure of CRR/ CAD IV (Basel III)
Introduction to Market Risk
Trading Book: the market value of counterparty credit risk

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25

Basics of Risk Management


Risk inventory

Completeness of Risk Profile

Market Price
Risks

Credit
Risks

Operational
Risks

Liquidity
Risk

Other Risks

Normal
Changes

Issuer Risk

Key Risk Indicator & Risk Self


Assessment

Inventory

Framework
Conditions

Extraordinary
Changes

Counterparty
Risk

Loss Case
Database &
Int. Model

Sale

Business
Risks

Reputation
Risks

Issues of Interaction and Correct Aggregation

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Basics of Risk Management


Available capital is the risk buffer, required capital is the risk.

Supply side of capital:

Views on Capital

Capital an institution has


Tier I & II Capital
Pillar 1
Pure regulatory perspective
Regional divergence resulting from
differing accounting standards and
regulatory discretion in recognition of
capital across countries

Capital an institution needs

Regulatory
Tier II

Demand side of capital:

Buffer

Discret.
RWA
Tier I

x 8%

Regulatory Capital (RWA)


Basel II capital (Pillar I formulas and
Pillar II requirements)
Differences in adoption of Basel II
across countries

Economic
Risk Taking Capacity
Pillar 2
Overall risk-bearing capacity
(typically Tier I plus certain hybrids
plus expected earnings)
Differences arise from different
accounting regimes

Tier I Capital
Tier I based target capital ratios
Rating agency perspective
frequently the binding constraint

Expected
Earnings

Buffer

Discret.

Tier I

ECAP

Rating Agency*
Buffer

Discret.
Tier I

Frequently
the key
constraint

Required
Capital

Economic Capital (ECAP)


Capital required from an economic
perspective, covers unexpected
losses
All risks
Rating Agency Capital Requirements
Reflects regulatory capital plus
analysts judgment
Usually to address multiple
agencies (S&P, Moodys, Fitch,
etc.)

* Illustrative
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Regulatory vs. economic capital

RORAC =
2

Net revenues
[%]
Risk capital

RAROC =

Risk Capital

Net revenues - COE


[%]
Risk capital

Regulatory capital
Risk capital =
Economic capital
Credit Risk

Market Risk
Approaches

IR

EQ

FX

Commodities

Others1

Approaches

PD

Standardised
Approach

IR-risk
model

EQ-risk
model

FX-risk
model

CO-risk
model

Spec.
models

Standard.

External

LGD

EaD

External
1. Regulatory
Capital

Foundation
Internal
Model2,3

VaR [99%,10d]
P&L = sensitivities * risk factors

Internal
IRBA

Advanced
Aggregation

Internal
RWA = LossVasicek[99.9%,1Y]
Simulation of risk factors
(credit, market, ...)

2. Economic
Capital

Internal
Model

VaR [pbank-specific,1y]
P&L = sensitivities * risk factors

Credit Risk
Models

PD

LGD

EaD

CVaR= Loss distrib. [1y,pbanksp.]


1:

Others: weather/ electricity derivatives


Internal model in regulatory section is the internal model with regulatory-defined {horizon, confidence level}.
3: DB, AR 2008, p. 95 : We calculate value-at-risk for both internal and regulatory reporting using a 99% confidence l
evel. For internal reporting, we use a holding period of one day. For regulatory reporting, the holding period is ten days.
2:

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Step can be left out by


directly simulating the
loss.

28

Regulatory vs. economic capital

RORAC =
2

Net revenues
[%]
Risk capital

RAROC =

Net revenues - COE


[%]
Risk capital

Regulatory capital
Risk capital =
Economic capital

Risk Capital
Market
Risk

Credit
Risk

...

...

1. Regulatory
Capital
...

2. Economic
Capital

...

Operational Risk

Basic

Basic Indicator
Approach

Standardised

Gross-Income
Approach

Advanced

VaR[99.9%, 1y]

Business Risk

Risk Diversification

VaR[pbankspec., 1y]

Aggregation
Model

...

...

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Regulatory Model
(if VaR: scaled if not 99.9%)

29

9. Value management
B Profitability of risks: RAROC/ RORAC
Regulatory vs. economic capital

Deutsche Bank
2

Risk Capital

Deutsche Bank, Annual Report 2008, p. 71

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Economic Capital

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Basics of Risk Management


Economic capital is the maximum annual loss at a given
confidence level.
Confidence level, e.g. SBG: p = 99.925% (derived from target debt rating)

Statistical Approach to Risk

Probability

Worst Cases

1-p

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0
Economic Capital
p

Expected
Outcome

Value/
Return

The quantification of risks requires


statistics and the concept of probability
The future value (of a banks assets) is
uncertain due to the risks it faces
This is described by the probability
distribution of value
The Expected Outcome is close to
the most likely outcome
Worst cases (severe drops in value)
are much less likely but not
impossible
The shaded area describes the probability
for the value to drop below x (worst
cases), i.e. the banks Probability of
Default, and determines the banks credit
rating
The Economic Capital that a bank needs
to survive this worst case is given by
(Expected Outcome x)
If a bank wants to have a better target
rating (i.e. lower PD) it requires more
Economic Capital as x will be lower
32

Basics of Risk Management


In credit risk there are only adverse surprises.

Credit Risk

70%

Equity Risk

2.9%

Market Risk

Operational Risk

Business Risk

3.9%

15.5%

3.4%

Risk of loss to the group as a result of the failure


by a client or derivative counterparty to meet its
contractual obligations.
Loss = payment shortfall
Distribution: beta, vendor-specific (e.g. KMV)1
Parameter on individual transaction: PD, LGD,
EaD
Parameters on portfolio level: correlation, copula,
distribution

Repayment

Interest Rate Risk,


BB

4.3%

Probability

Worst Cases
1-p

Expected Contractual
Outcome (EL) Obligation
Economic Credit Risk Capital
p

1 Non-distributional approaches are also possible (e.g. empirical distributions)


FrankfurtSchool.de

33

Basics of Risk Management


Equity risk results from strategic equity positions in the
banking book.
Credit Risk

70%

Equity Risk

2.9%

Market Risk

Operational Risk

Business Risk

3.9%

15.5%

3.4%

Risk of losses from changes in market prices


and/ or dividend payments of equities of banking
book positions.
Loss = value/ dividend loss
Distribution: normal or others
Parameters: trend, volatility, distribution
Parameters on portfolio level: correlation

4.3%

Probability

Worst Cases

1-p

FrankfurtSchool.de

Interest Rate Risk,


BB

0
Economic Equity
Risk Capital

Expected
Outcome (EL)

Value

34

Basics of Risk Management


Market risk comprises all risks of the trading book.

Credit Risk

70%

Equity Risk

2.9%

Market Risk

Operational Risk

Business Risk

3.9%

15.5%

3.4%

Risk of losses from changes in market prices


(equities, interest rates, commodities, FX, credit
spreads, recovery rates, correlations, implied
volatilites) of trading book positions.
Loss = loss in (mark-to-market) values
Distribution: normal, student-t, others
Parameters: trend, volatility, distribution
Parameters on portfolio level: correlation, copula

4.3%

Probability

Worst Cases

1-p

FrankfurtSchool.de

Interest Rate Risk,


BB

0
Economic Market
Risk Capital

Expected
Outcome (EL)

Value

35

Basics of Risk Management


Operational risk results from running a bank/ company.

Credit Risk

70%

Equity Risk

2.9%

Market Risk

Operational Risk

Business Risk

3.9%

15.5%

3.4%

Risk of losses resulting from inadequate or failed


processes, people and systems or from external
events inclusing information and legal risk but
excluding reputational and strategic risk.
Loss = losses from above mentioned categories
Distribution: Compound Poisson
(Frequency: Poisson, Severity: Normal-, Student-t,
Beta, ...)
Parameters: expected frequency, expected severity,
volatility of severity
Parameters on portfolio level: correlation, copula

4.3%

Probability

Losses
Worst Cases
1-p

FrankfurtSchool.de

Interest Rate Risk,


BB

Expected
Outcome (EL)
Economic OpRisk Capital

36

Basics of Risk Management


Business risk is a widely neglected risk type.

Credit Risk

70%

Equity Risk

2.9%

Market Risk

Operational Risk

Business Risk

3.9%

15.5%

3.4%

Risk of losses resulting from decreasing


revenues compared to the cost base due to
macroeconomic, strategic and/ or reputational
reasons.
Loss = shortfall in revenues
Distribution: Normal or others
Parameters: expected revenues,
volatility of revenues

Interest Rate Risk,


BB

4.3%

Probability

Revenues
Worst Cases

1-p

FrankfurtSchool.de

x
Economic
BR Capital

Expected
Revenues (ER)

37

Basics of Risk Management


Interest rate risk in the banking book is affects the
net interest income.
Credit Risk

70%

Equity Risk

2.9%

Market Risk

Operational Risk

Business Risk

3.9%

15.5%

3.4%

Risk of a reduction of net interest income (NII)1


of the banking book due to adverse movements
in interest rates resulting from a interest rate
maturity mismatch between assets and liabilities.
Loss = shortfall of NII
Distribution: Normal or others
Parameters: expected yield curve changes,
volatility of yield curve changes

Interest Rate Risk,


BB

4.3%

Probability

NII
Worst Cases

1-p

Expected NII

Economic
IRRBB Capital
p

No PV-perspective as no MtM-accounting in banking book.

FrankfurtSchool.de

38

Basics of Risk Management


The individual risk types must be aggregated to the
overall EC-position.
Credit Risk

70%

Equity Risk

2.9%

Market Risk

Operational Risk

Business Risk

3.9%

15.5%

3.4%

Interest Rate Risk,


BB

4.3%

Aggregation Model
(e.g. correlation,
copula)
Group Economic
Capital

SBG EC as of 31.12.20091

With probability of 99.925%, the loss from SBGs banking


activities will not exceed 44,762 mR in 2010.
Is 44,762 mR a lot or little? => compare to available risk buffer

FrankfurtSchool.de

39

Basics of Risk Management


Economic capital is the maximum annual loss for a
given confidence level.
Group Economic
Capital

SBG EC as of 31.12.20091

With probability of 99.925%, the loss from SBGs banking


activities will not exceed 44,762 mR in 2010.

Available financial resources (AFR) = all funding that can


absorb losses.1

Actual default probability is much smaller than 0.075%:


p* that equals: EC = AFR

Institut-dependent: Tier 1 capital + qualifying sub debt + hidden reserves + ... CoBa: T1, BBVA: T1+T2, Unicredit = T1+T2+T3+Adjustments.

FrankfurtSchool.de

40

Basics of Risk Management


Economic capital adequacy (ratio) varies mainly due to
bank-specific AFR-definitions.

As of 31.12.2009, 2 No disclosure per risk-type.

FrankfurtSchool.de

41

Economic capital measurement framework

Shareholder &
Boards Concern

Risk Appetite
Statement

Key concern: Is anticipated

Serves to communicate how much

earnings volatility
acceptable?

Dividend cut / profit warning

risk the institution is willing to take

Earnings at Risk (EaR) capacity

Probability

Self-sustaining growth

= 1 in 510 years event

Maximum portfolio concentrations

Focus on risk measures


that capture volatility
around expected outcomes,
such as Earnings at Risk

Target debt rating


Target capital ratios
Target liquidity ratios
plus other criteria, such as
acceptable vs. unacceptable risks
Negative signal to markets e.g. profit
warning

Debt holders &


regulators concern

Poor performance e.g. dividends


reduced
Senior management reshuffled

Key concern: Can the institution


survive the anticipated earnings
volatility?

Regulatory takeover

Insolvency = 1 in 2000+ years event

Capital base lost

Focus on risk measures that capture


extreme loss events

Expected

Earnings

Requires Economic Capital

FrankfurtSchool.de

42

42

Economic capital measurement framework

Consistency
Capital
Allocation
Framework

Risk Limit
Framework
...

Buffers

...
ML3

ML2
ML1

No
operational
risk limits

...

