Book 3. Operational Risk

FRM Part 2

OR 23. High-Level Summary of Basel III Reforms

Presented by: Sudhanshu

Module 1. Summary of Basel III Reforms

Module 1. Summary of Basel III Reforms

Topic 1. Motivations for Revising the Basel III Framework

Topic 2. Standardized Approach (SA) for Credit Risk

Topic 3. Internal Ratings-Based (IRB) Approaches for Credit Risk

Topic 4. Credit Valuation Adjustment (CVA) Risk Framework

Topic 5. Operational Risk Framework

Topic 6. Leverage Ratio Framework

Topic 7. Output Floor

Topic 1. Motivations for Revising the Basel III Framework

• The 2007–2009 global financial crisis exposed major weaknesses in the regulatory framework (Basel II), which failed to prevent widespread banking failures and systemic shocks.

• In December 2017, the Basel Committee introduced final Basel III reforms to be implemented starting in 2022, aiming to:

  • Expanding the robustness and sensitivity of the standardized approach (SA) for measuring credit risk, credit valuation adjustment (CVA) risk, and operational risk.

  • Restricting the use of internal model approaches for credit risk, CVA risk, and operational risk.

  • Establish a leverage ratio buffer to backstop against excessive leverage, particularly for G-SIBs (Global Systemically Important Banks).

  • Introduce output floors to reduce model-based capital arbitrage.

Practice Questions: Q1

Q1. The Basel III reforms restricted the use of internal model approaches for all of the following risk categories except:
A. credit risk.
B. systemic risk.
C. operational risk.
D. credit valuation risk.

Practice Questions: Q1 Answer

Explanation: B is correct.

The use of internal model approaches are restricted for credit risk, operational risk, and credit valuation risk.

Practice Questions: Q2

Q2. The Basel III reforms introduced a leverage buffer ratio for all:
A. global banks.
B. unregulated global banks.
C. global systemically important banks.
D. banks regulated by the U.S. Federal Reserve and the European Banking Authority.

Practice Questions: Q2 Answer

Explanation: C is correct.

The Basel III reforms revise the leverage ratio framework by adding a leverage ratio buffer for G-SIBs that must be met with Tier 1 capital.

Topic 2. Standardized Approach (SA) for Credit Risk

• Basel III reforms enhanced the standardized approach (SA) by doing the following:

  • Increasing the granularity of risk-weight definitions, and hence, improving the risk sensitivity of the measures.

    • For example, under all Basel II, the same risk weight was applied to all residential mortgages; under Basel III reforms, the risk weight of a residential mortgage depends on the loan-to-value ratio.

    • More granular treatments were also developed for rated and unrated exposures to banks and corporates, as well as residential and commercial real estate, retail exposures, subordinated debt and equity, and off-balance sheet items.

  • Reducing the reliance on external credit ratings as an assessment of credit risk.

  • Providing the foundation for the revised output floor

Topic 3. Internal Ratings-Based (IRB) Approaches for Credit Risk

• IRB Crisis Performance: Internal ratings-based approaches for credit risk proved problematic during the financial crisis due to complexity, lack of cross-bank comparability, and inadequate modeling of certain asset classes.
• Advanced IRB Flexibility: A-IRB approach allowed banks to estimate probability of default, loss given default, exposure at default, and exposure maturity in certain cases, providing maximum modeling flexibility.
• Foundation IRB Constraints: F-IRB approach requires fixed values for LGD and EAD parameters, which were the two factors contributing most to risk-weighted asset variability across institutions.

• Basel III reforms:

  • took away the A-IRB approach for exposures to large and mid-size corporates, as well as banks and other financial institutions, and required the use of the F-IRB approach in those cases;

  • required input floors for PD, LGD, and EAD to force more conservative estimates of credit risk; and

  • provided more specific requirements for how banks estimate model parameters.

Practice Questions: Q3

Q3. The advanced internal ratings-based (A-IRB) approach for credit risk will no longer be permissible to use under the Basel III reforms for each of the following except:
A. large corporate exposures.
B. mid-size corporate exposures.
C. banks and other financial institutions.
D. residential and commercial real estate.

