# Bank6003 Notes

BANK6003 Final Exam Notes TOPIC 4A: Credit Risk – Estimating Default Probabilities Overview * Theory of credit risk less developed than VaR based models of market risk. * Much less amenable to precise measurement than market risk – default probabilities are much more difficult to measure than dispersion of market movements. * Measurement on individual loans is important to FI for pricing and setting limits on credit risk exposure. Default Risk Models 1. Qualitative Models * Assembling relevant information from private and external sources to make a judgement on the probability of default. Borrower specific factors (idiosyncratic or specific to individual borrower) include: reputation, leverage, volatility of earnings, covenants and collateral. * Market-specific factors (systematic factors that impact all borrowers include): business cycle and interest rate levels. * FI manager weighs these factors to come to an overall credit decision. * Subjective 2. Credit Scoring Models * Quantitative models that use data on observed borrower characteristics to calculate a score that represents borrower’s probability of default or sort borrowers into different default risk categories.
Payoff in a CDS does not include accrued interest on the bond that is delivered (negative direction) 5. Restructuring clause in a CDS contract may lead to a payoff when there is no default (positive direction) 6. LIBOR is greater than the risk-free rate assumed (positive direction) Estimating Default Probabilities from Credit Spreads * Average hazard rate between time zero and time t * s(t) = credit spread, t = maturity, R = recovery rate * s = 240bps, R = 0. 40, hazard rate = 0. 04 = 4% Real World vs Risk-Neutral Default Probabilities * Real world = backed out of historical data Risk-neutral = backed out of bond prices or credit default swap spreads * Produce very different results. Why? * Corporate bonds are relatively illiquid * Subjective default probabilities of bond traders may be much higher than the estimates from Moody’s historical data * Bonds do not default independently of each other. This leads to systematic risk that cannot be diversified away. * Bond returns 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 VaR and scenario analysis. Use risk-neutral for valuing for credit derivatives and PV of cost of default Option Models * Based on the idea that equity prices can provide more up-to-date information for estimating default probabilities. * Employ option pricing methods e. g. KMV. * Used by many of the largest banks to monitor credit risk. Merton’s Model * 1974 – company’s 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 required * Option pricing model enables value of a firm’s equity today to be related to the value of its assets today and the volatility of its assets.

