Internal credit risk models capital allocation and performance measurement pdf

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Chapter No.

Internal Credit Risk Models: Capital Allocation and Performance Measurement

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He is responsible for the management information and decision support function for the executive committee on enterprise-wide market, operational, credit and liquidity risk, as well as RAROC and ROE models.

Before joining ABN Amro, Michael was head of the corporate research unit at First Chicago NBD Corporation, where he was chair of the global risk management research council and head of the market risk analysis unit. Michael is a member of the editorial boards of the Journal of Financial Regulation and Compliance and the Journal of Risk.

Behind every good book is an excellent team, and I am very fortunate to have two excellent teams of people on both sides of the Atlantic. First, I extend my infinite appreciation to Conrad Gardner, Senior Commissioning Editor of Risk Books, for recognising the value of this book even from its initial glimmering. It was his enthusiasm and belief in the importance of the subject matter, and his confidence in my writing ability, that gave me the chance to proceed.

In my futile search for thoughtful proverbs for the dedication page, Conrad Gardner brilliantly offered some"Whoever understands the first truth, should understand the ultimate truth.

I am also deeply honoured to be the first single author ever published by Risk Books. Without the assistance of very able editors in crafting the proper phrasing and wording, the voice of reasonno matter how profound the thoughts of the authorwould remain unheard. To this end, I am indebted to Ben Mullane, Desk Editor, who carefully and skilfully crafted and shaped the core truths of the book into all that it is. Many thanks also to Romilly Hambling and Corinne Orde, who diligently assisted Conrad Gardner in the technical editing and typesetting of the book.

On this side of the Atlantic, my colleagues who performed the real work in the trenches deserve much praise. Many of the technical appendices, though not credited to anyone in particular, are clearly reflective of her work. She performed the calculations for almost all of the numerical examples in the book, and truly she deserves to be considered a co-author of this book. Heartfelt thanks are due to my colleague, Dr Stevan Maglic, who performed all the Monte Carlo simulation exercises and thought of clever ways to simulate the loss distributions of very large portfolios.

He was also responsible for preparing two important appendices. I extend my gratitude to my colleague, Dr Weixiong Li, for extending our preliminary internal model into one that has the capability of performing mark-to-market valuation, credit migration, multi-year analysis and macroeconomic risk analysis.

Notwithstanding being the most junior of our team, Thanh Tran was outstanding in his graphic illustration work and carefully performed due diligence tests on the numerical calculations of our internal model. To him I extend my sincere thanks.

How useful this book is remains to be seen. I was given a rare opportunity to speak my mind and to present sensible solutions to a very delicate dilemma in our industry, and I took it.

Curiously, my intent in writing this book is not that people will simply read it like a text, but more to open up a dialogue on a fundamentally difficult and political topic that goes to the heart of the financial industry and the function of its regulatory supervisors.

Finally, much gratitude is owed to all the unsung heroes on the Street who have advocated reform since our initial debate on market risk capital adequacy many, many years ago. It is too clear and so it is hard to see, A dunce once searched for fire with a lighted lantern, Had he known what fire was, He could have cooked his rice much sooner.

Whoever understands the first truth, Should understand the ultimate truth, The last and first, Are they not the same? It is also no longer a secret that the anomalies in the Capital Accord have been universally exploited by big banking institutions through clever innovations in the capital markets with the use of such vehicles as asset securitisation programmes, credit derivatives and other recent technological and financial innovations.

In effect, banks have been able to lower their risk-based capital requirements significantly without actually reducing the material credit risk embedded in their banking portfolios.

For the most part, the basic core of the Capital Accord regarding credit risk remains unchanged. The irony of it all is that the Accord, which originally provided an international credit risk capital standard for G10 countries, was subsequently more widely adopted as the global benchmark for regulatory credit risk capital adequacy standards for the world's largest banks. Within the European Union, the Accord was first adopted for banks through two directives, the Solvency Ratio and the Own Funds directives, and was later also applied to investment banks.

