Basel 2.5,Basel Ill,andDodd-FrankChapter 13RiskManagementandFinanciallnstitutions3e,Chapter13,CopyrightJohnC.Hull2012
Basel 2.5, Basel III, and Dodd-Frank Chapter 13 Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 1
Basel 2.5 (Implementation: Dec 31, 2011). Stressed VaR for market riskCalculated over one year period of stressedmarket conditionsCapital = max(VaRt-1,m. ×VaRavg)+max(sVaRt-1, m, ×VaRavg)Incremental Risk ChargeEnsures that products such as bonds and creditderivatives in the trading book have the samecapital requirement that they would if they were inthe banking book2RiskManagementandFinancialInstitutions3e,Chapter13,CopyrightJohnC.Hull2012
Basel 2.5 (Implementation: Dec 31, 2011) • Stressed VaR for market risk – Calculated over one year period of stressed market conditions – Capital = max(VaRt-1 ,mc ×VaRavg) +max(sVaRt-1 , ms ×VaRavg) • Incremental Risk Charge – Ensures that products such as bonds and credit derivatives in the trading book have the same capital requirement that they would if they were in the banking book Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 2
Basel2.5 continuedComprehensiveRiskMeasureDesigned to make sure sufficient capital iskept for instruments in the trading book thatdepend on on credit default correlationsStandard approach:ABBBBBAAA orBelow BCredit RatingAA4%8%28%1.6%SecuritizationsDeduction3.2%8%18%52%ResecuritizationsDeduction3RiskManagementandFinancialInstitutions3e,Chapter13,CopyrightJohnC.Hull2012
Basel 2.5 continued ⚫ Comprehensive Risk Measure ⚫ Designed to make sure sufficient capital is kept for instruments in the trading book that depend on on credit default correlations ⚫ Standard approach: Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 3 Credit Rating AAA or AA A BBB BB Below B Securitizations 1.6% 4% 8% 28% Deduction Resecuritizations 3.2% 8% 18% 52% Deduction
Basel IllCapital Definitionand RequirementsCapitalConservationBufferCountercyclical BufferLeverage RatioLiquidity RatiosCapital for CVA RiskRiskManagementandFinancialInstitutions3e,Chapter13,CopyrightJohnC.Hull20124
Basel III ⚫ Capital Definition and Requirements ⚫ Capital Conservation Buffer ⚫ Countercyclical Buffer ⚫ Leverage Ratio ⚫ Liquidity Ratios ⚫ Capital for CVA Risk Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 4
Capital Definition andRequirementsThree types:Common equity Tier 1Additional Tier 1Tier 2Definitions tightenedLimitsCommonequity>4.5%ofRWATier 1 > 6% of RWATier 1 plus Tier2 > 8% of RWAPhased implementation of capital levels stretching to January1,2015Phased implementation of capital definition stretchingtoJanuary 1, 2018RiskManagementandFinancialInstitutions3e,Chapter13,CopyrightJohnC.Hull20125
Capital Definition and Requirements • Three types: – Common equity Tier 1 – Additional Tier 1 – Tier 2 • Definitions tightened • Limits – Common equity > 4.5% of RWA – Tier 1 > 6% of RWA – Tier 1 plus Tier 2 > 8% of RWA • Phased implementation of capital levels stretching to January 1, 2015 • Phased implementation of capital definition stretching to January 1, 2018 Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 5
Capital Conservation Buffer Extra 2.5% of common equity required innormal times to absorb losses in periodsof stress If total common equity is less than 7%(=4.5%+2.5%) dividends are restrictedTo bephasedinbetweenJanuary1,2016and January 1, 20196RiskManagementandFinancialInstitutions3e,Chapter13,CopyrightJohnC.Hull2012
Capital Conservation Buffer ⚫ Extra 2.5% of common equity required in normal times to absorb losses in periods of stress ⚫ If total common equity is less than 7% (=4.5%+2.5%) dividends are restricted ⚫ To be phased in between January 1, 2016 and January 1, 2019 Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 6
