Operational Risk and Resiliency

Question 1

CORF

Answer 1

Corporate Operational Risk Function

Question 2

Risk-Adjusted Return On Capital (RAROC)

Answer 2

• RAROC makes the risk adjustment to the numerator by subtracting a risk factor from the return—e.g., expected loss.
• RAROC also makes the risk adjustment to the denominator by substi-tuting economic capital for accounting capital.

Question 3

Generic after-tax RAROC equation for capital budgeting

Answer 3

• Expected revenues are the revenues that the activity is expected to generate (assuming no losses).
• Costs are the direct expenses associated with running the activity (e.g., salaries, bonuses, infrastructure expenses, and so on).
• Expected losses, in a banking context, are primarily the expected losses from default; they correspond to the loan loss reserve that the bank must set aside as the cost of doing business. Because this cost, like other business costs, is priced into the transaction in the form of a spread over fund-ing cost, there is no need for risk capital as a buffer to absorb this risk. Expected losses also include the expected loss from other risks, such as market risk and operational risk.
• Taxes are the expected amount of taxes imputed to the activity using the effective tax rate of the company.
• Return on risk capital is the return on the risk capital allocated to the activity. It is generally assumed that this risk capital is invested in risk-free securities, such as government bonds.
• Transfers correspond to transfer pricing mechanisms, primar-ily between the business unit and the treasury group, such as charging the business unit for any funding cost incurred by its activities and any cost of hedging interest rate and cur-rency risks; it also includes overhead cost allocation from the head office.
  Economic capital is the sum of risk capital and strategic capital where
  where strategic risk capital = goodwill + burned-out capital

Question 4

Return On Risk-Adjusted Capital (RORAC)

Answer 4

• RORAC makes the risk adjustment solely to the denominator.

Question 5

Adjusted RAROC

Answer 5

• If the project’s “RAROC less the project’s risk premium” is greater than the risk-free rate, then the firm’s shareholders are compensated for the non-diversifiable systematic risk they bear when investing in the activity.
• That is, if the project’s adjusted RAROC exceeds the risk-free rate, it should be accepted by the firm. Otherwise, if it is less than the riskfree rate, the project should be rejected.

Question 6

Other Risk-Adjusted performance measurement

Answer 6

• ROC (return on capital) = RORAC. It is also called ROCAR (return on capital at risk).
• RORAA (return on risk-adjusted assets) = net income/ risk-adjusted assets.
• RAROA (risk-adjusted return on risk-adjusted assets) = risk-adjusted expected net income/risk-adjusted assets.

Question 7

S (Sharpe ratio)

Answer 7

= (expected return - risk-free rate)/ volatility. The ex post Sharpe ratio—i.e., that based on actual returns rather than expected returns—can be shown to be a multiple of ROC.

Question 8

EVA (economic value added), or NIACC (net income after capital charge)

Answer 8

Is the after-tax adjusted net income less a capital charge equal to the amount of economic capital attributed to the activity, times the after-tax cost of equity capital. The activity is deemed to add shareholder value, or is said to be EVA positive, when its NIACC is positive (and vice versa). An activity whose RAROC is above the hurdle rate is also EVA positive.

Question 9

Bank Holding Companies (BHC) Capital Policy

Answer 9

• the main factors and key metrics that influence the size, timing, and form of capital distributions
• the analytical materials used in making capital distribution decisions (e.g., reports, earnings, stress test results, and others)
• specific circumstances that would cause the BHC to reduce or suspend a dividend or stock repurchase program
• factors the BHC would consider if contemplating the replacement of common equity with other forms of capital
• key roles and responsibilities, including the individuals or groups responsible for producing the analytical material ref-erenced above, reviewing the analysis, making capital distribution recommendations, and making the ultimate decisions

Question 10

Capital for Market Risks Associated with Trading Activities

Answer 10

• The five categories of positions:
  
  • fixed income securities and interest rate derivatives other than options, for which remaining maturity was a key driver
  • equity securities and equity derivatives other than options
  • foreign exchange
  • commodities
  • all types of options
• Capital charges were calculated separately for specific risk (SR) and general market risk (MR)

Question 11

Market Risks Associated with Trading Activities

Answer 11

• m is a multiplier determined by the regulator

Question 12

Basel capital for credit losses

Answer 12

Question 13

Basel tier capital

Answer 13

Question 14

VaR and Stressed VaR combination (market risk capital)

Answer 14

Question 15

Liquidity coverage ratio

Answer 15

Question 16

Net stable funding ratio

Answer 16

Question 17

Operational risk capital requirement

Answer 17

Operational risk capital = BIC * ILM

Question 18

The standardised approach methodology components

Answer 18

• Business Indicator (BI) which is a financial-statement-based proxy for operational risk
• Business Indicator Component (BIC), which is calculated by multiplying the BI by a set of regulatory determined marginal coefficients (α_i)
• Internal Loss Multiplier (ILM), which is a scaling factor that is based on a bank’s average historical losses and the BIC

Question 19

The Business Indicator

Answer 19

• the interest, leases and dividend component (ILDC)
• the services component (SC)
• the financial component (FC)

Question 20

The Business Indicator components calculation

Answer 20

Question 21

Internal Loss Multiplier (ILM)

Answer 21

Loss Component (LC) is equal to 15 times average annual operational risk losses incurred over the previous 10 years. The ILM is equal to one when the loss and business indicator components are equal.

Question 22

Minimum operational risk capital (ORC)

Answer 22

Question 23

Basel II and Basel III guidelines for operational risk governance

Answer 23

• The board of directors of a bank should ensure that the bank’s framework is subject to independent review by audit or other appropriately trained parties.
• Banks should view risk transfer tools as complementary to, rather than a replacement for, thorough internal operational risk control. Risk transfer via outsourcing should not be used to relieve management of their responsibility to manage operational risk, and outsourcing can actually introduce additional operational risks to the bank.
• The board of directors should approve and review the risk appetite of the bank.
• Staff responsible for monitoring and enforcing compliance with the institution’s risk policy should have authority independent from the units they oversee.

