Tier 1 capital

From Wikipedia, the free encyclopedia

Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed
of core capital,[1] which consists primarily of common stock and disclosed reserves (or retained earnings),[2] but
may also include non-redeemable non-cumulative preferred stock.

Capital in this sense is related to, but different from, the accounting concept of shareholders' equity. Both tier 1
and tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the
replacement Basel II accord. Tier 2 capital is senior to Tier 1, but subordinate to deposits and the deposit
insurer's claims. These include preferred stock with fixed maturities and long-term debt with
minimum maturities of over five years.

Each country's banking regulator, however, has some discretion over how differing financial instruments may
count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems.

The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note
that this is not the same as expected losses which are covered by provisions, reserves and current year profits.
In Basel I agreement, Tier 1 capital is a minimum of 4%ownership equity but investors generally require a ratio
of 10%.

Tier 1 capital ratio

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets. Risk-weighted
assets are the total of all assets held by the bank which are weighted for credit risk according to a formula
determined by the Regulator (usually the country's central bank). Most central banks follow the Bank for
International Settlements (BIS) guidelines in setting formulae for asset risk weights. Assets
likecash and coins usually have zero risk weight, while certain loans may have a risk of 100%.

The tier 1 Capital ratio is calculated in two ways. There is the Tier 1 common capital ratio and the Tier 1 total
capital ratio. In general, Tier 1 ratio is tier 1 capital / risk adjusted assets (RWA). If someone deposits $10 and
the bank lends out all $10 assuming a RWA of 90% and we will assume the bank began with $2 of original
equity, then the bank would now have risk adjusted assets of $9 ($10*0.9) and it would have equity of $2
implying a ratio of $2/$9 or 22%.

In this example common capital and total capital would be the same. However, if its capital base included
preferred shares or had non controlling interests, than these would be included in the total capital ratio but not
in the Tier 1 common ratio. This means that the common ratio will always be less than or equal to the total
capital ratio.
Tier 2 capital
Tier 2 capital is a measure of a bank's financial strength with regard to the second most reliable form
of financial capital from a regulatory point of view. The forms of banking capital were largely standardized in
the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel
II accord. National regulators of most countries around the world have implemented these standards in local
legislation.

Tier 1 capital is considered the more reliable form of capital, which comprises the most junior (subordinated)
securities issued by the firm. These include equity and qualifying perpetual preferred stock.

There are several classifications of tier 2 capital. In the Basel I Accord, tier 2 capital is composed
of supplementary capital, which is categorised as undisclosed reserves, revaluation reserves, general
provisions, hybrid instruments and subordinated term debt. Supplementary capital can be considered tier 2
capital up to an amount equal to that of the core capital.[1]

Undisclosed Reserves

Undisclosed reserves are not common, but are accepted by some regulators where a bank has made a profit
but this has not appeared in normal retained profits or in general reserves of the bank.

[edit]Revaluation Reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is
brought to account. A simple example may be where a bank owns the land and building of its head-offices and
bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The
increase would be added to a revaluation reserve.

[edit]General Provisions

A general provision is created when a company is aware that a loss may have occurred but is not sure of the
exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to
provide for losses that were expected in the future. As these did not represent incurred losses, regulators
tended to allow them to be counted as capital.

[edit]Hybrid Instruments

Hybrids are instruments that have some characteristics of both debt and shareholders' equity. Provided these
are close to equity in nature, in that they are able to take losses on the face value without triggering
a liquidation of the bank, they may be counted as capital. Preferred stocks are hybrid instruments.

[edit]Subordinated Term Debt

Subordinated debt is debt that ranks lower than ordinary depositors of the bank.

Credit risk is an investor's risk of loss arising from a borrower who does not make payments as
promised. Such an event is called a default. Another term for credit risk is default risk.

