Irc, Cva and Var - New Methods in Basel

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Table of contents

I.Introduction3
II.Incremental Risk Charge – IRC4
1.Strengths of Incremental Risk Charge Model4
2.Weaknesses of Incremental Risk Charge Model4
3.Effectiveness of Incremental Risk Charge Model5
III.Credit Valuation Adjustment (CVA)6
1.Strengths of Credit Valuation Adjustment6
2.Weaknesses of Credit Valuation Adjustment6
3.Effectiveness of Credit Valuation Adjustment6
IV.Stressed VAR7
1.Strengths of Stressed VAR Model7
2.Weaknesses of Stressed VAR Model8
3.Effectiveness of Stressed VAR Model8
V.Conclusion9
VI.References10
VII.Appendices13
1.Reflective Statement13
2.Evidence of the preparation15
3.Evidence of my contribution and engagement with the session16

I. Introduction
Last financial crisis was seen as a strong slap on the global economy. It has awakened Basel Committee on Banking Supervision (BCBS) about the importance of an aggregation between market and credit risks that banks have to cope with. In accordance with Saunders and Cornett (2011), definition of market risk is “the risk related to the uncertainty of an FI’s (financial institution) earnings on its trading portfolio caused by changes, and particularly extreme changes, in market conditions”. Interest rate risk and foreign exchange risk are some typical example for market risks (Saunders and Cornett, 2011). Meanwhile, credit risk is defined as risk increased when borrowers, bond issuers and counterparties in derivatives transaction may default (Hull, 2010).

According to Madigan (2010), it would be greater risks when credit and market risks associated than the sum of individual factors. Therefore, it might lead to worse impacts to banks’ operations. From the crisis’s consequences, Nout Wellink – chairman of the Basel Committee believes that it is necessary for supervisors to learn experiences from recent events, thus set up new methods for banks to cope with fore problems (Ferry, 2008). These new rules which are reflected in Basel III support each other to efficiently measure and manage correlated risks, thus calculate capital requirement to cover these risks. A report by Goeth (2010) defines Basel III as an extensive set of measures reformed in order to enhance the regulation, supervision and risk management in terms of banking.

This report mentions new methods with their strengths, weaknesses and effectiveness to help banks control and measure risks effectively, especially combination of credit and market risks. They are incremental risk charge (IRC), credit valuation adjustment (CVA) and stresses value at risk (VAR) model.

II. Incremental Risk Charge – IRC
1. Strengths of Incremental Risk Charge Model
In order to avoid crisis, banks must satisfy capital requirement demanded by Basel Committee to cover individual as well as correlated risks. IRC is a method which helps banks to estimate minimum capital needed to cover risks from unsecuritised credit instruments caused by default and migration events (BCBS, 2009b). It means IRC model calculates the maximum risks in the worst case when banks cannot securitise any products. As a result, banks have to set up the suitable capital for their own business and make sure that they can overcome difficulties even in the worst situation. In other words, banks will be safe from default and migration events, and more importantly, they can avoid crisis by using IRC model.

In Basel III, with IRC model, risks can be measured for a one-year capital horizon at 99.9% confidence level, instead of a 10-day VAR at the 99% confidence level as in Basel II (Davidson, 2009). The extension of capital horizon is one of IRC’s strengths because it can evaluate and calculate banks’ risks more effectively and accurately than 10-day VAR. The reason is one-day or 10-day VAR cannot comprise completely large cumulative price variation occurring several weeks or months as well as large daily losses which only happen...
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