Irc, Cva and Var - New Methods in Basel
Table of contents
I. Introduction 3
II. Incremental Risk Charge – IRC 4 1. Strengths of Incremental Risk Charge Model 4 2. Weaknesses of Incremental Risk Charge Model 4 3. Effectiveness of Incremental Risk Charge Model 5
III. Credit Valuation Adjustment (CVA) 6 1. Strengths of Credit Valuation Adjustment 6 2. Weaknesses of Credit Valuation Adjustment 6 3. Effectiveness of Credit Valuation Adjustment 6
IV. Stressed VAR 7 1. Strengths of Stressed VAR Model 7 2. Weaknesses of Stressed VAR Model 8 3. Effectiveness of Stressed VAR Model 8
V. Conclusion 9
VI. References 10
VII. Appendices 13 1. Reflective Statement 13 2. Evidence of the preparation 15 3. Evidence of my contribution and engagement with the session 16
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
I. Introduction 3
II. Incremental Risk Charge – IRC 4 1. Strengths of Incremental Risk Charge Model 4 2. Weaknesses of Incremental Risk Charge Model 4 3. Effectiveness of Incremental Risk Charge Model 5
III. Credit Valuation Adjustment (CVA) 6 1. Strengths of Credit Valuation Adjustment 6 2. Weaknesses of Credit Valuation Adjustment 6 3. Effectiveness of Credit Valuation Adjustment 6
IV. Stressed VAR 7 1. Strengths of Stressed VAR Model 7 2. Weaknesses of Stressed VAR Model 8 3. Effectiveness of Stressed VAR Model 8
V. Conclusion 9
VI. References 10
VII. Appendices 13 1. Reflective Statement 13 2. Evidence of the preparation 15 3. Evidence of my contribution and engagement with the session 16
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
References: Basel Committee on Banking Supervision, (2011a) Application of own credit risk adjustments to derivatives. Bank for International Settlements. Basel. Basel Committee on Banking Supervision, (2011b) Basel III: A global regulatory framework for more resilient banks and banking systems. Bank for International Settlements. Basel. Basel Committee on Banking Supervision, (2011c) Interpretive issues with respect to the revisions to the market risk framework. Bank for International Settlements. Basel. Benford, J. & Nier, E. (2007) Monitoring cyclicality of Basel II capital requirements. [Online]. Available at: http://www.bankofengland.co.uk/publications/fsr/fs_paper03.pdf (Accessed: 28 December 2011) Bushnell, C Butler, C. (1999) Mastering value at risk: a step-by-step guide to understanding and applying VAR. London: Financial Times/Prentice Hall. Cameron, M. (2011) ‘Securitising CVA’, Risk, 24(2), p. 29. Davidson, C Ferry, J. (2008) ‘Wary of the IRC’, Risk, 21(9), p. 26. Goeth, P. (2010) Basel III – Design and Potential Impact. [Online]. Available at: http://www.garp.org/media/529782/basel%20iii_goeth112410.pdf (Accessed: 28 December 2011) Hull, C Linsz, D. M. (2010) Basel Committee on Banking Supervision, Consultative Document “Strengthening the Resilient of Banking Sector”. [Online]. Available at: http://www.bis.org/publ/bcbs165/boac.pdf (Accessed: 28 December 2011) Madigan, P Stretton, C. (2011) Market risk. [Online]. Available at: http://www.deloitte.com/assets/Dcom-SouthAfrica/Local%20Assets/Documents/7.%20Basel%20flyer%20-%20Market%20Risk.pdf (Accessed: 03 January 2012) Varotto, S