Investor losses include lost principal and interest, decreased cash flow, and increased collection costs,

which arise in a number of circumstances:

 A consumer does not make a payment due on a mortgage loan, credit card, line of credit, or other
loan
 A business does not make a payment due on a mortgage, credit card, line of credit, or other loan
 A business or consumer does not pay a trade invoice when due
 A business does not pay an employee's earned wages when due
 A business or government bond issuer does not make a payment on a coupon or principal
payment when due
 An insolvent insurance company does not pay a policy obligation
 An insolvent bank won't return funds to a depositor
 A government grants bankruptcy protection to an insolvent consumer or business
[edit]Types of credit risk

 Default risk
 Credit spread risk
 Downgrade risk
[edit]Assessing credit risk
Main articles:  Credit analysis and  Consumer credit risk

Significant resources and sophisticated programs are used to analyze and manage risk. Some companies
run a credit risk department whose job is to assess the financial health of their customers, and extend
credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and
transferring risk. They also use third party provided intelligence. Companies like Standard &
Poor's, Moody's Analytics, Fitch Ratings, and Dun and Bradstreet provide such information for a fee.

Most lenders employ their own models (credit scorecards) to rank potential and existing customers
according to risk, and then apply appropriate strategies. With products such as unsecured personal loans
or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving
products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some
products also require security, most commonly in the form of property.
Credit scoring models also form part of the framework used by banks or lending institutions grant credit to
clients. For corporate and commercial borrowers, these models generally have qualitative and
quantitative sections outlining various aspects of the risk including, but not limited to, operating
experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once
this information has been fully reviewed by credit officers and credit committees, the lender provides the
funds subject to the terms and conditions presented within the contract (as outlined above).

Credit risk has been shown to be particularly large and particularly damaging for very large investment
projects, so-called megaprojects. This is because such projects are especially prone to end up in what
has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, etc. – the
costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the
debt.[1]

[edit]Sovereign risk
Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or
reneging on loans it guarantees.[2] The existence of sovereign risk means that creditors should take a two-
stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should
consider the sovereign risk quality of the country and then consider the firm's credit quality. [3]

Five macroeconomic variables that affect the probability of sovereign debt rescheduling are: [4]

 Debt service ratio

 Import ratio
 Investment ratio
 Variance of export revenue
 Domestic money supply growth

The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of
export revenue and domestic money supply growth. Frenkel, Karmann and Scholtens also argue that the
likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity
gains. Saunders argues that rescheduling can become more likely if the investment ratio rises as the
foreign country could become less dependent on its external creditors and so be less concerned about
receiving credit from these countries/investors.[5]

[edit]Counterparty risk
Counterparty risk, otherwise known as default risk, is the risk that an organization does not pay out on
a bond, credit derivative, credit insurance contract, or other trade or transaction when it is supposed to.
[6]
 Even organizations who think that they have hedged their bets by buying credit insurance of some sort
still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer
term systemic issues.[7]

Large insurers are counterparties to many transactions, and thus this is the kind of risk that prompts
financial regulators to act, e.g., the bailout of insurer AIG.

On the methodological side, counterparty risk can be affected by wrong way risk, namely the risk that
different risk factors be correlated in the most harmful direction. Including correlation between the portfolio
risk factors and the counterparty default into the methodology is not trivial, see for example Brigo and
Pallavicini[8]

A good introduction can be found in a paper by Michael Pykhtin and Steven Zhu. [9]

[edit]Mitigating credit risk

Lenders mitigate credit risk using several methods:

 Risk-based pricing: Lenders generally charge a higher interest rate to borrowers who are more
likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan
such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit
spread).
 Covenants: Lenders may write stipulations on the borrower, called covenants, into loan
agreements:
 Periodically report its financial condition
 Refrain from paying dividends, repurchasing shares, borrowing further, or other specific,
voluntary actions that negatively affect the company's financial position
 Repay the loan in full, at the lender's request, in certain events such as changes in the
borrower's debt-to-equity ratio or interest coverage ratio
 Credit insurance and credit derivatives: Lenders and bond holders may hedge their credit risk
by purchasing credit insurance orcredit derivatives. These contracts transfer the risk from the
lender to the seller (insurer) in exchange for payment. The most common credit derivative is
the credit default swap.
 Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in
total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may
attempt to lessen credit risk by reducing payment terms from net 30to net 15.
 Diversification: Lenders to a small number of borrowers (or kinds of borrower) face a high
degree of unsystematic credit risk, calledconcentration risk. Lenders reduce this risk
by diversifying the borrower pool.
 Deposit insurance: Many governments establish deposit insurance to guarantee bank deposits
of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is
becoming insolvent, to avoid a bank run, and encourages consumers to holding their savings in the
banking system instead of in cash.

Standardized approach (credit risk)

Not to be confused with  Standardized approach (operational risk).