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Volatilities * Equation together with the option pricing relationship enables value and volatility of assets to be determined from value and volatility of equity. Example * Company equity = \$3m * Volatility of equity = 80% * Risk-free rate is 5% * Debt = \$10m * Time to debt maturity = 1 year * Value 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 * Expected loss 1. 2% * Recovery rate 91% Use of Merton’s Model to estimate real-world default probability (e. g. Moody’s KMV) * Choose time horizon Calculate cumulative obligations to time horizon (D) * Use Merton’s model to calculate a theoretical probability of default * Use historical data to develop a one-to-one mapping of theoretical probability into real-world probability of default. * Distance to default TOPIC 4B: Credit Value at Risk Background * Credit risk is the risk of loss over a certain time period that will not be exceeded with a certain confidence level. * Calculate credit risk to determine both regulatory capital and economic capital. * Time horizon for credit risk VaR is often longer than that for market risk. Market risk usually one-day time horizon and then scaled up to 10 days for the calculation of regulatory capital. * Credit risk VaR, for instruments that are not held for trading, is usually calculated with a one-year time horizon/ * Historical simulation is the main tool used to calculate market risk VaR, but a more elaborate model is usually necessary to calculate credit risk VaR. * Key aspect is credit correlation. Defaults (or downgrades or credit spread changes) for different companies do not happen independently of each other. * Credit correlation increases risks for a financial institution with a portfolio of credit exposures.
Capital charge for each line is calculated by multiplying its gross income by the denoted beta. Total capital charge: KTSA= (GI1-8 ? ?1-8) To qualify for use of this approach, a bank must satisfy, at a minimum: – Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework – It has an operational risk management system that is conceptually sound and implemented with integrity. – It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas. 3.
Advanced Measurement Approach (AMA) * Regulatory capital requirement is determined using the quantitative and qualitative criteria for the AMA. * Banks can only use this approach if their local regulators/supervisory authorities have provided approval. * Qualitative Standards 1. Bank must have independent operational risk management function that is responsible for the design and implementation of banks’ operational risk management framework. 2. Bank’s internal operational risk measurement system must be closely integrated into the day-to-day risk management processes of the bank. 3.
There must be regular reporting of operational risk exposures and loss experience to business unit management, senior management, and to the board of directors. 4. Bank’s operational risk management system must be well documented. 5. Internal and/or external auditors must perform regular reviews of the operational risk management processes & measurement systems. * Quantitative Standards 1. Banks must demonstrate that its approach captures potentially 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 internal data, relevant external data, scenario analysis and factors reflecting the business environment and internal control systems. Distributions important in estimating potential operational 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 far as possible. One possibility is to assume a Poisson distribution: only need to estimate an average loss frequency. 2. Loss severity distribution * Distribution of the size 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 Data Operational risk losses have not been recorded as well as credit risk losses * Important losses are low-frequency high-severity losses * Loss frequency should be estimated from internal data 2. External Data * Data sharing or data vendors * Data from vendors: * Based on publicly available 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 Control Factors * Takes account of: * Complexity of business line * Technology used * Pace of change * Level of supervision * Staff turnover rates Power Law * Prob (v > x) = Kx-a * Power law holds well for the large losses experienced by banks. * When loss distributions are aggregated, the distribution with the heaviest tails tends to dominate. This means that the loss with the lowest alpha defines the extreme tails of the total loss distribution. Insurance * Important decision re operational risk is the extent to which it should be insured against.
Moral Hazard * Risk that the existence 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 security measures – making a robbery more likely than it would otherwise have been. * Solution * 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 good 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 * Sarbanes-Oxley Act 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 being assessed and handled well. * Gives the SEC the power to censure the board or give it additional responsibilities. A company’s auditors are not allowed to carry out any significant non-auditing services. * Audit committee of the board must be made aware of alternative accounting treatments. * CEO and CFO must return bonuses in the event that financial statements are restated. TOPIC 6: LIQUIDITY RISK Overview * Liquidity 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 Liquidity Risk * Liquidity trading risk – markets can become illiquid very quickly.
Cannot unwind asset position at a fair price fire sale prices. * Liquidity funding risk – risk of being unable to service cash flow obligations. Liquidity needs are uncertain. Liquidity Trading Risk * Price received for an asset depends on: * The mid market price * How much is to be sold * How quickly it is to be sold * 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.
Is Liquidity Improving? * Spreads are narrowing but arguably the risks of liquidity black holes 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 Management and Supervision (June 2008) * GFC regulators responded by undertaking a fundamental review of existing guidance of liquidity management and issued a revised set of principles on how banks should manage liquidity. Fundamental Principle for the Management and Supervision of Liquidity Risk 1.
Sound management of liquidity risk – robust risk management framework. Governance of Liquidity Risk Management 2. Clearly 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 projecting 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 effective diversification. 8. Effectively 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. Maintain a cushion of unencumbered, high quality liquid assets in case of stress scenarios. Public Disclosure 13. Publicly disclose information on a regular basis The Role of Supervisors 14. Regularly perform a comprehensive assessment of a bank’s overall liquidity risk management framework. 15.
Supplement point 14 by monitoring a combination of internal reports, prudential reports and market information. 16. Should intervene to require effective and timely remedial action to address liquidity deficiencies. 17. Should communicate with other regulators e. g. central banks – cooperation TOPIC 7: CORE PRINCIPLES OF EFFECTIVE BANKING SUPERVISION Overview * Most important global standard for prudential regulation and supervision. * Endorsed by vast majority of countries. * Provides benchmark against which supervisory regimes can be assessed. * 1995: Mexican and Barings Crises Lyon Summit in 1996 for G7 Leaders. 1997: Document 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 Core Principles * 2011: Basel Committee mandates a major review, issues revised consultative paper. The 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 major groups * Framework for supervisory authority – Principle 1 * Licensing and structure – Principles 2-5 * Prudential regulations and requirements – Principles 6-18 *
Methods of ongoing banking supervision – Principles 19-21 * Accounting and disclosure – Principle 22 * Corrective and remedial 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 hold sufficient capital and reserves. * Strong and effective supervision is a public good 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 good corporate governance and enhance market transparency Revised Core Principles (2011) * Core Principles and assessment methodology merged into a single document. * Number of core principles increased to 29. * Takes account of several key trends and developments: * Need to deal with systemically important banks * Macroprudential focus (system-wide) and systemic risk * Effective crisis management, recovery and resolution 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 importance of good corporate governance and risk management, as well as compliance with supervisory standards. Supervisory powers, responsibilities and functions 1.
Clear responsibilities and objectives for each authority involved. Suitable legal framework. 2. Supervisor has operational independence, transparent processes, sound governance and adequate resources, and is accountable. 3. Cooperation and collaboration with domestic authorities and foreign supervisors. 4. Permissible activities of banks is controlled. 5. Assessment of bank ownership structure and governance. 6. Power to review, reject and impose 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 appropriate range of techniques and tools to implement supervisory approach. 10. Collects, reviews and analyses prudential reports and statistical returns. 11. Early address of unsafe and unsound practices. 12. Supervises banking group on consolidated 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 appropriate capital adequacy requirements. 17. Banks have an adequate credit risk management process. 18. Banks have adequate 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 arm’s length basis. 21. Banks have adequate policies re country and transfer risk. 22. Banks have an adequate market risk management process. 23.
Required 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 restricted 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 period * SIFIs * Required to hold additional loss absorbency capital, ranging from 1-2. 5% in common equity

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