CL3

CL2
CL1
Risk
Limits

Other
risks

Op.
Risk

Op.
Risk

Market
risk

...
Derive
operational
risk limits

Other
risks

Transform
risk taking
capacity into
risk limits

Consideration
of correlations
and
diversification
effects
Ecap/Regulatory
Capital Limits

FrankfurtSchool.de

BU 3

Deduction
from
risk taking
capacity
without limits

BU 2
Market risk
Credit risk

Credit
risk

BU 1
Available
Equity

Available
Equity

Allocated
Capital

43

Economic capital measurement framework


If economic capital is used to manage the bank, then there must be a
robust, trusted and efficient economic capital reporting process

Strategy
Finance Director

Strategy
Group Treasury
Capital structure

Chair
Group Risk
Capital allocation
Methodology
Group Risk
Risk-type Heads:
Responsible for the
development of EC
models and review and
challenge

Membership:
Group and Cluster
representatives

Calculation
Group Risk
Ensure consistent economic capital calculation
and allocation

Responsibility of Group
Finance
FrankfurtSchool.de

Methodology
CRO

Economic Capital
Steering
Committee

Reporting
Group Finance
Collation and reporting of
Group EC and EP
figures

Strategic Planning
GS&P

ExCo

Data provision
Business units

Responsibility of Group Risk


44

Hierarchy of relevant terms


Risk Management

to be adequate and effective

Defines and
implements

Risk Bearing Capacity

considers

Business Strategy
Risk Strategy
Internal Monitoring Procedures

Internal Control System

Internal Audit

Structural and operational


organisation
Processes for identifying, assessing,
treating, monitoring and
communicating risks
FrankfurtSchool.de

45

Structure of MaRisk
General requirements (AT)
AT 1 Preliminary remarks
AT 2 Scope of application
AT 2.1 Affected institutions
AT 2.2 Risks
AT 2.3 Transactions
AT 3 Overall responsibility of sen. managmnt.
AT 4 General requirements for risk managmnt.
AT 4.1 Risk-bearing capacity
AT 4.2 Strategies
AT 4.3 Internal control system
AT 4.3.1 Structural and operational arrangements
AT 4.3.2 Processes for identifying, assessing,
treating, monitoring and communicating risks
AT 4.4 Special functions
AT 4.4.1 Risk Control ( new 2012)
AT 4.4.2 Internal Audit
AT 4.4.3 Compliance
AT 4.5 Risk management at group level
AT 5 Organisational guidelines
AT 6 Documentation
AT 7 Resources
AT 7.1 Personnel and incentive systems
AT 7.2 Technical facilities and related processes
AT 7.3 Contingency plan
AT 8 NPP / Changes in processes
AT 9 Outsourcing

FrankfurtSchool.de

Special requirements (BT)


BTO Requirements for the structural and operational
arrangements
BTO 1 Lending business
BTO 1.1 Separation of functions and voting
BTO 1.2 Requirements for lending business processes
BTO 1.3 Procedure for the early detection of risks
BTO 1.4 Risk classification procedure

BTO 2 Trading business


BTO 2.1 Separation of functions
BTO 2.2 Requirements for trading business processes

BTR Requirements for processes for identifying,


assessing, treating, monitoring and communicating risks
BTR 1 Counterparty risks
BTR 2 Market price risks
BTR 2.1 General requirements
BTR 2.2 Market price risks in trading book
BTR 2.3 Market price risks in banking book (incl. int. rate
risks)
BTR 3 Liquidity risks
BTR
Operational
risks for Internal Audit
BT 2 4Special
requirements
BT 2.1 Duties of the internal auditing function
BT 2.2 General principles for the internal auditing function
BT 2.3 Planning and conduct of the audit
BT 2.4 Reporting obligation
BT 2.5 Reaction to findings

46

Overview on recent updates to MaRisk


2. update 2009
Financial Crisis
Concentration Risk (overhaul)
Other Risk (more detailed now)
Risk Bearing Capacity (more detailed now)
Stress test (overhaul)
Liquidity risk (overhaul)
Evaluation of positions (more detailed now)
Group management (overhaul)
Remuneration systems (new)
Strengthening of supervisory functions (update)
Credit
Issuers (more detailed now)
Societ Generale
Trade process
internal deals and cancellations
/ corrections (more detailed now)
IT access rights (more detailed now)
Other
Consideration of equity capital
Recovery process of troubled banks

FrankfurtSchool.de

3. update 2010
Financial Crisis
Risk inventory (new)
Concentration Risk (another overhaul)
Risk Bearing Capacity (still more
details)
Diversification effects (new)
Risk strategies (more detailed now)
Strategy process (new)
Stress test (another overhaul)
Liquidity risk (another overhaul)
Societ Generale
Trade process
reconciliation and
issues (more detailed now)
IT access rights (clarification)
Other
Risk Management not confined to
reporting period
47

Overview on recent updates to MaRisk


4. update 2012
Special Functions
Details on Risk Control function /
department
Compliance function
Code of ethics
Capital Requirments
Detailed processes to determine future
capital needs
Other
Increased responsibilities for FX loans
Enforced job rotation for traders
Transfer pricing for Liquidity costs

FrankfurtSchool.de

48

Regulatory Capital definition


Publication of final common template for capital disclosure

BCBS-Paper No 221, June 2012

...
85

85 items

FrankfurtSchool.de

49

Regulatory Capital definition


Status quo and Intention
Status Quo
Banks may report high Tier1 ratio
even with low common equity ratio
though common equity is best to
absorb losses on a going concern
basis

Basel III - Amendments


3.1 Capital quality

1. Higher common equity- (CE-)


and Tier 1-ratio.
2. Mandatory CE- and Tier 1-ratios
(=Pillar 1-ratios)

3.2 Capital definition

Motivation

No harmonised list of regulatory


adjustments to Tier1&2 capital
Among Basel Committee countries
Hence, no consistent capital base

Harmonize regulatory capital


across jurisdictions by common
list of criteria and strengthen capital
quality by stricter CE- and Tier
conditions.
3.3 Capital disclosure

Often insufficient disclosure and


hence weak transparency

FrankfurtSchool.de

Increase and harmonize granularity


of regulatory capital disclosure

50

Regulatory Capital
Higher and mandatory CE- and Tier 1-capital ratios.
3 Pillar concept
1
2
3
Assets

Changes Basel II => Basel III


Liabilities
(i) Banking book

Loans
Securitised
liabilities
Tradeable
liabilities
Tradeable Assets
Ly Reserve

Others
Tier 3
Tier 2
Equity
addTier 1

Other assets
1. Credit Risk
(CR)

CE

2. Market Risk
(MR)

RWAMR

+
3. Operational
Risk (OpR)
3:

Tier 3
Tier 2
CE

RWACR

1:

(ii) Trading book

2. MR

1. Credit Risk (CR)

2. MR

Deposits

RWAOpR

RWAbank
CE-capital
ratio

!
2%
(4.5%)3

Tier 1 Capital

RWAbank

!
4%
(6%)3

Tier 1ratio

Tier 1 Capital

RWAbank

!
8%2
(8%)3

Total
Capital
Ratio

Regulatory Capital Adequacy2

Have more equity than debt character (e.g. Preferred stocks), 2: Germany: only TCR has to be reported.
Basel 3 figures as of 1/1/2019. Also: Under Basel III, all 3 capital ratios are now mandatory (Pillar 1).

FrankfurtSchool.de

51

Regulatory Capital and Capital Ratios

Sources of volatility on capital


adequacy
Volatile
(IFRS & cycle
effects of earnings)

Cyclical

Eligible Capital (Tier 1, 2, 3)


Credit Risk RWA + Market Risk RWA + Op. Risk (+ Pillar 2)
Highly cyclical

Volatile

(PD & LGD effects)

(market parameters)

Under Basel I, the key driver of capital


volatility was business volume
Under Basel II, additional factors play
a role:
Credit cycles
Risk model related effects,
e.g. stability or recalibration

FrankfurtSchool.de

Regulatory
Capital Adequacy
Ratio (%)

Increased transparency
and stakeholder scrutiny
of capital adequacy
(rating agencies, debt
and equity markets,
regulators)

52

Regulatory Capital
Tier 2 - capital for existential losses only, Tier 1 for all others.

Tier2

Tier1

Capital types & Instruments

Key
elements

Goingconcern
capital

Common equity
(including retained
earnings)
Additional Tier-1

Goneconcern
capital

No detailed
instruments

Characteristics (Selection)
Absorb serious, but not existential losses
(going-concern basis):
subordinated
fully discretionary non-cum. divid./ coupons
no maturity or incentive to redeem
Absorb existential losses
(gone-concern basis):
subordin. to depositors and general creditors
maturity > 5yrs
no further subcategories

Tier 3 abolished

FrankfurtSchool.de

53

Regulatory Capital
Capital categories: Basel II vs. Basel III1

Basel II

Basel III

Tier 1
Tier 2
Tier 3

max. 50%
of Tier 1

Tier 3
1:

Additional
core capital
Tier 2

Loss absorption
gone concern

Tier 2
2nd class

max. 100%
of Tier 1

Common
equity

Loss absorption
going concern

Tier 2
1st class

Innovative
hybrid capital
(max. 15%
of Tier 1)

Tier 1 - capital ratio

max. 50%
of Tier 1

Totasl capital ratio

Hybrid
core
capital

Common equity ratio

Common
equity

Bundesbank, Guericke, TSI-conference, July 2010

FrankfurtSchool.de

54

Regulatory Capital
Tier 1\ Common equity

Tier 1
Tier 2

Goneconcern
capital

T1, T2

Key
elements

Goingconcern
capital

Minority
Interest

T1, T2

Definition

Regulatory
Adjustm.

Capital

Disclosure

FrankfurtSchool.de

Pillar 3
report

Characteristics (Complete)
Common equity Tier 1 Capital

Common shares meeting criteria for classification as


common shares for regulatory purposes (or the equivalent for
non-joint stock companies);
Stock surplus (share premium) resulting from the issue of
instruments included
Common Equity Tier 1;
Retained earnings;
Accumulated other comprehensive income and other disclosed
reserves;
Common shares issued by consolidated subsidiaries of the
bank and held by third
parties (ie minority interest) that meet the criteria for inclusion in
Common Equity
Tier 1 capital. See section 4 for the relevant criteria; and
Regulatory adjustments applied in the calculation of Common
Equity Tier 1

Instruments:

55

Regulatory Capital
Tier 1\ Common equity

Tier 1
Tier 2

Goneconcern
capital

T1, T2

Key
elements

Goingconcern
capital

Minority
Interest

T1, T2

Definition

Regulatory
Adjustm.

Capital

Disclosure

FrankfurtSchool.de

Pillar 3
report

Characteristics (Complete)
Common equity Tier 1 Capital
Regulatory criteria: for classification as common shares for
regulatory purposes (or the equivalent for non-joint stock
companies);
Most subordinated claim in liquidation of bank
Unlimited claim on residual assets in proportion to own shares
of issued capital
Principal is perpetual
No exception of buying back, redeeming or cancelling the
instrument
Distributions only paid out of distributable items
Distributions only paid after all other legal and contractual
obligations have been met, no preferential distribution
Each CET instrument is pari passu with all the others
Recognition as equity capital in case of insolvency
Instrument is classified as equity capital pursuant to relevant
accounting standards
Directly issued without (in)direct funding of the purchase by the
bank
No securing or covering by guarantees of the issuer
Issuance only after approval of the owners of the bank
Clear and separate disclosure on the balance sheet
(no hidden reserve !!!)

56

Regulatory Capital
Tier 1\ Additional Tier 1

Tier 1
Tier 2

Goneconcern
capital

T1, T2

Key
elements

Goingconcern
capital

Minority
Interest

T1, T2

Definition

Regulatory
Adjustm.

Characteristics (Complete)
Additional Tier 1 Capital

Capital (and are not included in Common Equity Tier 1)


Stock surplus (share premium) resulting from the issue of
instruments included in Additional Tier 1 capital;
Instruments issued by consolidated subsidiaries of the bank and
held by third parties
that meet the criteria for inclusion in Additional Tier 1 capital and
are not included in Common Equity Tier 1
Regulatory adjustments applied in the calculation of Additional
Tier 1 Capital

Instrument:

Capital

Disclosure

FrankfurtSchool.de

Pillar 3
report

57

Regulatory Capital
Tier 1\ Additional Tier 1

Tier 1
Tier 2

Goneconcern
capital

T1, T2

Key
elements

Goingconcern
capital

Minority
Interest

T1, T2

Definition

Regulatory
Adjustm.

Capital

Disclosure

FrankfurtSchool.de

Pillar 3
report

Characteristics (Complete)
Additional Tier 1 Capital

Issued and paid in


Subordinate to depositors, general creditors and subordinated
debt of bank
No securing or covering by guarantees of the issuer
Perpetual, no incentives to redeem
Callable at initiative of the issuer only after (a minimum) of 5
years
Repayment of principal only aftrer supervisory approval
Distributions cannot be made obligatory
Dividends only paid out of distributable items
No credit-sensitive dividend feature
No contribution to liabilities in case of over-indebtness
If instrument is classified as a liabilitiy for accounting purposes,
principal loss absorption mechanism is required
No (in)direct purchase/ funding by the bank
No hindrance of recapitalisation
Unlimited availability of proceeds

Regulatory criteria:

58

Regulatory Capital
Tier 2

Tier 1
Tier 2

Goneconcern
capital

T1, T2

Key
elements

Goingconcern
capital

Minority
Interest

T1, T2

Definition

Regulatory
Adjustm.

Characteristics (Complete)
Tier 2 Capital

Instruments issued by the bank that meet the criteria for


inclusion in Tier 2 capital (and not included in Tier 1 capital);
Stock surplus (share premium) resulting from the issue of
instruments included in Tier 2 capital
Instruments issued by consolidated subsidiaries of the bank and
held by third parties that meet the criteria for inclusion in Tier 2
capital and are not included in Tier 1 capital.
Certain loan loss provisions
Regulatory adjustments applied in the calculation of Tier 2
Capital.

