Bank6003 Notes

BANK6003 Final Exam Notes TOPIC 4A Credit assay Estimating failure Probabilities Overview * genuineisticness of confidence fortune slight positive than VaR base models of securities industry run a replication a chanceiness. * Much slight amenable to precise judgement than market chance scorn probabilities argon much to a greater extent ambitious to measure than statistical distri al one(a) ifion of market movements. * bill on individual loans is big to FI for pricing and conniption limits on extension jeopardy exposure. Default Risk Models 1. Qualitative Models * assemblage relevant development from private and external sources to mold a nonion on the opportunity of slackness. Borrower specific reckons (idiosyncratic or specific to individual borrower) embroil reputation, supplement, volatility of earnings, covenants and col juvenileral. * market-specific factors ( ashesatic factors that impact both borrowers include) patronage cycle and int erest roll take aims. * FI administerr weighs these factors to come to an boilersuit denotation stopping point. * Subjective 2. Credit win Models * valued models that use information on observed borrower characteristics to report a score that re bows borrowers prospect of inadvertence or sort borrowers into variant nonpayment jeopardy categories.Linear Prob mogul Models (LPMs) * Econometric model to explain quittance experience on past/old loans. * Regression model with a dummy dep culminationent variable Z Z = 1 slackness and Z=0 no evasion. * Weakness no vouch that the estimated slight probabilities will always dis role model between 0 and 1 (theoretical flaw) Logit and Probit Models * developed to oercome weakness of LPM. * explicitly re fixed the estimated range of default probabilities to lie between 0 and 1. * Logit as meates chance of default to be logistically distri entirelyed. Probit assumes probability of default has a cumulative normal scattering f unction. Linear Discriminant Analysis * Derived from statistical technique called multivariate summary. * Divides borrowers into high or low-toned default take chances classes. * Altmans LDM = most famous model developed in the late 1960s. Z 1. 8 ( critical measure), there is a high chance of default. * Weaknesses * further considers cardinal extreme theatrical roles (default/no default). * Weights train not be nonmoving over clock. 3. newfound Credit Risk Evaluation Models Newer models yield been developed use fiscal theory and monetary market data to make inferences about default probabilities. * Most relevant for evaluating loans to large corpo respect borrowers. * realm of precise active continuing research by FIs. Credit Ratings * Ratings trade relatively infrequently accusative of evaluations constancy. * Only chance when there is reasonableness to believe that a long-term change in the companys ac assent entryworthiness has taken place. * S&P AAA, A A, A, BBB, BB, B and CCC * Moodys Aaa, Aa, A, Baa, Ba, B and Caa Bonds with evaluates of BBB and above ar considered to be investment grade Estimating Default Probabilities 1. Historical Data * beard by rating agencies e. g. cumulative average default rates * If a company starts with a * Good character reference rating, default probabilities t ending to ontogeny with time. * Poor credit rating, default probabilities tend to falloff with time. * Default Intensity vs Unconditional Default Probability * Default strength or hazard rate is the probability of default conditional on no earlier default. * Unconditional default probability is the probability of default as seen at time zero. Default intensities and unconditional default probabilities for a Caa rated company in the third family * Unconditional default probability = Caa defaulting during the tertiary socio- scotch class = 39. 709 30. 204 = 9. 505% * Probability that Caa will survive until the end of year 2 = 100 30. 204 = 69. 796%. * Probability that Caa will default in 3rd year conditional on no earlier default = 0. 09505/0. 69796 = 13. 62% recovery Rate * Usually defined as the charge of the trammel net 30 days after default as a sh be of its suit time value. * Recovery rate % = 1 LGD% * Ranking of beats * superior Secured * Senior Unsecured Senior Subordinated * Subordinated * Junior Subordinated Credit Default Swaps * Instrument that is very useful for estimating default probabilities is a CDS. * buyer of the amends obtains the right to grass stick withs issued by the company for their t cardinal value when a credit shell occurs and the seller of the policy agrees to buy the bonds for their face value when a credit event occurs. * The total value of the bonds that cig bet be exchange is k straight off as the CDS notional principal. * totality amount paid per year, as a percent of the notional principal, to buy certificate is cognise as the CDS out disperse. Buyer of th e instrument acquires bulwark from the seller against a default by a particular company or country (the reference entity) * utilisation buyer pays a premium of 90bps per year for $100m of 5-year protection against company X. * Premium is know as the credit default spread. It is paid for the life of contract or until default. * If there is a default, the buyer has the right to sell bonds with a face value of $100m issued by company X for $100m. * Payments argon unremarkably do quarterly in arrears * In the