Market risk is the risk to changes in market conditions. This chapter looks at various ways to consider market risk, assesses market risk and then examines the process of market risk management. A ...market risk control department might employ one or many of the common methodologies, such as scenario analysis, Value at Risk (VaR), and sensitivity analysis. Risk is divided into layers within the trading organisation. Mindful of the regulatory limits, the board of the firm will decide the total amount of risk available. The market risk control department sets appropriate limits for trading, monitors market risk and reports breaches to ensure that the firm has control over its market risk. The chapter summarises some early regulatory requirements. It outlines the three pillars of Basel II and then discusses one market risk limit arising from them known as capital adequacy ratio.
This chapter contains sections titled:
Portfolio Credit Models
Credit Contagion from Common Factors
Credit Contagion from Counterparty Risk
Evidence on Counterparty Risk Exposures
Effects of ...Counterparty Risk
Conclusions
Note
About the Authors
Although beneficial allocational effects have been a central motivator for the Basel II capital adequacy reform, the interaction of these effects with Basel II’s procyclical impact has been less ...discussed. In this paper, we investigate the effect of capital requirements on the allocation of credit and its interaction with procyclicality, and compare Basel I and Basel II type capital requirements. We consider competitive credit markets where entrepreneurs of varying ability can apply for loans for one-period investment projects of two different risk types. The risk of a project further depends on the state of the economy, modelled as a two-state Markov process. In this type of setting, excessive risk taking typically arises because higher-type borrowers cross-subsidize lower-type borrowers via a pricing regime based on average success rates. We find that risk-based capital requirements (such as Basel II) alleviate the cross-subsidization effect and can be chosen so as to implement first-best allocation. This implies that the ensuing reduction in the proportion of high-risk investments may mitigate the procyclical effect of Basel II on economic activity. Moreover, we find that optimal risk-based capital requirements should be set lower in recessions than in normal times. Our simulations show that when measured by either cumulative output or output variation, Basel II type capital requirements may actual be slightly less procyclical than flat capital requirements. The biggest reduction in procyclicality is however achieved with optimal risk-based capital requirements which are considerably higher than Basel II requirements and which are adjusted downwards in recession periods.
This paper addresses factors which have prompted the need for further revision of banking regulation, with particular reference to the Capital Requirements Directive. The Capital Requirements ...Directive (CRD), which comprises the 2006/48/EC Directive on the taking up and pursuit of the business of credit institutions and the 2006/49/EC Directive on the capital adequacy of investment firms and credit institutions, implemented the revised framework for the International Convergence of Capital Measurement and Capital Standards (Basel II) within EU member states. Pro cyclicality has attracted a lot of attention – particularly with regards to the recent financial crisis, owing to concerns arising from increased sensitivity to credit risk under Basel II. This paper not only considers whether such concerns are well-founded, but also the beneficial and not so beneficial consequences emanating from Basel II’s increased sensitivity to credit risk (as illustrated by the Internal Ratings Based approaches). In so doing it considers the effects of Pillar 2 of Basel II, namely, supervisory review, with particular reference to buffer levels, and whether banks’ actual capital ratios can be expected to correspond with Basel capital requirements given the fact that they are expected to hold certain capital buffers under Pillar 2. Furthermore, it considers how regulators can respond to prevent systemic risks to the financial system during periods when firms which are highly leveraged become reluctant to lend. In deciding to cut back on lending activities, are the decisions of such firms justified in situations where such firms’ credit risk models are extremely and unduly sensitive - hence the level of capital being retained is actually much higher than minimum regulatory Basel capital requirements ?
In Chapter 11 we reviewed some of the tools that can be used for monitoring and identifying financial stability risks. In this chapter we look at some of the tools that central banks might use to ...intervene, safeguard, and restore financial stability. Following the analytical framework used in the previous chapters, we review the tools in the context of three focus areas: (1) the macroeconomy, (2) financial institutions, and (3) financial markets. In each of the focus areas, we look at the tools are meant to be used ex ante (i.e., sustaining financial stability by reducing the probability of a crisis happening, or reducing the severity of losses given a crisis), and those that are meant to be used ex post (i.e., managing a crisis that is unfolding, or providing a recovery resolution).
Banks that choose credit rating models for capital calculations depending solely on an accuracy criterion may overlook the effect of their selection on the rating migration that could lead to higher ...capital requirements. Although most of the recognised factors affecting migration such as macroeconomic conditions, country and sector are not related to the bank, the model's selection is an internal decision that could reduce capital charges. In this paper, we focus on assessing the migration differences of two popular structural credit risk models in corporate lending, the Merton's distance to default and the econometric model using the logit function. The key conclusion of this paper is that migration between the two models can be substantially different depending on the parameters' values. This result highlights banks' need to consider migration levels together with prediction accuracy when selecting a credit rating model for their regulatory and economic capital calculations.
This paper compares alternative procedures to mitigate the procyclicality of the new risk-sensitive bank capital regulation (Basel II). We estimate a model of the probabilities of default (PDs) of ...Spanish firms during the period 1987-2008, and use the estimated PDs to compute the corresponding series of Basel II capital requirements per unit of loans. These requirements move significantly along the business cycle, ranging from 7.6% (in 2006) to 11.9% (in 1993). The comparison of the different procedures is based on the criterion of minimizing the root mean square deviations of each smoothed series with respect to the Hodrick-Prescott trend of the original series. The results show that the best procedures are either to smooth the inputs of the Basel II formula by using through-the-cycle PDs or to smooth the output with a multiplier based on GDP growth. Our discussion concludes that the latter is better in terms of simplicity, transparency, and consistency with banks’ risk pricing and risk management systems. For the portfolio of Spanish commercial and industrial loans and a 45% loss given default (LGD), the multiplier would amount to a 6.5% surcharge for each standard deviation in GDP growth. The surcharge would be significantly higher with cyclically-varying LGDs.
This paper compares alternative procedures to mitigate the procyclicality of the new risk-sensitive bank capital regulation (Basel II). We estimate a model of the probabilities of default (PDs) of ...Spanish firms during the period 1987-2008, and use the estimated PDs to compute the corresponding series of Basel II capital requirements per unit of loans. These requirements move significantly along the business cycle, ranging from 7.6% (in 2006) to 11.9% (in 1993). The comparison of the different procedures is based on the criterion of minimizing the root mean square deviations of each smoothed series with respect to the Hodrick-Prescott trend of the original series. The results show that the best procedures are either to smooth the inputs of the Basel II formula by using through-the-cycle PDs or to smooth the output with a multiplier based on GDP growth. Our discussion concludes that the latter is better in terms of simplicity, transparency, and consistency with banks’ risk pricing and risk management systems. For the portfolio of Spanish commercial and industrial loans and a 45% loss given default (LGD), the multiplier would amount to a 6.5% surcharge for each standard deviation in GDP growth. The surcharge would be significantly higher with cyclically-varying LGDs.
This paper proposes a new model for portfolio sensitivity analysis. The model is suitable for decision support in financial institutions, specifically for portfolio planning and portfolio management. ...The basic advantage of the model is the ability to create simulations for credit risk predictions in cases when we virtually change portfolio structure and/or macroeconomic factors. The model takes a holistic approach to portfolio management consolidating all organizational segments in the process such as marketing, retail and risk.