Instrument:

Capital

Disclosure

FrankfurtSchool.de

Pillar 3
report

59

Regulatory Capital
Tier 2

Tier 1
Tier 2

Goneconcern
capital

T1, T2

Key
elements

Goingconcern
capital

Minority
Interest

T1, T2

Definition

Regulatory
Adjustm.

Characteristics (Complete)
Tier 2 Capital

Issued and paid in


Subordinated to depositors and geenral creditors of the bank
No securing or covering by guarantees of the issuer
Minimum maturity of five years, no incentives to redeem, no
step-ups
Callable at the initiative of the issuer only after (min.) period of 5
years
No rights for the investors to accelerate repayment
No credit sensitive dividend feature
No (in)direct purchase/ funding by the bank
Unlimited availability of proceeds

Criteria:

Capital

Disclosure

FrankfurtSchool.de

Pillar 3
report

60

Regulatory Capital
Minority interest

Tier 1
Tier 2

Goneconcern
capital

T1, T2

Key
elements

Goingconcern
capital

Minority
Interest

T1, T2

Definition

Regulatory
Adjustm.

Characteristics (Complete)
Minority Interest
Definition: capital issued by fully consolidated subsidiaries and
hold by third parties
Subsidiary must also be a bank
Criteria for CE-T1, T1 or T2 must be fulfilled
Particular recognition rules

Capital

Disclosure

FrankfurtSchool.de

Pillar 3
report

61

Regulatory Capital
Regulatory adjustments

Tier 1
Tier 2

Goneconcern
capital

T1, T2

Key
elements

Goingconcern
capital

Minority
Interest

T1, T2

Definition

Regulatory
Adjustm.

Characteristics (Complete)
Regulatory adjustments

Goodwill and other intangibles


Deferred tax assets relying on future profitability
Cash flow hedge reserve (<0: added/ >0: deducted)
Unrealised gains/ losses due to own credit risk (DVA)
Own shares (treasury shares)
Reciprocal capital holdings with other banks, financial or
insurance entities
...

Deducted from CE-T1:

Capital

Disclosure

FrankfurtSchool.de

Pillar 3
report

62

Regulatory Capital
Banks to disclose more details about their regulatory capital.

Tier 1
Tier 2

Goneconcern
capital

T1, T2

Key
elements

Goingconcern
capital

Minority
Interest

T1, T2

Definition

Regulatory
Adjustm.

Characteristics (Complete)
Disclosure requirements
- Link regulatory capital to balance sheet capital
- Report all regulatory adjustments and items not deducted from
Common Equity Tier 1
- Disclose positions that have been subject to limits and minima
- Description of capital instruments issued
-Disclosed capital ratios have to be accompanied with
comprehensive explanation about their computation
- Publish terms and conditions of all instruments included in
regulatory capital
December 2011:
BCBS published capital disclosure template (as of 1.1.2018) for
comments by Feb.2012
(http://www.bis.org/publ/bcbs212.pdf)

Capital

Disclosure

FrankfurtSchool.de

Pillar 3
report

63

Agenda

1.
2.
3.
4.
5.

Overview about relevant national and international regulatory requirements


Basics of Risk Management
Objectives and Structure of CRR/ CAD IV (Basel III)
Introduction to Market Risk
Trading Book: the market value of counterparty credit risk

FrankfurtSchool.de

64

Objectives and Structure of CRR/ CAD IV (Basel III)


Milestones of international banking regulation
Basel I => Basel II
Past
Basel I
(1988 2007)

Market Risk
Amendment
(bcbs 24)

International Convergence
of Capital Measurement
and Capital Standards
(bcbs 128)

Credit
risk

Legal
implementation
in Germany

Market
risk
Credit
risk,
IRBA
Op.
risk

Supervisory review

Market
risk

Regulatory risk
measurement

3 Pillar concept
1.
2.

Minimum capital
requirements

International
convergence of
capital
measurement
and capital
standards
(bcbsc111)

Current
Basel II
(2007 currently)

Solvency Directive (as of 1.1.2007)


MaRisk

1:

Regulatory risk model can be either regulatory models (standardized appraoches) or internal models with specific
regulatory (minimum) requirements (confidence levels, data history, etc.).

FrankfurtSchool.de

65

Objectives and Structure of CRR/ CAD IV (Basel III)


Basel II stabilizes banks through three pillars:
1. Minimum capital, 2. Supervision, and 3. Disclosure
3 Pillar concept
1. MINIMUM
CAPITAL

Key Aspects

Regulator
is happy
if ...

Credit Risk
Market Risk
Operational Risk
Capital
requirements
better
differentiated and
more closely tied
to economic risk
Range of
approaches
(internal and
standardized
models)

Total capital ratio 8%

2. SUPERVISORY
REVIEW

Board and Senior

Mgt. Oversight
Sound capital
assessment (ICAAP)
Comprehensive
assessment beyond
Pillar1-risks
Interest Rate Risk
Banking Book
Model risk
...
Business and risk
strategies
Internal control
review

Capital adequacy processes

3. MARKET
DISCIPLINE

Disclosure:
Scope of

application
Capital Structure
Capital Adequacy
Credit Risk
Market Risk
Operational Risk
Interest Rate Risk
Other Risks
ICAAP

Pillar III - report

Sound infrastructure

1:

Regulatory risk model can be either regulatory models (standardized appraoches) or internal models with specific
regulatory (minimum) requirements (confidence levels, data history, etc.).

FrankfurtSchool.de

66

Objectives and Structure of CRR/ CAD IV (Basel III)


Milestones of international banking regulation
Basel I => Basel II => Basel 2.5 => Basel III
3 Pillar concept
1
2
3
Pillar 1: Solvency Directive (as of 1.1.2007)

Basel II
(2007 currently)

Basel II Minimum capital ratio


International Convergence
of Capital Measurement
and Capital Standards
(bcbs 128)

Op.
risk

8%
RWACR + RWAOpR + RWAMR

Remark: RWAX = 12.5 * VaRX = Unexpected lossX

=> details: next slide

3.
Market discipline

Credit
risk,
IRBA

Capital Ratio

Pillar 2: Minimum Requirements on Risk Mgt

Supervisory review

Market
risk

Regulatory risk
measurement

Minimum capital
requirements

3 Pillar concept
1.
2.

CapitalTier1+CapitalTier2

Cf. this slide +2


Pillar 3: Solvency Directive (as of 1.1.2007)

Solvency Directive (as of 1.1.2007)


MaRisk

FrankfurtSchool.de

67

Objectives and Structure of CRR/ CAD IV (Basel III)


Milestones of international banking regulation
Basel I => Basel II => Basel 2.5 => Basel III
3 Pillar concept
1
2
3

(i) Banking book

Assets

(ii) Trading book

Liabilities

Basel II Minimum capital ratio


CapitalTier1+CapitalTier2
8%

Loans

RWACR + RWAOpR + RWAMR

Securitised
liabilities
Tradeable
liabilities
Tradeable Assets
Ly Reserve

1. Credit Risk
(CR)

RWACR

2. Market Risk
(MR)

RWAMR

3. Operational
Risk (OpR)

RWAOpR

Remark: RWAX = 12.5 * VaRX = Unexpected lossX

Others
Tier 3
Tier 2
Equity
addTier 1

Other assets

1:

Capital Ratio

2. MR

1. Credit Risk (CR)

2. MR

Deposits

CE
Sted Appr.

RW1(regul. segment, ext. rating)

IRBA

K (PDInternal, R, ...)* LGDEx-/Internal

Sted Appr.
Internal
Basic/ Sted
Internal

8%
x EaDEx-/ Internal

RW1(regul. segment, instrument characteristics)


VaR99Internal
%,10 d = max{VaR10,1%,t 1 ;

x 12.5

mc 60
VaR10,1%,t i },3 mc 4
60 i =1

Risk weight (regulatory segment)

Gross income

VaR99AMA
.9%,1Y = VaR ( severity, frequency)

RW: risk weight

FrankfurtSchool.de

68

Objectives and Structure of CRR/ CAD IV (Basel III)


Milestones of international banking regulation
Basel I => Basel II => Basel 2.5 => Basel III

3 Pillar concept
1
2
3
Pillar 2: Minimum Requirements on Risk Mgt
AT 3 Overall responsibility of the board
AT 4.1 Risk-bearing capacity
AT 4.2 Strategies
AT 4 General requirements for risk management
AT 4.3 Internal control system
AT 4.4 Internal audit
AT 5 Organisational guidelines
AT 6 Documentation
AT 7 Resources
AT 8 Activities in new products or new markets
AT 9 Outsourcing
BT 1 Special requirements on internal control system
BTO 1 Lending business
BTO Requirements on organisational and operational setup
BTO 2 Trading business
BTR 1 Counterparty risks
BTR 2 Market risks
BTR Requirements on risk management
BTR 3 Liquidity risks
BTR 4 Operational risks
BT 2Special requirements for internal audit

FrankfurtSchool.de

69

Objectives and Structure of CRR/ CAD IV (Basel III)


Milestones of international banking regulation
Basel I => Basel II => Basel 2.5 => Basel III
Past
Basel I
(1988 2007)

Basel 2.5
(2012 currently)

Basel III
([2013,2018] - )

International Convergence
of Capital Measurement
and Capital Standards
(bcbs 128)

Revisions to the
market risk
framework
(bcbs 157)

Strengthening
resilience of the
banking sector
(bcbs 164)

Credit
risk

Market
risk
Credit
risk,
IRBA
Op.
risk

Supervisory review

Market
risk

Regulatory risk
measurement

3 Pillar concept
1.
2.

3.
Market discipline

Market Risk
Amendment
(bcbs 24)

Basel II
(2007 currently)

Minimum capital
requirements

International
convergence of
capital
measurement
and capital
standards
(bcbsc111)

Current

Market
risk
Credit risk

Leverage Ratio
Legal
implementation
in Germany

Solvency Directive (as of 1.1.2007)


MaRisk

Liquidity risk

1:

Regulatory risk model can be either regulatory models (standardized appraoches) or internal models with specific
regulatory (minimum) requirements (confidence levels, data history, etc.).

FrankfurtSchool.de

70

Objectives and Structure of CRR/ CAD IV (Basel III)


Although tightly regulated by Basel II, global regulators
identified 7 major vulnerabilities (2-7).

Crisis
main
drivers

Level and quality of capital basis diminished

Systemic counterparty risks materialised:


Large (interbank loans/ deposits AND OTCderivatives) and opaque (OTC)
interconnectedness of institutions
Migration risk in counterparty credit risk for OTC
transactions ignored so far in capital ratio

strengthening
individual
institutions in
periods of stress

Actions
on two
levels

Excessive leverage and procyclical deleveraging

6a Transmission of shocks through the cycle

(procyclicality)
6b Failure of large banks (e.g. Lehman) threatened

the global banking system


(global systemically important banks)
7

Micro level:

Event risks (Defaults, Migration) of credit


derivatives and securitizations in trading book

Insufficient liquidity buffers

FrankfurtSchool.de

Macro level:
addressing system
wide risks and
amplification
effects.

71

Objectives and Structure of CRR/ CAD IV (Basel III)


Basel 2.5/ III : Pillar -1 context

Basel III and CRR ( Basel II )


Basel 2.5

Pillar 1 (Minimum standards)

Market risk
(bcbs 193)

bcbs 189

C
4

Basel III

1. Core Equity Tier1 Ratio

4.5%

12.5*( KCR + VaROpR + VaRMR + sVaRMR + IRM + VaR_CVA ) + [2.5%-8.5%]

B
3

D
5

4
Capital
definition

Risk
coverage

Leverage
ratio

6a Countercyclicality
Systemic
207 6b
Risk
7 Liquidity
risk
(bcbs 188, 238,
271)
1)

3 CapitalCore Tier1
2
3

2. Tier 1 Capital Ratio

CapitalCore Tier1 + Capitaladdit. Tier1


RWA 2 4

6
6.0%
+ [2.5%-8.5%]
6

3 CapitalCore Tier1 + Capitaladdit. Tier1+ CapitalTier2


3. Total Capital Ratio

4. Leverage Ratio

RWA 2 4

3 CapitalCore Tier1 + Capitaladdit. Tier1


Total Assets + {0/5/25/50/100}% Off-Balance

5. Liquidity Coverage Ratio 7

6. Net Stable Funding Ratio 7

Highly quality liquid assets


Outflows min(75% Outflows; Inflows)
Available stable funding
Required stable funding

8.0%
+ [2.5%-8.5%]
6
3%

100%1

100%

1.1. 2015/2016/2017/2018/2019: 60%/ 70%/ 80%/ 90%/ 100%

FrankfurtSchool.de

72

Objectives and Structure of CRR/ CAD IV (Basel III)


Reporting Compliance Disclosure
Application of CAD IV and CRR

3. Liquidity
Coverage Ratio

BCBS 188

5. EBA Liquidity
Monitoring tools1

BCBS 165

4. Net Stable
Funding Ratio

Enter into force CRR (28/6/13) and CAD IV (17/7/13)

BCBS 189

2. Leverage
ratio

BCBS 164

1. Capital ratios
(CET1, T1, TC)

Start CAD IV- and CRR trilogue (EU Com/ council/ parl.)