The continued usage of a flawed framework with such global implications is definitely unconscionable and, therefore, irresponsible. A further irony is that the regulators themselves are perplexed: With the formal RBC risk-based capital ratios rendered less useful, judgmental assessments of capital adequacy through the examination process necessarily have assumed heightened importance. Yet, this process, too, has become problematic as regulatory capital arbitrage has made credit risk positions less transparent.

While examination assessments of capital adequacy normally attempt to adjust reported capital ratios for shortfalls in loan loss reserves relative to expected future charge-offs, examiners' tools are limited in their ability to deal effectively with credit riskmeasured as the uncertainty of future credit losses around their expected levels.

Analogous to the trading book VAR models, internal credit risk models are rapidly being developed to support internal capital allocation schemes and economic capital adequacy in lieu of regulatory capital.

These laudable initiatives not only provide the banks with a more sophisticated and appropriate mechanism for managing portfolio credit risk, but an internal credit risk model can also serve as a basis for estimating the risk-adjusted profitability of the various lines of business, which, in turn, can be used to evaluate performance and compensation. More importantly, the combined effort invested in internal credit risk modelling and economic capital allocation schemes has, slowly but surely, been incorporated into the risk management processes of these banks, directly affecting day-to-day portfolio credit risk management, the risk-adjusted pricing and hedging of transactions, portfolio concentration and diversification effects, collateral management and other strategic decision-making processes.

All of these are important ingredients of prudent risk management across the enterprise and, consequently, of the prudential assessment of bank capital adequacy - the basic tenet of the Capital Accord.

Objectives of the Book So, what really is an internal credit risk model? What is it supposed to do? And what components must it have? This book seeks to answer these questions readers are referred to the last part of chapter 2 for a preview of its contents. Given the inadequacy of the Capital Accord and the developmental efforts of major banking institutions, it is only a matter of time before internal models for credit risk are the main risk management tool of the banking book.

In the meantime, it is important for both the industry and the regulatory supervisors to agree swiftly on a common framework for measuring and managing credit risk, thereby accelerating the near-term use of internal models and promoting greater transparency in the market. It is not too early to start a dialogue along the lines of a possible near-term use of internal credit risk models.

In fact, there is no better place to begin the experiment than within the banks themselves. However, in the interim, as traditional techniques for assessing capital adequacy are rapidly becoming outmoded, improved supervisory methods are needed if capital-based prudential policies are to remain viable even over the shorter term. Because the most accurate information regarding risks in likely to reside within a bank's own internal risk measurement and management systems, supervisors should utilize this information to the extent possible.

Through simple explanations and accessible mathematics, the intention is to make the fundamental building blocks of the modelling effort, albeit quantitative, more transparent and accessible to a wider audience. Given the paucity of usable and coherent data on credit risk, the parameterisation of the internal model is, however, best left to the institution and the regulators to argue about in the years to come. The period from the late s to the early s saw important changes that contributed to growing regulatory and market pressures on banks to increase capital ratios.

The global adoption of the risk-based capital standards loudly trumpeted a greater regulatory interest in both the on- and off-balance sheet activities of major international banks. There is ample evidence to indicate that regulators have had a significant influence on the capital ratios of a large proportion of banks in the period since the s.

The major banking institutions have responded creatively to these regulatory challenges. Because capital ratios as dictated by capital adequacy regulations have become a primary measure of a bank's financial condition, it is important to understand how banks respond to binding capital regulation. It has, after all, become an exercise in "game theory". Consequently, because the reactions from banks take various forms, regulators must consider what response they wish to elicit when formulating new regulations so that the game is played in a prudent and transparent manner.

We therefore need to ask many interrelated questions, such as, What is capital? Why do banks need to hold capital to conduct their business? What is the role of capital in banking? How much capital should banks be required to hold? How do banks respond to different types of capital regulation? The capital framework was subsequently endorsed by the Group of Ten central bank governors.

Although the agreements set forth in the capital accord are not legally binding, member countries of the G10 are morally bound to implement the framework in their respective supervisory functions and to turn it into national law by December As it stands today, the Basle Capital Accord of ubiquitously remains the definitive global benchmark for solvency requirements among the world's largest banks.

