credit risk - standardised approach

Credit Risk - Standardised Approach

Belgian Bankers AcademyPrague, October 2005

2

Agenda

1. Introduction to Basle II• Scope of Application• Basel I and II• Overview of Minimum Capital Requirements• Standardised versus IRB Approach• Partial Use

2. Minimum Capital Requirements for Credit Risk: Standardised Approach• Exposure Classes• External Ratings and Risk Weights• Credit Risk Mitigation

• Guarantees and Credit Derivatives• Collateral

• Examples

3. Questions and Answers

3

Internationally active Banks

Basel

Banks within the European Union

EU

Range of application of the Basel framework in the Czech Republic

Banks in CzechRepublic

“CNB“

”Good Conduct” “Mandatory” “Mandatory”

4

The Basel Committee

• The BCBS was formed in 1974 by the Group of 10 central bank governors following the failure of West German bank Bankhaus Herstatt

• Committee members include representatives from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the U.K. and the U.S.

• From its inception, its primary mission has been to promote stability in the global banking system in the pursuit of two guiding principles

• No foreign banking system should escape supervision

• Supervision must be adequate for all banks operating internationally

• Its primary objective is to formulate standards, guidelines and best practices that individual authorities will implement

5

Regulatory Capital

Economic Capital≠

• Lack of differentiation within credit risk

• Limited recognition of risk mitigation instruments

• No explicit consideration of other risks

Deficiencies of the current regulatory framework (Basel I)

„Regulatory Arbitrage“

6

Concept of Basel II – Three pillar architecture

Qualitative assessment

SupervisoryReview-Process

• Fulfilment of qualitative requirements• Not fully captured risk• Risks not taken into account• External factors

Market-Discipline

Disclosure

• Approaches chosen by the bank• Relevant information

MinimumCapital requirements

Requirements

• Risk weighting/Rating• Risk mitigation• Operational risk

7

Basel 2 - Evolution

1960 1970 1980 1990 2000 2001 2002 2003 2005 20062004

3-6-3 principle

Liberalisation

1974: G10 launch Basel Committee

1988: Basel I Accord

1990: 100 countries apply Basel I

1996: Market riskJune/1999: CP1

Jan/2001: CP2

Apr&May: QIS1,2

Nov: QIS2,5

Oct: QIS3

May: Release of CP3

July: QIS3 resultspublished

June 2004: the new Accordpublished

Jan: start parallel run

Jan: Basel 2 comes in force

2007

8

Scope of Basel II framework

No general reduction of the capital level in the financial system

Promote safety and soundness in the financial system

Continue to enhance competitive equalityWhat?

Complete recognition of all types of risk

Orientation on the bank‘s individual risk profileHow?

Focus on internationally active banks

Principles suitable for application on smaller banksWho?

9

Pillar I

Pillar IPillar II Pillar III

Credit risk Securitization Operational Risk

SA IRB

FIRB AIRB

SA IRB BIA SAAMA

Exceptions RBA IAA SFA

10

Implementation schedule for Basel II

01.01.06 01.01.07 01.01.08 01.01.09 01.01.10

F-IRB (incl. Retail)

Advanced approaches for credit risk and/or operational risk

Parallel run Floor (95 %) Floor (90 %) Floor (80 %)

Parallel run

Standardised approach

Start of Basel II(Standardised and Foundation) Start of Basel II

(Advanced and AMA)

11

Implementation schedule for EU-Directives

01.01.06 01.01.07 01.01.08 01.01.09 01.01.10

F-IRB (incl. Retail)

Advanced approaches for credit risk and/or operational risk

Floor (95 %) Floor (90 %) Floor (80 %)

Basel I-weighting

Standardised approach

Start of Basel II(Standardised and Foundation) Start of Basel II

(Advanced and AMA)

12

Data history for IRB

Retail corporate,sovereigns,banks

PD

LGD

EAD

Basic requirement

Basic requirement

Transition Transition

5 Years 5 Years

5 Years

5 Years

2 Years

2 Years

2 Years

2 Years

7 Years

7 Years

7 Years

7 Years

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Calculation of minimum capital requirements

> 8%Risk weighted assets* + [(Market Risk + Operational Risk) x 12.5]

Regulatory Capital

• Definition of the regulatory capital

• Minimum total capital ratio of 8% to risk weighted assets

• Techniques for market risk assessment

No changes• Techniques for credit risk

assessment

• Operational Risk

• Capital elements within the IRB-Approach (shortfall/excess ofProvisions)

New

* For IRB-Part of RWA a Scaling Factor of 1.06 applies

14

Externally provided

Possible approaches for credit risk

CollateralGuaranteesCredit derivativesNetting

Externally providedNo limitation

No consideration**Exceptions: Option 2 Banks Orig. Mat. < 3M and Risk Mitigation/Haircuts

2.5 Y 1 - 5 Years

Calculation methods

Externally provided Externally provided

Externally provided Internal procedures

Externally provided

External/internal Haircuts

Option

Effort

Standardised Internal Ratings Based

Simple Comprehensive

Foundation AdvancedApproach

Risk weighting External ratingsInternal estimation

Externally provided

Maturity

15

Partial Use of IRB in the EU

• Exposure to Sovereigns, if number of relevant counterparties is limited and set-up of a rating system would be unnecessary burdensome

• Exposure to banks, if number of relevant counterparties is limited and set-up of a rating system would be unnecessary burdensome

• Exposure to non essential businesses, and exposure to small sized businesses (Participations <10% of own funds, if less then 10 participations<5%)

• Exposures to Central Governments (of originating Member States) and their instrumentalities (assuming the same risk profile)

• Intra Conglomerate exposure

• Participations with risk weight 0%

• Participations in Governmental framework programs for the benefit of specific sectors in the economy.