event of default, there is a final examination accrual payment by the buyer * Attractions of the CDS market Allows credit guesss to be traded in the same way as market stakes * wad be employ to transfer credit jeopardys to a third party * Can be utilise to diversify credit peril Credit Indices * true to track credit default swap spreads. * Two important specimen portfolios argon * CDX NA IG, portfolio of 125 investment grade companies in trades union America * iTrax x Europe, portfolio of 125 investment grade companies in Europe * Updated on March 20 and September 20 apiece year. * Example * 5 year CDX NA IG index is bid 165bp, toss 166bp. Quotes signify that a trader base buy CDS protection on all 125 companies in the index for 166 basis points per company. * Suppose an investor wants $800,000 of protection on to each one company. * The total approach shot is 0. 0166 x 800,000 x 125 = $1,660,000. * When a company defaults, the investor receives the usual CDS way out and the annual payment is reduced by 1,660,000/125 = $13,280. * Index is the average of the CDS spreads on the companies in the aboriginal portfolio. physical exercise of Fixed Coupons * Increasingly CDS and CDS indices trade like bonds so that the plosiveic protection payments remain fixed. A coupon and a retrieval rate is specified. * Quoted spread coupon, buyer of protection makes an sign payment. * Quoted spread coupon, seller of protection makes an initial payme nt. Credit get arounds * Extra rate of interest required by investors for manner a particular credit assay. CDS breaks and Bond Yields * CDS toilet be utilise to hedge a position in a bodily bond. * Example investor buys a 5-year corporate bond consequenceing 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 spread is 2% p. . Effect of the CDS is to convert the corporate bond to a risk-free 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 risk-free rate for the remainder of the five years. The Risk-Free Rate * The risk-free rate used by bond traders when quoting credit spreads is the Treasury rate. * Traditionally used LIBOR/swap rate * Normal market conditions risk free rate is 10bp less than the LIBOR/swap * Stressed conditions, the gap is much hi gher Asset Swaps Provide a direct estimate of the scanty of a bond yield over the LIBOR/swap rate. * Example plus swap spread for a particular bond is quoted as 150 basis points. 3 possible situations 1. Bond sells for its par value of 100. play along A pays the coupon and Company B pays LIBOR plus 150bp. 2. Bond sells downstairs par, rank 95. Company A pays $5 per $100 of principal at the outset. afterwards that, Company A pays the coupon and Company B pays LIBOR plus 150bp. 3. Bond sells above par, say 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 asset swap spread is the present value of the damage of default. CDS-Bond Basis * CDS-Bond Basis = CDS spread minus the bond yield spread * Bond yield spread is normally considerd as the asset swap spread * Should be close to zero, but there are a number of reasons why it deviates 1. Bond may sell for a pr ice pregnantly several(predicate) from par (above par = positive basis, below par = negative basis) 2. There is counterparty risk in a CDS (negative watchfulness) 3. There is a cheapest-to-deliver bond choice in a CDS (positive direction) 4.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 anticipate (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% sure human race vs Risk-Neutral Default Probabilities * Real world = backed out of historic data Risk-neutral = backed out of bond prices or credit default swap spreads * Produce very different results. Why? * Corporate bonds are relatively illiquid * S ubjective default probabilities of bond traders may be much higher than the estimates from Moodys historical data * Bonds do not default nonsymbioticly of each separate. This leads to remainsatic risk that cannot be change away. * Bond returns are highly skewed with limited upside. The non- establishmentatic 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 differential gears and PV of constitute of default Option Models * ground on the idea that rightfulness prices can generate more up-to-date information for estimating default probabilities. * Employ natural selection pricing methods e. g. KMV. * Used by many of the largest bounds to monitor credit risk. Mertons Model * 1974 companys equity is an resource on the assets of the company. * fair-mindedness value at time T as max(VT D, 0) * VT is value of the profligate * D is the debt repayment r equired * Option pricing model enables value of a firms equity today to be link up to the value of its assets today and the volatility of its assets.Read also Recording command Fund Operating Budget and Operating TransactionsVolatilities * 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 * anticipate prejudice 1. 