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Basic Principles for Credit Risk Management. Prof. Dan Galai. Types of Financial Risks. Types of financial risks. Components of financial risks. Market. Financial risks. Credit. Operational. Liquidity. Human Factor. Legal & Regulatory. ETN 49 1/2. PJF 98 5/8. C M 40 3/4.

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types of financial risks3
Types of financial risks
  • Components of financial risks

Market

Financial risks

Credit

Operational

Liquidity

Human Factor

Legal & Regulatory

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slide4

ETN

49 1/2

PJF

98 5/8

CM

40 3/4

9.25%

8.75%

Yield

%

5 yrs

Term to Maturity

Types of financial risks

  • Market risk is multidimensional

Equity risk

Financial risks

Market risk

Interest rate risk

Currency risk

Commodity risk

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slide5

Types of financial risks

  • One can “slice and dice” these multiple dimensions of risks

Interest rate

Market risk

Commodity prices

Currency risk

Equity risk

Transaction risk

Credit risk

Financial

risks

Portfolio

concentration risk

Process risk

Operational

risk

Infrastructural or

Leverage risk

Model risk

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the old regulatory environment

The old regulatory environment:

BIS 1988 or the Accord

bis 88
BIS 88

Capital adequacy requirements

1. Assets to capital multiple (overall measure of the bank’s capital adequacy)

Total assets (including specified off-balance sheet items) / capital < 20

2.Risk based capital ratio (solvency ratio which focuses on credit risk associated with on-and off-balance sheet exposures)

Capital >8% of Risk Weighted Assets (RWA)

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bis 888
BIS 88

Risk weighted amount=

S Assets * WA +

S Credit equivalent * WCE

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slide9

BIS 88

  • Risk capital weights by broad on-balance sheet asset category (WA)

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slide10

BIS 88

Calculating BIS risk-weighted amounts for derivative products

Step 1: Credit-equivalent amount

Current replacement cost

Add-on amount

Credit equivalent

+

=

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slide11

BIS 88

Add-on factors by type of underlying and maturity

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bis 8812
BIS 88

Calculating BIS risk-weighted amounts for derivative products

Step 1: Credit-equivalent amount

Current replacement cost

Add-on amount

Credit equivalent

+

=

Step 2: Risk weighted amount

Counterparty risk weighting

Risk weighted amount

Credit equivalent

x

=

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slide13

BIS 88

  • Risk capital weights for off balance credit equivalents by type of counterparty (WCE)

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bis 8814
BIS 88

Counterparty Risk for Portfolio 1 (with a corporate counterparty)

Replacement cost = 0 (at-the-money swap)

Add-on = 100M USD x 1.5% = 1,500,000 USD

Risk-weighted amount = 1,500,000 USD x 50% = 750,000 USD

Capital charge = 750,000 USD x 8% = 60,000 USD

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bis 8815
BIS 88
  • The Accord is flawed.
  • The Accord does not address complex issues like:
    • portfolio diversification (credit risk is partially offset by diversification across issuers, industries and geographical locations
    • netting

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bis 8816
BIS 88
  • The Accord produces a distorted assessment of actual risks and a misallocation of capital:
    • ignores market risk for tradable securities
    • generates regulatory arbitrage opportunities

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slide17

(1) Assume Libor (L) = 5.2%

13.75% =

(L+50) x $100 - (L-20) x $92

$8

The New Regulatory and Corporate Environment

Regulatory Arbitrage is forcing Regulators to move away from standardized approach toward internal models approach

Example of Regulatory Arbitrage:

High Quality Bank A

Funding Cost

Libor -20 bp

(on 92% of nominal)

Libor + 50 bp

XYZ$100M

Capital Charge = 8%

Net revenue = $1.1M

Return on capital = 13.7% (1)

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slide18

The New Regulatory and Corporate Environment

  • Long a corporate loan and long a credit swap from an OECD Bank to hedge credit risk exposure.

Example of Regulatory Arbitrage:

  • Capital treatment:
    • full offsetting of credit risk related to XYZ loan, no capital charge against loan package
    • capital add-on = Principal x risk weight (OECD Bank) x 8% = $100m x 20% x 8% = $1.6m

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slide19

(2) 17.5% =

$1.6

The New Regulatory and Corporate Environment

Example of Regulatory Arbitrage:

}

}

50 bp

High Quality

Bank A

Lower QualityBank B

Seller of credit derivative

Buyer of

credit

derivative

Zero

No default

or

Default

Par - recovery

Libor + 50 bp

XYZ$100M

Funding cost

Libor - 20 bp

(on 98.4 % of nominal)

Net Capital charge = 1.6%

Net revenue = $280,000

Return on capital = 17.5% (2)

(L+50) x $100 - 50bp x $100 - (L-20) x $98.4

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bis 8820
BIS 88
  • Regulators are slowly beginning to acknowledge that standardized regulatory measures such as growth in Risk Weighted Assets (RWA) fail to provide meaningful transparency in terms of measuring the Amount at Risk.

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bis 8821
BIS 88

Growth in RWA does not tell the whole story

  • Example 1: Revolvers less than one year do not require any RWA
  • Example 2: Loan to GE requires 5 times as much RWA as a loan to a Japanese City bank
  • Example 3: Loan to AA counterparty receives same RWA as a loan to BB counterparty
  • Example 4: RWA do not reflect concentration Risk

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bis 8822
BIS 88

Example: A single $100 loan to a BB counterparty receives same amount of RWA as 100 different $1 loans to 100 different BB counterparties

Total Risk

Specific Risk

Systematic Risk

Increasing Diversification

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