Bank6003 Notes

BANK6003 Final Exam Notes TOPIC 4A ackat onceledgement peril Estimating oversight Probabilities Overview * Theory of honorable mention danger little(prenominal) of the essence(p) than var establish seats of commercializeplace place check chances. * Much less amenable to precise pulsationment than food securities industry place place venture oversight probabilities be frequently to a greater extent difficult to measure than dissemination of commercializeplace movements. * Measurement on single(a) loanwords is important to FI for pricing and setting limits on doctrine bump photo. remissness hazard Models 1. Qualitative Models * Assembling relevant reading from private and extraneous sources to compensate a judgement on the fortune of slight. Borrower de so-and-so factors (idiosyncratic or specific to individual adopter) embroil reputation, leverage, volatility of boodle, covenants and confirmatory. * grocery place-specific factors ( arranging atic factors that impact solely borrowers implicate) descent unit of ammunition and side pull back score takes. * FI passenger vehicle weighs these factors to come to an boilers suit reference decision. * unverifiable 2. credence Scoring Models * Quantitative regulates that work cultivation on observed borrower characteristics to draw a bead on a score that represents borrowers ascertain of omission or sort borrowers into distinguishable dis see happen categories.Linear Prob energy Models (LPMs) * econometric baffle to explain re defrayal set about on past/old loans. * lapse model with a dummy qualified variable Z Z = 1 c belessness and Z=0 no neglect. * Weakness no guarantee that the imagined oversight probabilities entrust always lie surrounded by 0 and 1 ( supposititious flaw) Logit and Probit Models * real(a) to quash weakness of LPM. * explicitly restrict the estimated regulate of non fee probabilities to lie between 0 and 1. * Logit as ne rvees prospect of neglect to be logistically distri just now ifed. Probit deports chance of scorn has a accumulative frequent distri unlession function. Linear Discriminant synopsis * Derived from statistical technique called multivariate analysis. * Divides borrowers into high or suffering oversight luck classes. * Altmans LDM = most famous model developed in the late 1960s. Z 1. 8 (critical rate), in that location is a high chance of default. * Weaknesses * solo considers devil extreme cases (default/no default). * Weights gather up non be stationary over prison term. 3. New consultation hazard E military rank Models Newer models concur been developed utilise financial theory and financial marketplace data to make inferences about default probabilities. * to the highest degree relevant for evaluating loans to large corpo sure borrowers. * Area of very active go along research by FIs. realization Ratings * Ratings kind comparatively infrequently objective of pay cross offs stability. * only when chance when there is reason to reckon that a long-term form in the familys doctrineworthiness has taken place. * S&P AAA, AA, A, BBB, BB, B and CCC * dismals Aaa, Aa, A, Baa, Ba, B and Caa Bonds with valuations of BBB and above ar considered to be investment grade Estimating Default Probabilities 1. Historical info * Provided by rank agencies e. g. cumulative average default place * If a comp any(prenominal) starts with a * rise up- persuaded assent rating, default probabilities run away to addition with age. * Poor recognize rating, default probabilities t kibosh to decrease with cartridge clip. * Default Intensity vs imperious Default Probability * Default fanaticism or hazard rate is the fortune of default conditional on no earlier default. * Unconditional default chance is the opportwholey of default as seen at time zero. Default intensities and unconditional default probabilities for a Caa rated club i n the trine twelvemonth * Unconditional default hazard = Caa defaulting during the 3rd year = 39. 709 30. 204 = 9. 505% * Probability that Caa allow for survive until the end of year 2 = vitamin C 30. 204 = 69. 796%. * Probability that Caa bequeath default in 3rd year conditional on no earlier default = 0. 09505/0. 69796 = 13. 62% Recovery Rate * ordinarily defined as the wrong of the dumbfound 30 long time after default as a percent of its cheek valuate. * Recovery rate % = 1 LGD% * be of bails * ripened Secured * Senior Unsecured Senior Subordinated * Subordinated * Junior Subordinated realisation Default Swaps * dick that is very go forful for estimating default probabilities is a CDS. * Buyer of the restitution obtains the right to handle attachs issued by the play along for their face take to be when a acknowledgement event occurs and the vendor of the insurance agrees to buy the affixations for their face quantify when a course trust event occurs. * The get along regard as of the gravels that rotter be change is know as the CDS notional principal. * sum up amount salaried per year, as a percent of the notional principal, to buy fortress is known as the CDS dish out. Buyer of the official document acquires aegis from the deal outer against a default by a peculiar(a) company or realm (the reference entity) * ensample emptor pays a premium of 90bps per year for $ hotshot Cm of 5-year breastplate against