2% * Recovery rate 91% Use of Mertons Model to estimate real-world default probability (e. g. Moodys KMV) * Choose time panorama deem cumulative obligations to time horizon (D) * Use Mertons 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 passage over a certain time period that will not be lapseed with a certain confidence level. * Calculate credit risk to determine both regulatory hood and economic crown. * Time horizon for credit risk VaR is often longer than that for market risk. Market risk usually one-day time horizon and then(prenominal) scaled up to 10 days for the calculation of regulatory enceinte. * Credit risk VaR, for instruments that are not held for transaction, 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 different. * Credit cor relation increases risks for a financial institution with a portfolio of credit exposures.Introduction * Internal economic capital allocations against credit risk are found on sticks estimate of their portfolios probability engrossment function of credit losings. * Probability of credit losings exceeding about level, say X, is equal to the shaded field 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 terminationes will be substantially larger than expected sackes. * Target insolvency rate = shaded area under PDF to right of X * Allocated economic capital = X expected credit passing playes Expected vs Unexpected Credit deviation Expected = amount of credit loss expected on credit portfolio over the chosen time horizon * Unexpected = amount by which actual credit losings exceed expected credit loss. Economic roof Allocation * Economic capital = estimated capital required to support credit risk exposure. * Process is akin to VaR methods used for allocation of capital for market risk. * Probability of out of the blue(predicate) credit loss exhausting economic capital is less than the money boxs chump insolvency rate. * Target insolvency rate usually consistent with sought after credit rating. * AA rating implies a 0. 3% chance of default. Need liberal economic capital to be 99. 97% certain that credit losses will not cause insolvency. * Based on two inputs 1. cants target insolvency rate 2. Banks estimated PDF for portfolio credit losses * Two banks with identical portfolios could take 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 losses * Credit loss = current value prox value at the end of some time horizon. Precise definition of current/ succeeding(a) values cont ingent on specific credit loss paradigm. * modern gene dimensionn of credit risk models employ either of two conceptual paradigms 1. Default-Mode (DM) Paradigm * Most common. * Credit loss arises only if default occurs inside the time horizon. * Two-state model only two outcomes, default and non-default. * If borrower defaults, credit loss = banks credit exposure present value of future net recoveries (cash payments less workout expenses). * Current values are known but future values are uncertain. Estimate joint probability distribution with respect to 3 types of random variables 1. Associated credit exposure 2. index number denoting whether facility defaults during planning horizon 3. In the event of default, the loss granted default (LGD). Unexpected losses approach * Assumption that PDF is well-approximated by hold still for and banal 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 key out 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 boilers suit portfolio 2. Mark-to-Market (MTM) Paradigm * Credit loss can arise in rejoinder to decline in credit risk smell. * Multi-state model default is only one of several possible credit ratings a loan could reincarnate to over the horizon. * Credit portfolio marked to market at the beginning and end of planning horizon. Likelihood of a customer migrating from its current risk rating to any other category inwardly the planning horizon is typically expressed in terms of a rating inflection matrix. language = current rating Column = prob of migrating to another risk grade * Gordian e stimation need to estimate credit risk mig symmetryns at end of horizon as well as future credit spreads (risk-premium associated with end-of-period credit rating). * Two approaches 1. Discounted contractual cash flow (DCCF) approach 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. * border ones differ mainly in how discount factors and yield spreads are estimated or calculated. TOPIC 5 OPERATIONAL RISK Overview * Definition the risk of loss resulting from in satisfactory of failed versed processes, people and systems or from external events. * Harder to quantify and manage unattached risk than credit or market risk. * FIs make a conscious finale to take a certain amount of credit and market risk but practicable risk is a necessary part of doing business. usable risk has dumbfound a more significant issue as a result of * increase use of highly automated a pplied science and sophisticated 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 working(a) loss events exceeding USD 100m since the end of the eighties * Internal fraud * External fraud * Employment practices and workplace preventative * Clients, products and business practices * Damage to physical assets * Business disruption and system failures Execution, oral communication and process focusing Regulatory Capital for Operational Risk * triple methods which represent a continuum of approaches characterised by increasing sophistication and risk aesthesia 1. sanctioned Indicator Approach (15% of gross income) 2. interchangeable Approach (different % for each business line) 3. Advanced Measurement Approach 1. Basic Indicator Approach * KBIA=GI ? ? GI = average annual gross income (net interest income + non-interest income) ? = 15% 2. Standardised Approach Ban k activities divided into 8 business lines.Capital cathexis 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 essential(prenominal) satisfy, at a minimum Its mesa of directors and aged commission, as appropriate, are actively involved in the oversight of the operational risk guidance framework It has an operational risk management system that is conceptually ponderous and implemented with integrity. It has sufficient resources in the use of the approach in the study business lines as well as the control and audit areas. 