Credit Risk - Standardised Approach

Belgian Bankers Academy

Prague, October 2005
Agenda

1. Introduction to Basle II
• Scope of Application
• Basel I and II
• Overview of Minimum Capital Requirements
• Standardised versus IRB Approach
• Partial Use

2. Minimum Capital Requirements for Credit Risk: Standardised Approach

• Exposure Classes
• External Ratings and Risk Weights
• Credit Risk Mitigation
• Guarantees and Credit Derivatives
• Collateral
• Examples

3. Questions and Answers

2
Range of application of the Basel framework
in the Czech Republic
Basel EU “CNB“

”Good Conduct” “Mandatory” “Mandatory”

Banks in Czech
Internationally Republic
active
Banks
Banks within the European Union

3
The Basel Committee

• The BCBS was formed in 1974 by the Group of 10 central bank

governors following the failure of West German bank Bankhaus Herstatt
• Committee members include representatives from Belgium, Canada,
France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain,
Sweden, Switzerland, the U.K. and the U.S.
• From its inception, its primary mission has been to promote stability in
the global banking system in the pursuit of two guiding principles
• No foreign banking system should escape supervision
• Supervision must be adequate for all banks operating internationally
• Its primary objective is to formulate standards, guidelines and best
practices that individual authorities will implement

4
Deficiencies of the current regulatory
framework (Basel I)

• Lack of differentiation within credit risk

• Limited recognition of risk mitigation instruments
• No explicit consideration of other risks

Regulatory
Capital ≠ Economic
Capital

„Regulatory Arbitrage“

5
Concept of Basel II – Three pillar architecture

Requirements Minimum
Capital requirements

• Risk weighting/Rating
• Risk mitigation
• Operational risk

Qualitative assessment Disclosure

Supervisory Market-Discipline
Review-Process

• Fulfilment of qualitative requirements • Approaches chosen by the bank

• Not fully captured risk • Relevant information
• Risks not taken into account
• External factors

6
Basel 2 - Evolution

Nov: QIS2,5

3-6-3 Oct: QIS3

principle 1988: Basel I Accord
June 2004:
the new Accord
Liberalisation Apr&May: QIS1,2 published

Jan/2001: CP2 Jan: Basel 2

comes in force

1960 1970 1980 1990 2000 2001 2002 2003 2004 2005 2006 2007

June/1999: CP1
1996: Market risk
July: QIS3 results
published
May: Release of CP3

1990: 100 countries Jan: start

apply Basel I parallel run
1974: G10 launch
Basel Committee
7
Scope of Basel II framework

Promote safety and soundness in the financial system

What?
Continue to enhance competitive equality

Complete recognition of all types Orientation on the bank‘s individual

How? of risk risk profile

Focus on internationally active Principles suitable for application on

Who? banks smaller banks

No general reduction of the capital level in the financial system

8
Pillar I

Pillar II Pillar I Pillar III

Credit risk Securitization Operational Risk

SA IRB SA IRB BIA AMA SA

FIRB AIRB Exceptions RBA IAA SFA

9
Implementation schedule for Basel II

Standardised approach

F-IRB (incl. Retail)

Parallel run Floor (95 %) Floor (90 %) Floor (80 %)

01.01.06 01.01.07 01.01.08 01.01.09 01.01.10

Parallel run

Advanced approaches for credit risk

and/or operational risk

Start of Basel II
(Standardised and Foundation) Start of Basel II
(Advanced and AMA)
10
Implementation schedule for EU-Directives

Standardised approach
Basel I-weighting

F-IRB (incl. Retail)

Floor (95 %) Floor (90 %) Floor (80 %)

01.01.06 01.01.07 01.01.08 01.01.09 01.01.10

Advanced approaches for credit risk

and/or operational risk

Start of Basel II
(Standardised and Foundation) Start of Basel II
(Advanced and AMA)
11
Data history for IRB

Retail corporate,
sovereigns,banks

Basic Transition Basic Transition

requirement requirement

PD 5 Years 2 Years 5 Years 2 Years

LGD 5 Years 2 Years 7 Years 7 Years

EAD 5 Years 2 Years 7 Years 7 Years

12
Calculation of minimum capital requirements

Regulatory Capital
> 8%
Risk weighted assets* + [(Market Risk + Operational Risk) x 12.5]

No changes New
• Definition of the regulatory capital • Techniques for credit risk
assessment
• Minimum total capital ratio of 8% to
risk weighted assets • Operational Risk
• Techniques for market risk • Capital elements within the IRB-
assessment Approach (shortfall/excess of
Provisions)

* For IRB-Part of RWA a Scaling Factor of 1.06 applies

13
Possible approaches for credit risk

Standardised Internal Ratings Based

Approach
Foundation Advanced

Internal estimation
Risk weighting External ratings
Externally provided

Collateral Simple Comprehensive

Guarantees
Credit Externally provided Externally Externally
provided provided No limitation
derivatives
Netting

Calculation Externally provided Externally Externally

provided provided Internal procedures
methods External/internal Haircuts

No consideration* 2.5 Y 1 - 5 Years

Maturity *Exceptions: Option 2 Banks Orig. Mat. < 3M and
Risk Mitigation/Haircuts Option

Effort 14
Partial Use of IRB in the EU

Permanent partial use is acceptable

• Exposure to Sovereigns, if number of relevant counterparties is limited and set-up of
a rating system would be unnecessary burdensome
• Exposure to banks, if number of relevant counterparties is limited and set-up of a
rating system would be unnecessary burdensome
• Exposure to non essential businesses, and exposure to small sized businesses
(Participations <10% of own funds, if less then 10 participations<5%)
• Exposures to Central Governments (of originating Member States) and their
instrumentalities (assuming the same risk profile)
• Intra Conglomerate exposure
• Participations with risk weight 0%
• Participations in Governmental framework programs for the benefit of specific
sectors in the economy.