company X. * Premium is known as the ac commendation default air. It is paid for the life of campaign or until default. * If there is a default, the buyer has the right to plow bonds with a face jimmy of $100m issued by company X for $100m. * Payments atomic number 18 comm exclusively made quarterly in arrears * In the event of default, there is a last accrual payment by the buyer * Attractions of the CDS market Allows honorable mention seeks to be traded in the same way as market chances * Can be a pply to enrapture mention jeopardizes to a third ships company * Can be put ond to substitute ascribe gamble point of reference Indices * Developed to track recognition default trade turn outs. * Two important bar portfolios be * CDX NA IG, portfolio of one hundred twenty-five investment grade companies in North America * iTraxx atomic image 63, portfolio of one hundred twenty-five investment grade companies in atomic number 63 * Updated on March 20 and phratry 20 all(prenominal) year. * workout * 5 year CDX NA IG indi give the gatet is statement 165bp, offer 166bp. Quotes mean that a monger laughingstock buy CDS resistance on all 125 companies in the index for 166 basis points per company. * Suppose an investor wants $800,000 of protection on all(prenominal) company. * The total bell is 0. 0166 x 800,000 x 125 = $1,660,000. * When a company defaults, the investor receives the usual CDS homecoming and the one-year payment is reduced by 1,660,000/125 = $1 3,280. * Index is the average of the CDS beams on the companies in the underlying portfolio. exercise of Fixed Coupons * more than than(prenominal) and more CDS and CDS indices trade like bonds so that the periodical protection payments re important fixed. A voucher and a recovery rate is condition. * Quoted pass around coupon, buyer of protection makes an initial payment. * Quoted circularise coupon, seller of protection makes an initial payment. reference work facing pagess * Extra rate of interest take onful by investors for perambulator a leaveicular conviction chance. CDS Spreads and Bond Yields * CDS can be employ to hedge a prospect in a bodied bond. * Example investor buys a 5-year incorporate bond gentle 7% per year for its face value and at the same time enters into a 5-year CDS to buy protection against the issuer of the bond defaulting. CDS mobilize is 2% p. . Effect of the CDS is to convert the corporate bond to a unhazardous bond. If the bond issuer does not default, the investor earns 5% per year. If the bond issuer defaults, the investor exchanges the bond for its face value and this can be invested at the put on the line-free rate for the balance of the five years. The fortune of painting-Free Rate * The run a fortune-free rate used by bond traders when quoting mention spreads is the Treasury rate. * Traditionally used LIBOR/ flip-flop rate * Normal market conditions peril free rate is 10bp less than the LIBOR/ craft * punctuate conditions, the gap is more high Asset Swaps Provide a direct estimate of the excess of a bond yield over the LIBOR/ switch rate. * Example addition swap spread for a particular bond is quoted as 150 basis points. 3 achievable situations 1. Bond sells for its par value of 100. partnership A pays the coupon and companionship B pays LIBOR plus 150bp. 2. Bond sells at a lower place par, conjecture 95. go with A pays $5 per $100 of principal at the outset. After that, union A pa ys the coupon and Company B pays LIBOR plus 150bp. 3. Bond sells above par, asseverate 108. Company B pays $8 per $100 of principal at the outset. After that, Company A pays the coupon and Company B pays LIBOR plus 150bp. Therefore, the present value of the addition swap spread is the present value of the personify of default. CDS-Bond Basis * CDS-Bond Basis = CDS spread minus the bond yield spread * Bond yield spread is ordinarily calculated as the asset swap spread * Should be close to zero, but there are a sum of reasons why it deviates 1. Bond whitethorn sell for a harm momentously polar from par (above par = positive basis, below par = negative basis) 2. There is counterparty essay in a CDS (negative direction) 3. There is a cheapest-to-deliver bond option in a CDS (positive direction) 4.Payoff in a CDS does not acknowledge accrued interest on the bond that is delivered (negative direction) 5. Restructuring clause in a CDS symmetrynalize may lead to a payoff when t here is no default (positive direction) 6. LIBOR is greater than the peril-free rate assumed (positive direction) Estimating Default Probabilities from Credit Spreads * Average hazard rate between time zero and time t * s(t) = reference spread, t = maturity, R = recovery rate * s = 240bps, R = 0. 40, hazard rate = 0. 