The term standardized approach (or standardised approach) refers to a set of credit riskmeasurement

techniques proposed under Basel II capital adequacy rules for banking institutions.

Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify
required capital for credit risk. In many countries this is the only approach the regulators are planning to
approve in the initial phase of Basel II Implementation.

The Basel Accord proposes to permit banks a choice between two broad methodologies for calculating their
capital requirements for credit risk. The other alternative is based on internal ratings.

[edit]The summary of risk weights in standardized approach

There are some options in weighting risks for some claims, below are the summary as it might be likely to be
implemented.

NOTE: For some "unrated" risk weights, banks are encouraged to use their own internal-ratings system based
on Foundation IRB and Advanced IRB in Internal-Ratings Based approach with a set of formulae provided by
the Basel-II accord. There exist several alternative weights for some of the following claim categories published
in the original Framework text.

 Claims on sovereigns
Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- unrated
Risk Weight 0% 20% 50% 100% 150% 100%

 Claims on the BIS, the IMF, the ECB, the EC and the MDBs

Risk Weight: 0%

 Claims on banks and securities companies

Related to assessment of sovereign as banks and securities companies are regulated.

Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- unrated

Risk Weight 20% 50% 100% 100% 150% 100%
 Claims on corporates
Credit Assessment AAA to AA- A+ to A- BBB+ to BB- Below BB- unrated
Risk Weight 20% 50% 100% 150% 100%

 Claims on retail products

This includes credit card, overdraft, auto loans, personal finance and small business.

Risk weight: 75%

 Claims secured by residential property

Risk weight: 35%

 Claims secured by commercial real estate

Risk weight: 100%

 Overdue loans

more than 90 days other than residential mortgage loans.

Risk weight:

150% for provisions are less than 20% of the outstanding amount

100% for provisions are between 20% - 49% of the outstanding amount

100% with supervisory discretion to reduce to 50% for provisions are 50% and more of the outstanding amount

 Other assets

Risk weight: 100%

 Cash

Risk weight: 0%

Foundation IRB
From Wikipedia, the free encyclopedia

The term Foundation IRB or F-IRB is an abbreviation of foundation internal ratings-based approachand it

refers to a set of credit risk measurement techniques proposed under Basel II capital adequacyrules for
banking institutions.
Under this approach the banks are allowed to develop their own empirical model to estimate the PD (probability
of default) for individual clients or groups of clients. Banks can use this approach only subject to approval from
their local regulators.

Under F-IRB banks are required to use regulator's prescribed LGD (Loss Given Default) and other parameters
required for calculating the RWA (Risk Weighted Assets). Then total required capital is calculated as a fixed
percentage of the estimated RWA.

[edit]Some formulae in Internal-ratings-based approach

Some credit assessments in standardised approach refer to unrated assessment. Basel II also encourages
banks to initiate internal-ratings based approach for measuring credit risks. Banks are expected to be more
capable of adopting more sophisticated techniques in credit risk management.

Banks can determine their own estimation for some components of risk measure: the probability of default
(PD), exposure at default (EAD) and effective maturity (M). The goal is to define risk weights by determining the
cut-off points between and within areas of the expected loss (EL) and the unexpected loss (UL), where the
regulatory capital should be held, in the probability of default. Then, the risk weights for individual exposures
are calculated based on the function provided by Basel II.

Below are the formulae for some banks’ major products: corporate, small-medium enterprise (SME), residential
mortgage and qualifying revolving retail exposure.
Notes:

 10 Function is taken from paragraph 272

 11 Function is taken from paragraph 273

 12 Function is taken from paragraph 328

 13 Function is taken from paragraph 229

In Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework
(BCBS) (November 2005 Revision)

 PD = the probability of default

 LGD = loss given default

 EAD = exposure at default

 M = effective maturity
[edit]The advantages
 Basel-II benefits customers with lower probability of default.

 Basel-II benefits banks to hold lower capital requirement as having corporate customers with lower
probability of default (Graph 1).

 Basel-II benefits SME customers to be treated differently from corporates.

 Basel-II benefits banks to hold lower capital requirement as having credit card product customers with
lower probability of default (Graph 2).
Advanced IRB
From Wikipedia, the free encyclopedia

The term Advanced IRB or A-IRB is an abbreviation of advanced internal rating-based

approach and it refers to a set of credit risk measurement techniques proposed
under Basel II capital adequacy rules for banking institutions.

