Basel I, Basel Il, andSolvencyIlChapter 12RiskManagementandFinanciallnstitutions3e,Chapter12,CopyrightJohnC.Hull2012
Basel I, Basel II, and Solvency II Chapter 12 Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012 1
History ofBankRegulationPre-19881988: BIS Accord (Basel I)1996: Amendment to BlS Accord1999: Basel Il first proposed2RiskManagementandFinancialInstitutions3e,Chapter12,CopyrightJohnC.Hull2012
History of Bank Regulation ⚫ Pre-1988 ⚫ 1988: BIS Accord (Basel I) ⚫ 1996: Amendment to BIS Accord ⚫ 1999: Basel II first proposed Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012 2
TheModelusedbyRegulators(Figure12.1,page272)X%WorstExpectedCase LossLossRequiredCapitalLoss overtimehorizonRiskManagementandFinancialInstitutions3e,Chapter12,CopyrightJohnC.Hull20123
The Model used by Regulators (Figure 12.1, page 272) Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012 0 1 2 3 4 Expected Loss X% Worst Case Loss Required Capital Loss over time horizon 0 1 2 3 4 Expected Loss X% Worst Case Loss Required Capital Loss over time horizon 3
Pre-1988Banks were regulated using balance sheet measuressuch as the ratio of capital to assetsDefinitions and required ratios varied from country tocountryEnforcement of regulations varied from country tocountryBankleverageincreased in1980sOff-balance sheet derivatives trading increasedLDC debt was a major problemBasel Committee on Bank Supervision set upRiskManagementandFinancialInstitutions3e,Chapter12,CopyrightJohnC.Hull20124
Pre-1988 ⚫ Banks were regulated using balance sheet measures such as the ratio of capital to assets ⚫ Definitions and required ratios varied from country to country ⚫ Enforcement of regulations varied from country to country ⚫ Bank leverage increased in 1980s ⚫ Off-balance sheet derivatives trading increased ⚫ LDC debt was a major problem ⚫ Basel Committee on Bank Supervision set up Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012 4
1988: BIS Accord (page 259) The assets:capital ratio must be less than20. Assets includes off-balance sheetitems that are direct credit substitutes suchas letters of credit and guarantees Cooke Ratio: Capital must be 8% of riskweighted amount. At least 50% of capitalmust be Tier 1.RiskManagementandFinancialInstitutions3e,Chapter12,CopyrightJohnC.Hull20125
1988: BIS Accord (page 259) ⚫ The assets:capital ratio must be less than 20. Assets includes off-balance sheet items that are direct credit substitutes such as letters of credit and guarantees ⚫ Cooke Ratio: Capital must be 8% of risk weighted amount. At least 50% of capital must be Tier 1. Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012 5
Types of Capital (page 262)Tier 1 Capital: common equity, non-cumulative perpetual preferred sharesTier 2 Capital: cumulative preferred stockcertain types of 99-year debentures,subordinated debt with an original life ofmore than 5 years6RiskManagementandFinancialInstitutions3e,Chapter12,CopyrightJohnC.Hull2012
Types of Capital (page 262) ⚫ Tier 1 Capital: common equity, noncumulative perpetual preferred shares ⚫ Tier 2 Capital: cumulative preferred stock, certain types of 99-year debentures, subordinated debt with an original life of more than 5 years Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012 6
Risk-Weighted Capital A risk weight is applied to each on-balance-sheetasset according to its risk (e.g. 0% to cash and govtbonds; 20% to claims on OECD banks; 50% toresidential mortgages; 100% to corporate loans,corporate bonds, etc.)Foreach off-balance-sheet item wefirstcalculate acredit equivalent amount and then apply a risk weightRisk weighted amount (RWA) consists ofsum of risk weight times asset amount for on-balance sheetitemsSum of risk weight times credit equivalent amount for off-balancesheetitems7RiskManagementandFinancialInstitutions3e,Chapter12,CopyrightJohnC.Hull2012
Risk-Weighted Capital ⚫ A risk weight is applied to each on-balance- sheet asset according to its risk (e.g. 0% to cash and govt bonds; 20% to claims on OECD banks; 50% to residential mortgages; 100% to corporate loans, corporate bonds, etc.) ⚫ For each off-balance-sheet item we first calculate a credit equivalent amount and then apply a risk weight ⚫ Risk weighted amount (RWA) consists of ⚫ sum of risk weight times asset amount for on-balance sheet items ⚫ Sum of risk weight times credit equivalent amount for offbalance sheet items Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012 7
Credit Equivalent Amount The credit equivalent amount is calculatedas the current replacement cost (if positive)plus an add on factorThe add on amount varies from instrumentto instrument (e.g. 0.5% for a 1-5 yearinterest rate swap; 5.0% for a 1-5 yearforeign currency swap)RiskManagementandFinancialInstitutions3e,Chapter12,CopyrightJohnC.Hull20128
Credit Equivalent Amount ⚫ The credit equivalent amount is calculated as the current replacement cost (if positive) plus an add on factor ⚫ The add on amount varies from instrument to instrument (e.g. 0.5% for a 1-5 year interest rate swap; 5.0% for a 1-5 year foreign currency swap) Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012 8
Add-on Factors (% of Principal)Table12.2,page261RemainingExchRateEquityPreciousOtherInterestMetalsCommoditiesMaturity (yrs)rateand Goldexcept gold51.57.510.06.015.0Example:A$100 millionswapwith3yearstomaturityworth$5millionwouldhaveacreditequivalentamountof$5.5millionRiskManagementandFinancialInstitutions3e,Chapter12,CopyrightJohnC.Hull20129
Add-on Factors (% of Principal) Table 12.2, page 261 Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012 Remaining Maturity (yrs) Interest rate Exch Rate and Gold Equity Precious Metals except gold Other Commodities 5 1.5 7.5 10.0 6.0 15.0 Example: A $100 million swap with 3 years to maturity worth $5 million would have a credit equivalent amount of $5.5 million 9
The MathNMZw,cZw,L, +RWAi=1j=1On-balance sheetOff-balance sheet itemscredit equivalentitems: principaltimes risk weightamount times riskweightFor a derivative C,= max(V,O) + a,L, where V, isvalue, L, is principal and a, is add-on factor10RiskManagementandFinancialInstitutions3e,Chapter12,CopyrightJohnC.Hull2012
The Math Risk Management and Financial Institutions 3e, Chapter 12, Copyright © John C. Hull 2012j N i M j RWA wi Li wj C = = = + 1 1 * On-balance sheet items: principal times risk weight Off-balance sheet items: credit equivalent amount times risk weight For a derivative Cj = max(Vj ,0) + ajLj where Vj is value, Lj is principal and aj is add-on factor 10