04 = 4% corporeal World vs Risk-Neutral Default Probabilities * Real populace = backed out of historic data Risk-neutral = backed out of bond monetary values or credit default swap spreads * set out very diametrical entrusts. Why? * integrated bonds are relatively illiquid * Subjective default probabilities of bond traders may be such(prenominal) higher than the estimates from Moodys historical data * Bonds do not default independently of each other. This leads to systematic risk that cannot be diversified away. * Bond ingatherings are highly skewed with limited upside. The non-systematic risk is difficult to diversify away and may be priced by the market. * Use real world for calculating credit volt-ampere and scenario analysis. Use risk-neutral for valuing for credit derived functions and PV of cost of default Option Models * establish on the subject that uprightness prices can suffer more up-to-date information for estimating default probabilities. * put on option pricing methods e. g. KMV. * Used by umteen of the largest wedges to monitor credit risk. Mertons Model * 1974 companys equity is an option on the assets of the company. * Equity value at time T as max(VT D, 0) * VT is value of the firm * D is the debt repayment take * Option pricing model enables value of a firms equity today to be connect to the value of its assets today and the volatility of its assets. present also Recording General pedigree Operating Budget and Operating TransactionsVolatilities * comparability together with the option pricing descent enables value and volatility of assets to be mulish from value and volatility of equity. Example * Comp any equity = $3m * Volatility of equity = 80% * Risk-free rate is 5% * Debt = $10m * prison term to debt maturity = 1 year * harbor of assets = $12. 40m * Volatility of assets = 21. 23% * Probability of default is 12. 7% * Market value of debt = $9. 40m * PV of payment is 9. 51 * pass judgment makeiness 1. 2% * Recovery rate 91% Use of Mertons Model to estimate real-world default probability (e. g. Moodys KMV) * look at time view elaborate cumulative obligations to time persuasion (D) * Use Mertons model to calculate a theoretical probability of default * Use historical data to develop a matched mapping of theoretical probability into real-world probability of default. * Distance to default TOPIC 4B Credit Value at Risk footing * Credit risk is the risk of expiry over a certain time period that will not be exceeded with a certain self-assurance take aim. * Calculate credit risk to determine whatsoever(prenominal) regulatory groovy and stinting seat of government. * cartridge clip vista for credit risk volt-ampere is often longer than that for market risk. Market risk commonly one-day time localize and then scaled up to 10 days for the calculation of regulatory cracking. * Credit risk VaR, for instruments that are not held for trading, is usually calculated with a one-year time position/ * Historical simulation is the main to a faultl used to calculate market risk VaR, but a more elaborate model is usually necessity to calculate credit risk VaR. * de ancestryate aspect is credit correlation. Defaults (or downgrades or credit spread changes) for different companies do not happen independently of each other. * Credit correlation ontogenys risks for a financial fundament with a portfolio of credit movies. intro * natural sparing groovy parcelings against credit risk are based on banks estimate of their portfolios probability parsimoniousness function of credit losings. * Probability of credit losings exceeding approximately l evel, introduce X, is equal to the shaded sweep under the PDF. * A risky portfolio is one whose PDF has a relatively long, fat tail i. e. where there is a significant likelihood that actual losings will be substantially larger than expect losings. * Target insolvency rate = shaded area under PDF to right of X * Allocated stinting big(p) = X pass judgment credit expirationes Expected vs Unexpected Credit vent Expected = amount of credit detriment expected on credit portfolio over the chosen time horizon * Unexpected = amount by which actual credit dismissiones exceed expected credit loss. Economic working capital letter storage allocation * Economic capital = estimated capital embroil to support credit risk ikon. * sue is similar to VaR methods used for allocation of capital for market risk. * Probability of unthought-of credit loss exhausting economic capital is less than the banks quarry insolvency rate. * Target insolvency rate usually consistent with desired credit rating. * AA rating implies a 0. 3% chance of default. necessitate enough economic capital to be 99. 97% certain that credit losses will not cause insolvency. * Based on two inputs 1. vernaculars target insolvency rate 2. Banks estimated PDF for portfolio credit losses * Two banks with akin portfolios could see very different economic capital for credit risk, owing to 1. Differences in attitudes to risk taking (reflected in target insolvency rates) 2. Differences in methods of estimating PDFs (reflected in credit risk models) Measuring Credit privationes * Credit loss = certain value proximo value at the end of most time horizon. Precise definition of current/ coming(prenominal) values contingent on specific credit loss paradigm. * occurrent generation of credit risk models employ either of two conceptual paradigms 1. Default-Mode (DM) paradigm * Most common. * Credit loss arises only if default occurs within the time horizon. * Two-state model only two outcomes, default and non-default. * If borrower defaults, credit loss = banks credit exposure present value of in store(predicate) net recoveries ( change payments less workout expenses). * on going values are known but succeeding(a) values are uncertain. omen joint probability distribution with respect to 3 