3.Advanced Measurement Approach (AMA) * Regulatory capital requirement is determined using the valued and qualitative criteria for the AMA. * Banks can only use this approach if their local regulators/supervisory governance have provided approval. * Qualitative Standards 1. Bank must have independent operational risk management function t hat is trustworthy for the design and capital punishment of banks operational risk management framework. 2. Banks inborn operational risk measurement system must be closely structured 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. Banks operational risk management system must be well documented. 5. Internal and/or external auditors must perform regular recapitulations of the operational risk management processes & measurement systems. * Quantitative Standards 1. Banks must demonstrate that its approach captures authorisationly 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 grainy to capture the study drivers of operational risk. 4. Operational risk measurement system must include the us e of internal data, relevant external data, scenario analysis and factors reflecting the business environment and internal control systems. dispersals important in estimating potential operational risk losses 1. Loss relative 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 Com mittee 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 share or data vendors * Data from vendors * Based on overtly 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 start 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 * complexness of business line * Technology used * Pace of change * take aim of oversight * Staff turnover rates origin Law * Prob (v x) = Kx-a * occasion law holds well for the large losses experienced by banks. * When loss distributions are aggrega ted, the distribution with the heaviest tails tends to dominate. This means that the loss with the lowest of import 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 estimate * Risk that the existence of the indemnification contract will cause the bank to behave differently than it otherwise would. * Example a bank insures itself against robberies. As a result of the policy policy, it may be tempted to be at large(p) 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 risk s. * 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 companys auditors are not allowed to carry out any significant non-auditing services. * Audit military commission of the board must be made aware of alternative story treatments. * CEO and CFO must return bonuses in the event that financial statements are restated. TOPIC 6 LIQUIDITY RISK Overview * liquid state 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 runniness Risk * runniness barter 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 legitimate 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.Proportional bid-offer spread= Offer price-bid priceMid-market price * Cost of liquidation 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 unhappy conditions. * Cost of liquidation in varianted markets i=1n12(? i+ i)? i * Mean an d SD, lambda is required confidence level Liquidity Adjusted 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 patronage Risk * Sources of liquidity * Liquid assets * Ability of liquidate trading positions (funding risk and trading risk are inter tie in) * Wholesale and retail deposits * Lines of credit and the ability to borrow at short notice * Securitisation * Central bank borrowing (lender of last resort) Basel III Regulation * Liquidity Coverage proportionality intentional to make sure that the bank can survive a 30 day period of acute stress * Net horse barn 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. optimistic and Negative 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 further losses. * changing 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 Del everaging CycleIs 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 meetings of investors are acting independently of each other. beliefs for Sound Liquidity Risk attention and supervision (June 2008) * GFC regulators responded by undertaking a hearty review of existing guidance of liquidity management and issued a rewrite 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 gamy risk management framework. Governance of Liquidity Risk Management 2. Cl azoic vocalize 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 oecumenically pr ojecting 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 impelling 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. bollock 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 banks overall liquidity risk management framework. 15.Supplement point 14 by monitor a faction of internal reports, prudential reports and market information. 