Permanent partial use is acceptable

16

Agenda




• Examples


17

EU: Standardized approach: exposureclasses

Exposure classes

1. Each exposure shall be assigned to one of the following exposure classes:(a) claims or contingent claims on central governments or central banks;(b) claims or contingent claims on regional governments or local authorities;(c) claims or contingent claims on administrative bodies and non-commercial undertakings;(d) claims or contingent claims on multilateral development banks;(e) claims or contingent claims on international organisations;(f) claims or contingent claims on institutions;(g) claims or contingent claims on corporates;(h) retail claims or contingent retail claims;(i) claims or contingent claims secured on real estate property;(j) past due items;(k) items belonging to regulatory high-risk categories;(l) claims in the form of covered bonds;(m) securitisation positions;(n) short-term claims on institutions and corporate;(o) claims in the form of collective investment undertakings (CIU);(p) other items. Article 79 and Annex VI

18

• For the purpose of capital requirement calculation, the exposure value is determined as follows:

• The conversion factor value for the off-balance item is• 100% for a “full risk” item (e.g. irrevocable bank guarantee)• 50% for a “medium risk” item (e.g. undrawn credit facility with maturity

over one year)• 20% for a “medium/low risk” item (e.g. letter of credit with goods as

collateral)• 0% for a “low risk” item (e.g. unconditionally cancelable credit facility)

• A detailed list of off-balance sheet items with corresponding conversion factors is introduced in Annex II.

EAD = Part of position in balance-sheet + Part of position off balance-sheet × Conversion factor

EAD assessment: General rule

19

Standardised approach Risk weighting

1 Assessment of Export credit agencies only for claims on sovereigns/central government2 Risk weighting corresponding to the sovereign risk weighting of the respective country3 Risk weighting corresponding to the individual banks4 Short term claims (original maturity < 3 months) get a one category more favourable risk weighting5 At national discretion, supervisory authorities may permit banks to risk weight all corporate claims at 100% without regard at external ratings6 For example, commercial paper

Claim

Sovereigns

Rating S&P and Export credit agencies1

Option 12

Option 23

Corporates5

Banks

AAA to AA- A+ to A- BBB+

to BBB- BB+ to B- Below B-“Unrated”

0% 20% 50% 100% 150% 100%

20%

20%

20%

50%50%

50% 100%

100%50%

100%

100%

150%

150%

150%

100%

100%

50%

AAA to AA- A+ to A- BBB+

to BB- Below BB- “Unrated”

Option 34 20% 20%320%3 50%3 150% 20%

1 2 3 4-6 7

Short term6 20% 100%50% 150%

A1 / P1 A2 / P2 A3 / P3 Others

Other position 100% Retail 75%

20

EU: Standardized approach

Credit quality steps

Exposure to Sovereigns

Method 11

Method 22Exposure to banks

2 3 4 5 6„Unrated“

20% 50% 100% 100% 150% 100%

50% 100%50% 100% 150% 50%

Method 33 20% 50%320%3 50%3 150% 20%

2 3 4 5-6 7

1

0%

20%

20%

1Minimum export insurancepremiums (MEIP)

50% 100% 100% 100% 150% 100%20%

Mortgage backed securities 20% 20%/50%4 20%/50%4 50% 100% 20%/50%410%

Exposure to Corporate 50% 100% 100% 150% 150% 100%20%Short term exposuresto banks/corporates 50% 100% 150% 150% 150%20%

Exposure to CIUS 50% 100% 100% 150% 150% 100%20%

Other exposures 100%

Retail 75%

Commercial real estate 50%

Housing credits 35%

1 (Option 1 in Basel II)2 Rating based Method ( Option 2 in Basel II)3 Short term option4 At discretion of the Regulator

Annex VI

21

Exposures to local governments, PSE, multilateral development banks and international organizations I

• Exposures to local governments and local authorities are treated as exposures to banks unless the national regulator has allowed them to be treated as exposures to sovereigns.

• Claims or contingent claims on administrative bodies and non-commercial undertakings (PSE – Public Sector Entities) are assigned RW = 100%, unless the national regulator has allowed them to be treated as exposures to institutions.

• Exposures to multilateral development banks and international organizations are treated as banks.

22

Exposures to local governments, PSE, multilateral development banks and international organizations II• The following banks and organizations are assigned RW = 0%:

• International Bank for Reconstruction and Development• International Finance Corporation• Inter-American Development Bank• Asian Development Bank• African Development Bank• Council of Europe Development Bank• Nordic Investment Bank• Caribbean Development Bank• European Bank for Reconstruction and Development• European Investment Bank• European Investment Fund• Multilateral Investment Guarantee Agency

• The following 3 international organizations also have a RW = 0%:• European Communities (EC)• International Monetary Fund (IMF)• Bank for International Settlements (BIS)

23

External Credit Assessment Institution (ECAI) ratings I

The national regulator has the discretion to assess the suitability of the External Credit Assessment Institution, ECAI, (but CEBS ruling)

Approval procedure

The criteria for approving an external agency (ECAI) by a regulator:• objectivity• independence• ongoing review• the resulting ratings meet the requirements for credibility and transparency

and are accepted by the market

General criteria

Annex VI part 2

24

External Credit Assessment Institution (ECAI) ratings II

The national EU regulator, with due consideration of the CEBS guidelines, has the authority to approve rating agencies.

The national regulator shall determine to which of the further specified credit quality steps (CQS) will be associated specific credit assessments of individual approved rating agencies. The result will be the mapping of risk weights (RW) to the determined grades.

Banks must use their selected ECAI and its ratings for all exposure types (no “cherry picking“).