15
Agenda

1. Introduction to Basle II
• Scope of Application
• Basel I and II
• Overview of Minimum Capital Requirements
• Standardised versus IRB Approach
• Partial Use

2. Minimum Capital Requirements for Credit Risk: Standardised Approach

• Exposure Classes
• External Ratings and Risk Weights
• Credit Risk Mitigation
• Guarantees and Credit Derivatives
• Collateral
• Examples

3. Questions and Answers

16
EU: Standardized approach: exposure
classes

Exposure classes
1. Each exposure shall be assigned to one of the following exposure classes:
(a) claims or contingent claims on central governments or central banks;
(b) claims or contingent claims on regional governments or local authorities;
(c) claims or contingent claims on administrative bodies and non-commercial undertakings;
(d) claims or contingent claims on multilateral development banks;
(e) claims or contingent claims on international organisations;
(f) claims or contingent claims on institutions;
(g) claims or contingent claims on corporates;
(h) retail claims or contingent retail claims;
(i) claims or contingent claims secured on real estate property;
(j) past due items;
(k) items belonging to regulatory high-risk categories;
(l) claims in the form of covered bonds;
(m) securitisation positions;
(n) short-term claims on institutions and corporate;
(o) claims in the form of collective investment undertakings (CIU);
(p) other items. Article 79 and Annex VI 17
EAD assessment: General rule

• For the purpose of capital requirement calculation, the exposure value is

determined as follows:
EAD = Part of position in balance-sheet + Part of
position off balance-sheet × Conversion factor

• The conversion factor value for the off-balance item is

• 100% for a “full risk” item (e.g. irrevocable bank guarantee)
• 50% for a “medium risk” item (e.g. undrawn credit facility with maturity
over one year)
• 20% for a “medium/low risk” item (e.g. letter of credit with goods as
collateral)
• 0% for a “low risk” item (e.g. unconditionally cancelable credit facility)
• A detailed list of off-balance sheet items with corresponding conversion
factors is introduced in Annex II.
18
 Standardised approach Risk weighting

Rating S&P and Export credit agencies1

AAA BBB+
Claim A+ to A- BB+ to B- Below B-
to AA- to BBB- “Unrated”
1 2 3 4-6 7
Sovereigns 0% 20% 50% 100% 150% 100%
Option 12 20% 50% 100% 100% 150% 100%
Banks Option 23 20% 50% 50% 100% 150% 50%
Option 34 20% 20%3 20%3 50%3 150% 20%
Corporates5 20% 50% 100% 150% 100%
AAA BBB+
A+ to A- Below BB- “Unrated”
to AA- to BB-
Other position 100% Retail 75%

Short term6 20% 50% 100% 150%

A1 / P1 A2 / P2 A3 / P3 Others
1 Assessment of Export credit agencies only for claims on sovereigns/central government
2 Risk weighting corresponding to the sovereign risk weighting of the respective country
3 Risk weighting corresponding to the individual banks
4 Short term claims (original maturity < 3 months) get a one category more favourable risk weighting
5 At national discretion, supervisory authorities may permit banks to risk weight all corporate claims at 100% without regard at external ratings 19
6 For example, commercial paper
EU: Standardized approach

Credit quality steps 1 2 3 4 5 6

Minimum export insurance „Unrated“
1 2 3 4 5-6 7
premiums (MEIP)
Exposure to Sovereigns 0% 20% 50% 100% 100% 150% 100%
Method 11 20% 50% 100% 100% 100% 150% 100%
Exposure to
Method 22 20% 50% 50% 100% 100% 150% 50%
banks
Method 33 20% 20% 20%3 50%3 50%3 150% 20%
Mortgage backed securities 10% 20% 20%/50%4 20%/50%4 50% 100% 20%/50%4
Exposure to Corporate 20% 50% 100% 100% 150% 150% 100%
Short term exposures 20% 50% 100% 150% 150% 150%
to banks/corporates
Exposure to CIUS 20% 50% 100% 100% 150% 150% 100%

Other exposures 100% Commercial real estate 50%

Retail 75% Housing credits 35%
1 (Option 1 in Basel II)
2 Rating based Method ( Option 2 in Basel II)
3 Short term option
4 At discretion of the Regulator
Annex VI
20
Exposures to local governments, PSE,
multilateral development banks and
international organizations I

• Exposures to local governments and local authorities are

treated as exposures to banks unless the national regulator
has allowed them to be treated as exposures to sovereigns.
• Claims or contingent claims on administrative bodies and non-
commercial undertakings (PSE – Public Sector Entities) are
assigned RW = 100%, unless the national regulator has
allowed them to be treated as exposures to institutions.
• Exposures to multilateral development banks and international
organizations are treated as banks.

21
Exposures to local governments, PSE,
multilateral development banks and
international organizations II
• The following banks and organizations are assigned RW = 0%:
• International Bank for Reconstruction and Development
• International Finance Corporation
• Inter-American Development Bank
• Asian Development Bank
• African Development Bank
• Council of Europe Development Bank
• Nordic Investment Bank
• Caribbean Development Bank
• European Bank for Reconstruction and Development
• European Investment Bank
• European Investment Fund
• Multilateral Investment Guarantee Agency
• The following 3 international organizations also have a RW = 0%:
• European Communities (EC)
• International Monetary Fund (IMF)
• Bank for International Settlements (BIS)
22
External Credit Assessment Institution (ECAI)
ratings I

Approval procedure
The national regulator has the discretion to assess the suitability of the External
Credit Assessment Institution, ECAI, (but CEBS ruling)

General criteria
The criteria for approving an external agency (ECAI) by a regulator:
• objectivity
• independence
• ongoing review
• the resulting ratings meet the requirements for credibility and transparency
and are accepted by the market

Annex VI part 2 23
External Credit Assessment Institution (ECAI)
ratings II

Principles
The national EU regulator, with due consideration of the CEBS guidelines, has the
authority to approve rating agencies.

The national regulator shall determine to which of the further specified credit quality steps
(CQS) will be associated specific credit assessments of individual approved rating
agencies. The result will be the mapping of risk weights (RW) to the determined grades.

Banks must use their selected ECAI and its ratings for all exposure types (no “cherry
picking“).

