rules for assigning instruments to trading/banking book – reduce possibility of arbitrage

trading book – short-term resale (<60D); underwriting commitments, instruments giving rise to a net
short credit position in the banking book; market-making
banking book – unlisted equities, real estate, retail credit, investments in a fund, derivatives and hedging
instruments with above underlying assets
Capital requirement = risk charges under the sensitivities based method (delta, vega, curvature (worse
of upward/downward shock to a risk factor)) + default risk charge + residual risk add-on (legal, strategic,
concentration risk)
delta – risk weights depend on time buckets (higher for shorter), correlation between different curves
Market illiquidity risk - instead of using a static 10-day horizon for VaR, use varying liquidity horizons
calculate risk charge under 3 correlation scenarios – max{med, hi, lo}
default risk – compute gross jump-to-default JTD risk positions, then apply risk weights based on credit
rating, offset with same obligor and hedge within same bucket  sum of bucket-level charges; 1Y time
horizon, 99.9% precentile, done weekly
securitization exposures in trading book must be capitalized using standardized approach
Internal model – risk factors must be based on real verifiable prices with high frequecy; stressed capital
add-on for non-modellable risk factors; approval:
a.)if >12 exceptions for 99th 1-day var or >30 for 97.5th var in past 1 year  back to standardized
b.) P&L attribution – unexplained (theoretical – hypothetical) daily PL/SD of hypothetical PL; ratio of
variances of unexplained/hypothetical  4 breaches over past 1 year  back to standardized
VaR: (99th percentile, unstressed/stressed, 10D liquidity horizons) (97.5th, stressed, varying liquidity
horizons for different risk factors e.g. 120 days for credit spread risk, computed for internal model)
Expected shortfall: (10D, unstressed)  (varying liquidity horizon, stressed)

Dodd-Frank Act – proposed in 2009, signed into federal law in 2010; reform of:
1.) regulatory framework – set up the Financial Stability Oversight Council, Consumer Financial
Protection Bureau, Federal Insurance Office
2.) banking structure (Volcker Rule) – separate trading activities from retail deposits; underwriting,
market making, hedging activities permitted; trading in US government also OK; repurchase agreement,
liquidity management are not counted as trading; prohibit ownership interest in or sponsoring a
hedge/private fund
- Foreign banking organizations permitted to trade if activity is conducted solely outside the US
3.) OTC derivatives market – central counterparty (CCP), all contracts reported to trade repositories
(TRs); non-centrally cleared contracts subject to higher capital requirements
4.) capital enhancements at banks (some differ from those of Basel III)

Basel II – 3 pillars (min capital requirements, supervisory review, market discipline);

min capital adequacy ratio (CAR = capital/RWA) of 8%; 3 tiers of capital (equity capital, long-term
subordinated debt, short-dated subordinated debt), min Tier 1 ratio of 4%, common equity >50% of Tier
1
Basel 2.5 – more rigorous guidelines for calculation of market risk capital (12-month period of market
stress, incremental risk charge for unsecuritized credit products, mitigation of regulatory charge
arbitrage), clearing thru CCP (higher risk weighting on other contracts)

Basel III (Dec 2010)– dynamical capital buffers to remove procylicality (banks forced to replenish capital
resources during crises), leverage restriction, liquidity provision; to be introduced in full by 2019
- focus on loss-absorbency – predominant form of Tier 1 capital must be common equity (enable a bank
to remain a "going concern", Tier 1 ratio 6% (i.e. 75% of total capital), common equity CET1>75% of Tier
1; Tier 2 categorized as a "gone concern" (the bank has failed) reserve to protect depositors, conversion
trigger required for subordinated/senior debt; Tier 3 capital (short-term subordinated debt) abolished; 2
capital buffers (capital conservation (additional 2.5% above min requirement), countercyclical (limit
procyclical effects, hold up to an additional 2.5% of common equity with excessive credit growth in the
market))
- 3% min leverage ratio (Tier 1 capital/gross on&off balance sheet exposures) - limit banks to lending 33
times their Tier 1 capital; non-risk based as full balance sheet or nominal value is used; 100% credit
conversion factor for unused commitments and letters of credit(10% for if unconditionally cancelable)
- Liquidity coverage ratio LCR (scenario stress test used; stock of high quality liquidity assets HQLA/total
net cash outflows over next 30 calendar days >100%; full implementation by 2019) and Net Stable
Funding Ratio NSFR (1-year horizon; available amount of stable funding i.e. liabilities/required amount
of stable funding i.e. assets >100%; promote changes away from short-term funding mismatches
toward more stable, longer-term funding)

