IV.

OPERATIONAL AND INTEGRATED RISK

IV. 1. EXTENDING VAR TO OPERATIONAL RISK .......................................................................... 4
Operational Risk ................................................................................................................................4
Top-Down Approaches .......................................................................................................................4
Bottom-up Approaches ......................................................................................................................6
Top-Down Models .............................................................................................................................7
Bottom-Up Models ............................................................................................................................8
Catastrophic Loss ...............................................................................................................................9
Catastrophe Options and Catastrophe Bonds .................................................................................... 10
Limitations to Operational Risk Hedging ........................................................................................... 11
IV. 2. CAPITAL ALLOCATION AND PERFORMANCE MEASUREMENT .................................. 12
Economic and Regulatory Capital ..................................................................................................... 12
Economic Capital and Risk-Adjusted Return on Capital (RAROC) ........................................................ 13
Attribution of Capital ....................................................................................................................... 14
Capital Charge ................................................................................................................................. 14
Allocation of Economic Capital ......................................................................................................... 16
Drawback of RAROC Approach ......................................................................................................... 16
Adjusted RAROC .............................................................................................................................. 16
IV. 3. LIQUIDITY RISK - CULP ........................................................................................................... 17
Definitions ....................................................................................................................................... 17
Funding Liquidity Risk and Market Liquidity Risk ............................................................................... 17
Measuring Liquidity Risk .................................................................................................................. 18
Cash Flow at Risk (CFaR) ................................................................................................................... 20
Liquidity-adjusted VAR (LVAR).......................................................................................................... 20
Monitoring Liquidity Risk ................................................................................................................. 21
Metallgesellschaft Case .................................................................................................................... 21
IV. 4. AMA APPROACH TO OPERATIONAL RISK ........................................................................ 22
Severity distributions ....................................................................................................................... 22
Frequency distributions.................................................................................................................... 23
Business-line diversification (correlation) ......................................................................................... 26
IV. 5. REGULATION .............................................................................................................................. 29
History............................................................................................................................................. 29
Regulation ....................................................................................................................................... 29
1988 Basel Accord ............................................................................................................................ 30
Basel II Accord ................................................................................................................................. 31
IV. 6. MODEL RISK ............................................................................................................................... 34
Model Risk....................................................................................................................................... 34
Quantifying Model Risk .................................................................................................................... 35
Managing Model Risk....................................................................................................................... 36
Quantification.................................................................................................................................. 36
Institutional Methods ...................................................................................................................... 37
Definition ........................................................................................................................................ 37
Efficient Market Hypothesis (EMH) ................................................................................................... 38
Role of Model Risk Manager............................................................................................................. 39

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IV. 7. CASE STUDIES ............................................................................................................................ 40
Financial Crisis at Metallgesellschaft ................................................................................................. 40
Stack-And-Roll Hedging Strategy ...................................................................................................... 40
Losses at Sumitomo ......................................................................................................................... 41
Collapse of Long-Term Capital Management (LTCM) ......................................................................... 41
Bankruptcy of Barings ...................................................................................................................... 42
Risk Management Measures ............................................................................................................ 42
IV. 8. OPERATIONAL RISK ................................................................................................................. 43
Approaches to estimating operational risk under Basel II .................................................................. 47
IV. 9. FINANCIAL CONGLOMERATES.............................................................................................. 52
Aggregating Risk .............................................................................................................................. 52
Silo Approach to Capital Regulation .................................................................................................. 52
Regulatory Debate ........................................................................................................................... 53
Capital Management of a Financial Conglomerate ............................................................................ 54
Economic Capital as a Common Currency for Risk ............................................................................. 54
Risk Aggregation: The Building Block Approach ................................................................................. 55
Diversification Benefits from Risk Aggregation .................................................................................. 55
Diversification Benefits at Each Aggregation Level ............................................................................ 56
Current Industry Practices ................................................................................................................ 56
3+1 Pillars ........................................................................................................................................ 57
IV. 10. ERM ............................................................................................................................................. 58
Total Risk = Systematic risk + non-diversifiable risk ........................................................................... 58
IV. 11. TECHNOLOGY AND OTHER OPERATIONAL RISKS ...................................................... 63
Definitions ....................................................................................................................................... 63
Risks of Implementing Technological Innovation ............................................................................... 63
Technology and Economies of Scale/Scope ....................................................................................... 63
Average Cost Curve in Banking ......................................................................................................... 63
Economies of Scope ......................................................................................................................... 64
Empirical Findings ............................................................................................................................ 64
Daylight Overdraft Risk .................................................................................................................... 64
IV. 12. A. INVESTORS AND RISK MANAGEMENT........................................................................ 65
Covariance/Correlation of Returns between Securities ..................................................................... 65
Diversification, Asset Allocation, and Expected Returns .................................................................... 66
The Capital Asset Pricing Model (CAPM) ........................................................................................... 67
Diversification and Risk Management ............................................................................................... 67
Capital Market Line (CML) ................................................................................................................ 68
CAPM .............................................................................................................................................. 68
Probability Distribution of Returns ................................................................................................... 70
Expected Return of a Portfolio.......................................................................................................... 72
Strategies for Diversifiable Risk ........................................................................................................ 72
Strategies and Policies to Reduce Systemic Risk ................................................................................ 72
Effect of Hedging on Firm Value........................................................................................................ 73
Risk Management Irrelevance Proposition ........................................................................................ 73
IV. 12. B. CREATING VALUE WITH RISK MANAGEMENT ........................................................ 74
Risk Management Irrelevance Proposition ........................................................................................ 74

