AIRB Overview Flashcards
(9 cards)
What is AIRB
Advanced Internal Rating Based approach is a method used to measure how much money should be kept for unexpected loses from loans and other credit products they offer.
It allows for flexibility as the bank can save based on how they choose to however they still must follow certain rules to ensure they are not being overly optimistic
What is Advanced Model Framework ?
Part of the AIRB approach, it is a detailed way of calculating how much the bank should hold to cover potential lossesbon loans and credit product
What is Regulatory Capital
Regulatory capital is the amount of capital that banks are required to hold by financial regulators to ensure they can absorb unexpected losses and continue to operate without major issues. This capital acts as a financial cushion, protecting the bank’s depositors, creditors, and the overall financial system in case the bank faces financial difficulties. The idea is to make sure that the bank has enough resources to handle losses from its loans and investments, especially in bad economic times, without needing a bailout or failing completely.
The more risky the assets, the more capital the bank needs to hold. This is meant to ensure that banks are managing their risks prudently and have a stable financial base.
Regulatory Capital = Risk weighted assets * Capital Ratio (%)
What is Risk weighted assets and Capital Ratio
- Risk-Weighted Assets are bank assets, that are weighted based on there risk. There 3 parameters that must be gotten to get the RWA (Risk weighted asset).
-Capital Ratio: This is a measure of the banks financial strength, expressed as a ratio of its capital to its risk-weighted assets. It indicates the banks ability to absorb losses and remain solvant.
What are the 3 Parameters needed to calculate the RWA
-PD - Probability of Default
-EAD - Exposure of Default
-LGD - Loss Given Default
What is PD (Probability of Default) ?
This is an estimate of the likelihood that the borrower will be unable to pay back their loan with in a year.
“The balance at default as a percentage of the limit at observation date
PD(%) = Defaulters/ (Non-Defaulters + Defaulters).”
What is EAD (Exposure at Default)?
This predicts the amount of money that could be lost if the borrower defaults on there loan.
“The balance at default as a percentage of the limit at observation date.
EAD% = Balance(def)/ limit(abs)”
What is LGD (Loss Given Default)?
This estimates what the percentage of the loan the bank will lose after considering any money they can recover, like selling the collateral.
“The percentage of the defaulted balance that will be recorded as an accounting loss
LGD(%) = (Balance(def) - Recovery + collection costs)/Balance(def)”.
When banks calculate the necessary capital to cover unexpected losses (referred to as Regulatory Capital), they must be cautious to avoid being overly optimistic about their risk assessments. This involves adding a layer of conservatism to the parameter used in the calculations: PD, EAD, LGD.
What are these Required Regulatory Conservatism?
1) Long run: There is uncertainty about long-term averages because a bank might not have experienced a full economic cycle in its data collection period. This means the data might not fully capture all potential economic ups and downs that affect the banks exposure to losses.
Simple analogy:
“Think of it like trying to predict the weather for a whole year just by looking at one month’s data. you might miss other conditions that could happen outside that month.”
2) Data and Asssumptions:
Sometimes the data banks use can be incomplete or tweaked to fit certain models, which can misrepresent the real risk. For example, cutting off data points them fit into a simpler model could lead to underestimating risk.
Simple Analogy:
“Imagine only counting sunny days when planning for an outdoor event and ignoring the possibility of rain simply because it hasn’t rained in the past few weeks”
3) Qualitative Adjustments(QA):
This involves adding expert judgement to the mix, especially when the data alone doesn’t tell the whole story or is ambiguous. These adjustments account for insights that aren’t directly observable or measurable form theexisting data
Simple Analogy:
“Its like a chef adjusting a recipe by taste because they know the ingredients don’t always taste the same; they use their experience to tweak the cooking process.”
4) Downturn:
This factor takes into account the added risk during economic downturns, when losses might be higher than usual. It also considers that the relationship between defaults and losses might not behave consistently through different economic conditions.
Simple Analogy:
Preparing your house for all seasons rather than just a sunny day, because weather can change drastically, and what works for one season might not work for another.
Note:
These conservation adjustment help ensure that banks hold enough capital to stay afloat even if things go worse than expected, similar to how you might pack an extra umbrella or jacket “just in case” the weather forecast is wrong
