articles Flashcards
RWAs
- credit RWAs
- market RWAs
- operational RWAs
- credit valuation adjustments
- counterparty
bonus: model change impact, methodology and policy
Risk Weighted Assets - Basel III sets guidelines
Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks and other financial institutions in order to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset.
Risk-weighted assets are used to determine the minimum amount of regulatory capital that must be held by banks to maintain their solvency. This minimum is based on a risk assessment for each type of bank risk exposure: credit, market, operational, counterparty and credit valuation adjustment risks. The riskier the asset, the higher the RWAs and the greater the amount of regulatory capital required.
Office of the Superintendent of Financial Institutions (OSFI)
Canadian regulator
basis point
0.01%
30 basis points = 0.3%
3 basis points = 0.03%
IFRS 9
- loan loss provisioning standard
capital charges
An amount of money equal to how much a business has tied up in assets multiplied by the weighted average cost of those assets. The computation of the economic profit of a business by its finance department involves subtracting its capital charge from its net operating profit.
https://dgstudentfinance.com/qa/what-are-capital-charges.html#:~:text=capital%20charge.,from%20its%20net%20operating%20profit.
company’s weighted average cost of capital (WACC)
Average interest rate a company must pay to finance its assets.
term repo
Under a term repurchase agreement (term repo), a bank will agree to buy securities from a dealer and then resell them back to the dealer a short time later at a pre-specified price. The difference between the re-purchase and sale prices represents the implicit interest paid for the agreement.
on-the-run
On-the-run Treasuries are the most recently issued U.S. Treasury bonds or notes of a particular maturity. On-the-run Treasuries are the opposite of “off-the-run” Treasuries, which refer to Treasury securities that have been issued before the most recent issue and are still outstanding. Media mentions about Treasury yields and prices generally reference on-the-run Treasuries.
If another set of Treasury notes get issued in the next month, those become the new on-the-run Treasuries, and the previously issued Treasuries are considered off-the-run. This cycle continues as each new batch is created, with every group other than the newest run deemed off-the-run for the rest of its associated time, until it is cashed in upon reaching maturity.
The most actively traded Treasuries at any point in time are those that are considered on-the-run. Due to the increased activity, they tend to have a higher initial cost and lower yield than off-the-run notes. This causes on-the-run Treasuries to be more liquid, as finding a buyer tends to be simpler than off-the-run options. This leads to more investments relating to hedging than to longer-term investments.
initial + variation margin payments
Variation margin – the other type of collateral – is paid daily from one side of the trade to the other, to reflect the current market value of the trade. Initial margin is held to cover the losses that could arise in the period between the defaulter’s last variation margin payment and the point at which the surviving party is able to hedge or replace the trade.
In cleared trades, this period is set at anywhere from five to seven days – so initial margin on a large portfolio can become a very significant commitment.
IM is posted when the trade is executed and then adjusted as necessary throughout the life of the trade. For centrally cleared trades, counterparties post IM to the clearing house; in non-cleared trades, to each other. It is usually posted in cash, government bonds or letters of credit.
bank’s risk-weighted capital buffer
A capital buffer is mandatory capital that financial institutions are required to hold in addition to other minimum capital requirements. Regulations targeting the creation of adequate capital buffers are designed to reduce the procyclical nature of lending by promoting the creation of countercyclical buffers as set forth in the Basel III regulatory reforms created by the Basel Committee on Banking Supervision.
Note that capital buffers differ from, and may exceed the reserve requirements set by the central bank.
https://www.investopedia.com/terms/c/capital-buffer.asp
In December 2010, the Basel Committee on Banking Supervision released official regulatory standards for the purpose of creating a more resilient global banking system, particularly when addressing issues of liquidity. Capital buffers identified in Basel III reforms include countercyclical capital buffers, which are determined by Basel Committee member jurisdictions and vary according to a percentage of risk-weighted assets, and capital conservation buffers, which are built up outside periods of financial stress.
LEVERAGE RATIO
The Basel III Tier 1 leverage ratio, first introduced in 2009, is a capital adequacy tool that measures a bank’s Tier 1 capital divided by its total exposures, including average consolidated assets, derivatives exposures and off-balance sheet items. Regulators and policy-makers believe that an underlying cause of the 2008 financial crisis was excessive leverage in the banking system, and so the intent behind the Basel III leverage ratio is to constrain the degree to which the bank can leverage its capital and improve the extent to which it can sustain negative shocks to its balance sheet.
