W 3 Flashcards
Regulatory Capital is first and foremost Maret Value or Book Value of Equity?
Regulatory Capital is first and foremost Book Value of Equity
Book value compaired to Market value is…
…much less volatile, leading to more stable assessment.
RWA is ? and calculated as ?
Risk Weighted Assets
Amount of Assets x risk weight
(more risk → higher weight)
Which are the accepted methods to compute credit equivalent under Basel I?
- Current Exposure Method
- Original Exposure Method
NRR stands for:
Net Replacement Ratio,
Ratio between the sum of the market value of all positions and the sum of the market value of only positions with a positive value
CEA stands for:
Credit Equivalent Amount
Used to compute capital reqments for off-balance sheet items under Basel
What are some of the critisism of Basel I?
▪ Only credit risk is considered, not market risk nor operational risk.
▪ Assets with different credit risk and same weight or viceversa
▪ Governance not considered
▪ No role given to market monitoring
Regulatory arbitrage occurs when …
…a loophole allows to “formally” abide the rules, while violating the “spirit” of the rule.
This allows to increase risk while keeping tier ratios constant.
Interest Rate Risk is:
change in value due to change in market cost of
capital
Liquidity Risk:
forced liquidation unfeasible, or feasible only at big discount
Currency Risk:
change in value due to change in exchange rates
Market risk is …
…the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets.
Claim: Internal Approach thus computes first the capital requirement and then the corresponding RWA.
True
What are the 3 pillars of Basel II?
- Minimum Capital Requirements
- Supervisory Review
- Market Discipline
Operational Risk is:
the risk of losses resulting from inadequate or failed internal process, people and systems, or external events
Two main inovations from Basel I to II allowed for…
Credit risk and Operational Risk
EAD stands for:
Exposed Assets to Default
Amount expected to be held of an asset by the time the latter may defaul
IRB stands for:
Internal Rating Based approach to credit risk.
Can be Foundation (F-IRB) or Advanced (A-IRB)
WCDR stands for:
Worst-Case Default Rate
Claim: Basel II generally has lower capital requirements for credit risk than Basel I?
True
Claim: Equity is the most reliable source of capital to protect other stakeholders
True
Sos: why equity is used as the main form of regulatory capital?
Due to its Loss Absorption properties
Equity has the highest level of loss absorption capacity within a financial institution’s capital structure.
In the event of financial distress or losses, equity holders are the last to be paid, making equity capital an effective buffer against insolvency.
SOS: Discuss briefly one reason why the market value of equity could have been potentially considered to be a better measure of regulatory capital than the book value of equity
Using market value would be preferred because it shows the bank’s ability to repay claimants in case of forced liquidation.
Assuming efficient financial markets, market value would reflect the value of the bank (what can it get in the market for its assets?).
It is a right proxy to repay claimants. In principle, a bank can alway sell its assets for repayment.
Sos: Discuss briefly one reason why the book value of equity is preferable to the market value of equity as a measure of regulatory capital.
The book value of equity is much less volatile, giving a more stable assessment.
What are the issues of using MV of equity as regulatory capital?
-we assume that the firm is listed
- we assume that the market value of the bank reflects the amount of money it can collect from selling its assets, but this is not the case in a crisis due to systemic risk
- It is volatile to market changes
Basel I determines how much capital is required as a function of RWA. The more risky the assets are, the … capital it needs.
more
What are some of the main criticisms of Basel 1?
Main criticisms of Basel I:
- only credit risk is considered
Basel I does not consider market risk, liquidity risk nor operational risk - weighting scheme
- assets’s risk weight only depends on the asset class, hence assets can have different credit risk (Italy vs Germany), but the same weight, or vice versa
- governance not considered
for the same level of credit risk, sophisticated banks could hedge this risk
better
- curbing market monitoring
no role given to market monitoring of banks. Now, if banks achieved the capital requirements, market participants did not further monitor the banks.
Regulatory arbitrage occurs when…
loopholes allow to formally abide by the rules, which violate the spirit of the rule.
What are the different types of market risk?
Different types of market risk:
- Interest rate risk = change in value due to change in market cost of capital
- Liquidity risk = forced liquidation unfeasible, or feasible only at big discount
- Currency risk = change in value due to change in exchange rates
- Systematic risk = common market risk (e.g. market risk premium)
How do you deal with market risk?
Two possible approaches
1. Standardized approach:
extra weight for market risk
- Internal approach (more freedom to banks): Value at Risk estimates
What is VaR?
The VAR describes how bad it can get due to changes in market value.
It is computed using daily data at (usually) 99% confidence level. So, there is a 1% probability that you will see worse losses than the VaR.
What is the MC factor used to determine regulatory VaR?
It reflects how good the regulators think you are at estimating expected returns for your assets.
If losses are not often worse than the VaR, then you can keep it at 3. Otherwise, it becomes 4.
What are the pros and cons of the intreal apprach to dealing with market risk? (VaR)
Pro: more refined, correlations on market movements can be considered
Con: more manipulation possible (state they are less exposed than they actually are) due to more freedom to banks
What are the 3 pillars of Basel II?
Pillar 1: minimum capital requirements.
Pillar 2: supervisory review.
Pillar 3: market discipline
Claim: In Basel II, weights depend on asset classes and credit ratings
True
Claim: In Basel I, weights depend on the asset class and credit risk
False: In Basel I, weights only depend on the asset class
