Jinu Chandrasekhar Head, Portfolio Risk Review, Global Portfolio Risk Standard Chartered Bank 13 May 2015 ASEAN Risk workshop Capital Treatment of Credit Risk under Basel III
Jinu Chandrasekhar
Head, Portfolio Risk Review, Global Portfolio Risk
Standard Chartered Bank
13 May 2015
ASEAN Risk workshop
Capital Treatment of Credit
Risk under Basel III
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Training Agenda
Agenda
2
1 Evolution of the capital adequacy framework 3
5 Basel III major credit items overview 7
6 Asset Value Correlation 8
7 Credit Valuation Adjustment 9
8 Specific Wrong Way Risk 10
Central Counterparty 12
3 Risk Weighted Assets – Standardised Approach 5
Key Takeaway 13
2 Three approaches to credit risk 4
9 Calibration of capital charge to stressed period 11
11
4 Risk Weighted Assets – AIRB Calculation 6
10
3
Production of a sound minimum standard of capital adequacy for internationally active banks as well as smaller institutions
Well-understood measure of capital adequacy that is comparable across banks and over time
Providing a reasonable level playing field between banks
Taking into account the effects of capital requirements on banks’ risk-taking incentives
Promoting improved risk measurement and management within banks
…towards the primary aim of the capital adequacy framework
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Evolution of the capital adequacy framework
Key milestones of the Basel accord
Risk-based capital requirements already existed in some jurisdictions. However, there were also other jurisdictions still then using leverage ratios or other
simple non risk-based metrics to regulate bank capital.
The 1988 Basel Capital Accord – “one size fits all” approach. Credit risk only was considered.
- A level playing field for all internationally active banks
- Eligible capital with a tiering structure acknowledging that not all capital has equal loss-absorbing capacity
- A set of simple asset risk weights prescribed - in recognition of varying risks of loss across different asset classes, including off balance sheet exposures
The Amendment to the capital accord to incorporate market risk
- Allowed, for the first time, to use internal models (value-at-risk) in the regulatory framework, subject to supervisory approval
Basel II: the New Capital Framework
- Motivated by the evolution of modelling approaches / designed to improve the incentives provided by the risk-based capital framework
- Introduction of three-pillars: Minimum Capital Requirements / Supervisory Review Process / Disclosure and Market Discipline
- Introduction of an explicit capital requirement for operational risk
Basel III: Strengthening of the regulatory capital requirements
- Increased quality and quantity of capital
- Reduced leverage through introduction of backstop leverage ratio – Leverage Ratio
- Increased short-term liquidity coverage – Liquidity Coverage Ratio
- Increased stable long-term balance sheet funding – Net Stable Funding Ratio
- Strengthened risk capture, notably counterparty risk – Asset Value Correlation (“AVC”), Credit Valuation Adjustments (“CVA”) charge, Wrong-way risk
Breakout of financial crisis – need for stronger capital requirements emerged.
Prior to
1988
1988
1996
2004
2008
2010
4
Evolution in the calculation methodology for Risk Weighted Assets
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Three approaches to credit risk
Three approaches for the calculation of Risk Weighted Assets
The capital regulations have grown in complexity in an effort to capture the risk sensitivity to the fullest extent where possible.
Advanced IRB
Internal models can be used for
determination of PD, EAD and
LGD
Collateral recognition allows
internal estimation, providing
differentiation for type of
guarantors, type of collaterals etc.
Foundation
Internal Ratings Based (“IRB”)
PD is allowed to be determined
using internal models
EAD and LGD are externally
provided by regulators
Supervisory treatment of collateral
and guarantees
Standardised Approach
Risk-based, yet relatively simple
Risk Weights based on external
ratings or asset class
Supervisory treatment of collateral
and guarantees
Advanced IRB reflects risk sensitivity to the fullest extent among the three approaches.