Minimum annual disclosure of:

• What ECAIs for what type of exposure
• The procedure of the regulator to grant approval

24
Article 81 and following ones. Annex VI part 2 and Annex XII part 2 p.6
Selection of Ratings

If several ECAIs rate the same debtor

Two ratings with diverging risk

The higher one
weights

If two of the lowest ones

are identical, that risk
More than two ratings with weight is the eligible
diverging risk weights Rating.
If not, the higher one of
the two ratings

Annex VIII part 1 p. 10

25
Intra Group (Conglomerate) exposure

Requirements:

• The counterparty is a credit institution, Financial Holding Company, Financial

institution, Asset Management Company under an acceptable Supervision.
• Both parties must be consolidating their balance sheets
• Share the same risk assessment, control and management
• Registered Office of the counterparty in the same Member State
• No substantial, legal or whatever impediment to transfer own funds between
the counterparts

0%-at national discretion possible

article 80, paragraph 7

26
Standardised approach: Retail loans

Definition of a Retail portfolio

Qualitative requirements:
• private individuals
• smaller companies
• ...

Quantitative requirements: • Max single credit of €1 million

• Sufficient diversification of the Retail
portfolio (Possibility: Max credit volume
of 0.2% of total Retail Portfolio)

Capital relief: Standard risk weighting of 75%

Possible problems: Credits higher than “1.01” mill. €

article 79, paragraph 2

27
Claims secured by real estate

Risk weight for loans secured entirely by residential

Residential real
property/mortgages on residential real estate:
estate 35%

Risk
Commercial real estate weight

Risk weight for loans secured by commercial property/mortgages on

Principle
commercial real estate: 100%

In highly-developed and long-established markets:

• Min [50% of MV*; 60% of LV*] 50%

• Loan amount minus Min [50% of MV*; 60% of LV*] 100%

Exception Conditions (to be added):

• Losses resulting from commercial real estate loans, up to the lower value of either
50% of MV or 60% of LV, must be < 0.3% of the yearly outstanding loans
• Total losses from commercial real estate loans must be < 0.5% of the yearly
outstanding loans
28
* Market value (MV) or lending value (LV) of the securing property
Units shares of CIUS

Base
• If a rating exists for a unit share of a CIUS the table must be applied
• High risk CIUS may bear a 150% risk weight

Qualitative requirements
At CIUS level:
• CIUS Management company located in the
EU
• Management company under an
acceptable Regulator, exchange of info
assumed
• Prospectus has info on asset composition
and investment restrictions
• Annual reporting minimum
Determination of rating
• Is it possible to assess the existing
exposure, is it possible to determine an
average exposure amount
• Risk weighting could be based on
investment restrictions
• Third parties could be appointed to
assess the risk exposure of the CIUS

annex VI, part 1, p.71 and following

29
Treatment of higher-risk assets

Specific provisions
Loans more than 90
days past due1 < 15% 15-20% 20-50% > 50%

Residential mortgage loans 100% 100% 50% 50%3

Other collateral2 150% 100% 100% 50%3

Other 150% 150% 100% 50%3

Other higher risk weights

• Securitisation tranches rated between BB+ an BB- risk weighted at 350%
• National supervisors may decide to apply a 150% or higher risk weight reflecting the higher
risks associated with some other assets, such as venture capital and private equity
investments
1 Claims that are more than 90 days past due are not allowed to be allocated to the Retail portfolio if the granularity
criterion is used as evidence for a sufficient diversification
2 Fully secured by those forms of collateral that are not recognised as eligible credit risk mitigation techniques
3 At national discretion 30
Off-balance sheet transactions

Risk weight dependent on:

OTC-
• Type of counterpart (sovereign/central bank, bank, corporate)
derivatives • External rating of the counterpart

Credit conversion
factor

• Irrevocable commitments with an original maturity of up to 20%

Principle

one year

• Irrevocable commitments with an original maturity longer

than one year 50%
Credit
commitment
Exceptions

• Commitments which can unconditionally be cancelled by the

bank at any time
• Commitments which are automatically cancelled at any time 0%
as a result of a deterioration in the borrower’s
creditworthiness, without any prior notice from the bank

31
Overview standardized approach risk
weightings

Basic rate: 100%

<100%: if an acknowledged rating is available

150%: credits granted deferred > 90 days

Exceptions

150%: high risk items

150%: bad rating

75%: Retail credits

50%: Commercial real estate mortgage backed credits

35%: Housing mortgages backed credits

32
Credit Risk Mitigation:
General Provisions

• Institutions using both the standardized approach, or foundation IRB, may take
into consideration the effect of Credit Risk Mitigation (CRM) during RW
calculation.
• All possible credit risk mitigation methods must be legally enforceable in all
relevant countries.
• In addition, institutions must ensure the efficiency of the entire process and
address risks connected therewith.
• Institutions must always ensure compliance with minimum requirements for CRM
procedures.
• If all defined requirements are met, the institution may decrease the value of RW
or EL in compliance with CAD.
• No exposure with a CRM instrument may have a RW higher than an identical, but
unprotected exposure.
• In cases when CRM has been incorporated in the calculation of RWA, the
provision on CRM is not further applied.
33
 Approach to credit risk mitigation

Risk mitigation techniques have developed considerably since

Principle: the implementation of the original Accord

Instruments: Guarantees
Credit
Collateral Netting
derivatives (balance sheet items)

Goals: • Appropriate treatment of residual risks

• Reduction in the capital requirement
• Balance between accuracy and complexity

34
Eligible collateral in the standardised
approach - I

Collaterals
Simple Approach Comprehensive Approach
• Cash on deposit / Gold • All instruments of the simple approach
• Debt securities with credit quality step (CQS) not worse than • Equities and convertible bonds, which are not included
in a main index but are listed on a recognized
3 (or 4 for sovereigns)
exchange2
• CIUS / mutual funds (extended)2
• Debt securities issued by a bank without rating (restrictions
apply) • Issued by a bank
• Listed on recognised exchange
• Equities and convertible bonds that are included in a main • Senior claim
• No other issue of the issuer rated worse lower than „3“
index (EU) or „BBB-, A3/P3“ (Basel)
• No indication of rating deterioration
• Sufficient liquidity
• CIUS / mutual funds (limited)
• Daily pricing
• Investment only in eligible risk mitigation instruments

35
Eligible collateral in the standardised
approach - II

Guarantees / Credit derivatives Netting

• Central banks and sovereigns with lower • Claims

risk weight than the counterparty
• Deposits
• Public sector (PSEs), banks and securities
firms with a lower risk weight than the
counterparty
• Multilateral development banks
• International organizations (with a 0% RW)
• Other entities with CQS 1 or 2
• NOT! Guarantees issued by a retail client !