Minimum annual disclosure of: • What ECAIs for what type of exposure• The procedure of the regulator to grant approval

Principles

Article 81 and following ones. Annex VI part 2 and Annex XII part 2 p.6

25

The higher oneTwo ratings with diverging risk weights

If two of the lowest ones are identical, that risk weight is the eligible

Rating.If not, the higher one of

the two ratings

More than two ratings with diverging risk weights

If several ECAIs rate the same debtor

Selection of Ratings

Annex VIII part 1 p. 10

26

Intra Group (Conglomerate) exposure

• The counterparty is a credit institution, Financial Holding Company, Financial institution, Asset Management Company under an acceptable Supervision.

• Both parties must be consolidating their balance sheets

• Share the same risk assessment, control and management

• Registered Office of the counterparty in the same Member State

• No substantial, legal or whatever impediment to transfer own funds between the counterparts

Requirements:

0%-at national discretion possible

article 80, paragraph 7

27

Standardised approach: Retail loans

Qualitative requirements:

Quantitative requirements:

Definition of a Retail portfolio• private individuals• smaller companies• ...

• Max single credit of €1 million• Sufficient diversification of the Retail

portfolio (Possibility: Max credit volume of 0.2% of total Retail Portfolio)

Capital relief: Standard risk weighting of 75%

article 79, paragraph 2

Possible problems: Credits higher than “1.01” mill. €

28

Commercial real estate

Claims secured by real estate

Risk weight for loans secured entirely by residential property/mortgages on residential real estate:

35%

Residential real estate

Exception

Risk weight for loans secured by commercial property/mortgages on commercial real estate:

In highly-developed and long-established markets:

• Min [50% of MV*; 60% of LV*]

• Loan amount minus Min [50% of MV*; 60% of LV*]

Principle

* Market value (MV) or lending value (LV) of the securing property

100%

100%

50%

Conditions (to be added):

• Losses resulting from commercial real estate loans, up to the lower value of either 50% of MV or 60% of LV, must be < 0.3% of the yearly outstanding loans

• Total losses from commercial real estate loans must be < 0.5% of the yearly outstanding loans

Risk weight

29

Units shares of CIUS

• If a rating exists for a unit share of a CIUS the table must be applied• High risk CIUS may bear a 150% risk weight

annex VI, part 1, p.71 and following

• CIUS Management company located in the EU

• Management company under an acceptable Regulator, exchange of info assumed

• Prospectus has info on asset composition and investment restrictions

• Annual reporting minimum

• Is it possible to assess the existing exposure, is it possible to determine an average exposure amount

• Risk weighting could be based on investment restrictions

• Third parties could be appointed to assess the risk exposure of the CIUS

At CIUS level: Determination of rating

Qualitative requirements

Base

30

Treatment of higher-risk assets

Other higher risk weights• Securitisation tranches rated between BB+ an BB- risk weighted at 350%• National supervisors may decide to apply a 150% or higher risk weight reflecting the higher

risks associated with some other assets, such as venture capital and private equity investments

1 Claims that are more than 90 days past due are not allowed to be allocated to the Retail portfolio if the granularitycriterion is used as evidence for a sufficient diversification

2 Fully secured by those forms of collateral that are not recognised as eligible credit risk mitigation techniques3 At national discretion

< 15% 15-20% 20-50% > 50%

Residential mortgage loans 100% 100% 50% 50%3

Other collateral2 150% 100% 100% 50%3

Other 150% 150% 100% 50%3

Specific provisionsLoans more than 90 days past due1

31

Off-balance sheet transactions

Risk weight dependent on:• Type of counterpart (sovereign/central bank, bank, corporate)• External rating of the counterpart

OTC-derivatives

• Irrevocable commitments with an original maturity of up to one year

• Commitments which can unconditionally be cancelled by the bank at any time

• Commitments which are automatically cancelled at any time as a result of a deterioration in the borrower’s creditworthiness, without any prior notice from the bank

Prin

cipl

e

0%

20%

• Irrevocable commitments with an original maturity longer than one year 50%

Credit conversionfactor

Creditcommitment

Exce

ptio

ns

32

Overview standardized approach risk weightings

<100%: if an acknowledged rating is available

150%: credits granted deferred > 90 daysExceptions

150%: high risk items

150%: bad rating

75%: Retail credits

50%: Commercial real estate mortgage backed credits

35%: Housing mortgages backed credits

Basic rate: 100%

33

Credit Risk Mitigation: General Provisions

• Institutions using both the standardized approach, or foundation IRB, may take into consideration the effect of Credit Risk Mitigation (CRM) during RW calculation.

• All possible credit risk mitigation methods must be legally enforceable in all relevant countries.

• In addition, institutions must ensure the efficiency of the entire process and address risks connected therewith.

• Institutions must always ensure compliance with minimum requirements for CRM procedures.

• If all defined requirements are met, the institution may decrease the value of RW or EL in compliance with CAD.

• No exposure with a CRM instrument may have a RW higher than an identical, but unprotected exposure.

• In cases when CRM has been incorporated in the calculation of RWA, the provision on CRM is not further applied.