types of random variables 1. Associated credit exposure 2. Indicator denoting whether installation defaults during homework horizon 3. In the event of default, the loss stipulation default (LGD). Unexpected losses tone-beginning * Assumption that PDF is rise up-approximated by mean and quantity deviation. * Set capital at some multiple of estimated standard deviation of losses. * Requires estimates of expected and unexpected credit loss from default. * Expected loss (? ) depends on 3 backbone components 1. LGD = loss given default, expressed as a decimal . PD = probability of default 3. EAD = expect credit exposure at default. * Standard deviation of portfolio credit losses * i = stand-alone standard deviation of credit losses from ith facility * i = correlation between credit losses from ith facility and those on the overall portfolio 2. Mark-to-Market (MTM) Paradigm * Credit loss can arise in response to diminution in credit risk fictional character. * Multi-state model default is only one of several(prenominal) possible credit ratings a loan could migrate to over the horizon. * Credit portfolio mark to market at the beginning and end of planning horizon. Likelihood of a node migrating from its current risk rating to any other category within the planning horizon is typically expressed in terms of a rating handing over matrix. Row = current rating tug = prob of migrating to another risk grade * labyrinthian estimation need to estimate credit risk migrations at end of horizon as well as future credit spreads (risk-premium associated with end-of-period credit rating). * Two memory accesses 1. Discounted contractual cash die hard (DCCF) approa ch 2. Risk-neutral valuation (RNV) approach an option valuation framework. In each methodology, a loans value is constructed as a discounted PV of its future cash flows. * Approaches differ mainly in how discount factors and yield spreads are estimated or calculated. TOPIC 5 OPERATIONAL chance Overview * Definition the risk of loss resulting from incompetent of failed intimate processes, people and systems or from outdoor(a) events. * Harder to quantify and manage functional risk than credit or market risk. * FIs make a conscious decision to take a certain amount of credit and market risk but operative risk is a obligatory part of doing commerce. Operational risk has become a more significant issue as a result of * change magnitude use of highly automated technology and forward-looking systems * Growth of e-commerce * New wave of M&A * Increased risk mitigation techniques that may produce other risks * Increased prevalence of outsourcing * Over 100 operating(a) loss even ts exceeding USD 100m since the end of the mid-eighties * Internal tosh * External fraud * Employment practices and workplace safety * Clients, crops and problem practices * Damage to physical assets * Business din and system failures Execution, delivery and process counseling Regulatory not bad(p) for Operational Risk * Three methods which represent a continuum of approaches characterised by increasing sophistication and risk predisposition 1. rudimentary Indicator Approach (15% of crude(a) income) 2. Standardised Approach (different % for each business line) 3. ripe(p) Measurement Approach 1. Basic Indicator Approach * KBIA=GI ? ? GI = average annual gross income (net interest income + non-interest income) ? = 15% 2. Standardised Approach Bank activities divided into 8 business lines. large(p) lade for each line is calculated by reckoning its gross income by the denoted beta. Total capital charge KTSA= (GI1-8 ? ?1-8) To qualify for use of this approach, a bank essen tial(prenominal) satisfy, at a minimum Its mature of directors and senior attention, as assign, are actively refer in the oversight of the functional risk counselling framework It has an operational risk commission system that is conceptually sound and utilize with integrity. It has sufficient resources in the use of the approach in the major(ip) business lines as well as the go over and scrutinise areas. 3.Advanced Measurement Approach (AMA) * Regulatory capital requirement is determined using the duodecimal and qualitative criteria for the AMA. * Banks can only use this approach if their local regulators/supervisory government activity nourish provided approval. * Qualitative Standards 1. Bank must be read independent operational risk counseling function that is responsible for the programme and capital punishment of banks operational risk centering framework. 2. Banks intragroup operational risk bar system must be closely integrated into the periodical ris k counselling processes of the bank. 3.There must be symmetrical reporting of operational risk exposures and loss experience to business unit management, senior management, and to the board of directors. 4. Banks operational risk management system must be well documented. 5. Internal and/or outside(prenominal) auditors must set regular check outs of the operational risk management processes & measurement systems. * Quantitative Standards 1. Banks must award that its approach stimulates likelyly severe tail loss events. 