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Bankruptcy and Distress Costs .......................................................................................................... 74
Taxes ............................................................................................................................................... 75
Optimal Capital Structure ................................................................................................................. 75
Large Undiversified Shareholders ..................................................................................................... 76
Manager Incentives.......................................................................................................................... 76
Debt Overhang ................................................................................................................................ 77
Information Asymmetries and Agency Costs of Managerial Discretion ............................................... 77
IV. 13. REPORT OF COUNTERPARTY RISK .................................................................................. 78
Risk Management and Risk-Related Disclosure Practices ................................................................... 80
1. Improving Transparency and Counterparty Credit Assessments ................................................... 80
2. Improving Risk Measurement, Management and Reporting ......................................................... 80
3. Prime Brokerage ......................................................................................................................... 81
Financial Infrastructure .................................................................................................................... 82
1. Documentation Policies and Practices ......................................................................................... 82
2. Operational Efficiency and Integrity ............................................................................................ 82
3. Netting, Close-out and Related Issues ......................................................................................... 83
Complex Financial Products .............................................................................................................. 83
4. Credit Derivatives ....................................................................................................................... 83
1. Governance-Related Guiding Principles......................................................................................... 84
2. Intermediary/Client Relationship ................................................................................................ 85
3. Risk Management and Monitoring .............................................................................................. 86
4. Enhanced Transparency .............................................................................................................. 87
Emerging Issues ............................................................................................................................... 88
1. Sale of Complex Products to Retail Investors ............................................................................... 88
2. Conflict Management ................................................................................................................. 89
3. Risk Management for Institutional Fiduciaries ............................................................................. 89
4. Official Oversight of Hedge Funds ............................................................................................... 90
Supervisory Challenges .................................................................................................................... 91
IV. 14. BASEL II CORE READINGS .................................................................................................... 92
Basel II Objectives ............................................................................................................................ 93
Scope .............................................................................................................................................. 94
Capital Requirements ....................................................................................................................... 95
Risk-Weighted Assets (RWA) ............................................................................................................ 97
First Pillar: Credit Risk ...................................................................................................................... 98
CRM Techniques ............................................................................................................................ 110
Asset Securitization........................................................................................................................ 111
Supervisory Backtesting Framework ............................................................................................... 113
Three-Zone Supervisory Framework ............................................................................................... 113
Operational Risk under the Basel II Accord ..................................................................................... 114
Four Principles of the Basel II Accord’s Second Pillar ....................................................................... 115
Issues to be focused in Second Pillar ............................................................................................... 116
Purpose of the Third Pillar .............................................................................................................. 116
Potential problems with risk analytics ............................................................................................ 117

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IV. 1. Extending VaR to Operational Risk
LO 57.1: Compare and contrast top-down and bottom-up approaches to measuring operational risk
LO 57.2: List and describe examples of top-down models for measuring operational risk
LO 57.3: List and describe examples of bottom-up models for measuring operational risk
LO 57.4: List and describe ways a firm can hedge against catastrophic operational losses
LO 57.5: Describe the characteristics of catastrophe options and catastrophe bonds
LO 57.6: Discuss limitations to operational risk hedging

Operational Risk
Operational risk (as defined by Kingsley et al, 1998) is the “risk of loss caused by failure in operational
processes or the systems that support them, including those adversely affecting reputational, legal
enforcement of contracts and claims.” Operational risk includes strategic risk and business risk, and
can arise from breakdowns of people, processes, and systems with the organization.