Question 24

The advanced internal ratings-based approach for credit risk (Basel II)

Answer 24

Under the advanced internal ratings-based (Advanced IRB) approach banks supply their own estimates of probability of default (PD), loss given default (LGD) and exposure at default (EAD). Since LGD is dependent on recovery rates, this also implies that the recovery rates are modelled. On the other hand, under the foundation ratings-based approach, they supply only PD, while LGD and EAD are set by the Basel Committee.

Question 25

The fundamental review of the trading book (FRTB) approach for securitized products

Answer 25

Basel II.5 introduced a Comprehensive Risk Measure for credit sensitive instruments dependent on credit correlation. Banks could use their internal models to calculate the CRM, with supervisory approval, and these models included the estimation of recovery rates. However, the FRTB withdrew the use of the CRM for securitized products due to there being too much volatility between different banks’ models in modeling securitizations. Banks are now required to use the standardized approach for these products.

Question 26

As under Basel II, the revised credit risk framework provides two main approaches for calculating credit RWAs

Answer 26

• Standardised approach (SA) - Under the SA, banks use a prescribed risk weight schedule for calculating RWAs. Similarly to Basel II, the risk weights depend on asset class and are generally linked to external ratings, but enhancements have been introduced.
• Internal ratings-based (IRB) approach - Under the IRB approach, banks can use their internal rating systems for credit risk, subject to the explicit approval of their respective supervisors. Similarly to Basel II, banks can use either the advanced IRB approach (ie use their internal estimates of risk parameters such as probability of default (PD), loss-given-default (LGD) and exposure-at-default (EAD)) or the foundation IRB approach (ie use only their internal estimates of PD). However, enhancements to and constraints on the application of IRB approaches for certain asset classes have been introduced under Basel III.

Question 27

Basel Capital for Credit Risk

Answer 27

• The standardized approach. Like Basel I, this included some increased sensitivity of risk weights to credit quality for borrowers with external ratings.
• The Foundation Internal Ratings-Based (IRB) approach. Here, risk weights were sensitive to internal measures of default probability, with the use of regulatory-specified loss given default parameters.
• The Advanced IRB approach. Risk weights were sensitive to internal measures of default probability, loss given default, and exposure at default.

Question 28

Basel Capital for Operational Risk

Answer 28

• Basic Indicator Approach: 15 percent of the bank’s average annual gross income over the past three years, ignoring any years of negative gross income. This could be a material amount of capital, given that gross income is usually far larger than net income. However, this approach is relatively easy to implement and may be chosen by banks that do not expect to be constrained by capital requirements.
• Standardized Approach: Like the basic indicator approach, but different multipliers are applied to gross income from different business lines.
• The Advanced Measurement Approach (AMA): Internal models are used to calculate a one-year VaR-like measure of operational risk losses at the 99.9th percentile. Operational risk capital is this amount less expected operational losses. This approach allows recognition of risk mitigants such as insurance under some circumstances.

Question 29

ERM risk level

Answer 29

• Determining the right amount of risk is one of the key goals when implementing ERM. One way to do this is to hold an amount of capital (reflecting an ideal risk-return tradeoff) which would lower the probability of financial distress to a level that matches the target credit rating. A VaR model or other methods could be used to determine this level. Once this target is set, it is then crucial to ensure that business unit managers keep this target firm-wide risk-return tradeoff in mind when evaluating new projects.
• What management can accomplish through an ERM program is not to minimize or eliminate but rather to limit the probability of distress to an acceptable level. Maximizing shareholder value requires an appropriate trade-off between risk and reward; even if a risk-minimizing strategy was potentially feasible, any strategy taken to minimize risk would generally not maximize shareholder value.

Question 30

Standardized Measurement Approach (SMA) for operational risk capital

Answer 30

= Business Indicator Component * Internal Loss Multiplier

Question 31

Impact tolerance

Answer 31

An impact tolerance quantifies the amount of disruption that could be tolerated by the bank in the event of a severe but plausible incident. By setting an impact tolerance, the firm is identifying its most crucial operational processes and can then allocate its resources towards these processes with the goal of remaining within the impact tolerance range.

Question 32

Stressed operational losses estimates

Answer 32

Will incorporate forward-looking and idiosyncratic factors into their stress scenarios

Question 33

Operational risks correlation with other market risks

Answer 33

Is typically low so assuming a zero correlation is conservative and an acceptable practice

Question 34

Basel main ratio

Answer 34

• CET1 capital ratio = (CET 1 capital)/(risk-weighted assets)
• Conservation buffer ratio = (CET 1 capital)/(Exposure)
• The bank’s leverage ratio = (Tier 1 capital)/(Exposure)
• The bank’s Tier 1 capital ratio = (Tier 1 capital)/(risk-weighted assets)
• The bank’s Total capital ratio = (Total capital)/(risk-weighted assets)
• The Net Stable Funding Ratio (NSFR) = (amount of stable funding)/(required amount of stable funding)

Question 35

The Basel three lines of defense model

Answer 35

• In the first line of defense business line managers manage the risk of their business lines.
• In the second line of defense the corporate operational risk function (CORF) reviews the risk controls put in place by the first line of defense and establishes firm-wide risk management procedures.
• In the third line of defense, an independent review (such as an internal auditor) reviews the effectiveness of the risk controls in the first two lines of defense.

Question 36

Basel II capital requirement

Answer 36

According to Basel II, banks should keep a capital of at least 8% of total risk-weighted assets