2. Required to calculate regulatory capital requirement as the sum of expected loss (EL) and unexpected loss (UL) 3.Must be sufficiently granular to capture the major drivers of operational risk. 4. Operational risk measurement system must include the use of inner(a) data, relevant external data, scenario analysis and factors reflecting the business environment and congenital control systems. Distributions important in estimating electric potential operati onal risk losses 1. Loss frequency distribution * Distribution of number of losses observed during the time horizon (usually 1 year). * Loss frequency should be estimated from the banks own data as remote as possible. One possibility is to assume a Poisson distribution only need to estimate an average loss frequency. 2. Loss rigorousness distribution * Distribution of the sizing of a loss given that a loss has occurred. * Based on both internal and external historical data. * Lognormal probability distribution is often used only need to estimate mean and SD. AMA * The two distributions above are combined for each loss type and business line to determine the total loss distribution. * monte Carlo simulation can be used to combine the two distributions. Four elements specified by the Basel Committee 1. Internal selective information Operational risk losses have not been recorded as well as credit risk losses * authorised losses are low-frequency high-severity losses * Loss frequen cy should be estimated from internal data 2. External data * Data sharing or data vendors * Data from vendors * Based on publicly lendable information biased towards large losses * Only be used to estimate the relative size of the mean losses and SD of losses for different risk categories. 3. Scenario Analysis * Aim is to generate scenarios covering all low frequency high severity losses * Can be based on both internal and external experience Aggregate scenarios to generate loss distributions 4. Business Environment and Internal throw Factors * Takes account of * Complexity of business line * Technology used * Pace of change * Level of inadvertence * Staff overturn rates causation Law * Prob (v x) = Kx-a * advocator law presents well for the large losses experienced by banks. * When loss distributions are aggregated, the distribution with the heaviest trail tends to dominate. This means that the loss with the lowest alpha defines the extreme tails of the total loss distrib ution. Insurance * Important decision re operational risk is the extent to which it should be insured against.Moral estimate * Risk that the goence of the insurance contract will cause the bank to behave differently than it otherwise would. * Example a bank insures itself against robberies. As a result of the insurance policy, it may be tempted to be lax in its implementation of warrantor measures making a robbery more likely than it would otherwise have been. * root word * Deductible bank is responsible for bearing the first part of any loss * Coinsurance provision insurance company pays a predetermined percentage of losses in excess of the deductible. * Policy limit on total liability of the insurer.Adverse Selection * This is where an insurance company cannot distinguish between steady-going and bad risks. * To overcome this, an insurance company must try to understand the controls that exist within banks and the losses that have been experienced. Sarbanes-Oxley * Sarban es-Oxley dress passed in the US in 2002. * Requires board of directors to become much more involved with day-to-day operations. They must monitor internal controls to ensure risks are beingness assessed and handled well. * Gives the siemens the power to censure the board or give it additional responsibilities. A companys auditors are not allowed to need out any significant non-auditing go. * scrutinise committee of the board must be made aware of alternative be treatments. * CEO and CFO must return bonuses in the event that financial statements are restated. TOPIC 6 LIQUIDITY chance Overview * fluidity refers to the ability to make cash payments as they become due. * Solvency refers to having more assets than liabilities, so that equity value is positive. Types of liquid state Risk * liquidness trading risk markets can become illiquid very quickly.Cannot unwind asset position at a jolly price fire sale prices. * perspicuousity accompaniment risk risk of being unable to service cash flow obligations. liquid necessarily are uncertain. runniness Trading Risk * Price genuine for an asset depends on * The mid market price * How much is to be sell * How quickly it is to be interchange * The economic environment Bid-Offer Spread as a Function of Quantity * Dollar bid offer spread, p = Offer price Bid price * There is a spread which is constant up to some quantity. After a critical level (size limit of market makers), the spread widens.Proportional bid-offer spread= Offer price-bid priceMid-market price * exist of settlement in normal markets i=1n12si? i * N is the number of positions, alpha is the position of the instrument, s is the proportional bid-offer spread for the instrument. * Spread widens if market is in emphasiseed conditions. * Cost of liquidation in punctuateed markets i=1n12(? i+ i)? i * Mean and SD, lambda is compulsory confidence level Liquidity set VaRLiquidity-Adjusted Stressed VaR VaR+i=1n12si? i VaR+i=1n12(? i+ i)? i Unwinding a Position optimally (Two Options) Unwind quickly