Operational risk events divided into:

High frequency/low severity (HFLS): occur regularly, but low-level losses

Low frequency/high severity (LFHS): rare but devastating

In this chart, losses are shown left of the mean (i.e., where negatives = loss) but

Top-Down Approaches
LO 57.1 Compare and contrast top-down and bottom-up approaches to measuring operational risk
The traditional approach is top-down: an overall cost of operational risk is determined for the firm. The
bottom-up approach is generally more advanced: operational risk is determined at the business unit (or
SBU, strategic business unit) level.

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Features of Top-Down Approach
Assesses overall, firm-wide cost of operational risk
Is typically a function of a target (macro) variable or variance in target
Top-Down variable; e.g., revenue, earnings
Approaches Does not distinguish between HFLS and low frequency high severity (LFHS)
operational risk events

Advantages Disadvantage

SIMPLE Little help or utility with regard to

designing/modifying procedures that
LOW DATA requirements
mitigate risk; does not really help with
(not data-intensive) prevention

Because top-down approach both (i)

aggregates risk (note: may “over-
aggregate”) and (ii) is backward-
looking, it is a poor diagnostic tool.
Note the tendency to over-aggregate.

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Bottom-up Approaches
Bottom-up approaches target specific operational risk problems. Importantly, they can distinguish
between high-frequency, low-severity (HFLS) events and low-frequency, high-severity (LFHS) event.

Features of Bottom-up Approaches

Analyzes risk from the perspective of individual business activities
Maps processes (activities) and procedures to risk factors & loss events to
Bottom-up
generate future scenario outcomes
Approaches Distinguishes between HFLS and LFHS

Advantages Disadvantage

DIAGNOSTIC: Useful because it can High data requirements

help employees correct weaknesses
PROSPECTIVE: Forward-looking
DIFFERENTIATES between HFLS and
LFHS
By overly disaggregating risk from
different business units/segments,
may omit interdependencies and
therefore correlations. Note the
tendency to under-aggregate (or
overly disaggregate)

Although a bottom-up approach has disadvantages (i.e., data-intensive and may under-
aggregate), generally the bottom-up approache is superior, according to the reading.
Keep in mind that bottom up is required to distinguish between high-frequency, low-
severity (HFLS) and low frequency, high severity (LFHS) loss events.

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Top-Down Models
LO 57.2 List and describe examples of top-down models for measuring operational risk
The six common top-down models are:

1. Multi-factor models
2. Income-based models
3. Expense-based models
4. Operating leverage models
5. Scenario analysis
6. Risk profiling models
Multi-Factor Models
Stock returns (as the dependent variable) are regressed against multiple factors. This is a multiple
regression where Iit are the external risk factors and the betas are the sensitivity (of each firm) to the
external risk factors:

Rit i 1i I1t 2i I2t it <IV. 1. 1>

The risk factors external to the firm; e.g., interest rates, GDP. Also, note the multi-factor model cannot
help model low-frequency, high-severity loss (LFHS) events.

Please note the characteristics of a multi-factor model. The mult-factor model based on
a multiple regression has several applications in the FRM. It has an intercept ( ). After
the intercept, it has several terms. Each term contains an external risk factor (I) and a
sensitivity to the risk factor (beta ). Finally, it has an error term or residual ( ).

Income-Based Models (aka, Earnings at Risk Models)

These are also called Earning at Risk (EaR) models. Income or revenue (as the dependent variable) is
regressed against credit risk factor(s) and market risk factor(s). The residual, or unexplained, volatility
component is deemed to be the measure of operational risk.