Under this approach the banks are allowed to develop their own empirical model to quantify
required capital for credit risk. Banks can use this approach only subject to approval from
their local regulators. For more background on the types of models banks have applied, see
the Jarrow-Turnbull model.

Under A-IRB banks are supposed to use their own quantitative models to estimate PD
(probability of default), EAD (Exposure at Default), LGD (Loss Given Default) and other
parameters required for calculating the RWA (Risk Weighted Asset). Then total required
capital is calculated as a fixed percentage of the estimated RWA.

[edit]Some formulae in internal-ratings-based approach

Some credit assessments in standardised approach refer to unrated assessment. Basel II
also encourages banks to initiate internal-ratings based approach for measuring credit risks.
Banks are expected to be more capable of adopting more sophisticated techniques in credit
risk management.

Banks can determine their own estimation for some components of risk measure: the
probability of default (PD), loss given default (LGD), exposure at default (EAD) and effective
maturity (M). For public companies, default probabilities are commonly estimated using
either the structural model of credit risk proposed by Robert Merton (1974) or reduced form
models like the Jarrow-Turnbull model. For retail and unlisted company exposures, default
probabilities are estimated using credit scoring or logistic regression, both of which are
closely linked to the reduced form approach. The goal is to define risk weights by
determining the cut-off points between and within areas of the expected loss (EL) and the
unexpected loss (UL), where the regulatory capital should be held, in the probability of
default. Then, the risk weights for individual exposures are calculated based on the function
provided by Basel II.
Below are the formulae for some banks’ major products: corporate, small-medium
enterprise (SME), residential mortgage and qualifying revolving retail exposure. (S being
Min(Max(Sales Turnover),5),50 )
Notes:

 10 Function is taken from paragraph 272

 11 Function is taken from paragraph 273
 12 Function is taken from paragraph 328
 13 Function is taken from paragraph 329
In Basel II: International Convergence of Capital Measurement and Capital Standards: a
Revised Framework (BCBS) (November 2005 Revision)

 PD = the probability of default

 LGD = loss given default
 EAD = exposure at default
 M = effective maturity
[edit]The advantages
 Basel-II benefits customers with lower probability of default.
 Basel-II benefits banks to hold lower capital requirement as having corporate
customers with lower probability of default (Graph 1).

 Basel-II benefits SME customers to be treated differently from corporates.

 Basel-II benefits banks to hold lower capital requirement as having credit card
product customers with lower probability of default (Graph 2).

[edit]
Probability of default
From Wikipedia, the free encyclopedia

Probability of default (PD) is a parameter used in the calculation of economic

capital or regulatory capital under Basel II for a banking institution. This is an attribute of a
bank's client.

[edit]Definition

The probability of default (also call Expected default frequency) is the likelihood that a loan
will not be repaid and will fall into default. PD is calculated for each client who has a loan
(for wholesale banking) or for a portfolio of clients with similar attributes (for retail banking).
The credit history of the counterparty / portfolio and nature of the investment are taken into
account to calculate the PD.

There are many alternatives for estimating the probability of default. Default probabilities
may be estimated from a historical data base of actual defaults using modern techniques
like logistic regression. Default probabilities may also be estimated from the observable
prices of credit default swaps, bonds, and options on common stock. The simplest
approach, taken by many banks, is to use external ratings agencies such as Standard and
Poors, Fitch or Moody's Investors Service for estimating PDs from historical default
experience. For small business default probability estimation,logistic regression is again the
most common technique for estimating the drivers of default for a small business based on
a historical data base of defaults. These models are both developed internally and supplied
by third parties. A similar approach is taken to retail default, using the term "credit score" as
a euphemism for the default probability which is the true focus of the lender.