34

Approach to credit risk mitigation

CollateralCredit derivatives

Netting(balance sheet items)

Risk mitigation techniques have developed considerably since the implementation of the original Accord

• Appropriate treatment of residual risks

• Reduction in the capital requirement

• Balance between accuracy and complexity

Principle:

Goals:

Instruments: Guarantees

35

Eligible collateral in the standardised approach - I

CollateralsSimple Approach Comprehensive Approach• Cash on deposit / Gold• Debt securities with credit quality step (CQS) not worse than

3 (or 4 for sovereigns)

• Debt securities issued by a bank without rating (restrictions apply)

• Equities and convertible bonds that are included in a main index

• CIUS / mutual funds (limited)

• All instruments of the simple approach• Equities and convertible bonds, which are not included

in a main index but are listed on a recognized exchange2

• CIUS / mutual funds (extended)2

• Issued by a bank• Listed on recognised exchange• Senior claim• No other issue of the issuer rated worse lower than „3“

(EU) or „BBB-, A3/P3“ (Basel)• No indication of rating deterioration• Sufficient liquidity

• Daily pricing• Investment only in eligible risk mitigation instruments

36

• Claims

• Deposits

• Central banks and sovereigns with lower risk weight than the counterparty

• Public sector (PSEs), banks and securities firms with a lower risk weight than the counterparty

• Multilateral development banks• International organizations (with a 0% RW)• Other entities with CQS 1 or 2• NOT! Guarantees issued by a retail client !

Eligible collateral in the standardisedapproach - II

Guarantees / Credit derivatives Netting

• Life Insurances• Cash lodged at other banks

Possibility to recognise:(as guarantees)

37

Risk weight

Conditions (to be added):Losses resulting from commercial real estate loans. up to the lower value of either 50% of MV or 60% of LV. must be < 0.3% of the yearly outstanding loansTotal losses from commercial real estate loans must be < 0.5% of the yearly outstanding loans

100%Loan amount minus Min [50% of MV*; 60% of LV*]

50%In highly-developed and long-established markets: Min [50% of MV*; 60% of LV*]

Exception

100%Risk weight for loans secured by commercial property/mortgages on commercial real estate:

Principle

Eligible collateral in the standardisedapproach - III

Commercial real estate

Risk weight for loans secured entirely by residential property/mortgages on residential real estate: 35%

Residential real estate

38

Qualitative requirements for financial collateral

• Legal certainty• Low correlation with exposure• Robust risk management process

• Strategy• Focus on underlying credit• Valuation• Policies. procedures. systems• Concentration risks• Roll-off risks

• Disclosure of information under Pillar III

Annex VIII, Part 2

39

Minimum requirements for guarantees and derivatives

• Unrestricted exposure enforcement to guarantors and coverage providers

• Unconditional coverage / Irrevocable commitment

• No unilateral cancellation of commitment of coverage provider possible

• No increase of fees of coverage if underlying exposure is declining

• No reduction in availability of coverage

• Asset-mismatch not acceptable

Requirements

Annex VIII, Part 2

40

Requirements for Netting

• Funded legal entitlement, in case of insolvency, bankruptcy etc...

• Quantification of exposure and liabilities• Awareness of residual risk exposure• Management and control of net position

exposure

Instruments • claims• deposits

Qualitative requirements

Calculation • As in the case of acceptance of other financial coverage instruments.

Annex VIII, Part 2

41

Residual Regulatory risks

Maturity mismatching Market pricerisk Asset-Mismatch

Risks stemming from insufficient coverage

Discrepancies between assets to be

secured and the underlying notional

assets (credit derivative)

Diverging market price evolution between

exposure and pledged item

Mismatch maturity of pledged asset with

underlying exposure

42

Risk mitigation in the Standardised Approach

Collateral Guarantees/credit derivatives

Netting(balance sheet positions)

Comprehensive Approach

Assessment of collateral instruments after consideration of haircuts resulting from residual risks

Haircuts in case of maturity mismatch

Remaining maturity of collateral minimum 3 months

Original maturity of collateral > 1 year

No consideration of maturity mismatches, if the term to maturity of the loan is > 5 years

Simple Approach

Substitution approach with a minimum weighting of 20%

Maturity match required

Collateral assessment minimum every 6 months

43

Minimum requirements• Pledge of maturity converging securities

• Valuation of underlying securities all 6 calendar months

Risk weighting• Covered exposure : Risk weighting of the pledged asset

20% Minimum risk weight

• Uncovered exposure: Risk weight of the debtor/ pledge grantor

Exceptions • Transactions undergoing a daily market value valuation and

subject to a daily margin call

• Cash deposits

• Government securities with an assigned 0% risk weight (20% discount on the market value)

Annex VIII, part 3 p.27 and following

Simple approach

44

The comprehensive approach

Step 2

Step 1

Calculation of the adjusted value of collateral (CA)Market value of the collateral- haircut for collateral- haircut for FX-risk

= adjusted value of collateral

Calculation of outstanding loan amount (E)

CA = C x (1-Hc-Hfx)

Calculation of the adjusted value of collateral in case of maturity mismatch (CAA)

Step 3CAA = CA x min [1 ; t - 0,25 / (min (5 ; T) - 0,25)]

EA = E x (1+He)Value of the exposure

Step 4 Calculation of the value of the exposure post collateral and post maturity mismatches

E**= max [0; (EA – CAA)]

Step 5 Calculation RWA with r = risk weight of the borrower RWA = E** x r

CAA = CA => E** = E* E*= max [0; (EA – CA)]

45

Add-ons and cut-downs

Impact of Haircut depends on

instrument Transactions type Frequency of market valuation and or margin call

• Cash / gold / bonds / shares / investment fund

• Issuer

• Rating

• Remaining maturity

• All Repo type transactions

• Other capital markets transactions

• Covered credit granting

• Number of days elapsing between valuations of underlying assts for covered credits

• Days elapsing before margin call occurring

Add-ons to Exposure (He)

Cut downs on pledged assets (Hc)

Cut downs for FX currencies (Hfx)

46

The comprehensive approach - standard supervisory haircuts (Basel II)

FX risk haircutUCITS and mutual fundsCashOther listed sharesShares included in a main index and gold

> 5 years

< 1 year> 1 year, < 5 years

> 5 years


> 5 years


Issue rating for bonds

Residual maturity Sovereigns(values in %)