Eit it 1 t C1 t 2t M2t it <IV. 1. 2>

Expense-Based Models
Operational risk is measured as fluctuations in historical expenses. This is the easiest approach but
ignores operational risks that are unrelated to expenses; further, a risk-reducing initiative that happened
to increase expenses (because it involved a cost) would be mischaracterized.

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Operating Leverage Models
This is a model that measures the relationship between variable costs and total assets. Operating
leverage is the change in variable costs for a given change in total assets.

Scenario Analysis
In this context, this is a generic label referring to an attempt to “imagine” various scenarios that contain
catastrophic shocks. By definition, scenario analysis attempts to anticipate low frequency high severity
(LFHS) risk events – but doing this generally is a subjective exercise.

Risk-Profiling Models
Refers to a system that directly monitors either performance indicators and/or control indicators.
Performance indicators track operational efficiency; e.g., number of failed trades, system downtime,
percentage of staff vacancies. Control indicators track the effectiveness of controls; e.g., number of
audit exceptions.

Bottom-Up Models
LO 57.3 List and describe examples of bottom-up models for measuring operational risk
There are three types of bottom-up approaches: process, actuarial and proprietary.

1. Process Models
The process approach attempts to identify root causes of risk; because it seeks to understand cause-
and-effect, in should be able to help diagnose and prevent operational losses.

Scorecards or Causal Networks

The scorecard breaks down complex processes (or systems) into component parts. Data are matched to
the component steps in order to identify lapses or breakdowns. Scorecards are process-intensive and
require deep knowledge of the business processes. The outcome is a process map.

Connectivity Models
Connectivity models are similar to scorecards but they focus on cause-and-effect. Examples of
connectivity models include fishbone analysis and fault tree analysis.

Reliability Models
Reliability models emphasize statistical techniques rather than root causes. They focus on the
likelihood that a risk event will occur. The typical metric is the event failure rate, which is the time
between events.

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2. Actuarial Models

Empirical Loss Distributions

Internal and external data on operational losses are plotted in a histogram in order to draw the
empirical loss distribution. Basically, it is assumed that the historical distribution will apply going
forward. As such, no specification or model is required (i.e., Monte Carlo simulation can fill in the gaps).

Parametric Loss Distributions

This approaches attempts to describe the operational loss distribution with a parametric distribution. A
common distribution for operational risk events is a Poisson distribution.

Extreme Value Theory (EVT)

This approach is not mutually exclusive to the empirical and parametric approaches. EVT conducts
additional analyses on the extreme tail of the operational loss distribution. For LFHS events, a common
distribution is the Generalized Pareto Distribution (GPD). Extreme value theory (EVT) implies the use of a
distribution that has fat-tails (leptokurtosis or kurtosis > 3) relative to the normal distribution.

3. Proprietary Operational Risk Models

Proprietary models include, for example, OpVar offered by OpVantage. A proprietary model implies the
vendor has their own database of event losses that can be used to help fit distributions.

Catastrophic Loss
LO 57.4 List and describe ways a firm can hedge against catastrophic operational losses
Three ways a firm can hedge against catastrophic operational loss include:

1. Insurance
2. Self-insurance
3. Derivatives

Insurance
Includes fidelity insurance (covers against employee fraud); electronic computer crime insurance,
professional indemnity (liabilities to third parties caused by employee negligence); directors’ and
officers’ insurance (D&O, covers lawsuits against Board and executives related to bread of their fiduciary
duty to shareholders); legal expense insurance; and stockbrokers’ indemnity (covers stockbroker losses
arising from the regular course of business).

Insurance contracts transfer risk to the insurance company, which can absorb the company-specific
(aka, non-systemic or unique) risk because they can diversify this risk among of pool of customers. In
theory, diversification can minimize/eliminate the company-specific risk.

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However, insurance contracts create a moral hazard problem: the policy creates an incentive for the
policy-holder to engage in risky behavior. Two other disadvantages: insurance policies limit coverage
(“limitation of policy coverage) and Hoffman claims “only 10 to 30% of possible operational losses are
covered” by insurance policies. In short, they rarely provide total coverage and never provide coverage
of all possible operational losses.