[edit]How to calculate the probability of default

The following steps are commonly used:

 Analyse the credit risk aspects of the counterparty / portfolio;

 Map the counterparty to an internal risk grade which has an associated PD: and

 Determine the facility specific PD. This last step will give a weighted Probability of
Default for facilities that are subject to a guarantee or protected by a credit derivative.
The weighting takes account of the PD of the guarantor or seller of the credit derivative.
 Once the probability of default has been estimated, the related credit spread and
valuation of the loan or bond is the next step. A popular approach to this critical element
of credit risk analysis is the "reduced form" modeling approach of the Jarrow-Turnbull
model.
[edit]How to calculate Through-The-Cycle probability of default
Through-the-Cycle (TTC) PD's are long-run probabilities of default which take into
consideration upturns and downturns in the economy. Conceptually, it is the simple
average, median or equilibrium of Point-In-Time (PIT) PD's (PD's which are calculated for
very short horizons) over a long period of time where several economic cycles have played
out. Usually, the simple regulatory formula is to take the long-term average of PIT PD's.
This is, however, impractical as long-term data is often limited for any obligor/portfolio
making calculations cumbersome. Furthermore, it is theoretically incorrect as
obligor/portfolio characteristics tend to metamorphisize over time making one estimation of
PD at one point-in-time incomparable with another estimate at another point-in-time.

In order to overcome these practical and theoretical hurdles it is possible to convert pure
PIT estimated PD's to TTC or Long-Term PD's by following some simple steps:

 Calculation of at least 1 PIT PD. This PD will be composed of defaults with and
without losses (i.e. LGD < 100%).
 Find the percentage of customers for the same obligor/portfolio (for which the PD
has been calculated) where there have been losses. This is often referred to as 'Loss
Frequencies' and these data are often recorded far back into time. Alternatively, use
public data on bankruptcies as a proxy.
 Take the ratio between the average of PIT PD's and the Average of Loss
Frequencies in overlapping years.
 Loss Frequency Averages are then multiplied with the found ratio. These are
referred to as 'Estimated PIT PD's'.
 Create a Time-Series with PD's and Estimated PIT PD's, where Estimated PIT PD's
are used to compliment existing PD's
 Last step is to calculate Long-Term Averages or Equilibriums based upon regression
techniques and steady-state macroeconomic data.
As most Practitioners have little data on PD's compared to data on losses, this method
provides a way of overcoming practical challenges. Furthermore, the method takes into
consideration existing default definitions (and changing default definitions) and cyclical
effects caused by macroeconomic forces as represented in Loss Frequency Data. One
crucial assumption, however, is the belief that the segment/obligor type has remained
relatively constant over the time period the time-series has been created for.

[edit]Expected Default Frequency(EDFTM)

Expected Default Frequency (EDFTM) is a trademarked term for the probability of default
derived from Moody's Analytics' (formerly Moody's KMV) public firm model, a structural
credit risk model originally based on the work of Stephen Kealhofer, John McQuown,
and Oldrich Vasicek. The public firm EDFTM model reflects numerous theoretical and
empirical variations on the traditional Black-Scholes-Merton structural model, and is
probably the best-known commercial implementation of the structural modeling framework.
Although often associated with a one-year time horizon, a term structure of EDF TM credit
measures from one to five years is calculated.
[edit]

Loss given default

From Wikipedia, the free encyclopedia

Loss Given Default or LGD is a common parameter in Risk Models and also a parameter
used in the calculation of Economic Capital or Regulatory Capital under Basel II for a
banking institution. This is an attribute of any exposure on bank's client. Exposure is the
amount that one may lose in an investment.

[edit]Definition

LGD is the credit loss incurred if an obligor defaults.

Loss Given Default is facility-specific because such losses are generally understood to be
influenced by key transaction characteristics such as the presence of collateral and the
degree of subordination.

[edit]How to calculate LGD

Theoretically, LGD is calculated in different ways, but the most popular is 'Gross' LGD,
where total losses are divided by exposure at default (EAD). Another method is to divide
Losses by the unsecured portion of a credit line (where security covers a portion of EAD.
This is known as 'Blanco' LGD. If collateral value is zero in the last case then Blanco LGD is
equivalent to Gross LGD. Different types of statistical methods can be used to do this.
Gross LGD is most popular amongst academics because of its simplicity and because
academics only have access to bond market data, where collateral values often are
unknown, uncalculated or irrelevant. Blanco LGD is popular amongst some practitioners
(banks) because banks often have many secured facilities, and banks would like to
decompose their losses between losses on unsecured portions and losses on secured
portions due to depreciation of collateral quality. The latter calculation is also a subtle
requirement of Basel II, but most banks are not sophisticated enough at this time to make
those types of calculations.

