The Microeconomic Foundations of Basel II - PowerPoint PPT Presentation

1 / 36
About This Presentation
Title:

The Microeconomic Foundations of Basel II

Description:

Minimum capital requirements cover credit risk and operational risk ... Base capital function reflects only default losses over a one-year horizon ... – PowerPoint PPT presentation

Number of Views:94
Avg rating:3.0/5.0
Slides: 37
Provided by: m1e2
Category:

less

Transcript and Presenter's Notes

Title: The Microeconomic Foundations of Basel II


1
The Microeconomic Foundations of Basel II
  • Erik Heitfield
  • Board of Governors of the Federal Reserve
    System20th and C Street, NWWashington, DC 20551
    USAErik.Heitfield_at_frb.gov

The views expressed in this presentation are my
own, and nod not necessarily reflect the opinions
of the Federal Reserve Board or its staff.
2
  • How did we get from here
  • The new framework is intended to align
    regulatory capital requirements more closely with
    underlying risks, and to provide banks and their
    supervisors with several options for the
    assessment of capital adequacy.
  • -- William McDonough
  • to here?

3
Todays Talk
  • The Basel Capital Accords
  • The asymptotic-single-risk-factor framework
  • The advanced-internal-ratings-based capital
    function
  • Asset correlation assumptions
  • Adjustment for maturity effects
  • Application the treatment of credit derivatives
    and financial guarantees

4
The Basel Capital Accords
5
Basel I
  • Signed by members of the Basel Committee on
    Banking Supervision in 1988
  • Establishes two components of regulatory capital
  • Tier 1 book equity, certain equity-like
    liabilities
  • Tier 2 subordinated debt, loan loss reserves
  • Weighs assets to broadly reflect underlying risk
  • Capital divided by risk-weighted assets is called
    the risk-based capital ratio
  • Basel I imposes two restrictions on risk-based
    capital ratios
  • 4 minimum on tier 1 capital
  • 8 minimum on total (tier 1 tier 2) capital

6
Basel II
  • Goal to more closely align regulatory capital
    requirements with underlying economic risks
  • Timeline
  • Work begun in 1999
  • Third quantitative impact study completed in
    December 2002
  • Third consultative package released for comment
    in May 2003
  • Completion targeted for early 2004

7
Basel II Three Pillars
  1. Minimum capital requirements cover credit risk
    and operational risk
  2. Supervisory standards allow supervisors to
    require buffer capital for risks not covered
    under Pillar I
  3. Disclosure requirements are intended to enhance
    market discipline

8
Credit Risk Capital Charges
  • Basel II extends the risk-based capital ratio
    introduced in Basel I
  • Risk weights will reflect fine distinctions among
    risks associated with different exposures
  • Three approaches to calculating risk weights
  • Standardized approach
  • Foundation internal-ratings-based approach
  • Advanced internal-ratings-based approach

9
Advanced IRB Approach
  • Risk-weight functions map bank-reported risk
    parameters to exposure risk weights
  • Bank-reported risk parameters include
  • Probability of default (PD)
  • Loss given default (LGD)
  • Maturity (M)
  • Exposure at default (EAD)
  • Risk-weight functions differ by exposure class.
    Classes include
  • Corporate and industrial
  • Qualifying revolving exposures (credit cards)
  • Residential mortgages
  • Project finance

10
The Asymptotic Single Risk Factor Framework
11
Value-at-Risk Capital Rule
  • Portfolio is solvent if the value of assets
    exceeds the value of liabilities
  • Set K so that capital exceeds portfolio losses at
    a one-year assessment horizon with probability a

12
Decentralized Capital Rule
  • The capital charge assigned to an exposure
    reflects its marginal contribution to the
    portfolio-wide capital requirement
  • The capital charge assigned to an exposure is
    independent of other exposures in the bank
    portfolio
  • The portfolio capital charge is the sum of
    charges applied to individual exposures

13
The ASRF Framework
  • In a general setting, a VaR capital rule cannot
    be decentralized because the marginal
    contribution of a single exposure to portfolio
    risk depends on its correlation with all other
    exposures
  • Gordy (2003) shows that under stylized
    assumptions a decentralized capital rule can
    satisfy a VaR solvency target
  • Collectively these assumptions are called the
    asymptotic-single-risk-factor (ASRF) framework

14
ASRF Assumptions
  • Cross-exposure correlations in losses are driven
    by a single systematic risk factor
  • The portfolio is infinitely-fine-grained (i.e.
    idiosyncratic risk is diversified away)
  • For most exposures loss rates are increasing in
    the systematic risk factor

15
ASRF Capital Rule
  • The ?th percentile of X is
  • Set capital to the ?th percentile of L to ensure
    a portfolio solvency probability of ?
  • Plug the ?th percentile of X into c(x)

16
ASRF Capital Rule
  • Consider two subportfolios, A and B, such that L
    LA LB,
  • Capital can be assigned separately to each
    subportfolio.

