Lecture 7: Basel I, II and II.5

Question 1

What is the main purpose of bank regulation?

Answer 1

Maintain trust in the financial system.

The fear that a bank default may poses a larger threat to the real economy than the default of a large industrial firm. Depositors typically have a portion of the their deposits secured, however, any amount in excess of the given level is unsecured, giving rise to fear of bank defaults and bank runs.

Question 2

Which types of capital for a bank is there?
Hint: 3 types

Answer 2

1) Tier 1 equity capital / CET 1
2) Additional Tier 1 capital / AT1
3) Tier 2 capital

Question 3

Share capital and retained earnings (i.e., equity capital on B/S) is classified as ____
A) Tier 1 equity capital / CET 1
B) Additional Tier 1 capital / AT1
C) Tier 2 capital

Answer 3

Share capital and retained earnings (i.e., equity capital on B/S) is classified as Tier 1 equity capital / CET 1

Question 4

____ capital is defined as instruments that are not common equity but are eligible for inclusion in tier 1. An example of such capital is a contingent convertible or hybrid security, which has a perpetual term and can be converted into equity when a trigger event occurs.

Fill in the blank word

Answer 4

AT1

Question 5

Loan capital (not equity), subordinated to senior debt (e.g., deposits and interbank loans) and additional reserves are classified as _____
A) Tier 1 equity capital / CET 1
B) Additional Tier 1 capital / AT1
C) Tier 2 capital

Answer 5

Loan capital (not equity), subordinated to senior debt (e.g., deposits and interbank loans) and additional reserves are classified as (C) Tier 2 capital

Question 6

AT1 capital: Supplementary capital, which are to be utilized in the event that CET1 is not sufficient to absorb all losses.
TRUE/ FALSE

Answer 6

FALSE - This is the tier 2 capital definition

Question 7

The _____ _____ determines the amount of capital a bank should have as a percentage of its total risk-adjusted assets (also known as the Cooke ratio, Solvency ratio, and Basel ratio).
Fill in the blank.

Answer 7

The CAPITAL RATIO determines the amount of capital a bank should have as a percentage of its total risk-adjusted assets (also known as the Cooke ratio, Solvency ratio, and Basel ratio).

Question 8

___ ___ ___ is a measure of the bank’s total credit exposure.
Fill in the blank.

Answer 8

RISK-ADJUSTED ASSETS (RWA) is a measure of the bank’s total credit exposure.

Question 9

According to the capital ratio introduced in Basel I, a bank must hold a sum of tier 1 and tier 2 capital corresponding to at least _____% of RWA.
A) 5%
B) 8%
C) 10%

Answer 9

According to the capital ratio introduced in Basel I, a bank must hold a sum of tier 1 and tier 2 capital corresponding to at least 8 % of RWA.

Question 10

According to the capital ratio introduced in Basel I, the sum of Tier I+II capital must be at least 8% of RWA.
In addition, CET1 must be at least ____% of RWA (and herein, ____% must be common equity).

Fill in the blanks.
A) 5%, 3%
B) 4%, 2%
C) 6%, 3%

Answer 10

In addition, CET1 must be at least 4% of RWA (and herein, 2% must be common equity).

Question 11

Different risk weights are assigned to different classes of assets, reflecting the probability of default for the respective asset class.

TRUE/ FALSE

Answer 11

TRUE

Question 12

Rank the following asset categories according to their risk weight (lowest risk weight/ safest first)

A) Corporate bonds and loans, loans to non-OECD countries
B) Cash, gold bullion, OECD government bonds
C) Uninsured residential mortgage loans
D) Claims on OECD banks, municipal bonds, agency bonds

Answer 12

B) Cash, gold bullion, OECD government bonds
D) Claims on OECD banks, municipal bonds, agency bonds
C) Uninsured residential mortgage loans
A) Corporate bonds and loans, loans to non-OECD countries

Question 13

In Basel I, there is not distinction between corporate bonds of different ratings - i.e., any type of corporate bond is assigned the same risk weight.
This was changed in Basel __.
A) II
B) II.5
C) III

Answer 13

In Basel I, there is not distinction between corporate bonds of different ratings - i.e., any type of corporate bond is assigned the same risk weight.
This was changed in Basel (A) II.

Question 14

The total risk weight of ON balance sheet items are calculated as?

Answer 14

Sumproduct of the risk weight of the given asset and the principal amount of the item

Question 15

The total risk weight of OFF balance sheet items are calculated as?