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Reporting (quarterly)
Pillar I - constraint
Disclosure
Reporting (quarterly)
Pill I - constraint
Disclosure
Reporting (monthly)
Pillar I - constraint
Disclosure
Reporting (quarterly)
Pill. II

Pill I - constraint

Disclosure: tba
Reporting (monthly/ quarterly2)
Pillar II - requirement
Disclosure: not envisaged

1)

(i) Contractual maturity ladder, (ii) Concentration of counterbalancing capacity by issuer/counterparty; (iii)
Concentration of funding by counterparty and product type; (iv) Prices for various lengths of funding; (v) Roll-over of
funding., 2) Quarterly if: (i) Not part of cross-boarder group, (ii) Individual TA < 1% * Individual TA of country,
(iii) TAGroup 30 bn EUR

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73

Objectives and Structure of CRR/ CAD IV (Basel III)


Regulators reaction: Basel 2.5 and Basel III
(Factsheet)

B. 2.5

Impact
2 Market risk
(trading book)
(bcbs 157)
3

bcbs 164

More liquidity

Others

A) VaR =
+ new stressedVaR
C) Tradeable & defaultable IR-positions: new incremental risk measure (IRM) for event risk1
Securitisations: (B) revised standardised model, (D) new comprehensive risk measure (~IRM+)

Capital
definition

3.1 Rise capital quality: (i) higher and (ii) mandatory CE-T1-&T1-ratios
3.2 Stricter capital definition:(i) T1:going concern. (ii) T2:gone c. (iii) Minority int. (iv) Adj.
3.3 Improve capital disclosure: (i) Pillar 3 report and (ii) website.

Counterparty
credit risk

New CVA-risk measure for downgrades of derivative counterparties


Wrong-way risk: stressed EaD (EEPE) for derivative exposures
Increased default correlation (+25%) for lending and trading exposures to large banks
Longer margin period of risk
Provide incentives to move OTC transactions to CCPs (by reduced risk-weight of 2%)
Reduce reliance on external ratings by using models with internal scores/ ratings.

Basel III

More/ less capital

VaRBasel II

5 Leverage ratio

New leverage ratio (volume-based minimum capital ratio) to avoid excessive leverage.

6a

Conservative/ through the cycle - credit risk parameters (PDttc, LGDdownturn)


Promote loan loss provisions based on expected loss (EL)
IASB: EL-provisioning in IFRS9
New permanent Capital conservation buffer (+2.5%)
New temporary Countercyclical buffer (0% -2.5%)

Countercyclicality
207 6b Systemic risk

New capital surcharge for global, systemically important banks2 (G-SIB) (1%-3.5%)

New Liquidity Coverage Ratio (Minimum liquidity reserve)


New Net Stable Funding Ratio (Minimum stable/ long-term funding)
New Monitoring/ Pillar-2 tools3

Liquidity risk
(bcbs 165, 238)

-------

1)

Event risk: default and migration risk.2) Regulators could impose individual surcharges before in Pillar 2. Now more
transparent 3) Tools: (a) Contract. maturity mismatch, (b) Funding concentr., (c) Available collat., (d) LCR by currency
FrankfurtSchool.de

74

Leverage ratio

Counterparty Credit Risk

CVA
Capital requirements

17/7/2013

1/1/2014

Capital Re-Definition
Capital disclosure
LCR, NSFR
Monitoring tools

Leverage

Applicable

CRR
1)

Enhanced
transparency
Systemic risk buffer
Other SIFI-buffers
Remuneration, Divy
Enhanced governance
Sanctions

31/21/2013

Conservation buffer
Anticyclical buffer

Adoption CAD IV

EU Banking Pass

Sanctions

Liquidity

28/6/2013

Access to taking up/


pursuit of business

Corproate Governance

Capital

Non-Basel III

Large exposures

Large exposures

Disclosure Requirements

Disclosure
Requirements

Single Rule Book

Single Rule Book

Adoption CRR

Capital buffers

EBA R-/ITS [Impact/ Calibr./ L2-Cap, Retail, Buffer use, HQLA)]

Access to taking up/


pursuit of business
Free movements of
services (EU Banking Pass)
Prudential Supervision
(Pillar II)

Mar/ 2013

CAD IV

BIII

Final Draft

CRR is a framework. Many details are outsourced to RTS/ ITS and are fixed in 2014.

Feb/ 2012

Basel III vs. CRR

Start Trilogue1

Objectives and Structure of CRR/ CAD IV (Basel III)

EU Commission, European council, European parliament

FrankfurtSchool.de

75

Objectives and Structure of CRR/ CAD IV (Basel III)


Basel III vs. CRR
CRR is a framework. Many details are outsourced to RTS/ ITS and are fixed in 2014.

CAD IV

BIII
Access to taking up/
pursuit of business
Free movements of
services (EU Banking Pass)
Prudential Supervision
(Pillar II)
Capital buffers

Access to taking up/


pursuit of business

Conservation buffer
Anticyclical buffer

Corproate Governance
Sanctions
Capital

CRR

Liquidity

1)

Non-Basel III

Due to national particularities


(structure of banking sector,
EU Banking Pass
legal and administrative system,
Enhanced
economic cycle) better national
transparency
discretion (supervisory license,
Systemic risk buffer
cross-border cooperation of
Other SIFI-buffers
regulators, capital buffer,
Remuneration, Divy
Internal Governance
Enhanced governance
(renumeration), ICAAP-process,
regulatory sanctions)
Sanctions

Capital Re-Definition
Capital disclosure
LCR, NSFR
Monitoring tools

Leverage

Leverage ratio

Counterparty Credit Risk

CVA
Capital requirements

Single Rule Book: harmonisation


of banking regulation/
Level-playing field in European
baking market

Large exposures

Large exposures

Disclosure Requirements

Disclosure
Requirements

Single Rule Book

Single Rule Book

EU Commission, European council, European parliament

FrankfurtSchool.de

76

Agenda

1.
2.
3.
4.
5.

Overview about relevant national and international regulatory requirements


Basics of Risk Management
Objectives and Structure of CRR/ CAD IV (Basel III)
Introduction to Market Risk
Trading Book: the market value of counterparty credit risk

FrankfurtSchool.de

77

Market risk: The capital charge for traded credit risk


(issuer specific risk) has been substantially increased.

BB

Trading Book
Credit
Risk
OpRisk

(I) Revised Internal Models:


A newVaR = oldVaR + stressedVaR
(1)
Basel II Pillar I

Market
Risk

All: Equity, IR, FX, Commodities

(II) Revised capital charges for (issuer-)specific interest rate risk:1

cc (IR\specific) =

VaRspecific + C
B
(2)
D 8%* (2))
B
VaRspecific + max( (4),

IR-risk positions
(Basel II-)Securitisations

nth-to-default

(Basel II-)CT-Securitisations (Basel II)-CT-NTD

Capital charge due to:


B revised standard ised model (IR\specific) for securitisations
(2)
C internal incremental risk measure IRM capturing default- and migration risk
(3)
C
D internal comprehensive risk measure capturing default-, migration - and all other price risks
(4)

Pillar II
Pillar III
1:

Here for a bank that makes maximal use of internal models

FrankfurtSchool.de

78

Market risk
Multiple model options to compute the capital charge.

All: newVaR = oldVaR + stressedVaR

Positions with (issuer-)specific interest rate risk:


Revised standardised model (IR\specific) for securitisations
C Internal incremental risk measure IRM capturing default- and migration risk for IR\ Non-securitisations
DI Internal comprehensive risk measure capturing default-, migration - and all other price risks for correlation trading
B

General1

Model options for


Pillar1 - market risk

Specific2 (spread risks)


Events3

Daily Fluctuations
C

1. Internal Model
General &
Specific

0
A

2. Internal Model
General &
Specific

3. Standardized
Approach
1)

VaRgen

SMgen

VaRspec

IR

SMspec

VaRgen+spec

IRM

Equity

FX, Commodities

IRM

IR

SMspec

IR

VaRspec

Equity

FX, Commodities

SMspec

IR, Equity

FX, Commodities

Fluctuations explained by an index. 2) Security-specific fluctuations.3)Events: defaults and migration

FrankfurtSchool.de

79

Market risk
Multiple model options to compute the capital charge.

All: newVaR = oldVaR + stressedVaR

Positions with (issuer-)specific interest rate risk:


Revised standardised model (IR\specific) for securitisations
C Internal incremental risk measure IRM capturing default- and migration risk for IR\ Non-securitisations
DI Internal comprehensive risk measure capturing default-, migration - and all other price risks for correlation trading
B

2. Market
Risk
(MR)

General

Specific (spread risks)


Daily Fluctuations

Event
C

VaRgen+spec
0
RWAMR

VaRgen

SMgen

FrankfurtSchool.de

VaRspec

IRM

SMspec

IR

Equity

FX, Commodities

IRM

IR

SMspec

IR

VaRspec

Equity

FX, Commodities

SMspec

IR, Equity

FX, Commodities

80

Market risk
Multiple model options to compute the capital charge.

All: newVaR = oldVaR + stressedVaR

Positions with (issuer-)specific interest rate risk:


Revised standardised model (IR\specific) for securitisations
C Internal incremental risk measure IRM capturing default- and migration risk for IR\ Non-securitisations
DI Internal comprehensive risk measure capturing default-, migration - and all other price risks for correlation trading
B

2. Market
Risk
(MR)

General

Specific (spread risks)


Daily Fluctuations

Event
C

RWAMR

VaRgen+spec

Basel II

Basel II
VaR gen
+ spec

IRC

e.g. IR

Additional

sVaR gen &spec

mc 60
max{VaR10,1%,t 1 ; VaR10,1%,t i }
60 i =1
ms 60
max{sVaR10,1%,t 1 ; sVaR10,1%,t i }
60 i =1

FrankfurtSchool.de

IRC0
1 11
IRC0 = 1.0 max( IRM 0 , IRM k )
12 k =0
Current
Incremental
Risk Measure

Average of IRM
across 12
weeks

81

Market risk
The event charge varies with the instrument category ( IR1

IR2 IR3

).

All: newVaR = oldVaR + stressedVaR

Positions with (issuer-)specific interest rate risk:


Revised standardised model (IR\specific) for securitisations
C Internal incremental risk measure IRM capturing default- and migration risk for IR\ Non-securitisations
DI Internal comprehensive risk measure capturing default-, migration - and all other price risks for correlation trading
B

2. Market
Risk
(MR)

General

Specific (spread risks)


Daily Fluctuations

Event
C

RWAMR

+
Basel II
VaR gen
+ spec + sVaR gen &spec

IR
1

Unsecured
credit products
not in
correlation
trading

IR2

Securitisations
not in CT

IR3

Correlation
trading (CT)

IRC0

SMspec

CRM

FrankfurtSchool.de

IR1

82

Market risk:
Details on stressed VaR.

Intended to replicate VaR of current portfolio if relevant market factors


were experiencing a period of stress

Stressed
Value at Risk

10-day, 99th percentile VaR model

Model inputs calibrated to 12-month period of significant financial stress


approved by supervisor, e.g. 2007/08

FrankfurtSchool.de

83

Market risk:
Details on IRM.

No specific approach prescribed but


B

Incremental
risk measure
(IRM)

model must satisfy soundness standards of internal ratings based


approach.

IRM must reflect default and migration risks.


If no IRM model is available, capital surcharge in terms of
standardised approach to specific risk has to be used.

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84

Market risk:
Details on IRM.

Shortcomings

VaR

BaselIII

mc 60
= max{VaR10,1%,t 1 ; VaR10,1%,t i }
60 i =1
ms 60
+ max{sVaR10,1%,t 1 ; sVaR10,1%,t i }
60 i =1
i : days

Additional Capital Charge

1 11
IRC0 = 1.0 max( IRM 0 , IRM k ), k : weeks
12 k =0
Market risk feature
Credit risk (IRB) feature (like in banking book)

Ignoring differences in market liquidity of


positions

Define liquidity horizon for re-balancing

(Typically) 99%-Daily VaR scaled up to 10


days
=> miss out infrequent daily losses
(< 2-3 times per year)

Use 99.9% confidence level


to account for infrequent (credit) event risks (of
default and migration) of unsecuritised credit
products

(Typically) 99%-Daily VaR scaled up (with


indep. assumption) to 10 days
Miss out large (autocorrelated) losses

Use capital horizon of 1 year


(accounting for cumulative losses)

Calibration on 250 trading days


underestimates capital for a potential
upcoming turmoil period

=> Credit characteristic: Use data like IRBframework


(time horizon for calibration IRB)

FrankfurtSchool.de

85

Market risk:
Revised Standardised Approach on securitisations.

