Basel I
Established in 1930 in Basel Switzerland this organization is known for establishing Basel 1, 2, and 3
BIS (bank for international settlements)
What are the "three pillars" of Basel II?
1.Rules: Minimum capital requirements
2.Supervisory review
3.Market discipline (disclosure, transparency)
What new form of market risk did Basel III introduce to replace VAR and why is this new market risk measure better?
New market risk measure is Expected Shortfall (ES). The reason ES replaces VAR is because VAR is unclear in how much a bank could loose in extreme events while ES is better at capturing the full picture of extreme losses
Around when was Basel I introduced?
During the 1980's specifically 1988
What are the two key principles covered in Basel 1?
1. Some forms of capital are more reliably available in a crisis (Tier 1 Capital and Tier 2 Capital)
2. Assets with more credit risk should be backed by more capital( A assets, B assets, C assets etc.)
According to Basel II what are four rules a financial institution must adhere to in order to use their internal model?
1.Model is back-tested for forecast accuracy
2.Model is subject to both internal and external audits
3.Market-risk estimates are considered in daily risk management
4.Bank has independent risk control unit that reports directly to sr. management
What are the five aspects that make a bank considered globally systematically important and what are the weights of each category?
1. Cross jurisdictional activity (20%)
2. Size (20%)
3. Interconnectedness (20%)
4. Substitutability (20%)
5. Complexity (20%)
The GFC and the Greek Debt Crisis
What type of Assets are considered A assets according to Basel 1 and what credit weight risk do they have?
A assets: cash and central bank reservers and high quality government debt
Credit weight: 0%
Basel II required capital for market risk only if a bank's trading exposure exceeds how much absolute exposure and how much relative exposure
Absolute exposure: $1Billion
Relative exposure: 10%
What two new ratios did Basel III introduce, what is their purpose, what are their formulas?
Introduced the Liquidity Coverage Ratio (LCR)
Purpose: Improve the banks’ ability to absorb shocks and reduce the risk of spillover from financial sector to the real economy, sets minimum level of liquidity for internationally active banks, and ensure the banks have enough high quality liquid assets to manage a 30-day stress test
Formula: high quality liquid assets/total net cash outflows over the next 30 calendar days is greater than or equal to 100%
Net Stable funding ratio (NSFR)
Purpose: improve a banks’ ability to absorb shocks and reduce the risk of spillover from financial sector to the real economy, sets minimum stable funding level, and Limit overreliance on short-term wholesale funding, encourages better assessment of funding risk across all on- and off-balance sheet items
Formula: available amount of stable funding/required amount of stable funding which is greater than or equal to 100%
Banks feared that the two new ratios created by Basel III, NSFR and LCR, would severely hurt banks and their profitability. Is that what ended up happening?
No that is not what ended up happening. Research shows that neither ratio had a major effect on bank profitability
List four strengths of Basel 1 and list 3 common bank risks that were ignored by Basel 1
Strengths: Limits “race to the bottom” by identifying key criteria, Standardizes definition of capital across countries, Discourages banks from seeking assets with more credit risk, Riskier assets require more capital, Ensures banks held higher-quality capital to absorb losses while still allowing for supplementary, lower-quality instruments
Risks ignored: Variation in risk within broad risk categories
Asset correlations / diversification: Banks with high diversification must hold same capital as banks with low diversification
Liquidity risk, Interest-rate risk, Market risk, and Operational risk
What is the name of the statistical measure that is central to Basel II's market risk capital requirements and what does it show?
VAR- value at risk
VAR shows the frequency distribution of potential returns and identifies the worst % of outcomes which is usually 1%
What is the expected loss formula and what does each part of the formula mean?
Expected loss = EAD x LDG x PD
EAD- Exposure at Default
this means the maximum potential loss the bank will suffer from a default
LDG- loss given default
fraction of the asset that will not be recovered from a default. If secured could loose 20% is not secured could loose 75%
PD- Probability of Default
Define "Boundary definition" and its purpose
Definition: A clearer, more rigid definition of the boundary between the trading book and the banking book
Purpose: Prevent regulatory arbitrage and discourage banks from shifting assets in and out of trading book for arbitrary reasons to reduce capital requirements
Basel I divided capital into two tiers: Tier 1 and Tier 2. What is another name for Tier 1 capital and Tier 2 capital, what is included in Tier 1 and Tier 2 capital, what is the minimum percentage needed for both, and what are the formulas for both?
Tier 1 Capital: Core Capital- common stock, Non-cumulative perpetual preferred stock, Retained earnings & any other “disclosed” reserves
Minimum: 4%
Tier 1 capital/Risk-Weighted Assets greater than or equal to 4%
Tier 2 Capital: Supplementary Capital- Subordinated term debt with original maturity 5+ yrs, Allowance for credit losses (LLR), Hybrid (debt/equity) instruments incl. preferred stock Coco: At pre-specified trigger event bond can be converted to equity, Special reserves: Revaluation or undisclosed reserves if accepted by supervisors
Minimum: 8%
Tier 1 + Tier 2 capital/Risk-Weighted Assets greater than or equal to 8%
What was the major flaw that the Greek Debt Crisis exposed in Basel II and why did European banks buy large amounts of Greek bonds?
The major flaw that the Greek Debt Crisis exposed was treating government bonds as essentially risk free. Because of this European banks held large amounts of Greek bonds with minimal capital backing and ignored the possibility of a country defaulting which then crushed European banks when Greeces true financial situation came to light. Banks bought large amounts of Greek bonds since they offered high yields and were considered safe under Basel II
What new modifications to Basel I capital-adequacy criteria did Basel III add, what are is the name of the new category introduced, what are the two new buffers and their purpose, what are the formulas for the buffers, and has the RWA for tier one capital changed if so by how much more or less
New category: CET1- common equity tier one
formula: CET1/risk-weighted assets greater than or equal to 4.5%
Two new buffers:
1. capital conservation buffer- if this buffer is too little regulators restrict dividends so banks can conserve capital and restrict other forms of payouts as well
formula: Additional CET1/Risk-weighted assets greater than or equal to 2.5%
2. Countercyclical capital buffer- imposed by regulators when credit is growing too rapidly. Ensures banks accumulate extra capital in good times to hold them over in bad times
formula: yet more CTE1/risk-weighted assets less than or equal to 2.5%
New RWA for tier 1 is 6% up from 4%
What are the characteristics of High Quality Liquid Assets (HQLA)?
Low risk- low volatility risk, low inflation risk, low duration, etc...
structured simply with clear pricing formulas that are easy to calculate
listed on a recognized exchange with an active and sizable market
preferred during "flight to quality" aka value rises during a crisis
Eligible to serve as collateral at central bank for intraday or overnight cash