Credit Risk of Traded
Products under Basel II
HEC Conference
Montreal
April 13, 2007
Niall Whelan, Director
Research & Model Risk Management
Scotiabank
The views expressed here are those of the author and not necessarily
those of Scotiabank.
Introduction and Terms
Three components of regulatory capital from trading activities:
1. Credit Risk
2. Market Risk
3. Operational Risk
Credit Risk: Counterparties may default, leading to losses
Market Risk: Market conditions may be adverse, leading to losses in the
trading portfolio
Operational Risk: Fraud, terrorism, pandemics, weather disasters etc.
may occur, leading to losses to physical or other assets
2
Layout of Talk
Focus:
• Credit risk with some discussion of market risk
• Excluding: operational risk
Agenda/Topics:
• The need for a special treatment
• History of regulatory capital and traded products
• pre-Basel
• Basel I
• Basel II
• Overview of Basel II requirements
• 5 chapters of Trading Book document
• Implementation
• “use test” and connections to other risk measures
• Pillar 1, 2 and 3 issues
3
Credit Risk of Trading Portfolios
Trading activities are significant businesses for most large banks:
• OTC derivatives
• repo and reverse-repo transactions
• security lending and borrowing
They can all generate losses when counterparties default and
should therefore be capitalised...
HOWEVER
... we do not generally know how much our exposure will be if and
when the counterparty defaults:
• values of traded products are intrinsically uncertain
• we do not know what the portfolio of transactions will be when default occurs
4
Market Risk of Trading Portfolios
Derivatives portfolios are marked-to-market on a daily basis
• Typically well hedged but not perfectly so
• There is some residual net open position
This net open position can deteriorate in value under adverse
market conditions
This effect is captured by Value-at-Risk (VaR) capital provisions.
Based on extreme movement over 10 days of exposure
• No banking book equivalent
• Illiquid positions may require special treatment
• Idiosyncratic risk factors may require special treatment
5
History of Regulatory Treatment for Capital
Pre-Basel
• There was no international consensus on setting of capital
• Regulators did not adhere to rigid capital ratios
• relied on judgment of risk by the banks and themselves
• echoed in current "principle-based" approach
• Capital ratios fell through time
• 1840 ratio was about 50%
• deposit insurance, access to central bank funds acted to buffer bank risk
• 1940 ratio was about 6-8%
• Huge bank failures in the US during the Depression lead to much more active
regulatory environment
• 1973 collapse of Bretton Woods coincided with emergence of a significant Capital
Markets industry to create a more dynamic and volatile FX and interest rate
trading environment
• 1980's: Latin American debt crisis as well as the S&L crisis in the US led to more
concern about the robustness of the banking industry. The US brought in a series
of ever tightening capital requirements
• 1988: the Basel I accord...
6
Traded Products under Basel I
What is the exposure associated with an OTC contract?
OTC credit risk is the mark-to-market plus notional times the following add-on factor:
Residual
Maturity
Interest
Rates
FX and
Gold
Equities
Precious Metals
(except Gold)
Other
Commodities
< 1 year
0%
1%
6%
7%
10%
1-5 years
0.5%
5%
8%
7%
12%
> 5 years
1.5%
7.5%
10%
8%
15%
Consider:
•
is silver really so different from gold?
•
what about a cross-currency equity derivative?
•
is a 1½ year swap really identical to a 4½ year swap?
•
etc...
only reverse repos attract credit risk capital (not repos), due to collateral
only securities lending attracts capital (not securities borrowing), due to collateral
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Basel I cont...
Further multiply by the counterparty riskfactor weight
Counterparty Type
Riskfactor Weight
OECD governments
0%
OECD banks and
public service
entities
20%
Corporate and
other
50%
Capital is then 8% of the product
Consider:
•
shouldn't the perceived risk vary with economic conditions?
•
are all OECD banks of equal credit risk?
•
is a CCC corporate really identical to a AA corporate?
•
etc...
8
Netting under Basel I
Netting is the legal ability to settle on the net value of a portfolio
of derivatives upon default by one counterparty (vs. deal by deal)
Potential to lessen the exposure at default
First recognised as an amendment in 1995
A' = 0.4*A + 0.6*NGR*A
A is the add-on ignoring netting
NGR =(net current replacement cost) / (gross replacement cost)
Consider:
• this is very ad-hoc
•
what about netting with collateral?
•
deeply out-of-the money portfolios still attract significant capital
•
not "coherent"/sub-additive
9
Market Risk Capital under Basel I
In 1996 Basel outlined capital treatment of market risk (VaR).
• Based on the 99'th percentile of market loss over a 10 day horizon, multiplied by 3
Distribution of Market Losses
99'th
percentile
-3
-2
-1
0
1
2
3
Loss (Arb. Units)
• Banks have wide latitude in deciding how this is determined
• Regulatory focus on self-consistency, back-testing, internal controls and validation
• The result is a key internal risk measure that is regularly reported in financial statements
• “Prototype” for internal modelling approach now embedded in Basel II
• Separate charge for "specific risk" for derivatives subject to idiosyncratic entity-specific
risk (equity derivatives, credit derivatives etc.)
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Basel II
The main document:
International Convergence of Capital Measurement and Capital
Standards: A Revised Framework, June 2004
A document specific to trading activities was published in April 2005
Two months of industry consultation led to...
The Application of Basel II to Trading Activities and the Treatment
of Double Default Effects, July 2005
1. The treatment of counterparty credit risk and cross-product netting
2. The treatment of double default
3. The short-term maturity adjustment in the IRB approach
4. Improvements to the current trading book regime
5. A capital treatment for failed trades and non-DvP transactions
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Counterparty Credit Risk under Basel II
  1