The Basel standards require banks to maintain a Tier 1 leverage ratio of at least 3%. Global systemically important banks should maintain an extra leverage ratio buffer, which the Basel Committee agreed in December 2017 to set at 50% of a bank’s risk-weighted capital buffer.
National regulators have implemented their own versions of the Basel III leverage ratio in their respective jurisdictions. As the methodology does not take into account the risk weighting of specific assets, banks say it punishes certain businesses like clearing – where the real risks are offset by client margin held – or assets held at the central bank that are theoretically riskless.
However, many regulators consider a risk-insensitive leverage ratio an essential complement to the risk-based capital ratios that also form part of capital adequacy regimes. Regulators say one of the lessons of the crisis was that risk-weighted measures can misrepresent a bank’s actual safety and soundness, and so the leverage ratio is a necessary “backstop”.
supplementary leverage ratio (SLR)
The supplementary leverage ratio is the US implementation of the Basel III Tier 1 leverage ratio, with which banks calculate the amount of common equity capital they must hold relative to their total leverage exposure. Large US banks must hold 3%. Top-tier bank holding companies must also hold an extra 2% buffer, for a total of 5%. The SLR, which does not distinguish between assets based on risk, is conceived as a backstop to risk-weighted capital requirements.
financial backstop
A term used in the financial industry to mean credit support or backup funds for a financial instrument or transaction. For example, bank revolving credit loans are often obtained to backstop commercial paper in the event that the commercial paper issuer defaults on its payments.
bank revolving credit loans
A revolving loan facility is a form of credit issued by a financial institution that provides the borrower with the ability to draw down or withdraw, repay, and withdraw again. A revolving loan is considered a flexible financing tool due to its repayment and re-borrowing accommodations. It is not considered a term loan because, during an allotted period of time, the facility allows the borrower to repay the loan or take it out again. In contrast, a term loan provides a borrower with funds followed by a fixed payment schedule.
net stable funding ratio
The net stable funding ratio is a liquidity standard requiring banks to hold enough stable funding to cover the duration of their long-term assets. For both funding and assets, long-term is mainly defined as more than one year, with lower requirements applying to anything between six months and a year to avoid a cliff-edge effect. Banks must maintain a ratio of 100% to satisfy the requirement.
value-at-risk
Value-at-risk is a statistical measure of the riskiness of financial entities or portfolios of assets. It is defined as the maximum dollar amount expected to be lost over a given time horizon, at a pre-defined confidence level.
Fundamental Review of the Trading Book (FRTB)
The Fundamental Review of the Trading Book is an international standard that sets out rules governing capital banks must hold against market risk exposures.
The Basel Committee on Banking Supervision designed the framework to remove supposed deficiencies in the previous market risk framework which came to light during the global financial crisis. It sets a higher bar for banks to use their own models for calculating capital; ensures banks are capturing tail risk events; and cements the boundary between trading and banking books.
Banks can either use their own internal models or a standardised approach to calculate capital under FRTB. For a desk to qualify for the internal models approach, they must pass two tests: a profit and loss attribution test and a backtest. The P&L attribution test compares the profit and loss generated by a bank’s front-office pricing system with the figures generated in the back office for risk measures. Backtesting compares the P&L values with the value-at-risk figures. In both tests, if a bank’s own estimates are found to deviate excessively from realised P&L on a given desk over a 12-month period, the desk risks losing IMA approval, and being forced to use the standardised approach.
Expected shortfall
Expected shortfall Expected shortfall is a risk measure sensitive to the shape of the tail of the distribution of returns on a portfolio, unlike the more commonly used value-at-risk (VAR). Expected shortfall is calculated by averaging all of the returns in the distribution that are worse than the VAR of the portfolio at a given level of confidence. For instance, for a 95% confidence level, the expected shortfall is calculated by taking the average of returns in the worst 5% of cases.
Value-at-risk
Value-at-risk measures the potential loss due to adverse market movements over a defined time horizon to a specified confidence level. The VAR output used for internal management purposes differs by bank. Because each bank sets the parameters and sensitivities of its VAR model differently, and use their own historical data as inputs, VAR model outputs are not comparable between firms.
Higher VAR amounts typically translate into increased market risk capital charges, which can erode the return on equity of banks’ trading units if they don’t bring in bumper revenues.
