Application of the minimum capital requirements

Question 1

From the Basel Accords regulations the minimum capital requirements are calculated by risk weighted assets (RWAs) - what is it?

Answer 1

• Determines the precise amount of capital required as some assets are riskier than others
  (risk weight x exposure) x solvency ratio
• Banks can apply either standardised or complex calculation methods

Question 2

What is the standardized risk weights?

Answer 2

Retail exposures = 75%

Wholesale exposure = 100%

Question 3

What if a bank wants to move from a standardised to complex calculation

Answer 3

They have to get approval

Question 4

What are the conditions that an exposure must hit all of to meet retail?

Answer 4

• It is one of many similar exposures
• The customer is a person or small to medium sized enterprise (SME)
• The connected group exposure does not exceed 1m euros

Question 5

What is the advanced Basel?

Answer 5

3 Credit risk features:

• Probability of default (PD) - the chance the customer will defaullt in the next 12 months
• Loss given default (LGD) - the percentage loss that would be incurred in the event of default
• Exposure at default (EAD) - the balance at default, considering further drawing against limits

Question 6

What is AIRB

Answer 6

It is Advanced Internal Ratings-based approach

• Calculation that combines the PD with the LGD and the maturity of the deal to give the risk weight
• Then RWA = Risk weight x EAD

Question 7

What is the FIRB (Foundation internal ratings based)

Answer 7

• It is because LGD model for large customers can be difficult to calculate due to covering various sectors of the business and the bank does not have enough data
• Therefore they allow fixed LGD percentages rather than their own internal estimates

Question 8

What are the special Basel Rules for certain assets

Answer 8

If the asset itself is cash generative from the lending such as lending for a power station.
In this example it is the riskiness of exposure from the asset, financial strength of the developer and the market in which the completed asset operates rather than just PD and LGD

Question 9

What is the result of Low LGD and low PD

Answer 9

• lower RWAS on a advanced basis rather than standardised

- However the cost of maintaining an advanced method is high and can only be useful to larger banks

Question 10

Explain PD (other than just probability customer will default in the next 12 months)

Answer 10

• Mathematical model which uses historical knowledge of how similar customers behave
• Similar to a scorecard where around 10 characteristics are assigned a number on the degree to which they impact the liklihood of default
• Total points score is converted to a PD%
• Different PD calculation models for different customers - e.g. time with bank and income

Question 11

Explain (EAD) Exposure at default - amount predicted to be owed by a customer at the time of default within one year time horizon?

Answer 11

• EAD cannot be lower than the present value
• Statistical evidence must support this model
• Or the banks must assume the facility becomes fully drawn at default and therefore hold capital for the full limit amount

Question 12

Explain Loss given default (LGD) - estimate of the amount of money that the bank would lose, in the event that the customer defaulted.

Answer 12

• Measured as a percentage of the balance on the facility, and takes into account the security and any guarantees in place
• Statistical experience of the losses on actual defaults must be used (unless using FIRB approach)
• Within asset finance the asset type is key as this may be determining factor at the time of default.
• Before Basel 3 - it was based on security or asset value adjusting for estimated recovery and realisation.
• Now Basel 3 - regulator requires LGD models to consider all characteristics which can be shown to impact the eventual loss. Of course the asset value is still key

Question 13

RWAs with operating leases - residual values, how does that change?

Answer 13

• 2 elements to an operating lease that must be considered- credit exposure (outstanding rentals) and residual value exposure the amount expected to realise.
• Credit exposure - result is the same for any lease therefore RWA calculated the same as any other deal
• RV exposure - Risk not connected to the customer instead it is linked to the asset and inability to sell it and realise RV.
  Rules specify that a risk weight of 1/t must be applied (t is remaining time in years) and t cannot be less than 1
  two years risk weight is 0.5 (1/2)
  Therefore op leases are capital intensive as they approach maturity