[edit]Calculating
LGD under the foundation approach (for corporate,
sovereign and bank exposure)
Under Basel II to calculate the risk-weighted asset, which goes into the determination of the
required capital for a bank or financial institution, the institution has to use an estimate of
the LGD for each corporate, sovereign and bank exposure. There are two approaches for
deriving this estimate: a foundation approach and an advanced approach.

[edit]Exposure without Collateral

Under the foundation approach, BIS prescribes fixed LGD ratios for certain classes of
unsecured exposures:

 Senior claims on corporates, sovereigns and banks not secured by recognized

collateral attract a 45% LGD.
 All subordinated claims on corporates, sovereigns and banks attract a 75% LGD.
[edit]Exposure with Collateral

The effective loss given default (LGD*) applicable to a collateralized transaction can be
expressed as

LGD* = LGD x (E* / E)

Where:

 LGD is that of the senior unsecured exposure before recognition of collateral (45%);
 E is the current value of the exposure (i.e. cash lent or securities lent or posted);
 E* should be calculated based on the following formula:

E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]}

Where:

 E* = the exposure value after risk mitigation

 E = current value of the exposure
 He = haircut appropriate to the exposure
 C = the current value of the collateral received
 Hc = haircut appropriate to the collateral
 Hfx = haircut appropriate for currency mismatch between the collateral and exposure
(The standard supervisory haircut for currency risk where exposure and collateral are
denominated in different currencies is 8%)
The *He and *Hc has to be derived from the following table of standard supervisory
haircuts:

However, under certain special circumstances the supervisors, i.e. the local central banks
may choose not to apply the haircuts specified under the comprehensive approach, but
instead to apply a zero H.

[edit]Calculating
LGD under the advanced approach (and for the retail-
portfolio under the foundation approach)
Under the A-IRB approach and for the retail-portfolio under the F-IRB approach, the bank
itself determines the appropriate Loss given default to be applied to each exposure, on the
basis of robust data and analysis. The analysis must be capable of being validated both
internally and by supervisors. Thus, a bank using internal Loss Given Default estimates for
capital purposes might be able to differentiate Loss Given Default values on the basis of a
wider set of transaction characteristics (e.g. product type, wider range of collateral types) as
well as borrower characteristics. These values would be expected to represent a
conservative view of long-run averages. A bank wishing to use its own estimates of LGD will
need to demonstrate to its supervisor that it can meet additional minimum requirements
pertinent to the integrity and reliability of these estimates.

[edit]Downturn LGD
Under Basel II, banks and other financial institutions are recommended to calculate
'Downturn LGD' (Downturn Loss Given Default), which reflects the losses occurring during a
'Downturn' in a business cycle for regulatory purposes. Downturn LGD is interpreted in
many ways, and most financial institutions that are applying for IRB approval under BIS II
often have differing definitions of what Downturn conditions are. One definition is at least
two consecutive quarters of negative growth in real GDP. Often, negative growth is also
accompanied by a negative output gap in an economy (where potential production exceeds
actual demand).

The calculation of LGD (or Downturn LGD) poses significant challenges to modelers and
practitioners. Final resolutions of defaults can take many years and final losses, and hence
final LGD, cannot be calculated until all of this information is ripe. Furthermore, practitioners
are of want of data since BIS II implementation is rather new and financial institutions may
have only just started collecting the information necessary for calculating the individual
elements that LGD is composed of: EAD, direct and indirect Losses, security values and
potential, expected future recoveries. Another challenge, and maybe the most significant, is
the fact that the default definitions between institutions vary. This often results in a so-called
differing cure-rates or percentage of defaults without losses. Calculation of LGD (average)
is often composed of defaults with losses and defaults without. Naturally, when more
defaults without losses are added to a sample pool of observations LGD becomes lower.
This is often the case when default definitions become more 'sensitive' to credit
deterioration or 'early' signs of defaults. When institutions use different definitions, LGD
parameters therefore become non-comparable.

Many institutions are scrambling to produce estimates of Downturn LGD, but often resort to
'mapping' since Downturn data is often lacking. Mapping is the process
of guesstimating losses under a downturn by taking existing LGD and adding a supplement
or buffer, which is supposed to represent a potential increase in LGD when Downturn
occurs. LGD often decreases for some segments during Downturn since there is a relatively
larger increase of defaults that result in higher cure-rates, often the result of temporary
credit deterioration that disappears after the Downturn Period is over. Furthermore, LGD
values decrease for defaulting financial institutions under economic Downturns because
governments and central banks often rescue these institutions in order to maintain financial
stability.