Capital=EAD*LGD*A*  N 
G(PD) 
G(0.999)   PD 


1-
  1-


1  e 50PD
  0.12w  0.24(1  w)
w
1  e 50
1  (M  2.5)b
A
0.45
1  1.5* b
2
Capital
b   0.11852  0.05478ln(PD) 
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
0.00
0.05
0.10
0.15
0.20
PD
Consider:
•1-e-50 = 1-10-22 is a built-in underflow
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Counterparty Credit Risk under Basel II cont…
Risk-weighted assets = 12.5*Capital
• RWA now a derived quantity, not fundamental to the capital calculation
PD and LGD are common to other asset classes
Trading book requirement is the determination of EAD and of M
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Counterparty Credit Risk under Basel II continued...
Determination of EAD and M for OTC: Three methods
1. Current exposure method (essentially Basel I augmented for credit derivatives)
2. Standardized method (I am not aware of any bank using this)
3. Internal (EPE) method
Determination of EAD and M for repo-style: Three methods
1. Standardised haircuts
2. Adapted VaR
3. Internal (EPE) method
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Counterparty Credit Risk under Basel II continued...
EPE method. Use an internal model to estimate expected exposures
over a one year time horizon
0.6
Expected
Exposure
0.4
Effective
Expected
Exposure
0.2
0.0
0.0
0.5
time (years)
1.0
Determine "running maximum" through time (roll-over risk)
Average of the running maximum times 1.4 is EAD
M is determined by a similar manipulation of the exposure profile
Factor of 1.4 is regulatory; it can be as small as 1.2
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Counterparty Credit Risk under Basel II continued...
Other considerations:
• Can be done at the level of a netting set
• Collateral treated as a negative offsetting position
• Under certain conditions can net OTC and repo-style
• Margin agreements effectively cap the potential exposure
• Based on expected exposure, not 99.9’th percentile
• Explains need for the scaling by 1.4
• Can impose one’s own scaling of:
EC(simulat ed exposures)
EC(expecte d exposures)
• Subject to a floor of 1.2
• Industry studies indicate 1.1 to 1.2 is typical
• Internal economic capital is an explicit component of the calibration
• We find about 20-30% relief relative to CEM
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The treatment of double default
Credit derivatives that are hedging loan exposures do not attract counterparty
capital
They are treated the same as a credit guarantee
Under certain conditions guarantees or credit derivatives can attract "double
default treatment"
• Reflects the probability that both the counterparty and the guarantor must default to
experience an exposure.
C '  C  0.15  160 PDg 
Consider:
This can actually increase capital if
Equation "should" be
PDg  0.0053
C '  capital determined using PD'
PD '  probability that both default
17
The short-term maturity adjustment in the IRB approach
Technical point.
By default M is floored at unity but in some cases it can be less
than one
Repo-style transactions with daily remargining are the most
important application
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Improvements to the current trading book regime
Not an extensive overhaul, implying an overall regulatory and
industry comfort with market risk under Basel I
Changes include:
• Greater oversight about what can be held in trading books
• Greater concern by regulators about validity of the 10-day unwind period in VaR
for illiquid positions
• More rigorous validation and stress testing standards
• Lessening of specific risk charge multiplier from 4 to 3
• Need to capture “event risk” and “incremental default risk” in specific risk
• Still somewhat contentious
• These are based on 99.9’th percentile of loss over one year
• Difficult to combine with market VaR defined as a multiple of 99’th over 10 days
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A capital treatment for failed trades and non-DvP transactions
Meant to plug a small hole in Basel I: how to treat trades which
have failed to settle
• DvP - treat as a forward contract
• non-DvP - treat as a loan
Typically so immaterial that applying a conservative factor is the
best approach
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Use Test
Related credit risk measures
• Economic Capital
Related market risk measures
Desk and business-level market
VaR
• Credit Line Utilisation
• Credit loss provisions (expected losses)
Principle is that the internal model for these measures should be
broadly in line (not necessarily identical) to what is done for Basel
• Systems/infrastructure
• Data
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Pillars 1, 2 & 3
We have focused mostly on Pillar 1 – the determination of capital
Significant Pillar 2 requirements – supervisory oversight. This
includes disclosure to regulators, back-testing, stress-testing, usetest and other evidence that the measures are embedded within a
robust risk framework
• Important consideration for regulators in light of the "principle-based" approach
• Connection to Economic Capital particularly important
Pillar 3 requirements – public disclosure. This is a relatively light
component for the Trading Book
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Bank Experiences
A major improvement. Principle-based/internal modelling approach makes sense
• Avoid “regulatory arbitrage”
• More granular and dynamic reflection of credit and market risk
• Use test requirements
Little time for consultation between first and second drafts of Trading Book document
• Regulators and Basel Committee were receptive to industry feedback
• Still some aspects of the accord that are somewhat contentious
Tendency for Trading Activities to be an "after thought"
• Basel guidelines came later
• Gap analysis from OSFI came later and was not paragraph-by-paragraph
• Internally
A major piece of work involving multiple departments across the bank
A valuable tool to improve banks’ internal processes
• Data flows and system information
• Consistency of risk assessment across business lines
• Improvement and rationalisation of internal risk measures
• VaR
• Economic Capital
• Loss provisions
• Credit line utilisation
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