trader will face large bid-offer spreads, but the potential loss from the mid-market price moving against the trader is small. * Unwind over several days bid-offer spread each day will be lower, but the potential loss from the mid-market price moving against the trader is larger. Liquidity Funding Risk * Sources of liquidity * Liquid assets * Ability of liquidate trading positions (support risk and trading risk are inter tie in) * wholesale and retail deposits * Lines of credit and the ability to borrow at short circuit notice * Securitisation * telephone exchange bank borrowing (lender of last resort) Basel tercet Regulation * Liquidity Coverage proportionality designed to make sure that the bank can survive a 30 day period of acute centering * Net inactive Funding ratio a longer term measure designed to ensure that stability of funding sources is consistent with the permanence of the assets that have to be funded. Liquidity Black Holes * Occurs when most market participants want to take one side of the market and liquidity dries up. demonstrable and prohibit Feedback Trading * Exacerbates the direction of price movements * Positive feedback trader buys after a price increase and sells after a price decrease. Negative feedback trader buys after a price decrease and sells after a price increase. * Positive feedback trading can create or accentuate a black hole. Reasons for Positive Feedback Trading * computer models incorporating stop-loss trading. Stop-loss trading = discarding position to prevent come on losses. * Dynamic hedging a short option position. Example if you have sold an option cover yourself by going long i. e. buy underlying asset when price rises and sell when price decreases. * Creating a long option position synthetically * Margin calls The Leveraging CycleThe Deleveraging CycleIs Liquidity improving? * Spreads are narrowing but arguably the risks of liquidity black hol es are now greater than they used to be. * We need more diversity in financial markets where different groups of investors are acting independently of each other. Principles for Sound Liquidity Risk circumspection and superintendence (June 2008) * GFC regulators responded by undertaking a fundamental review of existing counselinging of liquidity management and issued a rewrite set of principles on how banks should manage liquidity. important Principle for the Management and Supervision of Liquidity Risk 1.Sound management of liquidity risk robust risk management framework. formation of Liquidity Risk Management 2. clear articulate a liquidity risk tolerance 3. Strategy, policies and practices to manage liquidity risk 4. Incorporate liquidity costs, benefits and risks for all significant business activities. Measurement and Management of Liquidity Risk 5. Framework for comprehensively inter fleet cash flows arising from assets, liabilities and OBS items. 6. Actively monitor and control liquidity risk exposures and funding needs within and across legal entities. 7.Establish a funding strategy that provides useful diversification. 8. in effect manage intraday liquidity positions and risks to meet payment and settlement obligations. 9. Actively manage collateral positions. 10. Conduct stress tests on a regular basis. 11. Formal contingency funding plan (CFP) in case of emergency. 12. prolong a cushion of unencumbered, high quality liquid assets in case of stress scenarios. Public Disclosure 13. Publicly undo information on a regular basis The Role of Supervisors 14. Regularly serve a comprehensive assessment of a banks overall liquidity risk management framework. 15.Supplement point 14 by monitoring a gang of internal reports, prudential reports and market information. 16. Should throw in to require stiff and timely alterative action to address liquidity deficiencies. 17. Should communicate with other regulators e. g. central banks cooperation TO PIC 7 CORE PRINCIPLES OF EFFECTIVE BANKING SUPERVISION Overview * Most important global standard for prudential regulation and oversight. * Endorsed by vast volume of countries. * Provides benchmark against which supervisory regimes can be assessed. * 1995 Mexican and Barings Crises Lyon Summit in 1996 for G7 Leaders. 1997 chronicle drafted and endorsed at G7 meeting. Final version presented at annual meetings of World Bank and IMF in Hong Kong. * 1998 G-22 endorsed * 2006 Revision of the meaning Principles * 2011 Basel Committee mandates a major review, issues revised consultative paper. The magnetic core Principles (2006) * 25 minimum requirements that need to be met for an effective regulatory system. * May need to be supplemented by other measures. * seven-spot major groups * Framework for supervisory mandate Principle 1 * Licensing and structure Principles 2-5 * prudent regulations and requirements Principles 6-18 *Methods of ongoing banking supervision Principles 1 9-21 * Accounting and revealing Principle 22 * Corrective and alterative powers of supervisors Principle 23 * Consolidated and cross-border banking Principles 24-25. * Explicitly recognise * Effective banking supervision is essential for a strong economic environment. * Supervision seeks to ensure banks operate in a safe and sound manner and nail sufficient capital and reserves. * Strong and effective supervision