Insurance is a critical component of risk management. Remember the positives (risk

transfer to the insurance company; insurance company absorbs company-specific risk
via portfolio diversification) and the negatives (moral hazard, limitation of policy
coverage, lack of coverage for all operational loss events)

Self-Insurance
This is when the company holds (its own) capital as a buffer against operational losses. Holding capital
is expensive—firm can use liquid assets or line of credit. Some firms self-insure through a wholly-owned
insurance subsidiary.

Derivatives
Swaps, forward and options can all transfer operational risk. But derivatives do not necessarily hedge
against operational risk. It depends. Specifically, derivatives hedge if and when the derivative hedges a
risk (e.g., credit or market risk) that itself is correlated to operational risk.

Catastrophe Options and Catastrophe Bonds

LO 57.5 Describe the characteristics of catastrophe options and catastrophe bonds

Catastrophe Options
Catastrophe options (“cat options”) were introduced by the Chicago Board of Trade (CBOT). The CBOT
cat option is linked to the Property and Claims Service Office (PCS) national index of catastrophic loss; it
trades like a call spread (i.e., a long call is combined with a short call at a higher strike price). The “cat
option” has a payoff linked to an index of underwriting losses written on a pool of insurance policies.
Technically, it is a spread option. But unlike a typical option, the payoff does not have unlimited upside.
Cat options are useful because they have essentially no correlation to the S&P.

The weather derivative is a particular type of cat option. Its value derives from a weather-based index.
The most common are daily heating degree day (HDD) and cooling degree day (CDD).

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Cat Bonds
These are bonds with embedded options, where the embedded option is triggered by a catastrophe;
e.g., hurricane. The borrower pays a higher rate (i.e., the cost of the embedded catastrophic risk hedge)
in exchange for some type of debt relief; the most common is relief of both debt and principal. There
are three types of catastrophe bonds:

Indemnified notes: triggered by events inside the firm; i.e., debt relief is granted if the
internal event happens. But these require detailed analysis and are especially subject to
the moral hazard problem
Indexed notes: triggered by industry-wide losses are reflected by an independent index
(external to the company). There has been a trend away from indemnified and toward
indexed notes because indexed notes are not subject to moral hazards (i.e., they link to
external, index-based loss events not internal, company-specific loss events)
Parametric notes: like an indexed note, linked to an external event. However, cash flow
is based on a predetermined formula; e.g., some multiple of Richter scale for
earthquakes

Limitations to Operational Risk Hedging

LO 57.6 Discuss limitations to operational risk hedging
Operational risk is embedded in the firm—assessing it is subjective. It is very difficult to quantify cross-
correlations. Additionally, influences like the incentive scheme produce subtle, complex outcomes.
There are at least four limitation to operational risk hedging:

1. It can be difficult to identify and define the specific operational risk

2. Measurement of operational risks is often subjective

3. It is difficult to foresee unanticipated correlations between/among various operational risks

4. Data is often not available and/or reliable

Two normal means of benchmark are peer comparisons and extrapolation from history into the future.
However, both of these can be problematic when applied to the measurement of operational risk. As
firm cultures vary, peer comparisons may be misleading. Further, catastrophic events are “once in a
lifetime,” and therefore do not lend themselves to extrapolation.

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IV. 2. Capital Allocation and Performance
Measurement
LO 65.1: Distinguish between economic and regulatory capital.
LO 65.2: Describe the relationship between economic capital and risk-adjusted return on capital.
LO 65.3: Compute the RAROC for a loan.
LO 65.4: Explain how capital is attributed to market, credit, and operational risk and calculate the
capital charge for market risk and credit risk.
LO 65.5: Describe how economic capital is allocated for non-loan types of bank products.
LO 65.6: Explain why the RAROC approach may lead to incorrect economic capital allocation
decisions and how the second-generation RAROC approach addresses this issue, and calculate
a project’s adjusted RAROC to determine whether the project should be accepted.

Economic and Regulatory Capital

LO 65.1 Distinguish between economic and regulatory capital
Economic capital absorbs unexpected losses, up to a certain point, depending on the desired confidence
level. The confidence level is a policy decision that should be set by senior management and endorsed
by the board. Economic capital is most relevant to shareholders. First set aside reserves for expected
losses; e.g., such losses are priced into higher yields. Economic capital does not cover expected losses;
economic capital is meant to absorb unexpected losses.