Prior to the full implementation of the Basle Accord in , capital regulations consisted primarily of minimum capital standards uniformly applied to banks, regardless of their risk profiles and ignoring off-balance sheet activities. The agreement marked the first time that international minimum capital guidelines were linked to banks' capital requirements, albeit only to the credit exposures in their portfolios.

This will be elaborated in greater detail later on in the chapter. For the moment, one can briefly say that the capital framework was designed to provide a simple and crude distinction between the main types of credit risk. Specifically, the capital framework requires banks to hold capital equal to some percentage of all the "risk-weighted" assets in their portfolios.

The assignment of risk weights is based on the perceived credit quality of an individual obligor, measured on an instrument-by-instrument basis. The framework was originally directed mainly at the assessment of capital in relation to credit riskspecifically, the risk of counterparty failurebut other risks eg, market risk, liquidity risk, etc , although recognised by the Committee, were intentionally not addressed. More recently, the amendment 4 to the Capital Accord extended the initial requirement to include risk-based capital adequacy for market risk and specific risk in the trading books of the banks Basle, What was the cause of this urgency?

What prompted the promulgation of the Basle Capital Accord? Many think, incorrectly, that the Accord was the genesis of risk-based regulatory capital requirement. It was not. In fact, capital requirements existed prior to At this juncture in the exposition it should be reiterated that even though the most important issue at handthe management of credit risk and its attendant modelling effortwas conveniently lumped under the guise of regulatory capital requirement, it would not be beneficial for all parties involved regulators and practitioners alike to misconstrue the primary intent here of addressing credit risk modelling.

Capital requirement, with its attendant allocation issue, should be treated as a simple corollary of the more important effort of managing and containing credit risk. The next few sections continue with a historical perspective of the events that led to the establishment of the Accord. The term "safety net" refers to all governmental actionsregulations and enforcement of capital requirementsdesigned to enhance and protect the safety and soundness of the banking system in the United States.

The safety net may include deposit insurance, unconditional payment guarantees, access to discount windows and other government actions enacted to regulate the banking system in general. Prior to the start of the National Banking era of , capital ratios were already declining significantly. As the efficiency of the U. Empirical data support the hypothesis that, with stabilising factors established in the market, increasingly less capital is needed to protect against financial distress.

Empirical data show an accelerated decline of capital ratios after

Dimensions of Credit Risk

This is a non-GAAP financial measure. Apr 3, - For example, the PPA may allow one or both parties to terminate PPA prior to the commercial operation date if: 1 the federal production tax credit PTC is not available; 2 the seller's or purchaser's internal approvals, or any required regulatory or third party approvals, are not received; Price terms vary depending on the structure of the project financing, quality of the wind resource, available transmission resources, turbine performance characteristics, and many other issues. An example of performance measure that involves EC is return on risk adjusted capital Moreover, by contrast with regulatory capital models under Basel II, such as the advanced internal rating based AIRB model for credit risk, banks can make their own choices on how to model EC. Apr 15, - The near collapse of capital markets, sudden implosion of national economies, astronomic growth of national and individual debts, quick collapse of corporate structures, and the desperate search for genuine leadership are problems that defied conventional wisdoms. The five-force model needs a radical adjustment if it is to continue to be of use today.

Internal Credit Risk Models: Capital Allocation and Performance Measurement

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Capital is key to any financial institution. Companies in other industries need capital to buy property and production equipment. David Rowe, Dean Jovic and Richard Reeves explain why it is crucial for financial institutions to build an advanced economic capital framework and how that plays into current initiatives to implement the Basel II Capital Accord.

Applied Quantitative Finance pp Cite as. To assess the riskiness of credit-risky portfolios is one of the most challenging tasks in contemporary finance. The decision by the Basel Committee for Banking Supervision to allow sophisticated banks to use their own internal credit portfolio risk models has further highlighted the importance of a critical evaluation of such models. A crucial input for a model of credit-risky portfolios is the dependence structure of the underlying obligors. We study two widely used approaches, namely a factor structure and the direct specification of a copula, within the framework of a default-based credit risk model.