Basel III, Risk Assessment and Stress Testing

Understanding The Role Of Regulatory Bank Capital

• Overview of financial statements of banks – accounting principles
• Composition of the balance sheet – types of assets and liabilities
• Understanding the key elements of the P&L - statement of income
• Review of the distinction between the banking book and the trading book
• The equity capital of financial Institutions
• Illustration of the contrast between liquidity and solvency issues
• Distinguish between going concern and gone concern capital
• Explanation of bail-in able capital
• Accounting and regulatory definitions for own funds
• Prudential filters and revaluation reserves, AOCI
• Treatment of goodwill, intangibles, deferred tax assets
• Treatment of securitizations and off-balance sheet exposures

Requirements for Qualifying Capital under Basel III

• Definitions of Regulatory Capital – Core Tier 1, Tier 2
• Core Tier 1 – equity capital and disclosed reserves
• Supplementary Capital – Tier 2 – subject to discretion of supervisor/central bank
• Hybrid capital – Contingent Capital Instruments (CoCo’s)
• Subordinated debt - bail-in instruments
• Short-term subordinated debt covering market risk (Tier 3)
• Loss absorbency requirements
• Deductions from capital – goodwill and subsidiaries
• Supervisory discretion over cross holdings of other banks

Basel Treatment of Market Risk

• Value at Risk (VaR) – rationale, theory and methods of calculation
• Limitations of parametric VaR
• What about tail risk – does VaR capture this adequately?
• Expected Shortfall and FRTB
• Risk weightings for market risk
• Standardized approach
• Interest rate risk in both the trading book and banking book
• Overview of Internal Models Approach (IMA)
• Impact of market risk on instruments in the trading book
• Volatility and market stress
• Incremental Risk Charge
• Off Balance Sheet items

Operational Risk under Basel

• Definition of Operational Risk introduced into the Basel II framework
• The life cycle of Operational Risk
• Basel measurement approaches to be phased out by 2023:
• Basic Indicator
• Standard Approach
• Advanced Measurement Approaches
• Revised Standardized Approach replaces previous three methods
• Risk weightings under each approach
• Rogue trading – severity of losses
• Scenario generation – KRI’s, management involvement in adverse scenario modelling
• Quantifying the exposure and severity of “outliers” and tail risk
• Loss Distribution Approach (LDA) and Scenario Based Analysis (SBA)
• Application of VaR techniques to operational risk (Op VaR)
• Loss identification – measurement, management, monitoring, reporting
• Integrating operational risk management into the organizational risk management framework

Alternatives to using external credit ratings

• Developing internal scoring models for assessing corporate loan exposures
• Contrast of developed and emerging economy approaches to credit risk assessment

Credit Concentration Risk and Large Exposures

• Concentration risk - not adequately captured under the Pillar One approaches
• Brief summary of the Supervisory Review and Evaluation Process (SREP)
• Treatment of Concentration Risk within the Pillar II ICAAP framework
• Identifying sectoral concentration risk – general principles
• Quantifying concentration risk in GCC

Modeling and Stress Testing

• Explanation of the techniques for conducting stress tests
• Back testing using historical returns
• Scenario generation - stress testing using hypothetical returns
• Sizes of historical samples – are they sufficiently large to include wide variety of conditions?
• Danger of optimizing risk management parameters - over-fitting to the historical data
• Modeling methods – contingency scenarios
• Limitations of normal distribution as basis for probabilistic modelling
• Quantifying the exposure and severity of “outliers” and tail risk
• Explanation of Stressed Expected Shortfall methods

Drivers of Counter-party Risk (CCR)

• Separating market risk impact on trading positions from CCR
• Pricing counterparty risk – use of spreads, ratings
• Probability of Default (PD) – Estimation of PD and Exposure at Default (EAD)
• Expected Positive Exposure (EPE)
• Loss Given Default (LGD) and recovery rates
• Counterparty risk in credit default swaps
• Counterparty risk in interest rate swaps
• Experience of AIG and mono-lines insurance companies in financial crisis
• The role of a central clearing house
• Stress analysis and randomized stress scenarios
• Market factors which drive counter-party credit deterioration

Credit Value Adjustment (CVA) and collateral

• Definition of Credit Value Adjustment (CVA)
• Defining credit exposure in relation to market risk impact on derivatives
• Expected positive exposure and worst case exposure
• Nature of collateralization – ISDA treatment
• Benefits of effective collateral management
• Impact of netting on CVA
• Impact of collateral on CVA
• Hedging and credit default swaps
• Eligible hedging instruments
• Bilateral counterparty risk and collateral
• Over-collateralized positions and risk of counterparty default

Liquidity Coverage Ratio (LCR)

• Explanation of Liquidity Coverage Ratio (LCR)
• Criteria for inclusion as High Quality Liquid Assets (HQLA)
• Categories of HQLA – Level 1, Levels 2A and 2B
• Net Stable Funding Ratio (NSFR)
• Explanation of available funding (ASF) versus required funding (RSF)
• Weighting factors for ASF and RSF

Impact of Basel III on the Business Model of Banking

• Impact of the Basel III LCR on balance sheet exposures to non HQLA assets
• Hoarding of Level 1 HQLA assets
• Unintended consequences for macro liquidity from Basel III regulations
• Linkage of sovereign and domestic banking credit quality
• Decreased inventories of corporate bonds being held by primary dealers
• Requirements for unrealized losses with AFS securities to be deducted from CET1
• Explanation of Contingent Capital instruments (CoCo’s)
• Role of CoCo’s as contributor to AT1 for capital adequacy purposes
• Brief history of CoCo’s and inability to see the consequences from conversion
• Sovereign wealth fund exposure to CoCo’s – elevated liquidations of SWF assets
• Possible suspensions/reductions of coupon payments of CoCo’s
• Collateral netting across CCP’s
• Shortage of collateral – implications, effect on bank’s ROE
• Impact of TLAC on G-SIB banks

Implementation and Reporting Systems for Basel Compliance

• Efficacy of the monitoring and reporting mechanisms within banks and how they interface with overall risk management
• Avoiding silos
• Accounting, surveillance, IT systems and data storage back-up systems
• Monitoring of controls – quality and integrity of the procedures
• Development of contingency scenarios
• Role of the Chief Risk Officer
• Role of the Internal Auditor
• Developing dashboards for KRI’s for credit, market and operational risk