SM for
securitisations not in
CT PF

Specific interest rate risk for securitisations in trading book ought to be assessed by
standardised model
which is now equal to banking book model for securitisations: risk weights from
banking book according to external rating, no off-setting allowed.
For non-rated securitisations, inter alia the supervisory formula ought to be applied
resulting in risk weights between 8% and 100%

NR1

rated

SolvV

1:

Basel II Revisions (IRBA-banks)


Securitisations
Securitised, 1x
Re-securitised
non-securiti- Securitinon-securitisenior
non-senior
Ext. Rating sations
sations
sations
nonsenior
non-senior
granular
granular
granular
AAA
0% - 1,6%
0% - 1,6%
0,56%
0,96%
1,60%
1,60%
2,40%
AA+ to AA0,25% - 1,6%
0,25% - 1,6%
0,64%
1,20%
2%
2%
3,20%
A+
0,25% - 1,6%
0,25% - 1,6%
0,80%
1,44%
2,80%
2,80%
4%

BB8%
8%
52%
52%
52%
60%
68%
B+
12%
100%
12%
100%
100%
100%
100%
100%
B
12%
100%
12%
100%
100%
100%
100%
100%
B12%
100%
12%
100%
100%
100%
100%
100%
<= CCC+
12%
100%
12% 8% to 100%
100%
100%
100%
100%
100%
(depending on approach)

NR : non-rated.

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86

Market risk:
Revised Standardised Approach on securitisations.

2007/2010

1:

Before downgrades

After downgrades

See Market risk revisions, 712(iv).

FrankfurtSchool.de

87

Market risk:
Approach on Correlation Trading Positions.
Basel II trading book
Securitized portfolios (cash and synthetic)

Further products
Others Credit derivatives (SolvV, 299,(5) ff)
CDS

TR
S

CLN

nth-todefaul
t

Tranched (SolvV, 226)

Securitised, once
Liquid
underlying
assets
CT-Hedges

Non-tranched
(e.g. ABCP, Covered
Bonds, ...)

Re-securitised
(e.g. CDO)

NonLiquid
Assets

CT-Core Instruments

Regulatory definitions
Regulatory correlation trading portfolio
Real-world products
iTRAXX,
CDX,
singlename CDS

FrankfurtSchool.de

TR
S

CL
N

nth-todefaul
t

Tranches on
iTRAXX,
CDX

88

Market risk:
Internal model only for Correlation Trading portfolio.

CC = VaRnew + max{CRM;8% *CC(spec IR SM CT pfo)}

VaRnew = max{VaRt 1; mc *VaRavg} + max{sVaRt 1; ms * sVaRavg}, mc , ms 3

IM capital
charge (CC)
for CT pfo

CC(specIR SM CT pfo) standardised model capital charge for the


correlation trading portfolio for specific interest rate risk

CRM: comprehensive risk measure generalising the incremental risk measure


(IRM) to specific risks of securitisations

FrankfurtSchool.de

89

Market risk:
Explicit (comprehensive) list of risks to be covered by CRM.

Cumulative risk of multiple defaults, including ordering of


defaults, in tranched products
Credit spread risk, including gamma and cross-gamma
effects

Comprehensive risk
measure

Volatility of implied correlations, including cross effect


between spreads and correlations

CRM might generalize


IRM as surcharge for
non-securitisation and
non-NTD positions
all price risks = CRM

Basis risks between:


Spread of index and spreads of constituent single names
Implied correlation of index and implied correlation of bespoke
tranches

IRM = incremental
default and
migration risks

Recovery rate volatility

If dynamic hedging => hedge slippage risk and potential


rebalancing cost

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90

Market risk:
CRM as an extension of IRM: regulatory approval.

Interpretive issues with respect to the revisions to the market risk framework
November 2011, p. 7:
Question:
It would be important for banks to be allowed to enhance the IRC model to leave the
correlation book inside (ie, try to comply with the comprehensive risk measure but
within the IRC model). Would it be acceptable to extend the IRC framework to
comply with the comprehensive risk measure and perform a single calculation?
Answer:
Banks are allowed to enhance the IRC model to comply with the requirements for
the comprehensive risk measure. However, they are not allowed to perform a single
calculation covering exposures subject to the IRC charge and exposures subject to
the comprehensive risk capital charge. Disallowing a single calculation has the
effect of not allowing any diversification between the portfolios

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91

Market risk:
Fundamental Review of Trading book1

Scope:
Revisions, July 2009: quick fix, i.e. changes within fundamental framework
Revisions, May 2012: structural fix, i.e. changing the fundamental framework
Fundamental Element

1:

Weakness

Proposed remedy

1. Boundary Tradingvs. Banking book

- Subjective criterion: Intention to


trade
- Different risk weights in each
regime

More objective boundary:


1. Trading-evidence-based:
daily MtM and FV through P&L, almost no reclassification
2. Valuation-based:
market risk = any risk that threats regulatory and
accounting solvency of banks

2. Standardised
Approach

- Calibrated against normal/ longterm market circumstances

Capital requirements must be calibrated against times


of stress (see sVaR for IM-banks)
1. Re-calibration of Sted approach to financial distress

3. Risk measure VaR

- Does not capture tail risk (only start


of tail, but not shape of tail)

1. Expected shortfall: capturing size and likelihood of


stress (for both IM and SM)

4. Market Illiquidity

< Basel 2.5: markets perfectly liquid


Basel 2.5: partially incorp. by I-/CRM

1. Set of 5 liquidity horizons (10d, ..., 1Y)


2. Quantify Ly-risk for given 10 days Liquidity horizon
3. Ly premia for instruments that are prone to market
illiquidity
4. Pf-specific market liquidity: concentrations, large
portfolios

BCBS-paper: 219, May 2012, Consultation: till September 7th, 2012

FrankfurtSchool.de

92

2. Market risk:
Fundamental Review of Trading book1

Scope:
Revisions, July 2009: quick fix, i.e. changes within fundamental framework
Revisions, May 2012: structural fix, i.e. changing the fundamental framework
Fundamental Element

1:

Weakness

Proposed remedy

5. Hedging and
diversification

- Hedging can have basis risk


- Diversification often only applies to
gains, not to losses

1. Basis risk should be measured and capitalised


2. Limit diversification benefits (something that is
already incorproated in sted approach)

6. Closer alignment of
IM and Sted approach

-potential large differences


(regulatory optimisation?)
- difficult for supervisors to withdraw
model permission

1. Closer link (=> limiting diversification benefits for IM


like already in SM, calibrate SM against stress like
already done in IM)
2. Mandatory calculation of SM for ALL banks
3. IMC = min(IM,X%*SM)

7. Revised IMapproach

- Approval basis for IM: portfolios


=> Too large to verify quality
=> too much diversification across
desks
- Model backtesting

1. Model approaval on trading deck level


2. Daily P&L vs. risk measure on trading desk level
If inacceptable => desk must use SM

BCBS-paper: 219, May 2012, Consultation: till September 7th, 2012

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93

Market risk:
Fundamental Review of Trading book1

Scope:
Revisions, July 2009: quick fix, i.e. changes within fundamental framework
Revisions, May 2012: structural fix, i.e. changing the fundamental framework
Fundamental Element

Weakness

Proposed remedy

8. Revised SM
(SM not touched in
July 2009!!)

- Comparability
- Fall back (for IM-banks)
- Simple (for smaller banks)

Objective: more risk sensitive


1. Partial factor approach:
instruments with similar risk characterisics
=> same bucket => regulatory risk weights +
regulatory correlation matrix (new!)
2. Fuller risk factor approach:
Map instruments to set of regulatory risk factors
=> Pricing model to estimate own position
=> shocked
=> Hedging at risk factor level
regulatory aggregation for diversification

9. Credit risk

- Default and migration risk

1. study whether separate models

Excluded topics:

1:

(I) IRR in banking book


(Strukturbeitrag)

- Major risk,
not in Pillar 1, but in Pillar 2

Separate proposal in 2012

(II) Market- and credit


risk

- stand-alone charge: CVA


- stand-alone charge: Market-VaR

Both (market and credit ) risk lead to MtM-losses


some industry voices prefer integrated approach
Committee wants improvement of stand-alone CVA
first

BCBS-paper: 219, May 2012, Consultation: till September 7th, 2012

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94

Agenda

1.
2.
3.
4.
5.

Overview about relevant national and international regulatory requirements


Basics of Risk Management
Objectives and Structure of CRR/ CAD IV (Basel III)
Introduction to Market Risk
Trading Book: the market value of counterparty credit risk

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Counterparty Credit Risk:


Motivation of Basel III - amendments
Aim...

... by implementing...

More adequate capitalisation of credit


counterparty risks as under Basel III

a better understanding of wrongway risks (stressed exposures)


introducing CVA-risk charge

Provide Incentives to move from OTC


transactions to central counterparties
(CCPs)

low risk weights for CCP-derivatives:


Default risk: 2%,
Migration risk: 0%

Account for systemic risk,


interconnectedness and procyclicality

asset value correlation multiplier

Reduce Operational risks

new qualitative requirements for


back and stress testing

Motivation

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New Regulation of OTC Derivative Markets

All standardized OTC derivative contracts should be traded on exchanges or


electronic trading platforms, where appropriate, and cleared through central
counterparties by end-2012 at the latest. OTC derivative contracts should be
reported to trade repositories. Non-centrally cleared contracts should be subject
to higher capital requirements.

Grafik: PWC

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97

Counterparty Credit Risk:


New Regulation of OTC Derivative Markets
REGULATION OF DERIVATIVE MARKETS
EMIR
Clearing obligation for some classes of
OTC derivatives/ Exemption: intragroup
transactions (insofar as they do not
increase systemic risk)

MIFIR
Shifting derivatives trading to organized
markets (Organized Trading Facilities/
OTFs)

Transparency of trade and reporting


Clearing Obligation for Financial
requirements
Counterparties/ Non-Financial
Counterparties, insofar as the clearing
Specific monitoring in relation to financial
threshold is exceeded (whereby hedging
instruments and derivatives positions
does not count into the clearing threshold)
Derivative contracts are to be reported to
a transaction register (Trade Repository)
Supervisory by/ Reporting Obligations to
ESMA (European Securities and Markets
Authority)
Credit Risk Reduction

MIFID II
Increasing the competitive position of
European Financial Markets/Competition
among financial services providers
Strenghtening Investor Protection and
Confidence of Market Participants

Basel 2.5/3/3.5
Basel 2.5 : Increase of Capital
Requirements Trading Books: Incremental
Risk Charge, Comprehensive Risk Charge,
Stressed-VaR,Treatment of Securitized
Products in the Trading Book

Basel III: Abolishment of Tier 3


Organizational requirements and rules on Instruments (Short Term Subordinated
Bonds) as capital to cover risk in the
the conduct of business of investment
Trading Book.
firms respectively trading venues
Basel III: Introduction of CVA-Risk Increase of Transparency by Disclosure Charge -Requirement to cover price
volatility from Counterparty Risk with Risk
of Risk Positions
Capital
Credit Risk Reduction
Basel 3.5 (Fundamental Review of the
Trading Book): Substitution of Value at
Risk by Expected Shortfall to cover
Extremal Risk.
Classification of Trading Book Positions
by different Liquidity Horizons
Change of Standard Methods and
Internal Methods

New Transparency of the Derivative Markets: Central Clearing


Counterparties, Organized Trading Facilities and Transaktion
Repositories

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Investor protection and confidence


of market participants, Competition
among financial services providers,
Organizational requirements and
rules on the conduct of business of
investment firms respectively
trading venues

Trading Books: Higher


Requirements for Risk Capital,
Specific Focus on Price Volatilities
of Derivative Positions driven by
Counterparty Risk, Specific Focus
on Stress Scenarios and Extremal
Events
98

Central Clearing Counterparties


A CCP imposes itself as the legal counterparty to every trade.
This substitution of the counterparties by the CCP typically occurs through a
process known as novation, which discharges the contracts between the
original trading entities and creates two new, legally binding contracts one
between each of the original trading parties and the CCP.

