Madiha NiazAdnan SajidMuhammad RizwanImtiaz Malik

GROUP MEMBERS

TOPIC:

Liquidity Risk, Credit Risk, Market Riskand Bank Capital

• The purpose of this paper is to investigate the effect of new banking capital regulations introduced by Basel III taking a sample of 12 U.S bond indices with different maturities, credit ratings and industry sectors.

• Specifically it estimates the new capital requirements for:

a) credit and liquidity risk through IRC

b) risk of extreme market movements through stress tests based on 2007-09 crises

AIM OF PAPER

• Banks are required to have minimum amount of capital to absorb loses and operate smoothly.

• After the financial crises 2007-09 the BCBS devised a new rulebook as Basel III to strengthen the banking sector that would save them from future crises.

• Basel III mainly emphasized on market, liquidity and credit risk.

BACKGROUND

• The literature on Basel III is very less owing to its novelty. (2013-19)

• This study contributes to literature in several ways:

a) It provided interaction between liquidity and credit risk.

b) It estimated the sensitivity of credit, market and liquidity risk.

c) It test the influence of portfolio diversification on new trading book capital requirements in crises periods.

LITERATURE

This new regulation provided a long term cost benefit analysis:

• Higher capital requirements will make it more expensive for banks to fund their operations and the cost will be passed to the borrowers through higher lending rates resulting in lower lending activity and a lower GDP.

• But this cost is benefited by better capitalized banks which will lower the chances of bank crises.

cost-benefit analysis

The new requirement will cause trading book capital to increase on a large scale for which Basel committee has issued 2 quantitaive impact studies:

• Incremental risk charge(IRC) that accounts for the credit risk in the trading book.

• Stressed VaR that measures the potential losses due to price risk in a crises scenario.

The size of both IRC & SVaR should be much larger to push the trading book capital upto 8 times higher than the pre-crises level.

2 Quantitative Impact Studies

IRC requires banks to capture the default and credit migration risk for traded debt instruments in addition to that captured by VaR.

• Introduced to deal with the shortcomings of VaR model.

• Security price movements for more than 10 trading days.

• Measures credit risk for a year (capital horizon)

• After 3 months(liquidity horizon) banks are required to rebalance their portfolio with new level of risk than in beginning of period which allows banks to take risks and remain profitable in crises situation.

Incremental Risk Charge

Literature has defined two types of rating:

Through the cycle (TTC)• Rating in which rating

agencies evaluates the performance from medium to long term.

• Objective is to arrive at a stable rating in varying economic conditions.

• Suitable for long term institutional investors.

• Basel regulators favor TTC.

Point in time (PIT)• Focuses on short

term performance of the company.

• Useful for people interested in the ability of a firm to repay its short term loans

Rating

SVaR uses standard 99 confidence interval, 10day holding period, and at least one year worth of data but requires it to be calibrated to a stress period such as 2008.

So, price risk is measured with a value risk model estimated under stressed market condition.

Stressed VaR

• Old capital requirement= current VaR + Specific Risk charge.

• New capital requirement = current VaR + Specific Risk charge+ IRC + Stressed VaR.

Estimate of Incremental Risk Charge

CF : calibration FactorMAZ1,g: Maturity AdjustmentA Z: Recovery RateP D,1,g: probability of default under a

downturn scenarioPA,1,g: Average Probability….(Ex.V) EADz exposure at default for

asset z

impact of the liquidity horizonWe use the following procedure to measure the impact of the liquidity horizon on one-year default

probabilities:

generator matrixtransition matrix

cumulative one-year default probabilityIRC capital

The portfolios are represented by US corporate bond indices compiled by Bank of America-Merrill Lynch and sourced from Data stream

Data

The indices span two industry sectors

• Industrial

• Financial

INDICES SPAN

• AAA-AA• A-BBB, • three maturity bands• 5 to 10 years• 10 to 15 years• 15+ years The sample consists of daily returns over the period May 2004

August 2009. All indices exhibit negative skweness (except for the AAA-AA

10-15 year maturity index)

RATING GROUPS

• The sample consists of daily returns over the period May 2004 – August 2009

• period was chosen to include the recent crisis and to allow for enough observations to

• determine the pre-crisis VaR.