• Life Insurances
Possibility to recognise:
• Cash lodged at other banks
(as guarantees)
36
Eligible collateral in the standardised
approach - III

Residential real estate

Risk weight for loans secured entirely by residential
property/mortgages on residential real estate: 35%

Commercial real estate

Risk weight
Principle Risk weight for loans secured by commercial 100%
property/mortgages on commercial real estate:
Exception In highly-developed and long-established markets: 50%
Min [50% of MV*; 60% of LV*]

Loan amount minus Min [50% of MV*; 60% of LV*] 100%

Conditions (to be added):

Losses resulting from commercial real estate loans. up
to the lower value of either 50% of MV or 60% of LV.
must be < 0.3% of the yearly outstanding loans
Total losses from commercial real estate loans must
be < 0.5% of the yearly outstanding loans 37
Qualitative requirements for financial
collateral

• Legal certainty
• Low correlation with exposure
• Robust risk management process
• Strategy
• Focus on underlying credit
• Valuation
• Policies. procedures. systems
• Concentration risks
• Roll-off risks
• Disclosure of information under Pillar III
38
Annex VIII, Part 2
Minimum requirements for guarantees and
derivatives

Requirements

• Unrestricted exposure enforcement to guarantors and coverage providers

• Unconditional coverage / Irrevocable commitment
• No unilateral cancellation of commitment of coverage provider possible
• No increase of fees of coverage if underlying exposure is declining
• No reduction in availability of coverage
• Asset-mismatch not acceptable

Annex VIII, Part 2

39
Requirements for Netting

Instruments • claims
• deposits

• Funded legal entitlement, in case of

Qualitative requirements
insolvency, bankruptcy etc...
• Quantification of exposure and liabilities
• Awareness of residual risk exposure
• Management and control of net position
exposure

Calculation • As in the case of acceptance of other

financial coverage instruments.

40
Annex VIII, Part 2
Residual Regulatory risks

Risks stemming from insufficient coverage

Market price
Maturity mismatching Asset-Mismatch
risk

Discrepancies
Diverging market price between assets to be
Mismatch maturity of
evolution between secured and the
pledged asset with
exposure and pledged underlying notional
underlying exposure
item assets (credit
derivative)

41
 Risk mitigation in the Standardised Approach

Guarantees/credit Netting
Collateral
derivatives (balance sheet positions)

Simple Approach Comprehensive Approach

Substitution approach with a Assessment of collateral instruments after consideration of

minimum weighting of 20% haircuts resulting from residual risks

Maturity match required Haircuts in case of maturity mismatch

Collateral assessment Remaining maturity of collateral minimum 3 months

minimum every 6 months
Original maturity of collateral > 1 year

No consideration of maturity mismatches, if the term to

maturity of the loan is > 5 years
42
Simple approach

• Pledge of maturity converging securities

Minimum requirements
• Valuation of underlying securities all 6 calendar months

• Covered exposure : Risk weighting of the pledged asset

Risk weighting 20% Minimum risk weight

• Uncovered exposure: Risk weight of the debtor/ pledge

grantor

• Transactions undergoing a daily market value valuation and

Exceptions subject to a daily margin call
• Cash deposits
• Government securities with an assigned 0% risk weight
(20% discount on the market value)
43
Annex VIII, part 3 p.27 and following
The comprehensive approach

Step 1 Calculation of outstanding loan amount (E)

EA = E x (1+He)
Value of the exposure

Step 2 Calculation of the adjusted value of collateral (CA)

Market value of the collateral
- haircut for collateral
CA = C x (1-Hc-Hfx)
- haircut for FX-risk
= adjusted value of collateral

Step 3 Calculation of the adjusted value

of collateral in case of maturity CAA = CA x min [1 ; t - 0,25 / (min (5 ; T) - 0,25)]
mismatch (CAA)

Step 4 Calculation of the value of the exposure post

collateral and post maturity mismatches
E**= max [0; (EA – CAA)]

CAA = CA => E** = E* E*= max [0; (EA – CA)]

Step 5 Calculation RWA with r = risk weight of the borrower

RWA = E** x r 44
 Add-ons and cut-downs

Add-ons to Exposure Cut downs on pledged Cut downs for FX currencies

(He) assets (Hc) (Hfx)

Impact of Haircut depends on

instrument Transactions type Frequency of market valuation

and or margin call

• Cash / gold / bonds / • All Repo type • Number of days elapsing

shares / investment fund transactions between valuations of underlying
• Issuer • Other capital markets assts for covered credits

• Rating transactions • Days elapsing before margin call

• Covered credit granting occurring
• Remaining maturity

45
 The comprehensive approach - standard
supervisory haircuts (Basel II)
Assumptions: (1) daily reassessment of the securities, (2) daily remargining, (3) 10-business day holding period (=TN)

Issue rating for Sovereigns Banks/Corporates

Residual maturity
bonds (values in %) (values in %)

<_ 1 year 0,5 1

AAA - AA-/A1 > 1 year, <_ 5 years 2 4
> 5 years 4 8
<_ 1 year 1 2
A+ - BBB-/A2/A3 > 1 year, <_ 5 years 3 6
> 5 years 6 12
<_ 1 year 15
BB+ - BB- > 1 year, <_ 5 years 15
> 5 years 15
Shares included in a main index and gold 15
Other listed shares 25
Cash 0
UCITS and mutual funds Highest haircut applicable to securities in which the fund can invest
46
FX risk haircut 8
 The comprehensive approach - standard
supervisory haircuts (EU)
Assumptions: (1) daily reassessment of the securities
Issue rating for bonds Residual Sovereigns Banks/Corporates
maturity (values in %) (values in %)
20 days1 10 days1 5 days1 20 days1 10 days1 5 days1
≤ 1 year 0,707 0,5 0,354 1,414 1 0,707
<1 ≤ 5 years 2,828 2 1,414 5,657 4 2,828
CQS 1
> 5 years 5,657 4 2,828 11,314 8 5,657
≤ 1 year 1,414 1 0,707 2,828 2 1,414
<1 ≤ 5 years 4,243 3 2,121 8,485 6 4,243
CQS 2-3
> 5 years 8,485 6 4,243 16,971 12 8,485
≤ 1 year 21,213 15 10,607 N/A N/A N/A
CQS 4 <1 ≤ 5 years 21,213 15 10,607 N/A N/A N/A
> 5 years 21,213 15 10,607 N/A N/A N/A
Shares and convertible bonds 21,213 15 10,607 21,213 15 10,607
in the main index and gold
Other listed shares 35,355 25 17,678 35,355 25 17,678
Cash 0 0 0 0 0 0