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Central Clearing Counterparties


This arrangement places the CCP in a unique position in that it has direct
interaction and counterparty risk exposure with each trading party.
- This gives the CCP the incentive to closely monitor traders, as well as
access to the information needed to manage its risk
Market participants, by contrast, are essentially indifferent to the
creditworthiness of anyone but the CCP, which significantly decreases the
cost of risk monitoring
The CCP uses a variety of tools to manage risk:
- CCPs typically hold collateral from each market participant to serve as a
cushion against adverse market fluctuations.
- The CCP also monitors the positions of members and may periodically
require additional collateral following market movements to reestablish
an acceptable cushion against future losses.
- Rules are established dictating what assets are allowed to serve as
collateral, how much of a haircut should be given to specific assets in
determining their value as collateral, and how often margin calls should
take place
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Central Clearing Counterparties


CCPs also use loss-sharing arrangements to cover any additional losses
incurred beyond those covered by a defaulting traders collateral.
Mutualization of losses is a final layer of protection that insures the ability of
the CCP to perform its obligations notwithstanding the failure of one or
more traders
The CCPs unique position of being a common, substituted counterparty to
all trades in a centrally cleared market greatly simplifies the multilateral
netting of trade obligations.
Past studies have shown that multilateral netting can result in significant
decreases in risk exposure relative to the underlying gross positions

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Central Clearing obligation (art. 4 EMIR)


Clearing obligation for some classes of OTC derivatives
European CCPs are ICE Clear and Eurex Clearing.
Scope: Financial counterparties
Academic research, [Duffie and Zhu, 2009], suggest that too many CCPs do
not reduce counter partyrisks.
Non-financial counterparties, insofar as the clearing threshold is exceeded
(whereby hedging does not count into the clearing threshold, for example
Hedge Accounting pursuant to IAS 39) :
Source: PWC

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Implications for Collateral

EMIR/MIFID:
- Key themes and impact areas: EMIR will require OTC derivatives to be
standardized, where possible, so they can be centrally cleared and
traded on exchange-like platforms.
Introducing multilateral trading and organized trading facilities and
central counterparties (CCPs). This has meant an increase in the
complexity and number of margin calls and an increase in collateral
requirements
- Financial Firms impacted : All EU firms that are engaged in OTC
derivatives trading activity.
- Implications for collateral: The formal clearing obligations of the new
regime will require collateralization of swap transactions with specific
types of high-grade collateral something that is not currently required
under bilateral swaps deals

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Implications for Collateral

Dodd Frank:
- Key themes and impact areas: Mandated central clearing via CCPs in
attempts to reduce systemic risk and bring transparency to the often
perceived as opaque practices of bilateral OTC derivatives trading.
- Financial Firms impacted : All US firms that are engaged in OTC
derivatives trading activity.
- Implications for collateral: This will substantially increase the cost of
collateral, and will detrimentally affect liquidity as high-quality assets are
tied up at a CCP. Additionally, the fact that there will be multiple
CCPs globally will cause further fragmentation of these collateral assets

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Reporting obligation to a trade repository


applicable to contracts outstanding on or entered into after 16 August 2012
Reporting frequency: reporting no later than the working day following
conclusion, modification or termination of the contract
Details: main characteristics e.g. type, underlying, maturity, notional value,
price, settlement date
Delegation: counterparty or CCP may delegate the reporting of the details of
the derivative contract
Double reporting: counterparties and CCPs shall ensure that the details of
their derivative contracts are reported without duplication
Storage: at least five years following the termination of the contract

Source: PWC
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Future Framework for OTC-Derivatives


Increased electronification of certain product markets continue, catalyzed
by regulatory demands (e.g. IR Swaps, CDS)
Due to illiquidity in certain asset markets, investment banks still feature as
broker-dealers in market making role as an important price generation
entity

EQ
Elektronic
Trading Platform

FI

Comm

FX

Inter-dealer
Brokers

CCPs
Standardised Deals

Bilateral
Clearing

Transaktion Repository

Client

Investment Banks

Non-standardised Deals

Source: Oliver Wyman


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Future Framework for OTC-Derivatives

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107

107

ISDA Document Structure


Definitions
(Examples)
1994 CSA
(NY)
1995 CSA
(English)

2002 MA

2008 CSA
(Japanese)

Schedule

2006 Definitions
1992 US Municipal
Counterparty Definitions
2005 Commodity Definitions
2011 Equity Derivatives
Definitions
1997 Government Bond
Option Definitions
2003 Credit Derivatives
Definitions
1998 FX and Currency
Option Definitions
1998 Euro Definitions
short form confirmations only

1995 CSDeed
(English)

Confirmations
for covered transactions

Legend:
part of standardized contract
stand-alone document
to be signed seperately
refers to
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Adherence Letter

Protocols
(Examples)
EMU Protocol
2001 Credit Support Protocol
2002 Master Agreement
Protocol
2006 Novation Protocol II
CDS Protocols
Big Bang Protocol
Small Bang Protocol
Close-Out Amount Protocol

Source: Prof. Dr. Gnter Reiner, ISDA Master Agreement Kommentar, 2013 C.H.Beck

108

International Swaps and Derivatives Association


(ISDA), www.isda.org
ISDA : organization of participants in the market for over-the-counter
derivatives
more than 820 members in 57 countries; its membership consists of
derivatives dealers, service providers and end users
Examples for primary members: Glencore International AG, BP Plc, Citigroup,
Credit Suisse, Daewoo Securities Co., Deutsche Bank AG, J.P. Morgan Chase &
Co., Barclays, Bank of America Merrill Lynch, BNP Paribas, Citigroup, Credit
Suisse , UBS AG.
Headquarter: New York
Founded: 1985

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Deivatives Documentation
There are four aspects of the documentation which are of interest here:1. Confirmation
2. Master Agreement
3. Schedule to the Master Agreement
4. Credit Support documentation
Each individual transaction is connected to this Master Agreement by entering
into a confirmation (the Confirmation) which is a Confirmation of the trade
which two parties have entered into.
The Confirmation is expressed to be subject to the terms of the Master
Agreement.
The Confirmation sets out the details of each particular trade. The link to the
Master Agreement ensures that the trades are still governed by those
overarching rules.

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ISDA: Master Agreement and related documents


www.isda.org
ISDA Master Agreement: standardized contract to enter into derivatives
transactions which contains the terms and conditions by which all (or as many
as possible) of the derivatives transactions between the parties are governed
Accordingly, one master agreement will be entered into between a given
derivatives market participant and each of its counterparties regardless of how
many individual transactions are in place between it and each counterparty
The master agreement sets forth all of the terms needed to properly document
all types of derivatives and will cover as many of the potential contingencies
related to such transactions as is possible.
The majority of the terms of standard master agreements are market-accepted
and negotiation of master agreements has become routine

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ISDA: Master Agreement and related documents


www.isda.org
A typical master agreement will include definitions, terms covering the general
payment obligations of the parties, tax withholding terms, representations of
the parties, default terms, settlement terms in cases of default, general
contractual terms (e.g. choice of law), tax treaty provisions, requirements to
provide supporting documentation and notice provisions.
Trade Confirmation:
Derivatives transactions are usually entered into orally or electronically
Confirmations contains the evidence of the terms of the transaction
usually a short letter, fax or email (except for complex transactions) :
contain little more than dates, amounts, and rates
Form of the confirmation: set out in the Master Agreement
limited period of time is usually allowed for objections or amendments
to the confirmation after its receipt
Confirmations are exchanged to minimise the possibility of a dispute as
to the terms of a transaction occurring.
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ISDA: Master Agreement and related documents


www.isda.org
The ISDA master agreement involves a preprinted master agreement (either
local jurisdiction single currency or multicurrency-cross-border), a schedule,
and a form of confirmation.
Generically, these three documents are often referred to together as an ISDA
master.
The schedule is used to make certain elections and any modifications
(additions and deletions) to the standard terms in the preprinted form.
Credit support annex (CSA): Mitigation of counterparty credit risk by requiring
the party which is 'out-of-the-money' to post collateral (usually cash,
government securities or highly rated bonds) corresponding to the amount
which would be payable by that party when all the outstanding Transactions
under the relevant ISDA Master Agreement would be terminated.
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Single Agreement Philosophy


The master agreement is the part of the documentation which sets out the
manner in which the two counterparties are to conduct their derivatives
business with one another.
While Confirmations deal with specific transactions, the aim of the Master
Agreement is to deal with the legal issues and risks which arise outside the
structuresof an individual trade.
Importantly, the philosophy behind the International Swaps and Derivatives
Association (ISDA) documentation is that all of the confirmations entered
into between two parties together with their master agreement, schedule and
credit support documentation are to construed as constituting one single
contract

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Some Background: Regulatory Capital for Credit Risk


(Advanced) Internal Rating-based Approach
CRSA vs. IRBA-approach
Required credit risk capital
Credit quality weight (CRW) of the
Amount of credit equivalence depends on:
borrower
Structure of the contract,
x 8% x
CRW depends on: borrower
(Remaining) term, Collateral
segment, score, etc.
Netting agreements
Basel I

100%

x 8%

Basel II/ Standardized Appr.


Solv-D
IRBA

CRW (regul. segment, ext. rating)

x 8%

TA1
* EaD * 12.5

K (PD, R, ...)* LGD


Unexpected loss (Capital)
Risk-weighted assets

Basel I: overall banking-supervisory requirement


Basel II, Solv-D: Creditworthiness (RW) of the borrower and collateralization (EaD) of
loan
1)

TA : Total Assets

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Some Background: Regulatory Capital for Credit Risk


IRBA-capital charge: Example for retail exposure
PDinternal = 1%, LGDinternal = 45% => ... => capital charge = 4.51%
Loss probability

Assets

Liabilities

Retail loan
PDinternal = 1%
LGD internal= 45%

100

Deposits
Other liabilities

Others

Equity

Other
assets
Ly Reserve

100
0
45% Loss
(= LGD )

55% Recovery
(= 1-LGD )

Expected
Loss

Unexpected
Loss

0.45%

44.55%

LGD*PD
Loan rate

FrankfurtSchool.de

q99.9%,Retail = [

1 (PD)+ R1 (99.9%)
] LGD
1- R
1

[ x] := NormsDist( x)
1 (x) := NormsInv(x)

(1%)+ 15% (99.9%)


] 45%
1-15%
= 4.96%
= [

4.96%
q99.9%
Capital

EL = PD* LGD = 1% * 45% = 0.45%

Uncovered

Capital= q99.9%,retail EL = 4.51%

116

Some Background: Regulatory Capital for Credit Risk


Loss distribution
Example: Risk-adjusted pricing.
Risk parameters PD, LGD

Assets

100

Retail loan
PD = 1%
LGD = 45%

Liabilities
Deposits

Equity

Other
Ly Reserve assets

Branch
margin

EL = PD* LGD = 1% * 45% = 0.45%


q99.9%,Retail = [

RAROC

Other liabilities

Others

Risk-sensitive loan pricing

Loan rate

Operating
cost

(PD)+ R (99.9%)
] LGD
1- R
1

0.90%1

Customer
loan rate

(1%)+ 15% (99.9%)


] 45%
1-15%
= 4.96%
Capital
Capital= q99.9%,retail EL = 4.51%
= [

0.45%
Funding
cost

Breakeven rate

Risk Capital
(CVaR)

Capitalcost = 20% 4.51% = 0.90%

1)

0.90% = 20% * 4.51%

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Some Background: Regulatory Capital for Credit Risk


Loss distribution
The capital formula step by step.
Loss probability

Expected
loss
Margin

PD LGD

q99%

Capital
Capital= [ [

Loss given default


(LGD)

Recovery

100

Uncovered

1 (PD)+ R1 (99.9%)
] - PD] LGD
1- R

1 (PD)+ R1 (99.9%)
[
] LGD
1- R

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118

Some Background: Regulatory Capital for Credit Risk


IRBA-formulae
1 e 35PD
1 (1 e 35PD )
+
16%

, 3% R 16%
1 e 35
1 e 35
1 ( PD) + R 1 (99.9%)
K = [[
] PD]
1 R
R = 3%

Retail,
Non-mortgage

Corporates

TAS 5
1 e 50PD
1 (1 e 50PD ) 4% (1
)

R = 12%
+
24
%

45
50
50
1 e
1 e

0
2
b = (11.852% 5.478% ln( PD))
Maturity
Adjustment
M = min(5Y , max(1Y , Duration))
K = [[

Risk weight

Required capital
Risk-weighted
assets
Total Capital Ratio

SME1
Non-SME

8%...12% R 20%...24% ,
ATS = 5m...50m

1 ( PD) + R 1 (99.9%)
1 + ( M 2.5)b
] PD] [
]
1 1.5b
1 R

RW int ernal =

LGD Re gulatory
1
K
Internal
8%
LGD

IRBA-Foundation [45%: first, 75%: subordinated, 12.5%: lien)]


IRBA-Advanced

Required capital = EaD RW int ernal 8% (Note : Standardised Approach : RW external (segment, external rating))
RWA Credit risk = 12.5 Required capital
Capital Tier 1 + Tier 2 + Tier 3
TCR =
RWA Credit risk + RWA Market risk + RWA Operational risk

1)

SME
Firms with group total annual sales (TAS) of 50 Mio. EUR are entitled to a capital relief.
Fims with TAS < 5 Mio. EUR are set to 5 Mio. EUR.
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Counterparty Credit Risk:


Basel II vs. Basel III

Counterparty credit risk (CCR):


Risk that a counterparty to a transaction defaults or is downgraded
before the final settlement of the transactions cash flows.