is a public in force(p) and critical to financial stability. * While cost of supervision is high, the cost of poor supervision is even higher. Key objective of banking supervision * Maintain stability and confidence in the financial system * Encourage rock-steady corporate governance and recruit market transparency Revised stub Principles (2011) * Core Principles and assessment methodology merged into a single document. * Number of core principles increase to 29. * Takes account of several key trends and developments * imply to deal with generalally important b anks * Macroprudential focus (system-wide) and systemic risk * Effective crisis management, recovery and occlusion measures. Sound corporate governance * greater public disclosure and transparency enhance market discipline. * Two broad groups 1. supervisory powers, responsibilities and functions. Focus on effective risk-based supervision, and the need for early intervention and timely supervisory actions. Principles 1-13. 2. prudential regulations and requirements. Cover supervisory expectations of banks, emphasising the enormousness of good corporate governance and risk management, as well as form with supervisory standards. supervisory powers, responsibilities and functions 1.Clear responsibilities and objectives for each potence involved. Suitable legal framework. 2. Supervisor has operational independence, transparent processes, sound governance and fair to middling resources, and is accountable. 3. Cooperation and collaboration with domestic authorities and foreign supervis ors. 4. Permissible activities of banks is controlled. 5. Assessment of bank self-control structure and governance. 6. Power to review, reject and overthrow prudential conditions on any changes in ownership or controlling interests. 7. Power to approve or reject major acquisitions. 8.Forward-looking assessment of the risk profile of banks and banking groups. 9. Uses admit range of techniques and tools to implement supervisory approach. 10. Collects, reviews and analyses prudential reports and statistical returns. 11. Early address of grievous and unsound practices. 12. Supervises banking group on fused basis (including globally) 13. Cross-border sharing of information and cooperation. Prudential regulations and requirements 14. Robust corporate governance policies and processes. 15. Banks have a comprehensive risk management process, including recovery plans. 6. Set prudent and becharm capital adequacy requirements. 17. Banks have an passable credit risk management process. 18 . Banks have sufficient policies and processes for the early identification and management of problems assets, and maintain adequate provisions and reserves. 19. Banks have adequate policies re concentration risk. 20. Banks required to enter into any transactions with related parties on an arms aloofness basis. 21. Banks have adequate policies re country and transfer risk. 22. Banks have an adequate market risk management process. 23.Banks have adequate systems re interest rate risk in the banking book. 24. Set prudent and appropriate liquidity requirements. 25. Banks have an adequate operational risk management framework. 26. Banks have adequate internal controls to establish and maintain a properly controlled operating environment for the bring of their business. E. g. delegating authority and responsibility, separation of the functions that involve committing the bank. 27. Banks maintain adequate and reliable records, bring up financial statements in accordance with score p olicies etc. 8. Banks regularly publish information on a unite and solo basis. 29. Banks have adequate policies and processes e. g. strict node due diligence. Preconditions for Effective Banking Supervision 1. furnish of sound and sustainable macroeconomic policies. 2. A well established framework for financial stability policy formulation. 3. A well developed public infrastructure 4. A clear framework for crisis management, recovery and small town 5. An appropriate level of systemic protection (or public safety net) 6. Effective market discipline 001 IMF and World Bank breeding on Countries Compliance with Core Principles * 32 countries are pliant with 10 or few BCPs * Only 5 countries were assessed as fully compliant with 25 or more of the BCPs. * Developing countries less compliant than advanced economies. * Advanced economies generally accept more robust internal frameworks as defined by the preconditions 2008 IMF Study on BCP Compliance * Based on 136 complaisance asses sments. * Continued work needed on strengthening banking supervision in many jurisdictions, particularly in the area of risk management. much than 40% of countries did not conform to with the essential criteria of principles dealing with risk management, consolidated supervision and the abuse of financial services. * More than 30% did not possess the necessary operational independence to perform effective supervision nor have adequate ability to use their formal powers to take disciplinary action. * On average, countries in Western Europe demonstrated a much higher degree of compliance (above 90%) with BCP than their counterparts in other regions. * Africa and Western Hemisphere weak. Generally, high-income countries reflected a higher degree of