Banks/Corporates(values in %)

8Highest haircut applicable to securities in which the fund can invest

02515

3142

0,5

6284

1

151515 6 12

__

_

_

_

_BB+ - BB-

A+ - BBB-/A2/A3

AAA - AA-/A1

Assumptions: (1) daily reassessment of the securities, (2) daily remargining, (3) 10-business day holding period (=TN)

47

The comprehensive approach - standard supervisory haircuts (EU)

Assumptions: (1) daily reassessment of the securities

17,6782535,35517,6782535,355Other listed shares

000000Cash

Highest haircut applicable to securities in which the fund can investUCITS and mutual funds

5 days110 days120 days15 days110 days120 days1

N/AN/AN/A10,6071521,213≤ 1 yearCQS 4 N/AN/AN/A10,6071521,213<1 ≤ 5 years

8,4851216,9714,24368,485> 5 years

N/AN/AN/A10,6071521,213> 5 years10,6071521,21310,6071521,213Shares and convertible bonds

in the main index and gold

5,657811,3145,657811,314FX risk haircut

4,24368,4852,12134,243<1 ≤ 5 years1,41422,8280,70711,414≤ 1 year

CQS 2-3

5,657811,3142,82845,657> 5 years2,82845,6571,41422,828<1 ≤ 5 years0,70711,4140,3540,50,707≤ 1 year

CQS 1


Sovereigns(values in %)

Residual maturity


1 Liquidation period

48

Calculation of haircuts (H) - I

1. Selection of standard haircuts (H10=HN)

2. Selection of transaction type (TM)

3. Consideration of revaluationintervals (NR) •Daily Revaluation• 20 working daysSecured lending

•Daily Remargining• 10 working daysOther capital market

• 5 working daysRepo-style

•Condition•Holding periodTransaction

•Daily Remargining

FX risk haircut

UCITS and mutual funds

Cash

Other listed shares

Shares included in a main index and gold

> 5 years


> 5 years


> 5 years

< 1 year> 1year, < 5 years


Residual maturity Sovereigns(values in %)


8

Highest haircut applicable to securities in which the fund can invest

0

25

15

3

1

4

2

0,5

6

2

8

4

1

15

15

15

6 12

_

_

_

_

_

_

BB+ - BB-

A+ - BBB-/A2/A3

AAA - AA-/A1

49

Calculation of haircuts (H) - II

4. When the frequency of remargining or revaluation is longer than the minimum, the minimum haircut numbers will be scaled up depending on the actual number of business days between remargining or revaluation using the square root of time formula below:

H … haircut; HM … haircut under the minimum holding period; TM … minimum holding period for the type of transaction; NR … actual number of business days between remargining for capital market transactions or revaluation

for secured transactions.

When a bank calculates the volatility on a TN day holding period which is different from the specified minimum holding period TM, the HM will be calculated using the square root of time formula:

HN … haircut based on the holding period TNTN … holding period used by the bank for deriving HNTM … minimum holding period

( )M

MRM T

TNHH 1−+=

N

MNM T

THH =

50

Calculation of haircuts (H) - III

• Differences between Basel II and EU Directives:• Supervisory volatility adjustments (haircuts) are described

under the EU framework more in further detail• The calculation of haircuts proceeds in the same way,

however there are some differences in terminology, e.g.:“holding period” in Basel II = “liquidation period” in EU

51

Exercise 4

Calculate credit amounts outstanding, the adjusted values of the securities, the credit amounts after security underlying and the risk weighted assets for all the following credits (steps 1+2 and 4+5):

credit 1 Mio. Euro corporate Rating BBB, Remaining maturity 4 years, unsecured

credit 1 Mio. Euro corporate Rating BBB, Remaining maturity 4 years, secured 1 Mio. Euro cash

credit 1 Mio. Euro corporate Rating BBB, Remaining maturity 4 years, secured 900.000 USD cash, FX rate Euro/USD 0,90 (daily valuation)

credit 1 Mio. Euro corporate Rating BBB, Remaining maturity 4 years, securedMaturity matching T-Bond Nominal 900.000 Euro (Market value 1,05 Mio. Euro), monthly valuation (= 20 days)

Securities lending (daily valuation, daily re-margining) T-Bond Nominal 1,1 Mio. Euro (Marketvalue 1 Mio. Euro) to a Bank Rated A (Option II), Remaining maturity 6 Months, secured by a pledge on USD denominated T-Bond, Nominal 1 Mio. USD (Market value 972.000 USD, Euro/USD 0,90)

1

2

3

4

5

52

Solution 4 (I)

Case 1 (cash credit unsecured)

Case 2 (cash credit secured)

1. Credit amount outstanding E: 1.000.000 €Haircut credit: 0

2. Adjusted value security: 0Market value: 0Haircut Security: 0Haircut currency: 0

4. Secured Credit amount: 1.000.000 €

5. Risk weighted asset: 1.000.000 €Risk weight debtor: 100 %


2. Adjusted value security: 1.000.000 €Market value: 1.000.000 €Haircut Security: 0Haircut currency: : 0

4. Secured Credit amount: 0 €

5. Risk weighted asset: 0 €Risk weight debtor: 100 %

53

Solution 4 (II)

Case 4 (Lombard credit)

1.050.000 € x (1 - 0,0395)= 1.008.528,32 €

= 3,95 %20 + (20-1)

102 % x

Case 3 (cash credit secured in currency)

1.000.000 € x (1 - 0,1131) = 886.900 €

= 11,31 %1 + (20-1)

