Without netting the financial institutions exposure

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Without netting the financial institution’s exposure in the event of a default today is (N contracts with the defaulted party). With netting, it is 1 max( ,0) N i i V = 1 max( ,0) N i i V = 4. Basel II is based on three pillars: - Minimum capital requirements - Supervisory review : allow regulators in different countries some discretion in how rules are applied but seeks to achieve overall consistency in the application of the rules. It places more emphasis on early intervention when problems arise. Part of their role is to encourage banks to develop and use better risk management techniques and to evaluate these techniques. - Market discipline : require banks to disclose more information about the way they allocate capital and the risks they take. 5. Minimum capital requirements: Total capital = 0.08*(credit risk RWA + Market risk RWA + Operational risk RWA). 6. Market risk (1996 amendment to Basel I, continue to be used under Basel II): - It requires financial institutions to hold capital to cover their exposures to market - 9 -
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Study Notes: Risk Management and Financial Institutions By Zhipeng Yan risks as well as credit risks. It distinguishes between a bank’s trading book (normally marked to market daily) and its banking book. - The market risk capital requirement: k * VaR + SRC , where SRC is a specific risk charge. The VaR is the greater of the pervious day’s VaR and the average VaR over the last 60 days. The minimum value for k is 3. - SRC is a capital charge for the idiosyncratic risks related to individual companies. E.g. a corporate bond has two risks: interest rate risk and credit risk. The interest rate risk is captured by the bank’s market VaR measure; the credit risk is specific risk. 7. Credit risk capital (NEW FOR BASEL II) - For an on-balance-sheet item a risk weight is applied to the principal to calculate risk-weighted assets reflecting the creditworthiness of the counterparty. For off-balance-sheet items the risk weight is applied to a credit equivalent amount. This is calculated using either credit conversion factors or add-on amount. - Standardized approach (for small banks. In USA, Basel II will apply only to the largest banks and these banks must use the foundation internal ratings based (IRB) approach). Æ risk weights for exposures to country, banks, and corporations as a function of their ratings. - IRB approach – one-factor Gaussian copula model of time to default . WCDR: the worst-case default rate during the next year that we are 99.9% certain will not be exceeded PD: the probability of default for each loan in one year EAD: The exposure at default on each loan (in dollars) LGD: the loss given default. This is the proportion of the exposure that is lost in the event of a default. Suppose that the copula correlation between each pair of obligors is rho. Then WCDR = 1 1 [ ] (0.999) [ ] 1 N PD N N ρ ρ + It follows that there is a 99.9% chance that the loss on the portfolio will be less than N times EAD*LGD*WCDR.
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