Economic Capital (EC)

4%
EC( = VAR( ) - EL
3%

2%

1%
Expected ES
Loss (EL) VAR
0%

Regulatory capital is rule-based (e.g., BIS 88, BIS 98) with the intention to ensure enough capital is in the
banking system. Most financial institutions hold more capital than required by regulators.

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Economic Capital and Risk-Adjusted Return on Capital (RAROC)
LO 65.2 Describe the relationship between economic capital and risk-adjusted return on capital
(RAROC)
The denominator of risk-adjusted return on capital (RAROC) is risk-adjusted capital. This is the capital
required to absorb unexpected losses, which is the same as economic capital.

RAROC =
Risk-adjusted Return / Economic Capital
3.5%
EC( = VAR( ) - EL
3.0%

2.5%

2.0%

1.5%

1.0%

0.5% Expected
Loss (EL) VAR WCL
0.0%

RAROC for a Loan

LO 65.3 Compute the RAROC for a loan

Revenue + ROC - interest exp.- operating exp.- Expected loss

RAROC
economic capital
For example, assume the following:

A loan portfolio of $1 billion pays an annual rate of 7%

Expected losses are 1%
Economic capital amounting to 5% is invested at a rate of 6%
The loan is funded with deposits that earn (a deposit charge of) 5%
The bank’s annual operating cost is 8%

$70 MM 3 MM (47.5MM 8 MM ) 10 MM
RAROC 15%
50 MM

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Attribution of Capital
LO 65.4 Explain how capital is attributed to market, credit, and operational risk…
In practice, banks manage risk according to three classifications: market, credit and operational risk. To
be successful, a RAROC process must be “integrated” into the overall risk management process and
therefore must incorporate all three of these classifications and with some consistency in methodology.

Capital for Market Risk

In RAROC, market risk capital is attributed as a function of the risk expressed in the VAR calculation.

Capital for Credit Risk

Credit risk capital is a function of exposure, probability of default (usually a function of risk rating (RR) or
via algorithm), and recovery rates. The capital factors (i.e., applied as a percentage of face value) vary
based on RR and tenor.

Capital for Operational Risk

RAROC for operational risk is a work in progress. One approach is to assign a RR (e.g., on a scale of 1 to
5) to each business based on operational risk factors defined in terms of a breakdown of people,
processes or technology.

Capital Charge
LO 65.4 (continued) …and calculate the capital charge for market risk and credit risk

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The RAROC capital allocation for market risk requires a market risk (VAR) limit and the following
parameters:

F1 = a constant, to account for exceptional shocks, or to account for time required to

liquidate position (this is a buffer really)
F2 = charge for unused portion of the limit
F3 = penalty charge for exceeding the VAR limit

ChargeMR = (F1 VaR)

<IV. 2. 1>
(F2 Unused portion of limit) (F3 excess)

For example, assume the Value at Risk (VaR) limit is $1 million. Assume F1=2, F2=0.15,
and F3=3.0. Compute the capital charge (i) if VaR is $800,000 and (ii) if VaR is $1.2
million.

Regarding (i) VaR of $800,000: there is only an unused VaR and no excess. So, the F1 and F2 multipliers
apply. The charge is (a) $800,000 2 = $1.6 million (for the F1) plus (b) $200,000 (the “unused portion”)
0.15 = $30,000. The total charge is $1.6 million (F1) + $30,000 (F2) = $1.63 million.

Regarding (ii) VaR of $1.2 million: there is an excess VaR but no unused portion (note that either F2 or F3
apply, but not both). So, the F1 and F3 multipliers apply. The charge is (a) $1.2 million 2 = $2.4 million
(the F1 charge) plus (b) $200,000 3 = $600,00 (the F3 charge). The total charge $2.4 million (F1) +
$600,000 (F3) = $3 million.

Calculation of Charge for Credit Risk

A capital factor is expressed as a percentage of the market value of the position. Capital factors are
determined by a matrix:

• Tenor: longer tenor  higher capital factor

• Credit quality: lower quality  higher capital factor
Deriving the credit factors is a four step process:

1. Select a representative time period

2. Map risk ratings to the portfolio
3. Estimate expected and unexpected losses
4. Exercise judgment in assigning capital factors to adjust for imperfect data

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 of market discipline.
LO 68.18: Explain the negative bank behaviors that may result with the implementation of Basel II.
LO 68.19: Explain potential problems with the risk analytics of Basel II.
LO 68.20: Explain issues regarding the implementation of Pillar 2 (Supervision) and Pillar 3 (Market
Discipline) of Basel II.