UCITS and mutual funds Highest haircut applicable to securities in which the fund can invest

FX risk haircut 11,314 8 5,657 11,314 8 5,657

47
1 Liquidation period
Calculation of haircuts (H) - I

Issue rating for Sovereigns Banks/Corporates

Residual maturity
bonds (values in %) (values in %)

_ < 1 year 0,5 1

1. Selection of standard haircuts

>1
AAA - AA-/A1 _ < 5 years 2 4
year,
> 5 years 4 8

(H10=HN)
_ < 1 year 1 2
>1 6
A+ - BBB-/A2/A3 _ < 5 years 3
year,
> 5 years 6 12
_ < 1 year 15
>1
BB+ - BB- _ < 5 years 15
year,
> 5 years 15

Shares included in a main index and gold 15

Other listed shares 25

Cash 0

2. Selection of transaction type

UCITS and mutual funds Highest haircut applicable to securities in which the fund can invest
FX risk haircut 8

(TM)
Transaction •Holding period •Condition

Repo-style • 5 working days •Daily Remargining

3. Consideration of revaluation Other capital market • 10 working days •Daily Remargining

intervals (NR) Secured lending • 20 working days •Daily Revaluation

48
Calculation of haircuts (H) - II

4. When the frequency of remargining or revaluation is longer than the minimum, the
minimum haircut numbers will be scaled up depending on the actual number of
business days between remargining or revaluation using the square root of time
formula below:
N R + (TM − 1)
H = HM
TM
H … haircut;
HM … haircut under the minimum holding period;
TM … minimum holding period for the type of transaction;
NR … actual number of business days between remargining for capital market transactions or revaluation
for secured transactions.

When a bank calculates the volatility on a TN day holding period which is different
from the specified minimum holding period TM, the HM will be calculated using the
square root of time formula:
TM
HM = HN
TN
HN … haircut based on the holding period TN
TN … holding period used by the bank for deriving HN
TM … minimum holding period 49
Calculation of haircuts (H) - III

• Differences between Basel II and EU Directives:

• Supervisory volatility adjustments (haircuts) are described
under the EU framework more in further detail
• The calculation of haircuts proceeds in the same way,
however there are some differences in terminology, e.g.:
“holding period” in Basel II = “liquidation period” in EU

50
 Exercise 4

Calculate credit amounts outstanding, the adjusted values of the securities, the credit
amounts after security underlying and the risk weighted assets for all the following credits
(steps 1+2 and 4+5):

1 credit 1 Mio. Euro corporate Rating BBB, Remaining maturity 4 years, unsecured

2 credit 1 Mio. Euro corporate Rating BBB, Remaining maturity 4 years, secured 1 Mio. Euro cash

credit 1 Mio. Euro corporate Rating BBB, Remaining maturity 4 years, secured 900.000 USD cash,
3 FX rate Euro/USD 0,90 (daily valuation)

credit 1 Mio. Euro corporate Rating BBB, Remaining maturity 4 years, secured
4 Maturity matching T-Bond Nominal 900.000 Euro (Market value 1,05 Mio. Euro), monthly valuation (= 20
days)

Securities lending (daily valuation, daily re-margining) T-Bond Nominal 1,1 Mio. Euro (Marketvalue 1 Mio.
5 Euro) to a Bank Rated A (Option II), Remaining maturity 6 Months, secured by a pledge on USD
denominated T-Bond, Nominal 1 Mio. USD (Market value 972.000 USD, Euro/USD 0,90) 51
 Solution 4 (I)

Case 1 1. Credit amount outstanding E: 1.000.000 €

Haircut credit: 0
(cash credit unsecured)
2. Adjusted value security: 0
Market value: 0
Haircut Security: 0
Haircut currency: 0
4. Secured Credit amount: 1.000.000 €
5. Risk weighted asset: 1.000.000 €
Risk weight debtor: 100 %

Case 2
1. Credit amount outstanding E: 1.000.000 €
(cash credit secured)
Haircut credit: 0

2. Adjusted value security: 1.000.000 €

Market value: 1.000.000 €
Haircut Security: 0
Haircut currency: : 0

4. Secured Credit amount: 0€

5. Risk weighted asset: 0€
52
Risk weight debtor: 100 %
 Solution 4 (II)

Case 3 1. Credit amount outstanding E: 1.000.000 €

(cash credit secured in currency) Haircut credit: 0
2. Adjusted value security: 886.900 €
1 + (20-1)
8%x = 11,31 % Market value: 1.000.000 €
10
Haircut Security: 0
1.000.000 € x (1 - 0,1131) = 886.900 €
Haircut currency: 11,31 %
1.000.000 € – 886.900 € = 113.100 € 4. Secured Credit amount: 113.100 €
5. Risk weighted asset: 113.100 €
Risk weight debtor: 100 %

1. Credit amount outstanding E: 1.000.000 €

Case 4 (Lombard credit)
Haircut credit: 0

20 + (20-1)
2. Adjusted value security: 1.008.528 €
2%x = 3,95 % Market value: 1.050.000 €
10
1.050.000 € x (1 - 0,0395)= 1.008.528,32 € Haircut Security: 3,95 %
Haircut currency: 0
4. Secured Credit amount: 0€
5. Risk weighted asset: 0€
Risk weight debtor: 100 % 53
 Solution 4 (III)

Case 5 (securities lending credit)

1+4 1. Credit amount outstanding E: 1.003.500 €

HE = 0,5 % x = 0,35 % Adjusted value security: 0,35 %
10

1+4 2. Adjusted value security: 1.015.092 €

HC = 0,5 % x = 0,35 %
10 Market value: 1.080.000 €
1+4 Haircut Security: 0,35 %
HFX = 8%x = 5,66 % Haircut currency: 5,66 %
10

1.080.000 € x (1 - 0,0035 - 0,0566) = 1.015.092 €

4. Secured Credit amount: 0€

5. Risk weighted asset: 0€

Risk weight debtor: 50 %

54
 Exercise 5

Calculate the risk weighted asset, taking the maturity mismatch into account (Steps 1-5)