[edit]Correcting for different default definitions

One problem facing practitioners is the comparison of LGD estimates (usually averages)
arising from different time periods where differing default definitions have been in place. The
following formula can be used to compare LGD estimates from one time period (say x) with
another time period (say y):

LGDy=LGDx*(1-Cure Ratey)/(1-Cure Ratex)

[edit]Country-specific LGD
In Australia, the prudential regulator APRA has set an interim minimum downturn LGD of 20
per cent on residential mortgages for all applicants for the advanced Basel II approaches.
The 20 per cent floor is not risk sensitive and is designed to encourage the ADIs to
undertake further work, which APRA believes would be closer to the 20 per cent on average
than ADIs’ original estimates.

[edit]Importance

LGD warrants more attention than what has been given to it in the past decade, where
credit risk models often assumed that LGD was time-invariant. Movements in LGD result in
often proportional movements in required economic capital. According to BIS (2006)
institutions implementing Advanced-IRB instead of Foundation-IRB will experience larger
decreases in Tier 1 capital, and the internal calculation of LGD is a factor separating the two
Methods.
[edit]

Exposure at default
From Wikipedia, the free encyclopedia

Exposure at default (EAD) is a parameter used in the calculation of economic

capital or regulatory capital under Basel II for a banking institution. This is an attribute of any
exposure on bank's client.
[edit]Definition

In general EAD can be seen as an estimation of the extent to which a bank may be exposed
to a counterparty in the event of, and at the time of, that counterparty’s default. It is a
measure of potential exposure (in currency) as calculated by a Basel Credit Risk Model for
the period of 1 year or until maturity whichever is sooner. Based on Basel Guidelines,
Exposure at Default (EAD) for loan commitments measures the amount of the facility that is
likely to be drawn if a default occurs [1].

Under Basel II a bank needs to provide an estimate of the exposure amount for each
transaction, commonly referred to as Exposure at Default (EAD), in banks’ internal systems.
All these loss estimates should seek to fully capture the risks of an underlying exposure.

EAD is mainly used in banking businesses.

[edit]How EAD is calculated

Calculation of EAD is different under foundation and advanced approach. While under
foundation approach (F-IRB) calculation of EAD is guided by the regulators, under the
advanced approach (A-IRB) banks enjoy greater flexibility on how they would like to
calculate EAD.

[edit]Calculating EAD under foundation approach

Under F-IRB EAD is calculated taking account of the underlying asset, forward valuation,
facility type and commitment details. This value does not take account of guarantees,
collateral or security (i.e. ignores Credit Risk Mitigation Techniques with the exception of on-
balance sheet netting where the effect of netting is included in Exposure At Default). For on-
balance sheet transactions, EAD is identical to the nominal amount of exposure. On-
balance sheet netting of loans and deposits of a bank to a corporate counterparty is
permitted to reduce the estimate of EAD under certain conditions. For off-balance sheet
items, there are two broad types which the IRB approach needs to address: transactions
with uncertain future drawdown, such as commitments and revolving credits, and OTC
foreign exchange, interest rate and equity derivative contracts [2].

[edit]Calculating EAD under advanced approach

Under A-IRB, the bank itself determines the appropriate EAD to be applied to each
exposure. A bank using internal EAD estimates for capital purposes might be able to
differentiate EAD values on the basis of a wider set of transaction characteristics (e.g.
product type) as well as borrower characteristics. These values would be expected to
represent a conservative view of long-run averages, although banks would be free to use
more conservative estimates. A bank wishing to use its own estimates of EAD will need to
demonstrate to its supervisor that it can meet additional minimum requirements pertinent to
the integrity and reliability of these estimates. All estimates of EAD should be calculated net
of any specific provisions a bank may have raised against an exposure [2].

In terms of assigning estimates of EAD to broad EAD classifications, banks may use either
internal or external data sources. Given the perceived current data limitations in respect of
EAD (in particular external sources) a minimum data requirement of 7 years has been set.

[edit]The importance of EAD

For a risk weight derived from the IRB framework to be transformed into a risk weighted
asset, it needs to be attached to an exposure amount. Any error in EAD calculation will
directly effect the risk weighted asset and thereby affect the capital requirement.
[edit]