Basel II Objectives
Discuss the criticisms of the 1988 Basel I Accord and the objectives of the new Basel II Capital Accord

Criticisms of 1988 Basel I Accord:

Only addresses credit risk (the January 1996 Amendment addressed market risk)
Risks are not sufficiently differentiated; e.g., all corporate credit risk garnered 100%
weighting
Maturities not sufficiently differentiated; i.e., generally long-term and short-term
exposures treated the same
Portfolio benefits of diversification not incorporated
Does not fully recognize risk reduction benefits of credit risk mitigation (CRM)
techniques; e.g., credit derivatives, collateral, guarantees, and netting arrangements

Many claimed that Basel I encouraged “regulatory arbitrage:” the reduction of regulatory capital
without an equivalent reduction in actual risk.

Objectives of Basel II Accord

The fundamental objective is “to develop a framework that would further strengthen the soundness and
stability of the international banking system while maintaining sufficient consistency that capital
adequacy regulation will not be a significant source of competitive inequality among internationally
active banks.”

Further, under Basel II, objectives sought by the Committee include:

To adjust capital requirements to more closely reflect actual risk; i.e., “to arrive at
significantly more risk-sensitive capital requirements.”
To make greater use of banks’ internal systems as inputs to capital calculations.
To provide a range of options for determining capital requirements that are most
appropriate for their operations and their market discretion.
To recognize innovative risk management financial instruments
To recognize that home country supervisors have an important role
To broadly maintain the aggregate level of capital minimum capital requirements,
while also encouraging advanced, risk-sensitive approaches

Pillars of Basel II Accord

Describe the three pillars that are central to the Basel II Accord

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There are three pillars of the Basel II Accord are:

First Pillar: Minimum capital requirements

Second Pillar: Supervisory review process
Third Pillar: Market discipline
The pillars are interrelated: banks cannot simply meet the minimum capital requirements (first pillar).
Supervisors must review the implementation (second pillar) and the disclosures provided under the
third pillar “will be essential in ensuring that market discipline is an effective complement to the other
two pillars.”

As noted in the November 2005 update, “The Committee also wishes to highlight the need for banks and
supervisors to give appropriate attention to the second (supervisory review) and third (market
discipline) pillars of the revised Framework. It is critical that the minimum capital requirements of the
first pillar be accompanied by a robust implementation of the second, including efforts by banks to
assess their capital adequacy and by supervisors to review such assessments. In addition, the disclosures
provided under the third pillar of this Framework will be essential in ensuring that market discipline is an
effective complement to the other two pillars.” (paragraph 11)

Scope
LO 68.1 Discuss the scope of the Basel II Accord and how it applies to various bank subsidiaries or
business relationships

The framework is applied on a consolidated basis to internationally active banks. The framework applies
to all internationally active banks at every tier within a banking group, also on a fully consolidated basis.

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The scope of application includes, on a fully consolidated basis, any holding company that is the parent
entity within a banking group. Banking groups are groups that engage predominantly in banking
activities and, in some countries, a banking group may be registered as a bank.

To the greatest extent possible, all banking and other relevant financial activities (both regulated and
unregulated) conducted within a group containing an internationally active bank will be captured
through consolidation.

Significant minority investments in banking, securities and other financial entities, where control does
not exist, will be excluded from the banking group’s capital by deduction of the equity and other
regulatory investments. Alternatively, such investments might be, under certain conditions,
consolidated on a pro rata basis.

Operational Market
Credit Risk
Risk Risk

Approach Ratings M itigation Approach

External Basic
Standardized Standardized
Simple Indicator
Complex

Foundation
More

Comprh. Standardized
Internal IRB
Ratings
Advanced Internal
Based
M easurement
(IRB) Advanced
Internal Approach
IRB Internal (AM A)

Capital Requirements
LO 68.2 Define the types of capital, and discuss how each type is used to meet capital requirements
under Basel II

Total capital
8% <IV. 14. 1>
RWA Credit + [MRC Market 12.5]+[ORCOpr'l 12.5]
The total capital ratio must be no lower than 8%. Tier 2 capital is limited to 100% of Tier 1 capital. Total
risk weighted assets (RWA) are determined by multiplying the capital requirements for market risk and
operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting
figures to the sum of RWA for credit risk.