Cash credit of € 1 mln. to A-rated company, remaining maturity 4 years, collateralized by federal bond with a
1 market value of € 1 mln. (valued monthly) with a remaining maturity of 4 years

Cash credit of € 1 mln. to A-rated company, remaining maturity of 4 years, collateralized by federal bond with a
2 market value of € 1 mln. (valuation monthly) with a remaining maturity of 3 years

Cash credit of € 1 mln. to A-rated company, remaining maturity of 4 years, collateralized by federal bond with a
3 market value of € 1 mln. (valuation monthly) with a remaining maturity of 2 years

Cash credit of € 1 mln. to A-rated company, remaining maturity of 4 years, collateralized by federal bond with a
4 market value of € 1 mln. (valuation monthly) with a remaining maturity of 10 weeks

55
Solution 5 (I)

1. Credit amount outstanding E: € 1,000,000

Case 1 (no mismatch) Credit haircut: 0
2. Adjusted value of the collateral: € 960,500
20 + (20-1) Market value of the collateral: € 1,000,000
HC = 2% x = 3.95% Collateral haircut: 3.95%
10
Currency haircut: 0
€ 1,000,000 x (1 – 0.0395) = € 960,500 3. Adjusted value of the collaterals
after maturity mismatch: € 960,500
€ 1,000,000 - € 960,500 = € 39,500 4. Credit amount after collaterals and
maturity mismatch: € 39,500
€ 39,500 x 50% = € 19,750 5. Risk-weighted asset: € 19,750
Risk weight of debtor: 50%
1. Credit amount outstanding E: € 1,000,000
Case 2 (3-years remaining maturity) Credit haircut: 0
2. Adjusted value of the collateral: € 960,500
Market value of the collateral: € 1,000,000
20 + (20-1)
HC = 2% x = 3.95% Collateral haircut: 3.95%
10 Currency haircut: 0

Ca = € 960,500 x (2.75/3.75) = € 704,367 3. Adjusted value of the collaterals

after maturity mismatch: € 704,367

€ 1,000,000 - € 704,367 = € 295,633 4. Credit amount after collaterals and

maturity mismatch: € 295,633
€ 295,633 x 50% = € 147,816.50 5. Risk weighted asset: € 147,816.50
Risk weight of debtor: 50% 56
Solution 5 (II)
1. Credit amount outstanding E: € 1,000,000
Case 3 (2-years remaining Credit haircut: 0
maturity) 2. Adjusted value of the collateral: € 960,500
20 + (20-1) Market value of the collateral: € 1,000,000
HC = 2% x = 3.95% Collateral haircut: 3.95%
10
Currency haircut: 0
Ca = € 960,500 x (1.75/3.75) = € 448,233 3. Adjusted value of the collaterals
after security mismatch: € 448,233
€ 1,000,000 - € 448,233 = € 551,767 4. Credit amount after collaterals and
maturity mismatch: € 551,767
€ 551,767 x 50 % = € 275,883.5 5. Risk-weighted asset: € 275,883.5
Risk weight of debtor: 50%
1. Credit amount outstanding E: € 1,000,000
Case 4 (10-weeks remaining Credit haircut: 0
maturity) 2. Adjusted value of the collateral: €0
Market value of the collateral: €0
No collateral recognition Collateral haircut : 0%
Credit-rating weight = 50% Currency haircut: 0
3. Adjusted value of the collaterals
after maturity mismatch: €0
4. Credit amount after collaterals and
maturity mismatch: € 1,000,000
5. Risk-weighted asset: € 500,000
Risk weight of debtor: 50% 57
 Apportionment of guarantees and credit
derivatives

Substitution approach
Principle: Substitution of the risk weight of the credit user (CU) with the risk weight
of the guarantee or collateral provider

Adjusted value for guarantee / credit derivative: GA = G x (1 – HfX)

In case of credit derivatives, if they do not contain a debt restructuring provision
connected with a decrease of payments, the value G is decreased by 40%
Maturity mismatches (Collateral RP > 3 months)
GAA= adjusted value of the collateral after
maturity mismatch
GAA = GA x min [1 ; t – 0.25 / (min (5 ; T) – 0.25)]

Coverage: If GAA>E RWA = E x g

g = risk weight of the guarantee/collateral provider

If GAA<E (pro rata coverage) RWA = (E - GAA) x r + GAA x g

Senior / subordinate coverage treated separately 58

 Exercise 6

Calculate the risk-weighted asset of the credits collateralized with guarantees/ credit
derivatives (CD), taking residual risks into account

Cash credit over € 1 mln. to BBB-rated company, collateralized in full by guarantee from an AA-
1 rated bank, maturity matched

Cash credit of € 1 mln. to BBB-rated company, 4 year remaining maturity, collateralized in full by
2 credit derivative of a bank (AA rating) with 3 year remaining maturity

Cash credit of € 1 mln. to BBB-rated company, 4 years remaining maturity, collateralized with pro
3 rata guarantee in of an amount of US$ 720,000 (EUR/USD FX rate 0.90, valuation daily) by an
insurance (AAA rated) with 3 years remaining maturity

59
 Solution 6 (I)

debtor risk weight: 100%

Case 1 (fully guaranteed) Collateral risk weight: 20%
Exposure: € 1,000,000
Credit haircut: 0
Adjusted value for guarantee : € 1,000,000
Currency haircut: 0
Adjusted value for guarantee after € 1,000,000
maturity mismatch:
20% x € 1,000,000 = € 200,000 Risk-weighted asset: € 200,000

debtor risk weight: 100%

Case 2 (CD / mismatched maturity) Collateral risk weight: 20%
Exposure: € 1,000,000
Credit haircut: 0
Ca = € 1,000,000 x (2.75/3.75) = € 733,333
Adjusted value for the CD: € 1,000,000
Currency haircut: 0
(€ 1,000,000 - € 733,333) x 100% Adjusted value for the CD after € 733,333
maturity mismatch:
+ € 733,333 x 20% = € 413,334
Risk-weighted asset: € 413,334