Answer 15

Sumproduct of the risk weight of the given asset and the credit equivalent amount for off-balance sheet assets

Question 16

Credit-equivalent amount for OTC derivatives is calculated as the max of the current market value of the derivative and zero, plus an add-on amount

TRUE/ FALSE

Answer 16

TRUE

Question 17

Netting is part of the ISDA master agreement (bilaterally clearing), which refers to a clause in this agreement stating all OTC derivatives with a counterparty are treated as a single transaction in the event of a default. I.e., the counterparty cannot choose to default only part of the transaction.

TRUE/ FALSE

Answer 17

TRUE

Question 18

NRR stands for?
A) Net risk ratio
B) Netting risk ratio
C) Net replacement ratio

Answer 18

C) Net replacement ratio

Question 19

If all transactions in which the bank engages in have a positive value with the counterparty owing the bank money, the NRR will be:
A) NRR=1
B) NRR>1
C) NRR=0

Answer 19

A) NRR=1
If all transactions have a positive value with the counterparty, then, the NRR will be = 1: these transactions have a positive value which we lose in the event of counterparty default

Question 20

If all transactions in which the bank engages in have a negative value with the counterparty to whom the bank owes money, the NRR will be:
A) NRR=1
B) NRR>1
C) NRR=0

Answer 20

C) NRR=0

If all transactions have a negative value with the counterparty, we do not care. In this case, the NRR = 0: less money shall be put aside.

We don’t care because if the counterparty defaults, we will not lose any money

Question 21

What are the TWO approaches to measuring/ determining the capital charge taking into account both credit risk and market risk?
A) Linear approximation
B) Standardized approach
C) Historical simulation approach
D) Internal model-based approach

Answer 21

B) Standardized approach
D) Internal model-based approach

Question 22

Which of the following statements are true about the standardized approach for determining capital charge? (Select 1-4)
A) It assigns capital separately to each type of risk: interest rate risk, equity position risk, foreign exchange risk, commodity risk
B) Correlation between different types of instruments is taken into account
C) Reflects the benefits of diversification and hence lead to lower capital requirements
D) The approach is preferred by banks who are allowed to use it (must be approved by FSA)

Answer 22

A) It assigns capital separately to each type of risk: interest rate risk, equity position risk, foreign exchange risk, commodity risk

WRONG:
B) Correlation between different types of instruments is NOT taken into account
C) Reflects the benefits of diversification and hence lead to lower capital requirements –> THIS IS TRUE FOR INTERNAL MODEL-BASED APPROACH
D) The approach is preferred by banks who are allowed to use it (must be approved by FSA) –> THIS IS TRUE FOR INTERNAL MODEL-BASED APPROACH

Question 23

Which of the following statements are TRUE about the Internal Model-Based Approach? (Select 1-4)
A) The approach is based on VaR
B) Only sophisticated banks with well-established risk management functions are allowed to use it
C) It better reflects the benefits of diversification and hence lead to lower capital requirements
D) The approach is preferred by banks who are allowed to use it (must be approved by FSA)

Answer 23

All options are true

Question 24

The scaling factor (m_c) to be applied to the average 60 day VaR under the internal model-based approach for capital requirement calculation must be:
A) m_c ≥ 3
B) m_c = 3
C) m_c ≤ 3

Answer 24

A) m_c ≥ 3

Question 25

The specific risk charge (SRC) to be added to the capital requirement calculation under the internal model-based approach measures:
A) market risk
B) systematic risk
C) idiosyncratic risk

Answer 25

C) idiosyncratic risk = asset-specific risk

Question 26

Basel II was implemented in 2007, based on which three pillars?
A) minimum capital requirement
B) supervisory review
C) risk-weighted asset requirement
D) market discipline

Answer 26

A) minimum capital requirement
B) supervisory review
D) market discipline

Question 27

The minimum capital requirement under Basel II equals 8% of the sum of which risks?
A) credit risk
B) market risk
C) operational risk
D) liquidity risk

Answer 27

A) credit risk
B) market risk
C) operational risk

Question 28

Under Basel II’s pillar - Market Discipline - banks are required to disclose more information about the way they allocate capital and the risks they take. This induces an implicit “threat” of punishment by the investors: the market/investors now serve as a control mechanism against poor banks behaviour

TRUE/ FALSE

Answer 28

TRUE

Question 29

The credit risk requirements under Basel I had some significant weaknesses. This is calculated in a new way in Basel II. What are the two main differences introduced in Basel II?
A) credit risk of corporations are distinguished based on the borrower’s credit rating
B) operational risks are taken into account
C) correlation between bank defaults are taken into account
D) market risk requirement is calculated in a new way

Answer 29

In BASEL II:
A) credit risk of corporations are distinguished based on the borrower’s credit rating. Before, all loans to a corporation had a risk weight of 100%

B) operational risks are taken into account, incl. risk of losses from failures of the bank’s procedures or from an adverse external event

C) correlation between bank defaults are taken into account. Often, when one bank defaults, typically, multiple defaults will occur in the same sector – this correlation is now implemented in Basel II

Question 30

For credit risk, Basel II specifies three approaches to calculate the required capital for credit risk that a bank must hold. Which?