“Still, the direction of VAR at the different banks does hint at broad differences between their portfolios, and suggests that JP Morgan’s and Goldman Sachs’ risk exposures reduced far more than those at Morgan Stanley and BofA. This means the former two also likely saw their market risk capital requirements fall faster than the latter two, though this depends on how different their regulatory VAR measures were to their management metrics. “ https://www.risk.net/risk-quantum/7698111/top-us-dealers-trading-risk-indicators-varied-in-q3#cxrecs_s
*VAR levels are those published by each bank as their “management VAR”. All calibrated to a 95% confidence interval and a one-day holding period. Bank of America uses VAR calibrated to a 99% confidence interval as its primary management metric. The VAR estimates at this calibration for Q3 2020, Q2 2020 and Q1 2020 were $109 million, $81 million and $48 million.
These VAR outputs were calibrated to a 95% confidence interval using a one-day holding period, meaning losses are expected to exceed the estimates one day out of every 20. However, BofA also disclosed its VAR using a 99% confidence interval. At this calibration, its Q3 VAR was $109 million, up 35% on Q2.
*Can be daily https://www.risk.net/risk-quantum/7662856/natixiss-market-rwas-grew-49-over-q2
fair-value option
The fair value option is the alternative for a business to record its financial instruments at their fair values. GAAP allows this treatment for the following items:
A financial asset or financial liability
A firm commitment that only involves financial instruments
A loan commitment
An insurance contract where the insurer can pay a third party to provide goods or services in settlement, and where the contract is not a financial instrument (i.e., requires payment in goods or services)
A warranty in which the warrantor can pay a third party to provide goods or services in settlement, and where the contract is not a financial instrument (i.e., requires payment in goods or services)
The fair value option cannot be applied to the following items:
An investment in a subsidiary or variable interest entity that will be consolidated
Deposit liabilities of depository institutions
Financial assets or financial leases recognized under lease arrangements
Financial instruments classified as an element of shareholders’ equity
Obligations or assets related to pension plans, post-employment benefits, stock option plans, and other types of deferred compensation
When you elect to measure an item at its fair value, do so on an instrument-by-instrument basis. Once you elect to follow the fair value option for an instrument, the change in reporting is irrevocable. The fair value election can be made on either of the following dates:
The election date, which can be when an item is first recognized, when there is a firm commitment, when qualification for specialized accounting treatment ceases, or there is a change in the accounting treatment for an investment in another entity.
In accordance with a company policy for certain types of eligible items.
It is acceptable not to apply the fair value option to eligible items when reporting the results of a subsidiary or consolidated variable interest entity, but to apply the fair value option to these items when reporting consolidated financial statements.
It is much easier to apply the fair value option for both subsidiary-level and consolidated financial results, so do not attempt separate treatment, even though it is allowed by GAAP.
In most cases, it is acceptable to choose the fair value option for an eligible item, while not electing to use it for other items that are essentially identical.
If you take the fair value option, report unrealized gains and losses on the elected items at each subsequent reporting date.
sub ledgers in accounting
- accounts receivable ledger
- accounts payable ledger
- fixed assets ledger
- inventory ledger
- purchase ledger
- sales ledger
- cash ledger
sub ledgers in accounting
- accounts receivable ledger
- accounts payable ledger
- fixed assets ledger
- inventory ledger
- purchase ledger
- sales ledger
- cash ledger –
Capital Valuation Adjustments (KVA)
Capital valuation adjustment reflects the cost of holding regulatory capital as a result of a derivative position throughout the trade’s life. While it applies to all derivatives contracts, it is more punitive on trades that are not cleared. Basel III has increased the capital imposed on banks for holding derivatives contracts and KVA captures the cost of this additional regulatory capital.
Valuation Adjustments (XVAs)
- credit valuation adjustments (CVA)
- funding valuation adjustments (FVA)
- capital valuation adjustments (KVA)
- debit valuation adjustment (DVA)
- margin valuation adjustment (MVA)
Valuation adjustment is the umbrella name for adjustments made to the fair value of a derivatives contract to take into account funding, credit risk and regulatory capital costs. Dealers typically incorporate the costs associated with XVAs into the price of a new trade.
The oldest XVA is the credit valuation adjustment (CVA), which reflects the cost of hedging a client’s counterparty credit risk over the life of the trade. This includes the point-in-time view of CVA reflected in the profit and loss (P&L) statement, and the future volatility of CVA captured in the Basel III regulatory capital requirements.