Practice Questions: Q3 Answer

Explanation: D is correct.

The Basel III reform took away the A-IRB approach for exposures to large and mid-size corporates, as well as banks and other financial institutions, and required the use of the foundation IRB (F-IRB) approach in those cases.

Topic 4. Credit Valuation Adjustment (CVA) Risk Framework

• CVA risk arises from potential changes in the creditworthiness of counterparties in derivative contracts.

• It was a significant contributor to losses in the financial crisis.

• The Basel III reforms:

  • Incorporate market risk sensitivities and hedging instruments into the CVA framework to improve risk sensitivity.

  • remove the option to use the IRB approach to CVA risk, and require the use of a standardized approach (SA) or a basic approach.

  • improve consistency with the revised market-risk framework by basing the CVA framework on fair value sensitivities to market-risk factors.

Topic 5. Operational Risk Framework

• Prior framework included Advanced Measurement Approach (AMA) and three SAs, but proved insufficient in two important ways:

  • capital requirements were insufficient to cover bank losses from operational risk factors

  • the type of risk factors that led to these losses (e.g.,misconduct and inadequate systems and controls) were not captured adequately in the internal models.

• Revised Basel III framework

  • Replaced all previous methods with a single standardized approach (SA) for all banks.

  • Capital requirement is now based on bank's:

    • income, which is assumed to be positively correlated to future operational risk; and

    • historical operational risk losses, which are also assumed to be positively correlated to future operational risk.

Practice Questions: Q4

Q4. The new operational risk capital requirements under the Basel III reforms are determined by measures of the bank’s:
A. leverage and income.
B. income and historical operational risk losses.
C. income and expected operational risk losses.
D. leverage and expected operational risk losses.

Practice Questions: Q4 Answer

Explanation: B is correct.

Operational risk capital requirements are determined by measures of the bank’s income and historical operational risk losses, both of which are assumed to be positively correlated to future operational risk.

Topic 6. Leverage Ratio Framework

• The Basel III reforms revise the leverage ratio framework by: 

  • adding a leverage ratio buffer for G-SIBs that must be met with Tier 1 capital; and

  • refining the leverage ratio exposure measure to better reflect the exposure from derivatives and off-balance sheet items.

Topic 7. Output Floor

• Output Floor Purpose: Restricts large banks from gaining unfair advantages by significantly reducing capital requirements through internal approaches compared to standardized approaches, effectively setting minimum capital requirements.
• Calculation Method: Risk-weighted assets equal the higher of either total RWA from the bank's approved approach (standardized or internal) or 72.5% of total RWA using the standardized approach.

• Standardized approaches to be used when calculating the floor are based on the type of risk exposure:

  • The SA for credit risk,

  • The SA for measuring counterparty credit risk (SA-CCR) is used for derivatives.

  • The SA for credit risk is then applied to the counterparty.

  • For credit valuation adjustment (CVA) risk, the standardized approach (SA-CVA) or the basic approach (BA-CVA), both of which are discussed in LO 64.b, or 100% of the bank’s counterparty credit risk capital requirement.

  • For securitization risk, the choices are the external ratings-based approach (SECERBA), the standardized approach (SEC-SA), or a 1,250% risk weight.

  • For market risk, the SA is permitted.

  • For operational risk, the SA is permitted.

Practice Questions: Q5

Q5. The output floor sets the minimum level of:
A. leverage.
B. functional capital.
C. credit valuation adjustment (CVA) risk exposure.
D. risk-weighted assets.

Practice Questions: Q5 Answer

Explanation: D is correct.

The output floor sets a minimum level of risk-weighted assets.

Practice Questions: Q6

Q6. Under Basel III reforms, the approaches that can be used when calculating the output floor for CVA risk include all of the following except:
A. the basic (BA-CVA) approach.
B. the standardized (SA-CVA) approach.
C. the internal ratings-based (IRB-CVA) approach.
D. 100% of the bank’s counterparty credit risk capital requirement.

Practice Questions: Q6 Answer

Explanation: C is correct.

IRB approaches cannot be used for calculating the output loor floor CVA risk.