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Tier 1 Capital or “Core Capital”
This capital is “buffer of the highest quality.” It is equity capital: issued and fully paid common stock;
and non-cumulative preferred stock.

Tier 1 capital includes: Disclosed reserves, share premiums, retained earnings, and general reserves

Tier 2 Capital or “Supplementary Capital”

This capital gives some protection, but it is “imperfect buffer capital” because it ultimately will be
redeemed or charged against future income. Tier 2 capital includes:

Undisclosed (or hidden) reserves—in some countries, pass through earnings statement
but remain unpublished
Asset revaluation reserves —e.g., securities carried at costS that have additional market
value
General provisions or loan loss reserves—loan loss allowances taken against
anticipated credit losses
Hybrid debt capital instruments—if unsecured, subordinated, and fully paid up; e.g.,
cumulative preference shares

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Tier 3 Capital – for Market Risk only
This capital is only for covering market risk.

Tier 3 capital includes short-term subordinated debt with maturity of at least two years

Please note: The Revised Framework issued in November 2005 says: “the Committee intends to
undertake additional work of a longer term nature is in relation to the definition of eligible capital. One
motivation for this is the fact that the changes in the treatment of expected and unexpected losses and
related changes in the treatment of provisions in the Framework set out here generally tend to reduce
Tier 1 capital requirements relative to total capital requirements. Moreover, converging on a uniform
international capital standard under this Framework will ultimately require the identification of an
agreed set of capital instruments that are available to absorb unanticipated losses on a going-concern
basis. [The Committee] will explore further issues surrounding the definition of regulatory capital, but
does not intend to propose changes as a result of this longer-term review prior to the implementation of
the revised Framework set out in this document.

Risk-Weighted Assets (RWA)

Similar to Basel I, the minimum ratio of capital to RWA is 8%

Capital RWAk 8%
k

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The calculation of risk-weighted assets (RWA) can be done in one of the following ways:

Standardized approach
Internal ratings based approach: Foundation variant
Internal ratings based approach: Advanced variant

First Pillar: Credit Risk

LO 68.3 Describe the Basel II Accord’s requirements for calculating risk-weights using both the
standardized and internal ratings-based (IRB) approaches when accounting for credit risk
In regard to credit risk, banks can choose either a standardized approach (supported by external credit
ratings or “assessments”) or an internal ratings-based (IRB) approach. The IRB approach divides into
the more flexible Foundation IRB and the Advanced IRB.

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 Pillar 1
Capital
Requirements

Operational

Market
Basic/Standardized

Credit
or
Advanced/Internal

Standardized Approach
In the standardized approach for measuring credit risks, the risk weights applied to claims on sovereigns,
banks and corporations (including insurance companies) depend on the assessments made by external
credit assessment institutions recognized by supervisors.

Depending on the external risk score, rated claims are given a risk weight of 0%, 20%, 50%, 100% or
150%. Unrated claims are given a 100% risk weight.

Credit Assessments
Credit AAA to A+ to A- BBB+ to BB+ to
Assessment AA- BBB- B- Below B- Unrated
Sovereign 0% 20% 50% 100% 150% 100%
Banks - Option 1 20% 50% 100% 100% 150% 100%
Banks - Option 2 20% 50% 50% 100% 150% 50%
Banks - Short- 20% 20% 20% 50% 150% 20%
term claims
under Option 2
Corporates 20% 50% 100% 150% 100%

Standardized Approach: Differences from Basel I

Use of external ratings: in Basel I, risk weightings were effectively 100%. However, Basel
II allows for differentiation based on external credit assessments
Loans past due: a loan past due for more than 90 days requires a risk weight of 150%
(i.e., when specific provisions are less than 20% of the outstanding amount)
Credit mitigants: Basel II recognizes an expanded range of credit risk mitigants
Retail exposures: risk weights for residential mortgage exposures are reduced relative to
Basel I, as are other retail exposures

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