Transcript Integration Framework for Market and Credit Risks

Basic Principles for Credit Risk
Management
Prof. Dan Galai
Types of Financial Risks
Types of financial risks

Components of financial risks
Market
Financial risks
Credit
Operational
Liquidity
Human Factor
Legal & Regulatory
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Types of financial risks

Market risk is multidimensional
Equity risk
Financial
risks
Market
risk
9.25%
Interest rate risk
Yield 8.75%
%
5 yrs
Term to Maturity
Currency risk
Commodity risk
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Types of financial risks

One can “slice and dice” these multiple dimensions of
risks
Interest rate
Market risk
Commodity prices
Currency risk
Equity risk
Financial
risks
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Transaction risk
Credit risk
Portfolio
concentration risk
Operational
risk
Process risk
Infrastructural or
Leverage risk
Model risk
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The old regulatory
environment:
BIS 1988 or the Accord
BIS 88
Capital adequacy requirements
1. Assets to capital multiple (overall measure
of the bank’s capital adequacy)
Total assets (including specified off-balance sheet
items) / capital < 20
2. Risk based capital ratio (solvency ratio which
focuses on credit risk associated with on-and offbalance sheet exposures)
Capital >8% of Risk Weighted Assets (RWA)
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BIS 88
Risk weighted amount =
S Assets * WA +
S Credit equivalent * WCE
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BIS 88

Risk capital weights by broad on-balance
sheet asset category (WA)
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Risk weights
Asset category
0%
Cash and gold bullion, claims on OECD Governments like
Treasury bonds, insured residential mortgages.
20%
Claims on OECD banks and OECD public sector entities like
securities issued by U.S. Government agencies, claims on
municipalities.
50%
Uninsured residential mortgages.
100%
All other claims like corporate bonds and less developed country
debt, claims on non-OECD banks, equity, real estate, premises,
plant and equipment.
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BIS 88
Calculating BIS risk-weighted amounts for derivative products
Step 1: Credit-equivalent amount
Current
replacement cost
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+
Add-on amount
= Credit equivalent
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BIS 88
Add-on factors by type of underlying and maturity
Residual
Maturity
Interest
Rate
Exchange
Rate and
Gold
Equity
(%)
Precious
Metals
Except Gold
(%)
(%)
(%)
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Other
Commodities
(%)
One year or
less
0.0
1.0
6.0
7.0
10.0
Over one
year
to five years
0.5
5.0
8.0
7.0
12.0
Over five
years
1.5
7.5
10.0
8.0
15.0
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BIS 88
Calculating BIS risk-weighted amounts for derivative products
Step 1: Credit-equivalent amount
Current
replacement cost
+
Add-on amount
= Credit equivalent
Step 2: Risk weighted amount
Credit equivalent
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x
Counterparty
risk weighting
=
Risk weighted
amount
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BIS 88

Risk capital weights for off balance credit
equivalents by type of counterparty (WCE)
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Risk weights
Type of counterparty
0%
OECD governments
20%
OECD banks and public sector entities
50%
Corporate and other counterparties
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BIS 88
Counterparty Risk for Portfolio 1
(with a corporate counterparty)
Replacement cost
= 0 (at-the-money swap)
Add-on
= 100M USD x 1.5% = 1,500,000 USD
Risk-weighted amount = 1,500,000 USD x 50%
= 750,000 USD
Capital charge
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= 750,000 USD x 8% = 60,000 USD
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BIS 88
The Accord is flawed.
 The Accord does not address complex
issues like:

» portfolio diversification (credit risk is
partially offset by diversification across
issuers, industries and geographical
locations
» netting
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BIS 88

The Accord produces a distorted assessment
of actual risks and a misallocation of capital:
» ignores market risk for tradable securities
» generates regulatory arbitrage opportunities
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The New Regulatory and
Corporate Environment
Regulatory Arbitrage is forcing Regulators to move away from
standardized approach toward internal models approach
Example of Regulatory Arbitrage:
Libor + 50 bp
High
Quality Bank
A
Funding Cost
Libor -20 bp
(on 92% of nominal)
XYZ
$100M
(1) Assume Libor (L) = 5.2%
13.75% = (L+50) x $100 - (L-20) x $92
$8
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Capital Charge = 8%
Net revenue = $1.1M
Return on capital = 13.7% (1)
The New Regulatory and
Corporate Environment
Example of Regulatory Arbitrage:

Long a corporate loan and long a credit swap
from an OECD Bank to hedge credit risk exposure.
Capital treatment:


full offsetting of credit risk related to XYZ loan, no
capital charge against loan package
capital add-on = Principal x risk weight (OECD Bank) x 8%
= $100m x 20% x 8% = $1.6m
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The New Regulatory and
Corporate Environment
Example of Regulatory Arbitrage:
High
Quality
Bank A
Buyer of
credit
derivative
50 bp
Zero
or
Par - recovery
No default
Default
Lower
Quality
Bank B
}
Seller of
credit
derivative
Libor + 50 bp
XYZ
$100M
(2)
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17.5% =
Funding cost
Libor - 20 bp
(on 98.4 % of nominal)
(L+50) x $100 - 50bp x $100 - (L-20) x $98.4
$1.6
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Net Capital charge = 1.6%
Net revenue = $280,000
Return on capital = 17.5% (2)
BIS 88

Regulators are slowly beginning to
acknowledge that standardized
regulatory measures such as growth in
Risk Weighted Assets (RWA) fail to
provide meaningful transparency in
terms of measuring the Amount at Risk.
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BIS 88
Growth in RWA does not tell the whole story




Example 1: Revolvers less than one year do not
require any RWA
Example 2: Loan to GE requires 5 times as much
RWA as a loan to a Japanese City bank
Example 3: Loan to AA counterparty receives same
RWA as a loan to BB counterparty
Example 4: RWA do not reflect concentration Risk
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BIS 88
Example: A single $100 loan to a BB counterparty receives same amount
of RWA as 100 different $1 loans to 100 different BB counterparties
Total Risk
Specific Risk
Systematic Risk
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Increasing Diversification