108 % x


2. Adjusted value security: 886.900 €Market value: 1.000.000 €Haircut Security: 0Haircut currency: 11,31 %

4. Secured Credit amount: 113.100 €5. Risk weighted asset: 113.100 €

Risk weight debtor: 100 %

1.000.000 € – 886.900 € = 113.100 €


2. Adjusted value security: 1.008.528 €Market value: 1.050.000 €Haircut Security: 3,95 %Haircut currency: 0

4. Secured Credit amount: 0 €5. Risk weighted asset: 0 €

Risk weight debtor: 100 %

54

Solution 4 (III)

Case 5 (securities lending credit)

= 5,66 %1 + 4

108 % x

1.080.000 € x (1 - 0,0035 - 0,0566) = 1.015.092 €

= 0,35 %1 + 4

100,5 % x

= 0,35 %1 + 4

100,5 % xHC =

HE =

HFX =

1. Credit amount outstanding E: 1.003.500 €Adjusted value security: 0,35 %

2. Adjusted value security: 1.015.092 €Market value: 1.080.000 €Haircut Security: 0,35 %Haircut currency: 5,66 %

4. Secured Credit amount: 0 €

5. Risk weighted asset: 0 €Risk weight debtor: 50 %

55

Exercise 5

Calculate the risk weighted asset, taking the maturity mismatch into account (Steps 1-5)

Cash credit of € 1 mln. to A-rated company, remaining maturity 4 years, collateralized by federal bond with a market value of € 1 mln. (valued monthly) with a remaining maturity of 4 years

Cash credit of € 1 mln. to A-rated company, remaining maturity of 4 years, collateralized by federal bond with a market value of € 1 mln. (valuation monthly) with a remaining maturity of 3 years

Cash credit of € 1 mln. to A-rated company, remaining maturity of 4 years, collateralized by federal bond with a market value of € 1 mln. (valuation monthly) with a remaining maturity of 2 years

Cash credit of € 1 mln. to A-rated company, remaining maturity of 4 years, collateralized by federal bond with a market value of € 1 mln. (valuation monthly) with a remaining maturity of 10 weeks

1

2

3

4

56

Solution 5 (I)

Case 1 (no mismatch)

Case 2 (3-years remaining maturity)

€ 1,000,000 x (1 – 0.0395) = € 960,500

= 3.95%10

HC = 2% x

1. Credit amount outstanding E: € 1,000,000Credit haircut: 0

2. Adjusted value of the collateral: € 960,500Market value of the collateral: € 1,000,000 Collateral haircut: 3.95%Currency haircut: 0

3. Adjusted value of the collateralsafter maturity mismatch: € 960,500

4. Credit amount after collaterals andmaturity mismatch: € 39,500

5. Risk-weighted asset: € 19,750Risk weight of debtor: 50%

€ 1,000,000 - € 960,500 = € 39,500

€ 39,500 x 50% = € 19,750


2. Adjusted value of the collateral: € 960,500Market value of the collateral: € 1,000,000Collateral haircut: 3.95%Currency haircut: 0

3. Adjusted value of the collateralsafter maturity mismatch: € 704,367


5. Risk weighted asset: € 147,816.50Risk weight of debtor: 50%

Ca = € 960,500 x (2.75/3.75) = € 704,367

€ 1,000,000 - € 704,367 = € 295,633

€ 295,633 x 50% = € 147,816.50

= 3.95%10

HC = 2% x

20 + (20-1)

20 + (20-1)

57

Solution 5 (II)

Case 3 (2-years remaining maturity)

Case 4 (10-weeks remaining maturity)

No collateral recognitionCredit-rating weight = 50%


2. Adjusted value of the collateral: € 960,500 Market value of the collateral: € 1,000,000 Collateral haircut: 3.95%Currency haircut: 0

3. Adjusted value of the collaterals after security mismatch: € 448,233


5. Risk-weighted asset: € 275,883.5 Risk weight of debtor: 50%

Ca = € 960,500 x (1.75/3.75) = € 448,233

€ 1,000,000 - € 448,233 = € 551,767

€ 551,767 x 50 % = € 275,883.5


2. Adjusted value of the collateral: € 0Market value of the collateral: € 0Collateral haircut : 0%Currency haircut: 0

3. Adjusted value of the collaterals after maturity mismatch: € 0

4. Credit amount after collaterals andmaturity mismatch: € 1,000,000

5. Risk-weighted asset: € 500,000Risk weight of debtor: 50%

= 3.95%10

HC = 2% x20 + (20-1)

58

Apportionment of guarantees and credit derivatives

Principle:Substitution approach

Substitution of the risk weight of the credit user (CU) with the risk weight of the guarantee or collateral provider

Senior / subordinate coverage treated separately

Maturity mismatches (Collateral RP > 3 months)

Adjusted value for guarantee / credit derivative: GA = G x (1 – HfX)

GAA= adjusted value of the collateral aftermaturity mismatch GAA = GA x min [1 ; t – 0.25 / (min (5 ; T) – 0.25)]

RWA = E x gCoverage:

RWA = (E - GAA) x r + GAA x gIf GAA<E (pro rata coverage)

If GAA>Eg = risk weight of the guarantee/collateral provider

In case of credit derivatives, if they do not contain a debt restructuring provision connected with a decrease of payments, the value G is decreased by 40%

59

Exercise 6

Calculate the risk-weighted asset of the credits collateralized with guarantees/ credit derivatives (CD), taking residual risks into account

Cash credit over € 1 mln. to BBB-rated company, collateralized in full by guarantee from an AA-rated bank, maturity matched

Cash credit of € 1 mln. to BBB-rated company, 4 year remaining maturity, collateralized in full by credit derivative of a bank (AA rating) with 3 year remaining maturity

Cash credit of € 1 mln. to BBB-rated company, 4 years remaining maturity, collateralized with pro rata guarantee in of an amount of US$ 720,000 (EUR/USD FX rate 0.90, valuation daily) by an insurance (AAA rated) with 3 years remaining maturity