60
 Solution 6 (II)

Case 3
(Guaranteed pro rata with currency and
maturity mismatches)
debtor risk weight: 100%
Collateral risk weight: 20%
1 + (20 -1) Exposure: € 1,000,000
8% x = 11.31% Credit haircut: 0
10
Adjusted value for guarantee: € 709,520
€ 800,000 x (1-0.1131) = € 709,520 Currency haircut: 11.31%

Ca = € 709,520 x (2.75/3.75) = € 520,315 Adjusted value for the CD after

maturity mismatch: € 520,315
(€ 1,000,000 - € 520,315) x 100% + € 520,315 x 20% = € 583,748 Risk-weighted asset: € 583,748

61
Netting of assets

On-balance sheet Netting

Credit and deposits

Standard equation of the approach

Haircuts CA = C x (1- Hfx)

Mismatching maturities CAA = CA x min [1 ; t - 0,25 / (min (5 ; T) - 0,25)]

Impact determination: E**= max[0; (EA – CAA)]

Calculated risk weight asset: RWA = E** x r

62
On-Balance-Sheet Netting (I)

The bank has exposures with one counterparty (Rating BB):

N0 Type Amount in EUR Currency* RLZ

1 Claim 1.000 EUR 4
2 Deposit 200 EUR 3
3 Claim 200 USD 3
4 Deposit 1000 USD 4
Calculation of haircuts on a daily basis *FX rate EUR/USD = 1,00

There is no explicit comment on the order, in which the exposures have to be netted.
This order may have effects on the capital requirements.

63
On-Balance-Sheet Netting (II)

Option 1 FX-Priority (Haircuts for maturity mismatches)

Position 3 and 4 Position 1 and 2

Risk weight Borrower (r): 100 %
Risk weight Borrower (r): 100 % Exposure (E): 1.000 €
Exposure (E): 200 € Value of collateral (CA): 200 €
Value of collateral (CA): 1.000 € Adjusted value of collateral (CAA): 147 €
Adjusted value of collateral (CAA): 1.000 € „Adjusted surplus from Position 4 719
Remaining exposure (E**): 0€ Remaining exposure (E**): 134 €
Capital requirement: 0€ Capital requirement: 10,72 €

Option 2 Maturity-Priority (Haircuts for FX-mismatch)

Position 1 and 4 Position 2 and 3

Risk weight Borrower (r): 100 % Risk weight Borrower (r): 100 %
Exposure (E): 1.000 € Exposure (E): 200 €
Value of collateral (CA): 886,90 € Value of collateral (CA): 177,38 €
Adjusted value of collateral (CAA): 886,90 € Adjusted value of collateral (CAA): 177,38 €
Remaining exposure (E**): 113,10 € Remaining exposure (E**): 22,62 €
Capital requirement: 9,05 € Capital requirement: 1,81 €
64
 Netting of Securities lending and Repo-
Transactions (I)
If eligible Netting-agreements exist, net-positions can be calculated and haircuts will have
to be applied on these net positions.

E* = max {0, [(∑ (E) - ∑ (C)) + ∑ (Es x Hs) + (∑(Efx) x Hfx)]}

Alternatively: E* = max {0, [(∑ E - ∑ C) +VaR]}

RWA = r x E*
E* = Exposure after netting
E = Original Exposure
C = Market Value of Collateral
Es = Amount of Net position in a given security
Hs = Haircut applicable to Es
Efx = Net-FX position
Hfx = Haircut applicable to Efx
r = Risk weight of borrower
65
 Netting of Repos and reverse Repos (II) -
case
Bank A with Bank B (Rating A, => 50 %)
The following transaction:
Securities
Nr. Type Amount in EUR underlying Haircut1

1 Repo 1.000 share BMW 10,6 %

2 Reverse Repo 600 share BMW 10,6 %

E* = max {0, [(∑ (E) - ∑ (C)) + ∑ (Es x Hs) + (∑(Efx) x Hfx)]}

E = = security = 1.000 € (∑ (E) - ∑ (C)) = 0

Nr. 1 Bank A Bank B Es = 1.000 € - 600 € = 400 €
C= = Cash = 1.000 € Hs = 10,6 %

C = = security = 600 € Efx = 0 u. Hfx = 0

Nr. 2 Bank A Bank B E* = 400 € x 10,6 %

= 42,4 €
E= = Cash = 600 €
RWA = 42,4 € x 50 %
1transaction duration 5 days, daily margin call = 21,2 € 66
Netting Repo and securities lending (III)

Banks can make use of their own VaR models under specific qualitative and
quantitative requirements

Equation for unsecured exposure e.g. The risk weighted assets changes
as follows:

E* = max {0, [(∑ E - ∑ C) +VaR]}

RWA = r x E*
E* = Repo or securities lending after risk reduction
E = Markt value Exposure
C = value of received security
r = Risk weight debtor

67
Impact of maturity mismatch

Adjusted amount of collateral with maturity mismatch

Loan €100, duration 7 years, collateral €100, duration 6 years
120,00

100,00
Value of collateral (Euro)

80,00

60,00

40,00

20,00

0,00
7,00 6,50 6,00 5,00 5,00 4,50 4,00 3,50 3,00 2,50 2,00 1,50 1,00

Maturity of loan in years

Value of collateral (CP 3) Value of Collateral (final) 68
Conclusion: risk mitigation

• Method to calculate the effects is provided by supervision

• Optimal allocation of collateral on loans is complex
• Sophisticated requirements for collateral management systems
• Qualitative requirements on the management of collateral have to
be fulfilled
• Knowledge about the effect of credit risk mitigation on the capital
charge is essential

69
 Exercise 1

Please calculate the RWA for the following loans considering supervisory
haircuts and maturity mismatches
• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years.
1 Collateral is Government bonds; market value 1 Mio. € (revaluation every 20
days) with remaining maturity of 4 years
• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years.
2 Collateral is Government bonds; market value 1 Mio. € (revaluation every 20
days) with remaining maturity of 3 years
• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years.
3 Collateral is Government bonds; market value 1 Mio. € (revaluation every 20
days) with remaining maturity of 2 years
• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years.
Collateral is Government bonds; market value 1 Mio. € (revaluation every 20
days) with remaining maturity of 10 weeks