In general Basel framework designed to incentivise banks using AIRB through less capital requirements, compared to those
using Standardised approach. However, AIRB requires banks to be equipped with systems / granular historical data in order
for the internal models to be justified / approved.
Increased risk sensitivity accompanies added complexity which is ever increasing – the Basel Committee issued a discussion
paper (BCBS258) in July 2013 on striking the right balance between risk sensitivity, simplicity and comparability.
The pursuit of increased risk sensitivity, at the cost of added complexity
5
The Standardised Approach
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Risk Weighted Assets – The Standardised Approach
Risk weights prescribed for each exposure class to determine the credit risk RWA.
Simplicity – relatively straightforward to compare bank capital ratios under this regime.
Does not fully capture the different level of risk sensitivity (e.g. same risk weight on mortgage exposure with properties across different regions)
Exposure Class Remarks
Risk Weight
AAA to AA- A+ to A- BBB+ to
BBB- BB+ to BB- B+ to B- Below B- Unrated
Claims on Sovereigns 0% 20% 50% 100% 100% 150% 100%
Claims on the BIS, the IMF, the
ECB, the EC and the MDBs
The Bank for International Settlements
The International Monetary Fund
The European Central Bank
The European Community
Multilateral Development Banks (“MDBs”) qualifying
for 0% Risk Weight
0%
Claims on banks and securities
companies
Two options available – National supervisor to
choose one option to be applied 20% 50% 50% 100% 100% 150% 50%
Claims on corporates 20% 50% 100% 100% 150% 150% 100%
Claims on retail products Including credit card, overdraft, auto loans, personal
finance and small business 75%
Claims secured by residual
property 35% (depends on LTV)
Claims secured by commercial
real estate 100%
Overdue loans
(more than 90 days past due,
except qualifying residential
mortgage loans)
With specific provisions < 20% of the outstanding
amount 150%
With specific provisions ≥ 20% of the outstanding
amount 100%
With specific provisions ≥ 50% of the outstanding
amount AND supervisory discretion 50%
Other assets 100%
Risk Weights by exposure class and external ratings
6
IRB method - Key determinants of Risk Weighted Assets
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Risk Weighted Assets – IRB Calculation
Regulatory formula of Risk Weight calculation in IRB method (Corp, Bank and Sov.)
Risk Weight (“RW”) is a function of probability of default (“PD”), loss given default (“LGD”), maturity and firm size.
PD
RWA EAD Risk Weight = X
LGD M S
f PD can be that of the primary obligor as well as the guarantor.
LGD is driven by multiple factors (e.g. counterparty type, country of
incorporation, collateralisation, nature of transaction etc).
M: Regulatory floor (1 year) and cap (5 year) exists in maturity calculation.
S: Firms with annual sales of EUR50m or less are entitled to smaller RWA.
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where:
N(x) = the cumulative distribution function for a standard normal random variable
G(Z) = the inverse cumulative distribution function for a standard normal random variable
R = the coefficient of correlation
b = the maturity adjustment factor
50
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General provisions under IRB to cover Expected Loss
The original Basel II framework covers the risk of loss from a counterparty default. This loss is divided into two components, the expected loss
(“EL”) and the unexpected loss (“UL”), with the former covered by provisions and the latter covered by capital.
Under the AIRB approach, EL is calculated by the following formula:
Expected Loss = PD x EAD x LGD
7
Expansion within the Pillar 1 framework
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Basel III major credit items overview
Primarily to address FI systemic risks and counterparty credit risk
The Basel Committee on Banking Supervision (“BCBS”), through Basel III, attempts to ensure full coverage of risks in the Pillar I
framework, increasing the capital requirements against risks that had not been adequately captured in the Basel II framework.
