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The Incremental Risk Charge in Basel II

The Incremental Risk Charge in Basel II. Mark Staley Risk & Capital Modeling Group, Quantitative Analytics – Trading Risk April 2010. Sticker Shock: The impact of the new rules

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The Incremental Risk Charge in Basel II

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  1. The Incremental Risk Charge in Basel II Mark Staley Risk & Capital Modeling Group, Quantitative Analytics – Trading Risk April 2010

  2. Sticker Shock: The impact of the new rules Summary of the new rules and their motivation: - Injecting capital into the system - removing capital arbitrage IRC: challenges in measuring credit risk in the trading book The future Agenda

  3. Sticker Shock • In October 2009, BIS published “Analysis of the Trading Book Quantitative • Impact Study”.* The main findings, based on a survey of 43 banks across 10 • countries (including TD Bank), were as follows: • Average (median) overall capital under the new rules increases by 11% (3%). • Average (median) trading book capital increases 223% (102%). • The biggest contributors are: • - Stress-VaR: Average (median) trading book increases 110% (63%) • - Incremental Risk Charge (IRC): average (median) trading book increases 103% (60.4%). This represents an increase in capital for “specific risk” by a factor of nine! • * http://www.bis.org/publ/bcbs163.htm

  4. Sticker Shock • Note the wide variation: banks that previously developed debt-specific risk models are now seeing the biggest increases in IRC-capital.

  5. Summary of the new rules • Current Rules: • Capital = max { GMR VaR, 3 X (average GMR VaR over 60 days) } • + max { SR VaR, 4 X (average SR VaR over 60 days) } • where • GMR is “General market Risk” and SR is “Specific Risk”, both over 10 days, • measured at the 99% confidence level. Note that GMR and SR is pro-rated based on correlated total. • New Rules:* • Capital = max {VaR, 3 X (average VaR over 60 days) } • + max {Stress VaR, 3 X (average Stress VaR over 60 days) } • + IRC • where • VaR is the combined GMR and SR (10-days, 99% VaR), • Stress VaR is computed using data from a stressful period (2007-2008), • IRC is Credit VaR over one year at the 99.9% confidence level • *Revisions to the Basel II market risk framework: http://www.bis.org/publ/bcbs158.htm, • Guidelines for computing capital for incremental risk: http://www.bis.org/publ/bcbs159.htm

  6. Motivation for the new rules • Inject capital into the system: prevent a repeat of 2007-2008 credit crisis, when banks did not have enough capital to prevent insolvency. As of Dec. 15 2009, the loss was $732 billion.* Hence the introduction of “Stress VaR”. *Source: Bloomberg

  7. Motivation for the new rules • Prevent capital arbitrage: bank loans attract capital based on a one-year 99.9% VaR measure. This VaR model captures default risk and migration risk (through a “maturity adjustment factor”), and is calibrated to bank’s own “Through-the-Cycle” historical loss experience. This is much more punitive than capital requirements for credit exposures in the trading book (10-day VaR at 99% X 4). Up until now there has been an incentive to move assets off the balance sheet in order to save capital (witness the growth of securitization vehicles). Hence the introduction of “IRC”. • The new rules are provisional and somewhat piecemeal; a more comprehensive set of guidelines (Basel 3) will undoubtedly appear in the future…

  8. IRC • Chronology of IRC • October 2007: BIS Proposal to model default risk in the trading book (IDR). • March 2008: Expansion to include migration, spread risk (IRC). • July 2009: Final BIS document on IRC covering default and migration risk, but not spread risk. Securitization removed from IRC  now covered under standardized approach, which is more conservative. • January 2010: BIS issues “FAQ on IRC”. One question was “Are sovereign exposures to be included in IRC?” Answer: “Yes.” • National regulators continue to press for other enhancements. • ….. • Deadline for implementation: December 31, 2010.

  9. IRC • Credit portfolio modeling Portfolio value at time 0 Frequency Regulatory Capital 0.1% of samples Portfolio Value at 1 year horizon Unexpected Loss Expected Loss (already captured in pricing – on balance sheet)

  10. IRC • CreditMetrics (1997)* The following risks are captured: • Default risk • Downgrade risk (rising spreads) • Recovery risk • Concentration risk(portfolio diversification and correlation risk) Note: The Basel II formula** for capital is based on the CreditMetrics model (in the limit of an infinitely granular portfolio) * http://www.defaultrisk.com/_pdf6j4/creditmetrics_techdoc.pdf**Vasicek (2002), Risk. http://www.gloriamundi.org/picsresources/ovlld.pdf. Gordy, M. B. (2003) A risk-factor model foundation for ratings-based bank capital rules. Journal of Financial Intermediation 12, 199 - 232.

  11. IRC • CreditMetrics: Migration and Default Rating = AAA (upgrade)--> spreads go down--> value goes up P=0.7% Initial State:* Fixed rate loan, 5-year term* CAD * Subordinated* Obligor rating = AA --> spreads Value = discounted cash-flows Rating = AA (unchanged)--> no change in spreads--> no change in value P=90% P=8% Rating = A (downgrade)--> spreads go up --> value goes down P=1 bps Default--> subordinated: LGD=80%--> stdev of loss = 19%

  12. IRC • CreditMetrics: Default correlation Assets Value Threshold is Face-Value of Debt Probability of default

  13. IRC Challenges • Constant Level of Risk: • In the banking book, the minimum maturity is one year (e.g. revolving LOC). • We treat credit exposures in the banking book as “buy and hold”. • Trading exposures are not “buy and hold”. They are traded frequently. • BIS says that credit exposures should be modeled assuming a “constant level of risk”. • But a constant level of risk means no migrations and no defaults. • How do we square this circle?

  14. IRC Challenges • Constant Level of Risk: • In simulation we must take turns: • 1. Allow for migrations and defaults during one interval of time. • 2. Then reset all ratings to their original ratings. • 3. Repeat. • The first interval is called the “Liquidity Horizon”. The minimum liquidity horizon is three months.

  15. IRC Challenges • Constant Level of Risk: Challenges • What if an instrument matures before the liquidity horizon? • What if a credit default swap is more liquid than the underlying bond? How can one maintain different liquidity horizons while maintaining hedging properties on basis trades? • What is the sound of one hand clapping?

  16. IRC Challenges • Other Challenges: Migration and Default • How to treat Sovereign obligors differently from corporate obligors? • Should the probabilities of migration and default be based on “Through-the-Cycle” data or “Point-in-Time” data? Through-the-Cycle data would make IRC consistent with models in the banking book, but trading risk models are typically supposed to be more reactive to changing market conditions.

  17. The Future • Predictions for Basel 3 • We will need to address “downturn LGD” and “PD/LGD correlation” in the trading book. • We will need to capture “Downturn PD”. • Correlation modeling will be emphasized. • All risks will need to be modeled over a one-year horizon: historical simulation will no longer be an option. • The diversification benefits between trading and banking will need to be modeled explicitly: this will necessitate the development of the “Mother of all Models”.

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