1

2

3

60

Solution 6 (I)

Case 1 (fully guaranteed)

Case 2 (CD / mismatched maturity)

debtor risk weight: 100%Collateral risk weight: 20%

Exposure: € 1,000,000Credit haircut: 0

Adjusted value for guarantee : € 1,000,000Currency haircut: 0

Adjusted value for guarantee after € 1,000,000maturity mismatch:

Risk-weighted asset: € 200,00020% x € 1,000,000 = € 200,000



Adjusted value for the CD: € 1,000,000Currency haircut: 0

Adjusted value for the CD after € 733,333maturity mismatch:

Risk-weighted asset: € 413,334

Ca = € 1,000,000 x (2.75/3.75) = € 733,333

(€ 1,000,000 - € 733,333) x 100%

+ € 733,333 x 20% = € 413,334

61

Solution 6 (II)

Case 3 (Guaranteed pro rata with currency and maturity mismatches)



Adjusted value for guarantee: € 709,520Currency haircut: 11.31%

Adjusted value for the CD aftermaturity mismatch: € 520,315

Risk-weighted asset: € 583,748

Ca = € 709,520 x (2.75/3.75) = € 520,315

(€ 1,000,000 - € 520,315) x 100% + € 520,315 x 20% = € 583,748

= 11.31%1 + (20 -1)

108% x

€ 800,000 x (1-0.1131) = € 709,520

62

Netting of assets

On-balance sheet Netting

Credit and deposits

Standard equation of the approach

Impact determination:

Haircuts

Mismatching maturities

CA = C x (1- Hfx)

CAA = CA x min [1 ; t - 0,25 / (min (5 ; T) - 0,25)]

E**= max[0; (EA – CAA)]

RWA = E** x rCalculated risk weight asset:

63

On-Balance-Sheet Netting (I)

Type Amount in EUR Currency* RLZ

Claim 1.000 EUR 4

Deposit 200 EUR 3

Claim 200 USD 3

Deposit 1000 USD 4

N0

1

2

3

4

The bank has exposures with one counterparty (Rating BB):

Calculation of haircuts on a daily basis *FX rate EUR/USD = 1,00

There is no explicit comment on the order, in which the exposures have to be netted. This order may have effects on the capital requirements.

64

On-Balance-Sheet Netting (II)

Option 1 FX-Priority (Haircuts for maturity mismatches)

Position 1 and 2Position 3 and 4

Option 2

Position 1 and 4 Position 2 and 3

Maturity-Priority (Haircuts for FX-mismatch)

Risk weight Borrower (r): 100 %Exposure (E): 1.000 €Value of collateral (CA): 200 €Adjusted value of collateral (CAA): 147 €„Adjusted surplus from Position 4 719Remaining exposure (E**): 134 €Capital requirement: 10,72 €

Risk weight Borrower (r): 100 %Exposure (E): 200 €Value of collateral (CA): 1.000 €Adjusted value of collateral (CAA): 1.000 €Remaining exposure (E**): 0 €Capital requirement: 0 €

Risk weight Borrower (r): 100 %Exposure (E): 1.000 €Value of collateral (CA): 886,90 €Adjusted value of collateral (CAA): 886,90 €Remaining exposure (E**): 113,10 €Capital requirement: 9,05 €

Risk weight Borrower (r): 100 %Exposure (E): 200 €Value of collateral (CA): 177,38 €Adjusted value of collateral (CAA): 177,38 €Remaining exposure (E**): 22,62 €Capital requirement: 1,81 €

65

Netting of Securities lending and Repo-Transactions (I)

If eligible Netting-agreements exist, net-positions can be calculated and haircuts will have to be applied on these net positions.

E* = max {0, [(∑ (E) - ∑ (C)) + ∑ (Es x Hs) + (∑(Efx) x Hfx)]}

E* = Exposure after nettingE = Original ExposureC = Market Value of CollateralEs = Amount of Net position in a given securityHs = Haircut applicable to EsEfx = Net-FX positionHfx = Haircut applicable to Efxr = Risk weight of borrower

RWA = r x E*

E* = max {0, [(∑ E - ∑ C) +VaR]}Alternatively:

66

E =

Netting of Repos and reverse Repos (II) -case

Bank A with Bank B (Rating A, => 50 %)The following transaction:

= security = 1.000 €

= Cash = 1.000 €

Bank A Bank BNr. 1

Bank A Bank BNr. 2

Hs = 10,6 %

E* = max {0, [(∑ (E) - ∑ (C)) + ∑ (Es x Hs) + (∑(Efx) x Hfx)]}

C =

C = = security = 600 €

= Cash = 600 €E =

Es = 1.000 € - 600 € = 400 €

Efx = 0 u. Hfx = 0

RWA = 42,4 € x 50 %= 21,2 €

Type Amount in EUR Securities underlying

Repo 1.000 share BMW

Reverse Repo 600 share BMW

Nr.