Asset Value
Correlation
(“AVC”)
Credit Valuation
Adjustment
(“CVA”)
Wrong Way Risk
(“WWR”)
Calibration of
capital charge to
stressed period
Capturing risks of
certain financial
institutions that are
highly correlated to
the financial system
via the IRB formula
Reflecting
experience from
past crisis events
such as the global
financial crisis in
2008
An additional capital
charge to cover the
risk of mark-to-
market losses on the
expected
counterparty risk to
OTC derivatives
Transactions with a
CCP are exempted
from this
requirement
Securities financing
transactions (“SFT”)
can also be
exempted, subject to
supervisory approval
Introduction of an
explicit Pillar 1
capital charge for
specific WWR
Banks are exposed
to specific WWR if
future exposure to a
specific
counterparty is
highly, positively
correlated with the
counterparty’s
probability of default
Calibration of
counterparty credit
risk modelling
approaches such as
Internal Model
Methods (“IMM”) to
stressed period
Determine capital
charges for CCR
using stressed
inputs, similar to the
approach used for
determining
stressed VaR for
market risk
Central
Counterparty
(“CCP”)
Enhancing
incentives for
clearing instruments
through CCPs by
applying lower own
funds requirements
relative to bilateral
OTC transactions
Also, the additional
CVA capital charge
does not apply to
exposures towards
eligible CCPs
8
Higher capital requirement due to higher correlation to financial systems
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Asset Value Correlation
Application
Increasing the RW on exposures to certain financial institutions relative to the non-financial corporate sector in the IRB
approach.
Requiring additional capital for all unregulated financial institutions, and regulated financial institutions if they are large
enough to have a material influence on the overall financial systems in case of default.
Multiplier of 1.25 to the correlation coefficient in the IRB formula, effectively increasing the RW to a varying degree(depending
on probability to default).
Applied on exposures to large regulated financial firms (with assets of at least USD100bn) and to all unregulated financial
firms regardless of size.
Impact on the Risk Weight
Depending on the probability of default of an institution, the introduction of this multiplier increases the RW by approximately 10%
to 36%.
0%
10%
20%
30%
40%
0.03% 0.04% 0.05% 0.07% 0.09% 0.1% 0.2% 0.4% 0.5% 0.7% 0.9% 1.2% 1.5% 2.0% 2.7% 3.5% 4.6% 6.1% 8.0% 10.5% 13.8% 18.0% 24.6% 33.0%
Incremental RW (%)
Probability of Default
Impact of AVC charge application on the RW
Source: Standard Chartered
9
Capital charge on counterparty credit risk for derivatives
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Credit Valuation Adjustment
What it is
Capturing the potential mark-to-market losses associated with deterioration in the creditworthiness of a counterparty.
Two methods are allowed: Advanced method (for banks with IMM approval) and Standardised method.
Under Standardised method, three key determinants are i) PD, ii) maturity and iii) collateralisation of exposure.
CVA charge can be mitigated through dealing with exempted counterparties or via hedging.
Exemption rules under EU regulation (“CRD IV”)
The following transactions are exempt from the CVA capital charge:
- Transactions in relation to a qualifying CCP
- Transactions with non-financial counterparties where those transactions do not exceed the clearing threshold as
specified in the EMIR (European Market Infrastructure Regulation)
- Intragroup transactions
- Transactions with pension scheme arrangements
- Transactions with central banks and debt management offices in EU and certain countries (including Japan and the US)
- Transactions with multilateral development banks and development organisations which qualify for zero per cent Risk
Weight
10
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Specific Wrong Way Risk
Capturing high correlation between counterparty and underlying issuer
Specific Wrong Way Risk
Specific WWR manifest itself when there is a direct correlation between the nature of the trade and the counterparty:
- Self referencing (e.g. Bank ABC Securities sells protection on Bank ABC)
- Correlated credit
Banks must have procedures in place to identify, monitor and control cases of specific WWR, beginning at the inception of a
trade and continuing through the life of the trade.
Role of Stress Testing
Emphasis is on stress testing and scenario analysis practices to identify risk factors positively correlated with counterparty
credit worthiness.
How does it affect RWA – via increase in EAD
Single-name credit default swaps (“CDS”): the 100% notional of the CDS is to be used as the EAD of the counterparty, where
there exists a legal connection between the counterparty and the underlying issuer.