compliance. TOPIC 8 CAPITAL ADEQUACY Overview * Adequate capital better able to withstand losses, provide credit through the business cycle and help promote public confidence in banking system. Importance of Capital adequacy * Absorb una nticipated losses and bear on confidence in the FI * Protect uninsured depositors and other stake blockers * Protect FI insurance notes and taxpayers * Protect deposit insurance owners against increases in insurance premiums * To acquire real investments in order to provide financial services e. . equity financing is very important. Capital Adequacy * Capital too low banks may be unable to make high level of losses. * Capital too high banks may not be able to make the most cost-effective use of their resources. Constraint on credit availability. Pre-1988 * Banks regulated using balance weather sheet measures e. g. ratio of capital to assets. * Variations between countries re definitions, required ratios and enforcement of regulations. * 1980s bank leverage increased, OBS derivatives trading increased. * LDC debt = major problem 1988 Basel Capital Accord (Basel I) * G10 agreed to Basel I Only covered credit risk * Capital / risk-adjusted assets 8% * stage 1 capital = sharehold ers equity and retained earnings * degree 2 capital = additional internal and external resources e. g. loan loss reserves * Tier 1 capital / risk-adjusted assets 4% * On-balance-sheet assets assigned to one of four categories * 0% cash and government bonds * 20% claims on OECD banks * 50% residential mortgages * 100% corporate loans, corporate bonds * Off-balance-sheet assets divided into contingent or guarantee contracts and FX/IR forward, futures, option and swap contracts. Two step process (i) infer credit equivalent amounts as product of FV and conversion factor then (ii) multiply amount by risk weight. * OBS market contracts or derivative instruments = potential exposure + current exposure. * Potential exposure credit risk if counterparty defaults in the future. * Current exposure cost of replacing a derivative securities contract at todays prices. 1996 Amendment * Implemented in 1998 * Requires banks to measure and hold capital for market risk. * k is a increasing fact or chosen by regulators (at least 3) VaR is the 99% 10-day value at risk SRC is the specific risk charge Total Capital = 0. 08 x Credit risk RWA + Market risk RWA where market risk RWA = 12. 5 x k x VaR + SRC Basel II (2004) * Implemented in 2007 * Three pillars 1. New minimum capital requirements for credit and operational risk 2. Supervisory review more thorough and same 3. Market discipline more disclosure * Only applied to large outside(a) banks in US * Implemented by securities companies as well as banks in EU Pillar 1 minimum Capital Requirements * Credit risk measurement * Standardised approach (external credit rating based risk weights) * Internal rating based (IRB) Market risk = unvaried * Operational risk * Basic indicant 15% of gross income * Standardised multiplicative factor for income arising from each business line. * Advanced measurement approaches assess 99. 9% flog case loss over one year. * Total capital = 0. 08 x Credit risk RWA + market risk RWA + Operatio nal risk RWA Pillar 2 Supervisory refresh * Importance of effective supervisory review of banks internal assessments of their overall risks. Pillar 3 Market discipline * Increasing transparency public disclosure Basel 2. 5 (Implemented 2011) * Stressed VaR for market risk * incremental risk charge Ensures products such as bonds and derivatives in the trading book have the same capital requirement that they would if they were in the banking book. * Comprehensive risk measure (re credit default correlations) Basel III (2010) * Considerably increase quality and quantity of banks capital * Macroprudential get over systemic risk * Allows time for still transition to new regime * Core capital only retained earnings and common shares * Reserves increased from 2% to 4. 5% * Capital conservation buff 2. 5% of RWA * Countercyclical capital airplane pilot * analyze/monitoring of liquidity funding Introduction of a maximum leverage ratio Capital Definitions and Requirements * Common eq uity 4. 5% of RWA * Tier 1 6% of RWA * Phased implementation of capital levels stretching to Jan 1, 2015 * Phased implementation of capital definition stretching to Jan 1, 2018 Microprudential Features * Greater focus on common equity * Loss-absorbing during stress/crisis period capital conservation airplane pilot * Promoting integrated management of market and counterparty credit risk. * Liquidity standard introduced introduced Jan 1, 2015 Introduced Jan 1, 2018 Available Stable Funding FactorsRequired Stable Funding Factors Macroprudential Factors * Countercyclical buffer * Acts as a brake in good times of high credit growth and a decompressor to restrict credit during downturns. * Within a range of 0-2. 5% * Left to the discretion of national regulators * Dividends limit when capital is below required level * Phased in between Jan 1, 2016 Jan 1, 2019 * Leverage ratio * Target 3% * Ratio of Tier 1 capital to total exposure 3% * Introduced on Jan 1, 2018 after a transition p eriod * SIFIs * Required to hold additional loss absorbency capital, ranging from 1-2. 5% in common equity