Funding valuation adjustment (FVA) is the cost that arises when a dealer is unable to directly pass variation margin from an out-of-the-money client to an in-the-money client. The dealer then has to fund the margin itself, generating a cost.
Capital valuation adjustment (KVA) is the cost associated with holding regulatory capital against a trade.
There are also some valuation adjustments that are usually not explicitly charged to a client but are still seen as part of the XVA family. These include: debit valuation adjustment (DVA), which is reflected in the P&L statement as the dealer’s counterparty credit risk to the client; and margin valuation adjustment (MVA), which is the cost of funding the initial margin required to be held against a trade.
XVA calculations for the same trade can differ across banks, depending on their calculation methodology and existing portfolio. Many smaller banks do not charge clients for some or any XVA elements.
Larger dealers have specific desks whose job it is to hedge XVA exposures, while optimisation vendors offer services to help reduce them on a multilateral basis.
Credit Valuation Adjustments (CVA)
Credit valuation adjustment is a change to the market value of derivative instruments to account for counterparty credit risk. It represents the discount to the standard derivative value that a buyer would offer after taking into account the possibility of a counterparty’s default. Under current Basel III regulations, banks are required to hold capital against CVA. Under European Union rules, these charges do not apply to derivatives with non-financial corporate counterparties. CVA is the most widely known of the valuation adjustments, collectively known as XVA.
Funding Valuation Adjustment (FVA)
Funding valuation adjustment reflects the funding cost of uncollateralised derivatives above the risk-free rate of return. It represents the costs and benefits of writing a hedge for a client who is not posting collateral, and then hedging that trade with a collateralised one in the interbank market.
uncollateralised derivatives
https://www.eng.esterfinance.com/post/uncollateralized-derivatives-a-heterogeneous-and-non-transparent-market
Since the entry into force of the European regulation EMIR and its equivalents in other jurisdictions, all derivatives transactions among financial counterparties must be collateralized.
Uncollateralized derivatives are limited to trades between financial counterparties and non-financial counterparties, and therefore represent a very small fraction of the market. While a few non‑financial counterparties do choose to collateralise their derivatives, most companies and government entities choose or are constrained not to.
This is especially the case for derivatives coupled with project financing, LBO financing, or asset financing. Lenders do not want corporates to post the cash they have borrowed to hedging banks through margin calls, as this could create liquidity risk. Also, giving collateral to hedging banks would structurally make them senior to debt holders in case of a credit event affecting the borrower.
LBO
Leveraged bouyouts
A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.
collaterized
https://www.investopedia.com/terms/c/collateralization.asp#:~:text=Collateralization%20is%20the%20use%20of,of%20reassurance%20against%20default%20risk.
What Is Collateralization?
Collateralization is the use of a valuable asset to secure a loan. If the borrower defaults on the loan, the lender may seize the asset and sell it to offset the loss.
Collateralization of assets gives lenders a sufficient level of reassurance against default risk. It also helps some borrowers obtain loans if they have poor credit histories. Collateralized loans generally have a substantially lower interest rate than unsecured loans.
Buying on margin is a type of collateralized lending used by active investors. The collateral consists of assets in the investor’s account.
credit default swap index (CDX) derivatives
credit default swap hedges
A credit default swap (CDS) is an over-the-counter derivative contract that offers one counterparty protection against a credit event, such as the default or bankruptcy of an issuer. It can be thought of as insurance in the financial world.
The credit default swap index (CDX) tracks and measures total returns for the various segments of the bond issuer market so that the overall return of the index can be benchmarked against funds that invest in similar products.
hedging
Hedging is a strategy that tries to limit risks in financial assets.
Popular hedging techniques involve taking offsetting positions in derivatives that correspond to an existing position.
Other types of hedges can be constructed via other means like diversification. An example could be investing in both cyclical and counter-cyclical stocks.
Hedging CVA is a tricky business. Credit derivatives can be used under European Union rules to negate CVA capital charges without pumping up market RWAs. However, the accounting effects of CVA, which can eat into revenues, are driven by foreign exchange and interest rate movements, as well as by credit spread movements. Hedging these is tougher, as under EU rules those instruments offsetting the non-credit aspects of CVA are not exempt from market risk charges.