Equity derivatives referencing a single company: the EAD equals the full expected loss in the remaining fair value of the
underlying instruments assuming the underlying issuer is in liquidation, where there is a legal connection between the
counterparty and the underlying company.
11
IMM measure to reflect stressed period
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Calibration of capital charge to stressed period
Conservative approach to capital charge under IMM, in consideration of stressed period
Effective Expected Positive Exposure (“EPE”) as the basis for determining EAD for trading counterparties is retained under Basel
III but with parameters, such as volatility and correlation, using data from a stressed period.
Stressed EPE is to be based on model parameters calibrated over a three-year period that includes the one-year stressed
period used for Stressed VaR for credit assets.
Banks should calculate EAD using current market data and compare that data with the EAD derived using the stressed
parameters. Then, banks should use the higher of:
1) the portfolio-level capital charge based on Effective EPE using current market data; and
2) the portfolio-level capital charge based on Effective EPE using the three-year period that includes the one-year stressed
period (used for the Stressed VaR calculation).
Effective EPE under IMM
Expected Exposure (“EE”): the probability-weighted average
exposure estimated to exist on a future date.
EPE: the time-weighted average of individual EE’s estimated
for a given forecasting horizons (e.g. one year).
Effective EE: the maximum in the path of individual EE profile
for a given forecasting horizons.
Effective EPE: the average of Effective EE profile for a given
forecasting horizons. 0 0.25 0.5 0.75 1
Exp
os
ure
Time (years)
CCR Effective EE profile & Effective EPE
EE
EPE
Effective EE
Effective EPE
12
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Central Counterparty
Background
Capital requirements under Basel III for CCP exposures
Lessons learnt from Global Financial Crisis:
- The G20 commitment implemented a set of reforms designed for i) mandatory clearing of standardised OTC contracts, and
ii) increased capital costs on non-cleared derivatives contracts.
Basel III enhanced incentives for clearing instruments through CCPs:
- Potential reduction in Credit RWA, compared to bilateral trades
- Exemption from CVA capital charge for qualifying CCP related transactions
- Avoidance of punitive rules on margin requirements being imposed on OTC non-cleared trades
Key feature of CCP defence mechanism – CCP Default Waterfall
- Loss mutualisation among clearing members: contribution from clearing members of CCP via placement of default fund
- CCP’s skin in the game: a tranche of CCP’s capital to be used before default funds of non-defaulting clearing members
Trade exposure: when a bank is a clearing member of a CCP or acts as an agent / broker for its client’s trades
Margin exposure: when collaterals (margins) are posted directly to a CCP or its clearing member instead of a bankruptcy-remote
custodian
Default fund exposure: when a bank is a clearing member, it has to hold capital against the funded and/or unfunded
contributions that it has made to the CCP’s Default Fund pool
13
ASEAN Risk workshop – Capital treatment of credit risk under Basel III
Key Takeaway
Strengthening capital requirements under Basel III with a focus to CCR
AVC capital charge to capture higher systemic risks within large regulated FIs and/or unregulated FIs
CVA capital charge to cover potential mark-to-market losses arising from deterioration in creditworthiness of
counterparties
Explicit Pillar I capital charge for specific WWR to dis-incentivise trades where there exists high correlation between
counterparty and underlying issuer / company
Calibration of CCR exposure calculation under the IMM approach to a stressed period
Incentivise clearing through CCPs via reduction in capital charge
Objectives of the Basel III capital treatment of credit risk
To strengthen global capital regulations with the goal of promoting a more resilient banking sector
To improve the banking sector’s ability to absorb shocks arising from financial and economic stress, which, in turn,
would reduce the risk of a spillover from the financial sector to the real economy
To raise capital buffers for systemic banks / derivatives and inter-financial exposures
To provide additional incentives to move OTC derivative contracts to CCPs and exchanges
Q&A