credit lines are uncommitted, they can be withdrawn quickly if any concerns
capital market funding – wholesale markets (commercial paper, repurchase agreements, money market
instruments) vs retail deposits; refinancing risk
securitization reduce funding needs – offerings postponed if crisis, liquidity backstop agreements
(commitments to provide funding under certain conditions)
HQLA – unencumbered, free of any restrictions (not pledged as collateral) – good ratings, easy to value,
low correlation with risky assets, evidence of flight to quality; either by sale or repo, the asset can be
turned into cash quickly; Hair cut Level 1, 2A, 2B (0% central bank securities, cash; 15% corporate debt
AA- or better;25-50% residential MBS, corporate debt BBB- to A+, common equity shares); max of 40%
of level 2 assets
Cash flow- run-off rates set for different items e.g. 5% for stable deposits
Available Stable funding- capital, preferred stock, liabilities with effective maturities >1y, term deposits
Required stable funding – not expected to be turned into cash under stress; RSF factor (0% for cash and
unencumbered short-term instruments, 20% for unencumbered corporate bonds, 50% for
unencumbered gold and equity securities, 5% of undrawn credit facilities to clients)

When actual loss > expected loss  capital absorbs the loss
Loss absorbency hierarchy – current year profits  retained profits paid-up capital  preferred stock
 debt  depositors & creditors
Contingent capital instruments CoCo – convert from debt to equity once triggered; additional tier 1 AT1
CET1 – rule out hybrid debt (counted as equity but look like subordinated debt to investors)
Deductions – made from CET1, e.g. goodwill, investments in nonbanking subsidiaries, deferred tax
assets, increases in equity resulting from securitization
CET1 and AT1 need to be perpetual and are the most subordinated form of clam in the event of
liquidation, they are fully paid-up and not funded directly or indirectly by the bank
Maximum distributable amount MDA – if CET1 is 4.5-5.125%, banks must retain 100% of profits, if ration
6.375%-7%, need to retain 40%

IFRS 9 – can apply to groups of items; looks at whether a risk component can be identified and
measured and does not distinguish between types of items
Designation of hedging instruments:
- Time value of an option maybe separated from the intrinsic value
- forward element maybe separated from the spot element of a forward contract
- a proportion of the nominal amount maybe designated
A hedged item can be asset or liability, unrecognized firm commitment, a forecast transaction
fair value hedge – exposure to changes in fair value; for "fixed item" whose value will fluctuate
cash flow hedge – exposure to variability in cash flows; for "variable item" e.g. forecast transaction, FRN;
want to fix the amount of money you'll get to pay
adjust hedge ratio if hedging relationship ceases to meet the hedge effectiveness requirement
discontinuing hedge accounting may effect only a part of a hedging relationship
cash flow hedge – the portion of the gain or loss on the hedging instrument that is determined to be an
effective hedge is recognized in other comprehensive income (cash flow hedge reserve); remaining gain
or loss is hedge ineffectiveness that shall be recognized in profit or loss
A single hedging instrument may be designated as a hedging instrument of more than one type of risk,
those hedged items can be in different hedging relationships
hedging effectiveness assessment can be qualitative – e.g. the nominal amount, maturity and underlying
match, an economic relationship exists between the hedged item and the hedging instrument