A) The Standardized Approach (similar to Basel I but will minor modifications)
B) The Foundation Internal Ratings Based (IRB) Approach (only allowed in US)
C) Historical simulation approach
D) The Advanced IRB Approach

Answer 30

A) The Standardized Approach (similar to Basel I but will minor modifications)
B) The Foundation Internal Ratings Based (IRB) Approach (only allowed in US)
D) The Advanced IRB Approach

Question 31

The standardized approach under Basel II is similar to that of Basel I. However, modifications incl. changes in risk weights and inclusion of credit ratings.
TRUE/ FALSE

Answer 31

TRUE

Question 32

Which of the following statements are TRUE for the IRB approach for capital requirement?´

A) Capital requirement is based on 99% VaR for credit losses
B) When banks issue loans, the interest rate charged incorporates risk of counterparty default, which is taken into account in the IRB approach
C) Capital requirement is equals the 99.9% VaR minus the expected losses cut-off point
D) The IRB approach also takes default-correlation into account, modelled through the worst case default rate (WCDR)

Answer 32

B) When banks issue loans, the interest rate charged incorporates risk of counterparty default, which is taken into account in the IRB approach
C) Capital requirement is equals the 99.9% VaR minus the expected losses cut-off point
D) The IRB approach also takes default-correlation into account, modelled through the worst case default rate (WCDR)

WRONG: A) Capital requirement is based on 99% VaR for credit losses –> IT IS THE 99.9% VaR!

Question 33

When calculating the worst-case default rate (WCDR) used in the IRB approach for capital requirement, loan default correlation is taken into account. It is sensible to assume that loans do not default independently of each other.
TRUE/ FALSE

Answer 33

TRUE
In practice, loans do not default independently of each other - they are all influenced by macroeconomic variables, i.e. we typically have a positive correlation.

Question 34

When calculating the WCDR in the IRB approach, if the Copula correlation is equal to zero: ρ = 0, the loans default independently of each other. In this case, the WCDR is:
A) WCDR > Probability of default before time T (PD)
B) WCDR = PD
C) WCDR < PD

Answer 34

B) WCDR = PD

Question 35

Under the IRB approach, the higher the Copula correlation, the _____(higher/lower) the loan portfolio aggregate probability of default, and the ____ (higher/lower) the WCDR

Fill in the blanks.

Answer 35

Under the IRB approach, the higher the Copula correlation, the HIGHER the loan portfolio aggregate probability of default, and the HIGHER the WCDR

Question 36

When calculating the WCDR under IRP approach, the confidence level X used is:
A) 95%
B) 99%
C) 99.5%
D) 99.9%

Answer 36

D) 99.9%

Question 37

Clearing in the OTC market can take place via. two approaches . Which?

Answer 37

Bilateral clearing and central clearing

Question 38

Clearing in the OTC market can take place via two approaches.
In _____ clearing, each pair of market participants enters into an agreement describing how all outstanding transactions between them will be cleared. Here, an annex to the agreement defines collateral agreements.
Fill in the blank.

Answer 38

In BILATERAL clearing, each pair of market participants enters into an agreement describing how all outstanding transactions between them will be cleared. Here, an annex to the agreement defines collateral agreements.

Question 39

Clearing in the OTC market can take place via two approaches.
In _____ clearing, a central counterparty (CCP) stands between the two sides. This is very similar to an exchange clearing house. Here, the CCP acts as the counterparty for both sides of an agreement.
Fill in the blank.

Answer 39

In CENTRAL clearing, a central counterparty (CCP) stands between the two sides. This is very similar to an exchange clearing house. Here, the CCP acts as the counterparty for both sides of an agreement.

Question 40

Which of the following statements are true about the role of the central clearing party (CCP) in trade clearing? (Select 1-5)
A) The two counterparties no longer face credit risk exposure towards each other, but only with respect to the CC
B) If the trade is accepted by the CCP, the bilateral trade between A and B becomes two trades between A and the CCP and B and the CCP, respectively
C) Both parties provide initial and variation margin to the CCP, so that the CCP can cover losses in case of a member defaulting
D) Only standardized trades will be accepted by the CCP
E) If one is not a member of a CCP, they can clear their transaction through another member, who will likely charge a fee

Answer 40

All options are true