Basel II: Credit risk for OTC-derivatives


BaselII

RWACCR

= 12.5 * K * EaD = 12.5 * K * * EEPE

-factor accounts for


wrong-way risk (PD
increases with EaD) but in
expected terms

1 ( PD) + R * 1 (0.999)
1 + (M 2.5)b
PD *
K = LGD*

1 1.5b
1 R

1 e50PD
1 e50PD

R = 0.12*
+ 0.24* 1
50
1 e50
1

Basel II
credit risk

EEPE: effective expected positive exposure, b: maturity adjustment,


R: asset value correlation (AVC)
Main changes in Basel III to RWA calculation
1

Add downgrade risk surcharge to account for credit valuation adjustment (CVA)

2.1 Stress EEPE


2.2 Account for higher correlation by adjusting R with multiplicative factor

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120

Counterparty Credit Risk:


Basel II vs. Basel III

BaselII

RWACCR

= 12.5 * K * EaD = 12.5 * K * * EEPE

1 (PD) + R * 1 (0.999)
1 + (M 2.5)b

K = LGD*
PD * 1 1.5b
1

50PD
50PD
1 e

1 e

R = 0.12
0
.
24
1
50

1 e50
1
e

Basel II
Basel III
BaselIII

RWACCR

BaselII

CCR
= RWAstressed

+12,5 cc(CVA)

= 12,5 Kstressed(R 1.25banks) EEPEstressed + 12,5 cc(CVA)


2.2

Use a multiplicative
factor for R in calculation of K

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2.1 Stress EEPE for

general wrong way risk

1 Add a charge for CVA-

risk as an unexpected
loss component

121

Counterparty Credit Risk:


What exactly is EEPE?
Exposure Methods ...

Revalue the instrument


under each scenario

MtM(s,t)

EE: Expected E.
EPE: Exp. Positive E.
EEE: Effective Exp.E.
EEPE: Effective Exp.
Positive E.

MtM(s,t)

time

time

Average for each time


point

Quantile for each time point

EE(t)

PFE(t)
MtM(s,t)

MtM(s,t)

time

time
EEE(t)

EPE(t)

Effective EPE(t)

Exposure
EPE

EEE
EE

Exposure

EEE
Exposure

EE
time
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Effective EPE
time

time
122

Counterparty Credit Risk:


All Basel III-amendments regarding counterparty credit risk.
Proposed remedies to better account for counterparty credit risk (CCR)
(A) CPPs

Current treatment
is insufficient w.r.t.:

(B) OTC
(i) Regulatory capital calculation
Micro level

MtMdowngrade risk

1
CVA risk
2

(unexpected)
Default
risk
(accounted
for
currently
by Basel II)

Model
validation

2.1

wrong-way
risk

Stressed
effective EPE
Risk weight =
2%*8%

Collateralised CCPs

Macro level

Qualitative
requirements for back
and stress testing

New Capital
charge

CVA = 0

2.2 Multiplier for asset


value correlation
R: 1.25
Tackle shortcomings
in alpha estimation

monitoring general
wrong-way risk
Improve op. perf. of
collateral dept.

Margin
period of risk
4

New guidelines for


inferred ratings and
appropriateness of
unrated positions

Reliance
on external
ratings

(ii) CCR
management

Reduce reliance on
external ratings and
code of conduct for
rating agencies

Qualitative
requirements for back
and stress testing

back &
stress
testing

Incentives to move from


OTC to CCP
transactions
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For both, IM and SM


Only for IM
123

Counterparty Credit Risk:


CVA\ Motivation1

A derivative contract can have a positive or a negative market value


Derivatives with a positive value constitute a claim to the counterparty
If the counterparty defaulted, the loss would be the replacement cost of the contract
(i.e. the current market value)
A derivative contract with a defaultable counterparty is less worthy than a contract with a risk-free
counterparty
The lower the creditworthiness of the counterparty, the lower the market value of the contract.
The value of derivative contracts decrease, if the counterparty becomes riskier (e.g. an obvious indicator
is a downgraded). Note: the value decreases even if all market parameters have not changed!
Massive (unexpected) downgrades of counterparties (like the large investment banks in 2007/09)
generate large migration losses in derivative trading books.
These losses have not been backed with capital under Basel II, but have to be backed with capital under
Basel III.
The default risk of these contracts has been covered under Basel II.

1:

More background information on CVA can be found in the appendix.

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Counterparty Credit Risk


CVA\ CCR-capital charge covers default and migration.

Defaultable Derivatives:
Loans

Deutsche Bank

Deposits

Bank A enters into


Payerswap with DB:
Notional: 100m,
Maturity: 5Y
CDS-spread CP: 100 bp

Trading
book

Capital
CVA-Cap.

Basel III:Total capital charge Counterparty Credit Risk (CCR)


1. Counterparty default risk
(already in Basel II)2
x

Unexpected loss per 1 exposure


SA

OTC

IMM

RW(RatingExternal)1
K(PDInternal, R(PD)2)

CCP

2%

x LGD

8%

x
x

8%

+
Exposure [in ]

2. Counterparty migration
risk
Credit Value Adjustment
2.1

CEM,
SM, - CVAlosses
*EEPE2

2.33

( )2 + ( )2

2.2 ccMarket Risk-IRM(CVA(s))


0

x
2.1

Always

2.2

Only if approved VaRSpecific

1)

Derivatives are usually contracted with counterparties of the regulatory segment Corporates, Banks, Government,
2) EEPEBasel3: max(EEPEBasel2, EEPEstressed); For large banks and all unregulated financial firms: RBasel3 = 1.25*RBasel2.

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125

Counterparty Credit Risk:


CVA\ Default is usually far less probable than downgrades.

R(t+1)
AAA
AA
R(t)

A
BBB
BB
B
CCC

AAA

AA

BBB

BB

CCC

PD

91.23%
0.58%
0.04%
0.01%
0.02%
0.00%
0.00%

7.99%
90.21%
2.05%
0.15%
0.06%
0.05%
0.00%

0.54%
8.44%
91.47%
4.03%
0.20%
0.17%
0.25%

0.06%
0.57%
5.75%
90.18%
5.73%
0.27%
0.36%

0.08%
0.06%
0.42%
4.43%
83.74%
6.16%
1.03%

0.03%
0.09%
0.17%
0.75%
8.29%
82.49%
13.17%

0.06%
0.02%
0.02%
0.17%
0.88%
5.27%
52.52%

0.00%
0.02%
0.08%
0.28%
1.08%
5.59%
32.67%

Total capital charge Counterparty Credit Risk (CCR)


+

1. Counterparty default risk


x

Unexpected loss per 1 exposure


SA

OTC

IMM

RW(RatingExternal)1
K(PDInternal, R(PD))

CCP
1)

2%

x LGD

8%

x
x

8%

Exposure [in ]

2. Counterparty migration
risk
Credit Value Adjustment
2.1

CEM,
SM, - CVAlosses
*EEPE

2.33

( )2 + ( )2

2.2 ccMarket Risk-IRM(CVA(s))


0

Derivatives are usually contracted with counterparties of the regulatory segment Corporates, Banks, Government

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126

Counterparty Credit Risk:


CVA\ Downgrade losses substantially exceeded default losses.

Defaultable Derivatives:
Deutsche Bank
Bank A enters into
Payerswap with DB:
Notional: 100m,
Maturity: 5Y
CDS-spread CP: 100
bp

Loans
Deposits
Trading
book

Capital
CVA-Cap.

Total capital charge Counterparty Credit Risk (CCR)


1. Counterparty default risk

2. Counterparty migration
risk

Mark-to-market losses due to credit valuation adjustments (CVA) were not directly capitalised. Roughly
two-thirds of CCR losses were due to CVA losses and only one-third were due to actual defaults.
(BCBS, 2009)

1)

Derivatives are usually contracted with counterparties of the regulatory segment Corporates, Banks, Government

FrankfurtSchool.de

127

Counterparty Credit Risk:


CVA\ CCRBasel3 -Example using Standardised Approach

Defaultable Derivatives:
Loans

Deposits

Notional: 100m,
MtM: 5, Maturity: 5Y
Interest
rate swap 1

Deutsche Bank,
Rating: A+

Interest
rate swap 2
Capital

OA

Total capital charge Counterparty Credit Risk (CCR)


+

1. Counterparty default risk

OTC

SA

RW(RatingExternal)

8%

CEM

50%

8%

5 + 100 * 0.5%

Banks, risk-weight (rating):

1)

2. Counterparty migration
risk

2.33

( )2 + ( )2

0.22 m
Add-on

Derivatives are usually contracted with counterparties of the regulatory segment Corporates, Banks, Government

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128

Counterparty Credit Risk:


CVA\ CCRBasel3 -Example using Standardised Approach

Defaultable Derivatives:
Loans
Notional: 100m,
MtM: 5, Maturity: 5Y
Interest
rate swap 1

Deutsche Bank,
Rating: A+

OA

Deposits
Interest
rate swap 2
Capital

Total capital charge Counterparty Credit Risk (CCR)

OTC

SA

1. Counterparty
default risk

0.22 m

2. Counterparty migration risk


2.1

2.33

(0.5 0.8% 2.5 5.5)2 + 0.75 (0.8% 2.5 5.5)2


0.26 m

wi (external Rating), Mi: effective maturity, Bi : notional,


hedge: individual hedge, ind: index hedge

FrankfurtSchool.de

Rating

w_l

...

...

0.8%

...

...

129

Counterparty Credit Risk:


CVA\ CCRBasel3 -Example using Standardised Approach

Defaultable Derivatives:

2. Counterparty migration risk


2.1

2.33

(0.5 0.8% 2.5 5.5)2 + 0.75 (0.8% 2.5 5.5)2


Bank A
...

Interest
rate swap 1
CP = A+

...

Capital

MtM = 5
0.22
0.26

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130

Counterparty Credit Risk:


CVA\ Standardized Approach\ Details

value ~ N()
=>

CVA ~ N (0,

2. Counterparty migration risk

2.1

2.33

(0.5 0.8% 2.5 5.5)2 + 0.75 (0.8% 2.5 5.5)2

1 (CVA-changes, 84%quantile)
2.33 (99%-quantile)

FrankfurtSchool.de

131

Counterparty Credit Risk:


CVA\ Internal model\ Details

Internal CVA-capital
model only
internal
model for specific market
risk

2. Counterparty migration risk


2.2

ccMarket Risk-IRM(CVA(s))

VaR for zerobond with Notional = EaD, Issuer = counterparty, Maturity taken from longest unhedged derivative
Only risk factor: spread evolution (must be taken from VaR-model)
CVA-cc = cc(VaRnormal,general + VaRnormal,specific VaRstressed,general + VaRstressed,specific + 0*IRM)

Extremely high burdens for advanced CVA formula Bundesverband Deutscher Banken estimates that at most
two banks in Germany will apply the CVA advanced formula

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132

Counterparty Credit Risk:


CVA\ Internal model\ Details

Source: Michael Pykhtin and Steven Zhu


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133

Credit Default Swaps


A credit default swap is a bilateral contract (documented as a swap using a
confirmation under an ISDA Master Agreement) in which the Protection
Seller receives a fixed premium vs agreeing to pay a contingent floating
payment to the Protection Buyer if a Reference Entity suffers a Credit Event
and the credit default swap is triggered
Cash Flows before Credit Event
250

Protection Buyer
(Short Credit
Risk)

Quarterly Fixed CDS


Premium

Protection Seller
(Long Credit
Risk)

200

150

100

Protection Buyer
(Short Credit
Risk)

Fixed CDS Premium


Stops
Deliverable
Obligation
Notional Amount

Protection Seller
(Long Credit
Risk)

50

0
M rz . 0 6
M a i. 0 6
J u l. 0 6
S ep. 06
N ov. 06
Jan. 07
M rz . 0 7
M a i. 0 7
J u l. 0 7
S ep. 07
N ov. 07
Jan. 08
M rz . 0 8
M a i. 0 8
J u l. 0 8
S ep. 08
N ov. 08
Jan. 09
M rz . 0 9
M a i. 0 9
J u l. 0 9
S ep. 09
N ov. 09
Jan. 10
M rz . 1 0
M a i. 1 0
J u l. 1 0
S ep. 10
N ov. 10

Cash Flows if triggered following Credit Event*

Itraxx Serie 9

FrankfurtSchool.de

134

Credit Default Swaps


European CDS Spreads (2005-2011)
800

700

600

500

400

300

200

100

0
2005

2006
Autos

Industrial

FrankfurtSchool.de

2007
Construction

2008
Energy

2009
TMT

Financials Senior

2010

2011

Financials Subordinated

135

Credit Default Swaps

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136

Credit Default swaps: The network perspective


June 2008: Notional amount of single name credit default swaps = 38 trillion
USD
Dealer to dealer network: the 15 largest CDS dealers represent an almost
complete network representing 61 % in terms of outstanding CDS notional
Default of a firm on which a lot of CDS protection has been sold can strongly
affect exposures across the network.

