30. Capital management II - regulatory capital

Question 1

State the 3 tiers of capital outlined in the Basel Accords

Answer 1

1. Equity and disclosed reserves
2. Other reserves and various debt instruments
3. Certain types of shorter-dated capital (eg unsecure, subordinated debt with min maturity of 2 years)

Question 2

How is capital calculated under Basel II

Answer 2

Credit risk (1)
- Based on risk weighted assets using standard or IRB approach
-No allowance for diversification

Market risk (2)
- Standardised approach or an asset model to calculate 10-day 99% VaR

Operational risk (3)
- Based on scaled gross income (standardised or basic indicator) or …
… using advanced measurement approach based on internal models and scenario analysis

Total RWA = 1 + 12.5*[(2) + (3)]

Question 3

What is the Cooke ratio

Answer 3

Minimum tier 1 + tier 2 capital/ Basel ratio must be 8% of RWA

Question 4

How is Basel III a stronger basis than Basel II

Answer 4

• Minimum tier 1 capital is 6% of RWA
• Conservation buffer to reduce pro-cyclicality
• Further assets to be disallowed to reduce systemic risk
• Liquidity requirements via LCR and NSFR

Question 5

What are the two approaches to categorising RWA?

Answer 5

• Standardised approach
• Internal Ratings Based (IRB) approach

Question 6

Outline the standard approach to calculating RWA

Answer 6

• Under Basel I- most loans were weighted at 100% of nominal with exceptions like nominal/collateral backed loans
• Under Basel II- almost all rating s have a risk weighting category and hence risk weighting

Question 7

Outline the IRB approach

Answer 7

• Under Basel II- banks can categorise and risk weight assets based on credit rating determined by own IRB model
• Requires thorough credit assessment
• Must be approved by regulator

Question 8

Whatare the components of the twin peak approach for calculating pillar I capital

Answer 8

• Market consistent approach - SCR
• Basic valuation based on Solvency I- MCR

Question 9

Outline the SCR under Solvency II

Answer 9

• SCR must be achievable with 99.5% confidence interval over 1 year time horizon
• Being below = regulatory intervention
• Calculated using standard formula or approved internal model

Question 10

Outline the basis of the standard formula to calculating SCR under Solvency II

Answer 10

• Deterministic with some stochastic elements e.g., for guarantees
• Deals wuth market risk by limiting admissibility of some assets and stress tests
• Deals with credit risk by limiting exposure to individual counterparties
• Deals with uw risk by requiring additional solvency margins

Question 11

Which standards must internal model meet for Solvency II

Answer 11

• Use test- company must actually use it in risk management and decision-making
• Statistical quality standards- ensures realistic and reliable assumptions
• Calibration standards- ensures output xan be used to properly calculate SCR
• Profit and loss attribution
• Validation standards
• Documentation standards

Question 12

Outline the basis of the MCR under Solvency I

Answer 12

• 3M Euros + margin on premium/reserve amounts
• MCR must be achievable with 80-90% confidence over 1-year time horizon
• Being below == lose authorisation