Regulatory Models and Internal Models for Risk Analysis - Basel

Question 1

Under Basel 3 are internal models allowed?

Answer 1

Yes

Question 2

What can be measured using internal models in Basel 3?

Answer 2

Credit risk, market risk and operational risk.

Question 3

What are the methods of calculating Credit Risk under Basel 3?

Answer 3

1. Standardised Approach
2. FIRBA - Foundation Internal Ratings Based Approach
3. AIRBA - Advanced Internal Ratings Based Approach

Question 4

What is the Standardised Approach to calculating Credit Risk in Basel 3?

Answer 4

• Fixed risk weightings to different asset types.

Question 5

What is the FIRBA to calculating Credit Risk in Basel 3?

Answer 5

• Internally generated credit ratings.
• Based on bank’s own information on the credit worthiness of borrowers.
• The models build on common risk factors: Probability of Default, Loss Given Default, Exposure at Default, Maturity
• Only the Probability of Default is allowed to be estimated by the bank.

Question 6

For the FIRBA, what should the Probability of Default be based on?

Answer 6

The last 5 years of loan performance data from various borrowers.

Question 7

What is the AIRBA to calculating Credit Risk in Basel 3?

Answer 7

• Bank estimates all components of the model.
• Maturity should be assumed as 2.5 years except for corporate exposures.

Question 8

For AIRBA, what should the Probability of Default be based on?

Answer 8

The last 7 years of loan performance data from various borrowers.

Question 9

What is the minimum number of Probability of Default ratings required by Basel for use in Internal Models?

Answer 9

8

Question 10

How long must banks have used their IRB models before getting regulatory approval?

Answer 10

At least 3 years

Question 11

A bank using FIRBA should evidence that it has estimated PD for at least how many years?

Answer 11

3 years

Question 12

A bank using AIRBA should evidence that it has estimated LGD and EAD for how long?

Answer 12

3 years

Question 13

What are the methods a bank can use to calculate market risk for Basel?

Answer 13

1. Standardised Approach
2. Internal Models

Question 14

What is the capital charge applied to risk categories under the Standardised Approach to calculating market risk in Basel?

Answer 14

8%

Question 15

If a bank is using an Internal Model to calculate market risk what should they be calculating?

Answer 15

The 10 day VaR at a 99% confidence level for interest rates, exchange rate, commodity prices and equity prices.

Question 16

What is the Incremental Risk Capital charge?

Answer 16

An extra charge added under Basel 3 to the VaR framework. It is designed to capture default and migration risk within the trading book.

Question 17

What is the Credit Value Adjustment (CVA)?

Answer 17

An adjustment made to the value of OTC derivatives contracts to better reflect counterparty risk (Market price of derivatives counterparty risk).

Question 18

How is the Market Risk Capital Requirement calculated?

Answer 18

Market Risk Capital Requirement = One year VaR @ 99% confidence level + One year stress VaR + Incremental Risk Capital Charge (IRC) + Credit Value Adjustment (CVA)

Question 19

What are the ways that Operational Risk Capital can be calculated?

Answer 19

1. Basic Indicator Approach
2. Standardised Approach
3. Advanced Measurement Approach

Question 20

What is the Basic Indicator Approach?

Answer 20

Calculates the Operational Risk Capital requirement by:
- using a fixed % of the total annual gross income averaged over the previous 3 years as a risk indicator.
- more income earned = the larger the operational risk

Question 21

What is the current Basic Indicator?

Answer 21

15% of gross annual income average over the last 3 years.

Question 22

What is the Standardised Approach to calculating the Operational Risk Capital requirement?

Answer 22

• Bank activities are divided into 8 business lines.
• A fixed Beta factor is set against the 3 year average of the total gross income for the last 3 years for each business line.
• The Beta factor varies depending on the business line.

Question 23

What is the Advanced Measurement Approach (AMA) to calculating the Operational Risk Capital requirement?

Answer 23

Internally generated models that draw on loss history of the bank and even pooled loss histories of other banks.