16. Should intervene to require effective and well-timed(a) 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 bulk 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 cosmea Bank and IMF in Hong Kong. * 1998 G-22 endorsed * 2006 Revision of the Core Principles * 2011 Basel Committee mandates a study 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 potentiality Principle 1 * Licensing and structure Principles 2-5 * Prudential regulati ons and requirements Principles 6-18 *Methods of ongoing banking supervision Principles 19-21 * Accounting and manifestation Principle 22 * Corrective and remedial powers of supervisors Principle 23 * Consolidated and cross-border banking Principles 24-25. * Explicitly recognise * stiff 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 enhancer 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 tre nds 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 well timed(p) 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. Cooperat ion and collaboration with domestic authorities and foreign supervisors. 4. Permissible activities of banks is controlled. 5. Assessment of bank self-command 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. stout 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 defy 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 length 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 track record. 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 conduct of their business. E. g. delegating authority and responsibility, separation of the functions that involve committing the bank. 27. Banks maintain adequate and re liable records, prepare financial statements in accordance with accounting policies etc. 8. Banks regularly publish information on a consolidated and solo basis. 29. Banks have adequate policies and processes e. g. strict customer due diligence. Preconditions for Effective Banking Supervision 1. Provision 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 resolution 5. An appropriate level of systemic protection (or public safety net) 6. Effective market discipline 001 IMF and World Bank Study on Countries abidance with Core Principles * 32 countries are compliant 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 possess more robust internal frameworks as defined by the preconditions 2008 IMF Study on BCP Compliance * Based on 136 compliance assessments. * Continued work needed on strengthening banking supervision in many jurisdictions, particularly in the area of risk management. More than 40% of countries did not comply with the essential criteria of principles dealings 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 corrective 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 resist losses, provide credit through the business cycle and help farm public confid ence in banking system. Importance of Capital enough * realise unanticipated losses and preserve confidence in the FI * Protect uninsurable depositors and other stakeholders * Protect FI insurance funds 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 eat up high level of losses. * Capital too high banks may not be able to make the most efficient use of their resources. diffidence on credit availability. Pre-1988 * Banks regulated using balance 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 first derivatives trading increased. * LDC debt = major problem 1988 Basel Capital Accord (Basel I) * G10 agreed to Basel I Only covered credit risk * Ca pital / risk-adjusted assets 8% * layer 1 capital = shareholders equity and kept up(p) earnings * Tier 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 foursome 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) occur 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 * use in 1998 * Requires banks to measur e and hold capital for market risk. * k is a multiplicative factor 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 uniform 3. Market discipline more disclosure * Only applied to large international banks in US * Implemented by securities companies as well as banks in EU lynchpin 1 Minimum Capital Requirements * Credit risk measurement * Standardised approach (external credit rating based risk weights) * Internal rating based (IRB) Market risk = unchanged * Operational risk * Basic indicator 15% of gross income * Standardised multiplicative factor for income arising from each business line. * Advanced measurement approaches assess 99. 9% worst case loss over one year. * Total capital = 0. 08 x Credit risk RWA + market risk RWA + Operational risk RWA Pillar 2 Supervisory Review * 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 overlay systemic risk * Allows time for radiate transition to new regime * Core capital only retained earnings and common shares * Reserves increased from 2% to 4. 5% * Capital conservation buffer 2. 5% of RWA * Countercyclical capital buffer * Tracing/monitoring of liquidity funding Introduction of a maximum leve rage ratio Capital Definitions and Requirements * Common equity 4. 5% of RWA * Tier 1 6% of RWA * Phased implementation of capital levels stretchability 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 buffer * 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 quantify of high credit growth and a decompressor to restrict credit during downturns. * inwardly a range of 0-2. 5% * Left to the discretion of national regulators * Dividends curtail 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 tota l 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