CountercvclicalBuffer Extra equity capital to allow for cyclicalityof bank earningsLeft to the discretion of national regulatorsCan be as high as 2.5% of RWA Dividends restricted when capital is belowrequired levelTo be phased in between January 1, 2016and January 1, 20197RiskManagementandFinancialInstitutions3e,Chapter13,CopyrightJohnC.Hull2012
Countercyclical Buffer ⚫ Extra equity capital to allow for cyclicality of bank earnings ⚫ Left to the discretion of national regulators ⚫ Can be as high as 2.5% of RWA ⚫ Dividends restricted when capital is below required level ⚫ To be phased in between January 1, 2016 and January 1, 2019 Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 7
LeverageRatio Ratio of Tier 1 capital to total exposure(not risk weighted) must be greater than3%Exposure includes all items on balancesheet and some off-balance sheet itemsTo be introducedon January 1, 2018 aftera transition period8RiskManagementandFinancialInstitutions3e,Chapter13,CopyrightJohnC.Hull2012
Leverage Ratio ⚫ Ratio of Tier 1 capital to total exposure (not risk weighted) must be greater than 3% ⚫ Exposure includes all items on balance sheet and some off-balance sheet items ⚫ To be introduced on January 1, 2018 after a transition period Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 8
Liquidity Risk RatiosHighQualityLiquidAssets≥100%LiquidityCoverageRatioNetCashOutflowsfor30dayperiodforanacute30-daystressperiod(3notch downgrade,partial loss ofdepositslossofunsecured wholesale funding,increasedhaircuts onsecuredfunding,increasedcollateralrequirements,drawdownsonlinesofcredit,etc)Amount of Stable Funding≥100%Net Stable Funding Ratio =RequiredAmountofStableFundingforaperiodoflongertermstress.Eachcategoryoffunding(capital,deposits,etc)ismultipliedbyanavailablestablefunding (ASF)factortoformnumerator.Eachcategoryofrequiredfunding(assets,off-balancesheetexposuresismultiplied byarequired stablefunding factor (RSF)toformdenominatorTheLCRandNSFRwill be introducedon January1,2015andJanuary1,2018,respectively9RiskManagementandFinancialInstitutions3e,Chapter13,CopyrightJohnC.Hull2012
Liquidity Risk Ratios i smultiplied by a required stable funding factor (RSF) to form denominato r Each category of required funding (assets, off -balance sheet exposures i smultiplied by an available stable funding (ASF)factor to form numerator. for a period of longer term stress.Each category of funding (capital, deposits, etc) Required Amount of Stable Funding Amount of Stable Funding Net Stable Funding Ratio increased collateral requirements, drawdowns on lines of credit, etc) loss of unsecured wholesale funding, increased haircuts on secured funding, for an acute 30 - day stress period(3 notch downgrade, partial loss of deposits, Net CashOutflows for 30 day period High Quality Liquid Assets Liquidity Coverage Ratio 100% 100% = = Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 9 The LCR and NSFR will be introduced on January 1, 2015 and January 1, 2018, respectively
ASF Factors (Table 13.4, page 293)ASFFactorCategory100%Tier1andTier2capitalPreferredstockandborrowingwitharemainingmaturitygreaterthan1year90%Stabledemanddepositsandtermdeposits80%Lesstabledemanddepositsandtermdeposits50%Wholesaledemanddeposits0%Allotherliabilityandequitycategories10RiskManagementandFinancialInstitutions3e,Chapter13,CopyrightJohnC.Hull2012
ASF Factors (Table 13.4, page 293) Risk Management and Financial Institutions 3e, Chapter 13, Copyright © John C. Hull 2012 10 ASF Factor Category 100% Tier 1 and Tier 2 capital Preferred stock and borrowing with a remaining maturity greater than 1 year 90% Stable demand deposits and term deposits 80% Les stable demand deposits and term deposits 50% Wholesale demand deposits 0% All other liability and equity categories