1

2

Haircut1

10,6 %

10,6 %

1transaction duration 5 days, daily margin call

(∑ (E) - ∑ (C)) = 0

E* = 400 € x 10,6 % = 42,4 €

67

Netting Repo and securities lending (III)

Banks can make use of their own VaR models under specific qualitative and quantitative requirements

E* = Repo or securities lending after risk reductionE = Markt value ExposureC = value of received securityr = Risk weight debtor

Equation for unsecured exposure e.g. The risk weighted assets changes as follows:

E* = max {0, [(∑ E - ∑ C) +VaR]}

RWA = r x E*

68

Impact of maturity mismatch

0,00

20,00

40,00

60,00

80,00

100,00

120,00

7,00 6,50 6,00 5,00 5,00 4,50 4,00 3,50 3,00 2,50 2,00 1,50 1,00

Maturity of loan in years

Val

ue o

f col

late

ral (

Eur

o)

Loan €100, duration 7 years, collateral €100, duration 6 yearsAdjusted amount of collateral with maturity mismatch

Value of collateral (CP 3) Value of Collateral (final)

69

Conclusion: risk mitigation

• Method to calculate the effects is provided by supervision

• Optimal allocation of collateral on loans is complex

• Sophisticated requirements for collateral management systems

• Qualitative requirements on the management of collateral have tobe fulfilled

• Knowledge about the effect of credit risk mitigation on the capital charge is essential

70

Exercise 1

Please calculate the RWA for the following loans considering supervisory haircuts and maturity mismatches

• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years. Collateral is Government bonds; market value 1 Mio. € (revaluation every 20 days) with remaining maturity of 4 years



• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years. Collateral is Government bonds; market value 1 Mio. € (revaluation every 20 days) with remaining maturity of 10 weeks

1

2

3

71


Case 2 (rem. Mat. 3 years)

1,000,000 x (1 – 0.0395) = 960,500

= 3.95 %20 + 19

10HC = 2% x

1. Exposure E: 1,000,000 €Haircut exposure: 0

2. Adjusted value of collateral: 960,500 €Market value of collateral: 1,000,000 €Haircut Collateral: 3.95 %Haircut Currency: 0

3. Adjusted value of collateral after maturity mismatch: 960,500 €

4. Remaining exposure value: 39,500 €

5. Risk weighted assets: 19,750 €Risk weight of borrower: 50 %

1,000,000 € - 960,500 € = 39,500 €

39,500 € x 50 % = 19,750 €




4. Remaining exposure value 295,633 €

5. Risk weighted assets : 147,816.50 €Risk weight of borrower : 50 %

Ca = 960,500 € x (2.75/3.75) = 704,367 €

1,000,000 € - 704,367 € = 295,633 €

295,633 € x 50 % = 147,816.50 €

= 3.95 %20 + 19

10HC = 2% x

Solution 1 (I)

72


Case 4 (rem. Mat. 10 weeks)

No consideration of collateral. Riskweight of borrower = 50 %

Exposure E: 1,000,000 €Haircut exposure: 0



4. Remaining exposure value: 551,767 €

5. Risk weighted assets: 275,883.5 €Risk weight of borrower: 50 %

Ca = 960,500 € x (1.75/3.75) = 448,233 €

1,000,000 € - 448,233 € = 551,767 €

551,767 € x 50 % = 275,883.5 €


2. Adjusted value of collateral: 0 €Market value of collateral: 0 €Haircut Collateral: 0 %Haircut Currency: 0

3. Adjusted value of collateral after maturity mismatch: 0 €

4. Remaining exposure value: 1,000,000 €

5. Risk weighted assets: 500,000 €Risk weight of borrower:

= 3.95 %20 + 19

10HC = 2% x

Solution 1 (II)

73

Exercise 2

Please calculate the RWA for the following loans considering supervisory haircuts and maturity mismatches

• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years. Completely protected with a total Return Swap of 1 Mio. € (counterpart is insurance rated “AA”) with remaining maturity of 4 years



• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years. Completely protected with a total Return Swap of 1 Mio. € (counterpart is insurance rated “AA”) with remaining maturity of 10 weeks

1

2

74

1. Exposure E: 1,000,000 €Haircut Exposure: 0

2. Adjusted value of protection: 1,000,000 €Value of protection: 1,000,000 €Haircut for FX: 0 %

3. Value of guarantee after Maturity mismatch: 1,000,000 €

4. Risk weight guarantor 20%

6. Uncollateralised portion 0 €

5. Risk weight borrower 50%

5. Risk weighted assets total 200.000 €

1. Exposure E: 1.000.000 €Haircut Exposure: 0

2. Adjusted value of protection: 1.000.000 €value of protection: 1.000.000 €Haircut for FX: 0

3. Value of guarantee after Maturity mismatch: 733.333 €


6. Uncollateralised portion 266.667 €


5. Risk weighted assets total 280,000 €

Ca = 1,000,000 € x (2.75/3.75) = 733,333 €

1,000,000 € - 733,333 € = 266,667 €

295,633 € x 50 % = 147,816,50 €



Solution 2 (I)

75

1. Exposure E: 1,000,000 €Haircut Exposure: 0

2. Adjusted value of protection: 1,000,000 €value of protection: 1,000,000 €Haircut for FX: 0

3. Value of guarantee after Maturity mismatch: 466,667 €


6. Uncollateralised portion 533,333 €



1,000,000 € - 448,233 € = 551,767 €

551.767 € x 50 % = 275.883.5 €

1. Exposure E: 1.000.000 €Haircut Exposure: 0

2. Adjusted value of protection: 1.000.000 €value of protection: 1.000.000 €Haircut for FX: 0

3. Value of guarantee after Maturity mismatch: 0 €


6. Uncollateralised portion 1.000.000 €




Case 4 (rem. Mat. 10 weeks)

No consideration of collateral. Riskweight of borrower = 50 %

Solution 2 (II)

76

Exercise 3

Please calculate the Risk weighted Assets for the following loans collateralised with physical collateral

• Loan to a private individual of 500,000 € collateralised with physical collateral (private home) with total market value of 1,200,000 €

77

Case 2

1. Exposure 500,000 €

2. Risk weight of collateralised portion 35%


Solution 3

78

Agenda




• Examples


credit risk - standardised approach

Documents

risk mitigationhaircuts

operational risk x

market risk assessment

captured risk risks

types of risk orientation

banks individual risk

basel iiadvanced

basel framework