70
 Solution 1 (I)

Case 1 (no mismatch) 1. Exposure E: 1,000,000 €

Haircut exposure: 0

20 + 19 2. Adjusted value of collateral: 960,500 €

HC = 2% x = 3.95 % Market value of collateral: 1,000,000 €
10 Haircut Collateral: 3.95 %
Haircut Currency: 0
1,000,000 x (1 – 0.0395) = 960,500
3. Adjusted value of collateral after
maturity mismatch: 960,500 €
1,000,000 € - 960,500 € = 39,500 €
4. Remaining exposure value: 39,500 €

39,500 € x 50 % = 19,750 € 5. Risk weighted assets: 19,750 €

Risk weight of borrower: 50 %

Case 2 (rem. Mat. 3 years) 1. Exposure E: 1,000,000 €

Haircut exposure: 0
2. Adjusted value of collateral: 960,500 €
20 + 19 Market value of collateral: 1,000,000 €
HC = 2% x = 3.95 % Haircut Collateral: 3.95 %
10
Haircut Currency: 0
Ca = 960,500 € x (2.75/3.75) = 704,367 € 3. Adjusted value of collateral after
maturity mismatch: 704,367 €
1,000,000 € - 704,367 € = 295,633 € 4. Remaining exposure value 295,633 €
5. Risk weighted assets : 147,816.50 €
295,633 € x 50 % = 147,816.50 €
Risk weight of borrower : 50 % 71
 Solution 1 (II)

Case 3 (rem. Mat. 2 years) Exposure E: 1,000,000 €

Haircut exposure: 0

20 + 19 2. Adjusted value of collateral: 960,500 €

HC = 2% x = 3.95 % Market value of collateral: 1,000,000 €
10 Haircut Collateral: 3.95 %
Haircut Currency: 0
Ca = 960,500 € x (1.75/3.75) = 448,233 €
3. Adjusted value of collateral after
maturity mismatch: 448,233 €
1,000,000 € - 448,233 € = 551,767 €
4. Remaining exposure value: 551,767 €

551,767 € x 50 % = 275,883.5 € 5. Risk weighted assets: 275,883.5 €

Risk weight of borrower: 50 %

Case 4 (rem. Mat. 10 weeks) 1. Exposure E: 1,000,000 €

Haircut exposure: 0
2. Adjusted value of collateral: 0€
No consideration of collateral. Risk Market value of collateral: 0€
Haircut Collateral: 0%
weight of borrower = 50 % Haircut Currency: 0
3. Adjusted value of collateral after
maturity mismatch: 0€
4. Remaining exposure value: 1,000,000 €
5. Risk weighted assets: 500,000 €
Risk weight of borrower: 72
 Exercise 2

Please calculate the RWA for the following loans considering supervisory
haircuts and maturity mismatches
• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years.
1
Completely protected with a total Return Swap of 1 Mio. € (counterpart is
insurance rated “AA”) with remaining maturity of 4 years

2 • Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years.

Completely protected with a total Return Swap of 1 Mio. € (counterpart is
insurance rated “AA”) with remaining maturity of 3 years
• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years.
Completely protected with a total Return Swap of 1 Mio. € (counterpart is
insurance rated “AA”) with remaining maturity of 2 years
• Cash loan of 1 Mio. € to corporate rated “A”. Remaining maturity 4 years.
Completely protected with a total Return Swap of 1 Mio. € (counterpart is
insurance rated “AA”) with remaining maturity of 10 weeks 73
 Solution 2 (I)

Case 1 (no mismatch) 1. Exposure E: 1,000,000 €

Haircut Exposure: 0
2. Adjusted value of protection: 1,000,000 €
Value of protection: 1,000,000 €
Haircut for FX: 0%
3. Value of guarantee after Maturity mismatch: 1,000,000 €
4. Risk weight guarantor 20%
6. Uncollateralised portion 0€
5. Risk weight borrower 50%
5. Risk weighted assets total 200.000 €

Case 2 (rem. Mat. 3 years) 1. Exposure E: 1.000.000 €

Haircut Exposure: 0
2. Adjusted value of protection: 1.000.000 €
value of protection: 1.000.000 €
Ca = 1,000,000 € x (2.75/3.75) = 733,333 € Haircut for FX: 0
3. Value of guarantee after Maturity mismatch: 733.333 €
1,000,000 € - 733,333 € = 266,667 €
4. Risk weight guarantor 20%

295,633 € x 50 % = 147,816,50 € 6. Uncollateralised portion 266.667 €

5. Risk weight borrower 50%
5. Risk weighted assets total 280,000 € 74
 Solution 2 (II)

Case 3 (rem. Mat. 2 years) 1. Exposure E: 1,000,000 €

Haircut Exposure: 0
2. Adjusted value of protection: 1,000,000 €
value of protection: 1,000,000 €
Haircut for FX: 0
3. Value of guarantee after Maturity mismatch: 466,667 €
4. Risk weight guarantor 20%
1,000,000 € - 448,233 € = 551,767 € 6. Uncollateralised portion 533,333 €
5. Risk weight borrower 50%
551.767 € x 50 % = 275.883.5 €
5. Risk weighted assets total 360,000 €

Case 4 (rem. Mat. 10 weeks) 1. Exposure E: 1.000.000 €

Haircut Exposure: 0
2. Adjusted value of protection: 1.000.000 €
value of protection: 1.000.000 €
Haircut for FX: 0
No consideration of collateral. Risk
3. Value of guarantee after Maturity mismatch: 0€
weight of borrower = 50 %
4. Risk weight guarantor 20%
6. Uncollateralised portion 1.000.000 €
5. Risk weight borrower 50%
75
5. Risk weighted assets total 360,000 €
Exercise 3

Please calculate the Risk weighted Assets for the following loans
collateralised with physical collateral
• Loan to a private individual of 500,000 € collateralised with physical
collateral (private home) with total market value of 1,200,000 €

76
Solution 3

Case 2

1. Exposure 500,000 €
2. Risk weight of collateralised portion 35%
3. Risk weighted assets total 175,000 €

77
Agenda

1. Introduction to Basle II
• Scope of Application
• Basel I and II
• Overview of Minimum Capital Requirements
• Standardised versus IRB Approach
• Partial Use

2. Minimum Capital Requirements for Credit Risk: Standardised Approach

• Exposure Classes
• External Ratings and Risk Weights
• Credit Risk Mitigation
• Guarantees and Credit Derivatives
• Collateral
• Examples

3. Questions and Answers

78