Measuring Systemic Risk: insights from


network analysis (Rama Cont)
(Blue: Counterparty relations. Red:
counterparty CDS exposures resulting
from the default of a large name)

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137

Counterparty Credit Risk:


CVA\ Internal model\ Details

FrankfurtSchool.de

138

Counterparty Credit Risk:


CVA\ Internal model\ Details

Assume a 1y bond priced at par is insured by a CDS contract with spread s.


The recovery rate of the bond in the case of a default is R and its Probability of
Default is PD
The expected pay-off of the CDS contract in the case of a default is
(1-R)*PD
The upfront spread of the CDS contract should be equal to the expected pay-off
S = (1-R)*PD

Implied Default Probability :

sCDS
PD
1 R
FrankfurtSchool.de

sCDS = 240bps

R = 40%

2,40%
= 4%
PD =
1 40%
139

Counterparty Credit Risk:


CVA\ Internal model\ Details

Example: Exposure Profile of an Interest-Rate Swap (Source: Michael Pykhtin and Steven Zhu)

CVA-Charge:

(LGDmarket is the loss given default of the counterparty, EEi is the expected
exposure of the counterparty at time ti , Di is the default risk-free discount
factor at time ti .
FrankfurtSchool.de

140

Counterparty Credit Risk:


CVA\ Summary: Credit AND market risk in a trading book.

Bank A

Defaultable Derivatives:
Deutsche Bank

Debt

Bank A enters into


Payerswap with DB:
Notional: 100m,
MTM: 5y, Maturity: 5Y
CDS-spread CP: 100
bp
1. Market risk
(instrument pricing
with risk-free
counterparty/ no credit
spread of counterparty
!!)

Trading
book
Capital
5

MtM(r5y, constant csCounterparty)

MtM

Maturity
MtM

5Y

MtM(constant r5y, csCounterparty)

3. Pillar1 - Capital Ratio


=

CVA
CVAVaR99%,10d
99%

Capital T1+T2
12.5*(VaRCVA + K + VaRMR + VaROpR)
Maturity

10d

FrankfurtSchool.de

K = N(0,PDCP)
*LGD
**EEPE

2.1
Counterparty
default risk

MR-VaR99%,10d
99%
10d

2.2 CVA-risk
(no credit spread of
counterparty !!,
CVA-VaR:
stand.&stress
VaRgen&spec, 0*IRM)

5Y

141

Counterparty Credit Risk:


All Basel III-amendments regarding counterparty credit risk.
Proposed remedies to better account for counterparty credit risk (CCR)
(A) CPPs

Current treatment
is insufficient w.r.t.:

(B) OTC
(i) Regulatory capital calculation
Micro level

MtMdowngrade risk

1
CVA risk
2

(unexpected)
Default
risk
(accounted
for
currently
by Basel II)

Model
validation

2.1

wrong-way
risk

Stressed
effective EPE
Risk weight =
2%*8%

Collateralised CCPs

Macro level

Qualitative
requirements for back
and stress testing

New Capital
charge

CVA = 0

2.2 Multiplier for asset


value correlation
R: 1.25
Tackle shortcomings
in alpha estimation

monitoring general
wrong-way risk
Improve op. perf. of
collateral dept.

Margin
period of risk
4

New guidelines for


inferred ratings and
appropriateness of
unrated positions

Reliance
on external
ratings

(ii) CCR
management

Reduce reliance on
external ratings and
code of conduct for
rating agencies

Qualitative
requirements for back
and stress testing

back &
stress
testing

Incentives to move from


OTC to CCP
transactions
FrankfurtSchool.de

For both, IM and SM


Only for IM
142

Counterparty Credit Risk:


Wrong-way risk (PD(EaD))

Wrong-way risk
Positive correlation between EaD and PD
to a given counterparty.
specific: Typically arises from
poorly constructed transactions.
E.g.: bank holds long a put option
on shares of a counterparty that
provides own shares as collateral.
general: PD of counterparty is
positively correlated with market risk
factors.

100
%

PD
EaD

0%

default

Current Basel II approach to wrong-way risk


CCRBaselII = K * EaD = K * * EEPE

FrankfurtSchool.de

-factor to account for


wrong-way risk

143

Counterparty Credit Risk:


Wrong-way risk (PD(EaD))

Basel III approach to wrong-way risk


general wrong-way risk: NO EXPLICIT CAPITAL CHARGE but
Micro level
Stressed
effective expected positive
exposure

2.1

2.2

Macro level

CCR management / Op risk

Asset value
correlation multiplier

tackle shortcomings in factor estimation

R [0.12;0.24]

EEPE
Stress
scenario

*1.25

EEPEstressed

R [0.15;0.30]

specific wrong-way risk:


Implement
methodology to
identify specific
wrong-way risks

FrankfurtSchool.de

Identify
specific
wrong-way
risk for a
transaction

EaD = * EEPE
if CDS
Notional
EaD =
MtM|default if EQ - deriv.

144

Counterparty Credit Risk:


Stressed effective expected positive exposure (EEPE)
Does not account for wrong-way risk

Shortcomings
of EEPE
Is not appropriately estimated in periods of stress
2.1

Stressed EEPE (EEPEstressed)


effective expected positive exposure (EEPE):

EEPE:=

tk

,
EEE
tk

t k 1 yr

where effective expected exposure (EEE):


where EE denotes the expected exposure.

stressed EEPE:

Define 3yr period including


1yr stress period used for
stressed VaR (Market Risk
Revisions)

, )
EEEtk := MAXt tk (EE
t

EEPE:
Calibrate EEPE
parameters to this
period

Revised EaD calculation:

EaD = * MAX(EEPEstressed; EEPEcurrentdata )

FrankfurtSchool.de

145

Counterparty Credit Risk:


Stressed correlation (R) multiplier for critical counterparties.
2.2

Basel II correlation calculation:


1 e50PD
1 e50PD

R = 0.12
+ 0.241
1 e50
1 e50

Basel II
correlation

Observation:
R(financial firms)

Proposed
changes

Correlation (R) ranges from 12% to 24%

1.25

Multiplicative factor of 1.25 to R for exposures to financial intermediaries that are


regulated banks, brokers/dealers, insurance companies with assets of at least
USD25 billion
unregulated generating majority of revenues from financial activities
(e.g. hedge funds)

Comment

FrankfurtSchool.de

If a counterparty has low PD and, hence, high R, capital requirements can


increases by about 35%
Interbank lending becomes quite expensive, punishing good intermediaries

146

Counterparty Credit Risk:


Example: Stressed correlation (R) for critical counterparties.

BaselII

RWACCR

BaselII

Interbank lending market

Relative capital increase

CCR
RWAnew

1+ (M 2.5)b
* * EEPE
1 1.5b
1 + (M 2.5)b
* * EEPEstressed
= 12,5 * LGD*[(1.25* R( PD)) PD]*
1 1.5b
= 12,5 * LGD*[(R( PD)) PD]*

PD

AAA to BB-

FrankfurtSchool.de

PD
0,01%
0,02%
0,03%
0,04%

16,71%
16,72%
16,73%
16,74%

R 1,25*R
23,9% 29,9%
23,9% 29,9%
23,8% 29,8%
23,8% 29,7%

12,0% 15,0%
12,0% 15,0%
12,0% 15,0%
12,0% 15,0%

Relative
capital
increase
35,714%
36,074%
36,088%
36,001%

14,444%
14,441%
14,438%
14,435%

B+ to CCC

147

Counterparty Credit Risk:


All Basel III-amendments regarding counterparty credit risk.
Proposed remedies to better account for counterparty credit risk (CCR)
(A) CPPs

Current treatment
is insufficient w.r.t.:

(B) OTC
(i) Regulatory capital calculation
Micro level

MtMdowngrade risk

1
CVA risk
2

(unexpected)
Default
risk
(accounted
for
currently
by Basel II)

Model
validation

2.1

wrong-way
risk

Stressed
effective EPE
Risk weight =
2%*8%

Collateralised CCPs

Macro level

Qualitative
requirements for back
and stress testing

New Capital
charge

CVA = 0

2.2 Multiplier for asset


value correlation
R: 1.25
Tackle shortcomings
in alpha estimation

monitoring general
wrong-way risk
Improve op. perf. of
collateral dept.

Margin
period of risk
4

New guidelines for


inferred ratings and
appropriateness of
unrated positions

Reliance
on external
ratings

(ii) CCR
management

Reduce reliance on
external ratings and
code of conduct for
rating agencies

Qualitative
requirements for back
and stress testing

back &
stress
testing

Incentives to move from


OTC to CCP
transactions
FrankfurtSchool.de

For both, IM and SM


Only for IM
148

Counterparty Credit Risk:


Collateralized CPs fundamentals of margin period of risk.

Margin agreement: Contractual agreement that a counterparty posts collateral when its
exposure exceeds a specified level

Basic
definitions

Margin threshold: largest amount of exposure that remains outstanding until one party
has the right to call for collateral
Margin period of risk: delay between a margin call that a counterparty does not respond
to and the start of closing out that counterparty (default procedures)

Margin agreements reduce CCR but pose significant challenges to modelers as future
collateral amounts and margin calls ought to be modeled

Observations
Low margin periods of risk according to Basel II caused precipitated defaults and EaD
might be underestimated

FrankfurtSchool.de

149

Counterparty Credit Risk:


Collateralized CPs fundamentals of margin period of risk.
Proposed floors for margin period of risk (MPR)

floor

New

Basel II
correlation

MPRMin

Transaction type

5 days

Repo-style

10 days

Other CM-transactions

20 days

Secured lending,

20 days

Large netting setts1


Illiquid positions2

Condition
Daily
remargining
Daily revaluation

If more than 2 margin call disputes


in that netting set in last quarter

2*floor

How does MPR enter the capital calculation?


Basel III

RWACCR

= 12,5 Kstressed( R 1.25banks) EEPEstressed + 12,5 cc(CVA)


Should be calculated with margining

Banks that can calculate EEPE without margining, but not with margining,
need to proxy EEPE with margining:3
With margining
Withoutmarginagreement
EEPEstressed
= max(Marginthreshold+ PE(0,MPR);EEPEstressed
)

1)

Large netting sets


5,000 trades at any point during a quarter
positions
one or more trades with either (i) illiquid collateral or (ii) illiquid OTC-derivate (that cannot be easily replaced)
3) PE: expected increase in the netting sets exposure beginning from current exposure of zero over the margin period of risk.

2) Illiquid

FrankfurtSchool.de

150

Counterparty Credit Risk:


All Basel III-amendments regarding counterparty credit risk.
Proposed remedies to better account for counterparty credit risk (CCR)
(A) CPPs

Current treatment
is insufficient w.r.t.:

(B) OTC
(ii) CCR
management

(i) Regulatory capital calculation


Micro level
Macro level
MtMdowngrade risk

1
CVA risk

(unexpected)
Default
risk
(accounted
for
currently
by Basel II)

Model
validation

New Capital
charge

CVA = 0

2.1

wrong-way
risk

Stressed
effective EPE
Risk weight =
2%*8%

Collateralised CCPs

Qualitative
requirements for back
and stress testing
2.2 Multiplier for asset
value correlation
R: 1.25
Tackle shortcomings
in alpha estimation

Improve op. perf. of


collateral dept.

Margin
period of risk
4

New guidelines for


inferred ratings and
appropriateness of
unrated positions

Reliance
on external
ratings

monitoring general
wrong-way risk

Reduce reliance on
external ratings and
code of conduct for
rating agencies

Qualitative
requirements for back
and stress testing

back &
stress
testing

Incentives to move from


OTC to CCP
transactions
FrankfurtSchool.de

For both, IM and SM


Only for IM
151

Counterparty Credit Risk:


Reduced reliance on external ratings.

No understanding of risks inherent in rated instruments, in particular


securitisations
Negative incentives induced by external ratings

Objectives
towards usage
of external
ratings

banks neglect own independent internal assessment


production of good ratings by external rating agencies
cliff effects in capital requirements as external ratings are discrete

Bank prefers
PD instrument
at this side
of the cliff.

over
instrument
here!

true PD (internally
assessed)
regulatory
PD
cliffs
true
risk

FrankfurtSchool.de

152

Counterparty Credit Risk:


Reduced reliance on external ratings.

Committee will review the ratings-based approaches to securitisations and


reconsider/recalibrate the supervisory formula not depending on external
ratings.

Standardised inferred rating: an unrated exposure would only have an


inferred rating from low-quality issue specific or issuer ratings that rank pari
passu or senior to the unrated exposure.

Proposed
revisions

Assessing external ratings and unrated exposures: require banks to


assess whether the risk weight assigned to an exposure is appropriate. In
particular banks might prefer exposures likely to have a low rating to be left
unrated under the current Basel II approach, as a low rating has higher risk
weights than a non-rating

Code of conduct: IOSCO Code of Conduct Fundamentals for Credit Rating


Agencies to be applied

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153

Thank You and Merry Christmas !!!

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154