“ABN Amro prioritised hedging the capital implications of CVA through the newly-bought portfolio of CDX, saving some €15 million in capital charges in the process over the first half. Market RWAs shrank over Q2, too. This could mean the bank did not hedge all its accounting CVA, unlike Natixis, and therefore avoided a surge that could have cancelled out its CVA RWA savings.”
https://www.risk.net/risk-quantum/7666946/abn-amro-crushes-cva-charge-with-index-hedges-in-h1#cxrecs_s
PRA-designated investment firms
The Prudential Regulation Authority regulates around 1,500 banks, building societies, credit unions, insurers and major investment firms.
Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; “basis” refers to the discrepancy.
Margin Valuation Adjustment (MVA)
Margin valuation adjustment allows for the funding costs of the initial margin posted for a derivatives trade. This can apply to cleared trades, which require initial margin, and non-cleared trades, where initial margin requirements are being phased in over time. The central counterparty basis is also a form of MVA.
- credit RWAs
Credit risk, or default risk, is the risk that a financial loss will be incurred if a counterparty to a (derivatives) transaction does not fulfil its financial obligations in a timely manner. It is therefore a function of the following: the value of the position exposed to default (the credit or credit risk exposure); the proportion of this value that would be recovered in the event of a default; and the probability of default.
- credit RWAs
Credit risk, or default risk, is the risk that a financial loss will be incurred if a counterparty to a (derivatives) transaction does not fulfil its financial obligations in a timely manner. It is therefore a function of the following: the value of the position exposed to default (the credit or credit risk exposure); the proportion of this value that would be recovered in the event of a default; and the probability of default.
Credit risk is also used loosely to mean the probability of default, regardless of the value that stands to be lost.
https://www.risk.net/risk-quantum/banks/7710786/citis-counterparty-credit-risk-edged-higher-in-q3#cxrecs_s
- counterparty credit risk
“Other major US dealers also saw CCR RWAs rise over the quarter – Bank of America more so than Citi – but these were accompanied by an increase in exposures.”
EAD
Exposures at default
EAD
Exposures at default
EAD is the predicted amount of loss a bank may be exposed to when a debtor defaults on a loan. Banks often calculate an EAD value for each loan and then use these figures to determine their overall default risk. EAD is a dynamic number that changes as a borrower repays a lender.
https://www.investopedia.com/terms/e/exposure_at_default.asp
market funds (MMFs)
A money market fund is a type of mutual fund that invests in high-quality, short-term debt instruments, cash, and cash equivalents.
Though not quite as safe as cash, money market funds are considered extremely low-risk on the investment spectrum.
A money market fund generates income (taxable or tax-free, depending on its portfolio), but little capital appreciation.
Money market funds should be used as a place to park money temporarily before investing elsewhere or making an anticipated cash outlay; they are not suitable as long-term investments.
market RWAs
Market RWAs are calculated using either the internal model approach (IMA) or standardised approach (SA). The IMA market risk calculation consists of four components: a VAR-based requirement; a SVAR-based requirement; an incremental risk charge; and risks-not-in-VAR measure. The VAR- and SVAR-based RWA amounts are calculated by applying a multiplier to banks’ own model outputs. Natixis’s trading VAR is calibrated to a one-day time horizon and a 99% confidence level, meaning losses should only exceed the modelled estimate one trading day out of every 100.
CCR RWAs
CCR RWAs are assigned to OTC derivatives, repo-style transactions, eligible margin loans and cleared trades.
CCR RWAs
CCR RWAs are assigned to OTC derivatives, repo-style transactions, eligible margin loans and cleared trades.
RWAs for derivatives are generated using either a bank’s internal model method or the standardised current exposure method developed by the Basel Committee. Those for repos and margin loans are calculated using a collateral haircut approach.
“Citi’s counterparty exposures have flirted with the 50% risk density level before, last hitting it back in 2018. Still, the sharp jump higher last quarter suggests an adverse change to the creditworthiness of its portfolio over Q3.
It may be that certain exposures that held up through the early stages of the coronavirus crisis are now struggling, or that the bank’s risk models have refreshed their assessment of its clients’ default risks as new data has come in.
If CCR RWAs continue to climb while exposures fall or stay static, it may disincentivise the bank from expanding its derivatives, repo and margin loan portfolios for all but the safest clients.”
https://www.risk.net/risk-quantum/banks/7710786/citis-counterparty-credit-risk-edged-higher-in-q3#cxrecs_s
“Counterparties to over-the-counter derivatives, repo and margin loans got riskier over the second quarter, systemic US banks’ internal model outputs show.”
https://www.risk.net/risk-quantum/7671441/top-us-banks-counterparties-credit-quality-deteriorated-in-q2