17
The A-IRBCapital Formula
18
Merton Model
  • Obligor i defaults if its normalized asset
    return Yi falls below the default threshold ?.
  • where

19
Merton Model
  • The conditional expected loss function for
    exposure i given X is
  • Plugging the 99.9th percentile of X into ci(x)
    yields the core of the Basel II capital rule

20
Asset Correlations
  • The asset correlation parameter ? measures the
    importance of systematic risk
  • Under Basel II ? is hard wired
  • Asset correlation parameters were calibrated
    using data from a variety of sources in the US
    and Europe
  • For corporate exposures, ? depends on obligor
    characteristics
  • Asset correlation declines with obligor PD
  • SMEs receive a lower asset correlation

21
Maturity Adjustment
  • Base capital function reflects only default
    losses over a one-year horizon
  • The market value of longer maturity loans are
    more sensitive to declines in credit quality
    short of default
  • Higher PD loans are less sensitive to market
    value declines

22
Maturity Adjustment
  • Maturity adjustment function rescales base
    capital function to reflect maturity
    effects
  • b(PD) determines the effect of maturity on
    relative capital charges for a given PD
  • b(PD) is decreasing in PD
  • Note that K(PD,LGD,1) K(PD,LGD)

23
The A-IRB Capital Rule for Corporate Exposures
M 2.5LGD 45
24
The A-IRB Capital Rule
  • Basel II risk weight functions use a mix of
    bank-reported and supervisory parameters
  • Bank-reported parameters
  • Probability of default
  • Loss given default
  • Maturity
  • Exposure at default
  • Hard wired parameters
  • Asset correlations
  • Maturity adjustment functions
  • VaR solvency threshold

25
How should Basel II treat guarantees and credit
derivatives?
26
Credit Risk Mitigation
  • Banks can hedge the credit risk associated with
    an exposure
  • Financial guarantees
  • Single-name credit default swaps

Bank
Obligor
Guarantor
27
Substitution Approach
  • Basel II allows a bank that purchases credit
    protection to use the PD associated with the
    guarantor instead of that associated with the
    obligor
  • When PDgltPDo the substitution approach allows
    banks to receive a lower capital charge for
    hedged exposures
  • The substitution approach is not derived from an
    underlying credit risk model

28
Substitution Approach
LGD 45M 1
Unhedged
Guarantor PD1.00
Guarantor PD0.03
29
Substitution Approach
  • Shortcomings of the substitution approach
  • Provides no incentive to hedge high-quality
    exposures
  • Not risk sensitive for low-quality hedged
    exposures
  • Solution
  • The same ASRF framework used to derive capital
    charges for unhedged loans can be used to derive
    capital charges for hedged loans

30
ASRF/Merton Approach
  • A Merton model describes default by both the
    obligor (o) and the guarantor (g)
  • Two risk factors drive default correlations
  • X affects all exposures in the portfolio
  • Z affects only the obligor and the guarantor

31
ASRF/Merton Approach
  • Model allows for
  • Guarantors with high sensitivity to systematic
    risk
  • Wrong way risk between obligors and guarantors
  • Three correlation parameters

32
Joint Default Probabilities
Joint default probability is generally much lower
than either marginal default probability
?og 60
33
ASRF/Merton Approach
  • Plugging the 99.9th percentile of X into the
    conditional expected loss function for the hedged
    exposure yields an ASRF capital rule

34
ASRF/Merton vs. Substitution
  • ASRF provides incentive to hedge risk for all
    types of obligors
  • ASRF is more risk-sensitive for both high and low
    quality obligors and guarantors
  • ASRF may or may not generate lower capital
    charges than substitution

Unhedged
Guarantor PD1.00
Guarantor PD0.03
Unhedged
Guarantor PD1.00
Guarantor PD0.03
35
Summary
  • Basel II is intended to more closely align
    regulatory capital requirements with underlying
    economic risks
  • The ASRF framework produces a simple capital rule
    that
  • Achieves a portfolio VaR target
  • Is decentralized
  • Basel IIs IRB capital functions use a mix of
    bank-reported and hard wired parameters
  • The ASRF framework can be used to generate
    capital rules for complex credit exposures
  • Hedged loans
  • Loan backed securities

36
References
  • Basel Committee on Banking Supervision (2003),
    Third Consultative Paper http//www.bis.org/bcbs
    /bcbscp3.htm
  • Gordy, M. (2003), A risk-factor model foundation
    for ratings-based bank capital rules, Journal of
    Financial Intermediation 12(3), pp. 199-232
  • Heitfield, E. (2003), Using guarantees and
    credit derivatives to reduce credit risk capital
    requirements under the new Basel Capital Accord,
    in Credit Derivatives the Definitive Guide, J.
    Gregory (Ed.), Risk Books
  • Pykhtin, M. and A. Dev (2002), Credit risk in
    asset securitizations an analytical model, Risk
    May 2003, pp. 515-520
Write a Comment
User Comments (0)
About PowerShow.com