Chapter 4: Operational, Financial, and Strategic Risk - Review (Part 3 - Financial cont'd)

Question 1

VaR and EaR

Answer 1

Value at Risk (VaR): method of determining probability of loss on an investment portfolio over a certain, usually short, time

Earnings at Risk: the maximum expected loss of earnings within a certain degree of confidence. Usually used for nonfinancial organizations

Question 2

How does VaR work?

Answer 2

VaR measures the probability of a loss in an investment’s value exceeding a threshold level. For example, a one-day, 5% VaR of $300,000 means there is a 5% probability of losing $300,000 or more over the next day.

Question 3

Three benefits of VaR as a risk measure

Answer 3

• The potential loss associated with an investment decision can be quantified
• Complex positions (typically involving multiple investments) are expressed as a single figure
• Loss is expressed in easily understood monetary terms

Question 4

Limitation of VaR as a measure

Answer 4

• It does not accurately measure the extent to which to which a loss may exceed the VaR threshold.
• This can be addressed with Conditional Value at Risk (CVaR), which also takes into account extremely large losses that may occur

Question 5

How can Earnings at Risk be determined

Answer 5

• Determining EaR entails modeling the influence of factors such as changes in sales; production costs; and the prices of producs, commodities, and components used in production
• Monte Carlo simulation can simulate effects of types of uncertainty
• The probasbility that an organization’s earnings will be greater than the EaR threshold is represented by the area under the distribution curve to the right of the EaR threshold

Question 6

What is regulatory capital?

Answer 6

• Amount presribed by governments for financial institutions under their jurisdiction
• Dictates the amount of capital these institutions must hold to guard against risks
• Provides a sufficient cushion against unexpected reduction in the value of capital

Question 7

What is Basel I and how does it define capital?

Answer 7

Basel I is an agreement to create standard RBC requirements for credit risk.

Capital is defined on two tiers:

• Tier 1: Core capital, essentially the same as equity capital
• Tier 2: supplementary capital, includes all capital other than core capial (ex. gains on investment assets, long-term debt that matures after 5 years, excess reserves for loan losses)

Question 8

Weakness of Basel I and how Basel II addressed them

Answer 8

Basel I weak because it did not sufficiently take into account changes in assets’ risks or systemic risk

Basel II improved with three pillars:
* Minimum capital requirements that address risk
* Supervisory review of organization’s internal assessment process and capital adequacy
* Effective use of disclusre to strengthen market discipline and complement supervision

Question 9

Basel II’s two approaches to measuring a financial institution’s credit risk

Answer 9

• Standardized approach (ratings from international rating agencies to determine an instution’s creditworthiness)
• Internal ratings-based (IRB) approach: allwos banks to use their internal rating systems and credit-scoring models to evaluate boorowers’ creditworthiness and calculate regulatory capital

Question 10

Goals of Basel III to improve on Basel II

Answer 10

• Introduced a global liquidity framework
• Goals include improving quality, consistency, and transparency of banks’ capital base to help the commercial banking sector better absorb shocks from financila and exconomic stressors
• Offers improved risk management and governance
• Created a capital requirement (surcharge) for systemically important banks

Question 11

Four ways that Basel III accomplishes its goals

Answer 11

• Capital planning
• Continually monitoring risk exposures and capital needs
• Establishing procedures to control or mitigate banks’ risk exposures and capital positions
• Reporting requirements

Question 12

Five categories of capitalization under Basel III

Answer 12

• Well capitalized
• Adequately capitalized
• Undercapitalized
• Significantly undercapitalized
• Critically undercapitalized

Question 13

Under Basel III, regulators and banks can take the folloiwng actions when they are not well capitalized

Answer 13

• Suspend dividends and management fees
• Restrict asset growth
• Require institution to obtain approval for acquisitions or to develop a capital-restoration plan
• Restrict deposit interest rates or officer’s pay
• Appoint a receiver/conservator within given time frames

Question 14

RBC requirements for insurers

Answer 14

• Regulators establish minimum capital requirements for insurers to protect policyholders and claimants
• RBC system determines amount of capital an insurer needs to support its operations
• Asset risk, underwriting risk, and other risks applicable to the insurer are considered (i.e. credit risk for P&C comanies)
• RBC for Insurers Model ACt enables regulators to take action before an insurer becomes too financially weak

Question 15

Asset risk for insurers

(Insurer RBC requirements)

Answer 15

• Asset risk: risk that the aset’s value will decrease
• Decrease in asset value reduces policyholder’s surplus

Question 16

Credit risk for insurers

(Insurer RBC requirements)

Answer 16

• Reflects possibility that insurer will not be able to collect money owed to it
• Main sources: receivables; interest, dividends and real estate income; receivables from affiliates; receivalbes relating to uninsured accident and health plans; aggregate write-ins for assets

Question 17

Underwriting risk for insurers

(Insurer RBC requirements)

Answer 17

Insurer is at risk of underwriting loss if it collects insufficient premiums and/or significantly underestimates its loss reserves

Question 18

Action levels for insurers

(Insurer RBC requirements)

Answer 18

• Results of RBC formula determine action to be taken
• Ex. no action required if RBC is 200 percent or more of computed minimum
• At the lowest RBC computed minimum level (70-100%) the insurer is placed under regulatory control