MPF_RRFI - Lecture 06
Basel I, Basel II, and Solvency II (Chapter 15)
the reasons for regulating banks systemic risk
Bank Regulation Pre-1988
on the country level
ratio of capital/total assets
banks started competing globally international regulation
The 1988 BIS Accord
the Cooke ratio it is based on what is known as the bank’s total risk-weighted assets
Credit risk exposures can be divided into three categories:
1. Those arising from on-balance sheet assets (excluding derivatives)
2. Those arising for off-balance sheet items (excluding derivatives)
3. Those arising from over-the-counter derivatives
The Accord required banks to keep capital equal to at least 8\% of the risk-weighted
assets
(Tier 1 and Tier 2)
Netting
The word netting refers to a clause in the master agreement, which states that in the event of
a default all transactions are considered as a single transaction.
The 1996 Amendment
Marking to market is the practice of revaluing assets and liabilities daily using a model
that is
calibrated to current market prices. It is also known as fair value accounting.
The big banks were allowed to use an internal model-based approach for setting market risk
capital.
10-day VaR, 99\%
Basel II
The Basel II capital requirements applied to internationally active banks.
The Basel II is based on three pillars:
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1. Minimum Capital Requirements
2. Supervisory Review
3. Market Discipline
credit risk standardized vs. internal rating based approach
requires banks to keep capital for operational risk
Solvency II
no international standards for the regulation of insurance companies
The long-standing regulatory framework in the European Union, known as Solvency I, was
replaced by Solvency II in 2016.
Whereas Solvency I calculates capital only for underwriting risks, Solvency II considers
investment risks and operational risks as well.
Solvency II has many similarities to Basel II (three pillars)
Basel II.5, Basel III, and Other Post-Crisis Changes
(Chapter 16)
Basel II.5
It was perhaps unfortunate for Basel II that its implementation date coincided,at least
approximately, with the start of the worst crisis that financial markets had experienced since
the 1930s.
During the credit crisis, it was recognized that some changes were necessary to the
calculation of capital for market risk.
1. The calculation of a stressed VaR;
2. A new incremental risk charge; and
3. A comprehensive risk measure for instruments dependent on credit correlation.
increase of the regulatory capital for banks
Basel III
first published in December 2009 final version in December 2010 gradual
implementation 2013-2019
There are six parts to the regulations:
1. Capital Definition and Requirements
2. Capital Conservation Buffer
3. Countercyclical Buffer
4. Leverage Ratio
5. Liquidity Risk
6. Counterparty Credit Risk
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Contingent Convertible Bonds
They automatically get converted into equity when certain conditions are satisfied.
Typically, these conditions are satisfied when the company is experiencing financial
difficulties.
Use of Standardized Approaches
In December 2017, the Basel Committee announced that, starting in 2022, it would
require
the implementation of a standardized approach for all capital calculations.
A bank’s total capital requirement will be the maximum of (a) that calculated as before using
approved internal models and (b) a certain percentage of that given by the standardized
approaches.
The percentage will be 50% in 2022, rising to 72.5% in 2027.
Regulation of the OTC Derivatives Market (Chapter 17)
Before the 2007–2008 credit crisis, the OTC market was largely unregulated.
Since the crisis, the OTC market has been subject to a great deal of regulation.
Clearing in OTC Markets
bilateral vs. central clearing (CCP - central counterparty)
initial vs. variational margin
netting
Post-Crisis Regulatory Changes
3 main major changes:
1. A requirement that all standardized OTC derivatives be cleared through CCPs.
2. A requirement that standardized OTC derivatives be traded on electronic platforms.
3. A requirement that all trades in the OTC market be reported to a central trade repository.
About 25\% of OTC transactions were cleared through CCPs pre-crisis and the remaining
75\% were cleared bilaterally.
As a result of the new rules, these percentages have flipped.
More collateral required in general cash or government securities
Rehypothecation restricted.
OTC markets converge to exchange-traded markets
Fundamental Review of the Trading Book (Chapter 18)
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FRTB is a major change to the way capital is calculated for market risk.
After 20 years of using VaR with a 10-day time horizon and 99% confidence to determine
market risk capital, regulators are switching to using ES with a 97.5% confidence level and
varying time horizons.
The time horizons, which can be as high as 120 days,are designed to incorporate liquidity
considerations into the capital calculations.
Standardized approach and internal models approach specified.
Even when the use of the internal models approach is allowed, banks must also implement
the standardized approach.
Regulatory capital under the standardized approach is based on formulas involving the delta,
vega, and gamma exposures of the trading book.
Regulatory capital under the internal models approach is based on the calculation of stressed
expected shortfall.
Calculations are carried out separately for each trading desk.