SAMPLE

SUMMARY STATISTICS

• All indices exhibit negative skewed (except for the AAA-AA 10-15 year maturity index)

• substantial excess kurtosis

INDICES RESULT

Results• The IRC for our sample of corporate bond indices we need to

estimate two parameters, the recovery rate and the average default probability adjusted to account for a 3-month liquidity horizon.

• We employ the TTC and PIT transition matrices reported in Table 1 to obtain two estimates of liquidity horizon for each rating grade G (and given maturities).

• Finally, according to Basel regulation should be a “downturn” recovery rate and should be employed to compute the downturn expected loss as well as the average expected loss

• It may be argued that adopting the same downturn recovery to estimate both losses may not be appropriate.

Then the two definitions of capital we will compare are• Old capital requirement = Pre-crisis VaR• New capital requirement = Pre-crisis VaR + IRC + Stressed VaR

We find that

• As expected, the size of the IRC capital depends on the rating method employed in the analysis. With through-the-cycle ratings the IRC ranges from 4.91% of the total exposure for 5-10 year AAA-AA indices and 8.71% for 15+ year A-BBB indices. With point-in-time ratings, the percentages are lower at 3.85% and 7.39% respectively, due to the lower default rate of such ratings. IRC values across the financial and industrial sectors are identical because we could not source sector specific transition matrices (and default rates) for PIT ratings.

Cont…….

• The size of the IRC is substantial relative to the old trading book capital requirement but it varies markedly across ratings and maturities. This is primarily because old capital is very sensitive to these risk dimensions.

The ratios of IRC to old capital range from a minimum of 39% (AAA-AA )15+ year industrial index with PIT ratings) to 173% (A-BBB) 5-10 year industrial index with TTC ratings).

Cont…….

• The stressed VaR is always significantly larger than the IRC. For industrial bonds, stressed VaR ranges from a minimum of 1.98 times the level of the IRC

• for A-BBB bonds with 5-10 year maturity with TTC ratings) and a maximum of 6.82 times (for 10+ year AAA-AA bonds with PIT ratings). The ratios between the two risk measures are even larger for financial bonds where they range from

• 3.12 to 10.11.

Cont…….

• As a result of the previous observations, the newly proposed capital requirements for the trading book are much bigger than the old capital requirements. The reported New/Old capital ratios allow us to illustrate this point and show that new capital ranges, for industrial bonds, from a minimum of 4.07 times old capital (AAA-AA) 15+ maturity bonds with PIT ratings)

• which corresponds to an increase of 307% - to a maximum of 6.17 times (A-BBB 5-10 year maturity bonds with TTC ratings) – an increase of 517%. The multiples are bigger for financial bonds and are 5.48 (448%) and 9.07 (807%) respectively.

• In other words, following the current crisis, banks may be required to increase their trading book capital by more than 8 times relative pre-crisis levels, on the basis of the new rules.

• Financial indices are almost invariably more negatively Skewed.

• always fatter tails than industrial indices.

FINANCIAL INDICES

• "Basel III" is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector.

• improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source

• improve risk management and governance• strengthen banks' transparency and disclosures

BANKING CAPITAL

• bank-level, or micro prudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress.

• macro prudential, system wide risks that can build up across the banking sector as well as the pro cyclical amplification of these risks over time.

REFORM

• These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system wide shocks.

Cont…….

• Impact of new capital requirement for trading portfolio.

• (introduced by Basel III)

• Sample twelve US bound industry

SUMMARY

• Estimate new capital ,Liquidity risk ,credit risk

so called through IRC.

• potential for direct loss due to internal/external ratings downgrade or upgrade as well as the potential for indirect losses that may arise from a credit migration event” Incremental Risk Charge

IRC

• Credit migration risk should be treated both under the objective/empirical measure and the risk- neutral/pricing measure.

• When marking-to-model under the risk-neutral measure we need rating transitions in continuous time.

• We must model dependencies between rating transitions at issuer level and under both probability measures!

Cont……..

• Create markets and instruments to share and hedge risks.

• Provide risk advisory services.

• Act as counterparties by assuming the risk of others.

RISK EXTREME MARKET MOVEMENT

Influence stressed VaRs requirement have pricing of tradable asset

Implication for banks asset allocation strategies

GAP

Implication of banks profitability Availability of credit financial stability &

economic growth

GAP