Risk Weighted Asset calculation under BASEL Biswaranjan Mohanty

Risk Weighted Asset calculation under BASEL Biswaranjan Mohanty 25 April 2013

Basel II – Three Pillars First Pillar Minimum Capital Charges: Minimum capital requirements based on market, credit and operational risk to (a) reduce risk of failure by cushioning against losses and (b) provide continuing access to financial markets to meet liquidity needs, and (c) provide incentives for prudent risk management Second Pillar Supervisory Review: Qualitative supervision by regulators of internal bank risk control and capital assessment process including supervisory power to require banks to hold more capital than required under the First Pillar Third Pillar Market Discipline: New public disclosure requirements to compel improved bank risk management

Fundamental calculation Capital Adequacy Ratio = Tier I + Tier II ------------Risk weighted asset = Exposure X Risk weight of the counterpaerty 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

Basel II – Sovereign Capital Charges Sovereigns n Risk weights for sovereign exposures: Rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Risk Weight 0% 20% 50% 100% 150% 100% n Claims on non-central government public sector entities based on corporate exposure risk weights n Claims on multilateral development banks have 0% risk weight if conditions are met, including: (i) majority of MDB’s ratings are AAA, (ii) significant portion of shareholders are AA- or better rated sovereigns, (iii) funding is in form of paid-in equity with little or no leverage, and (iv) conservative lending criteria n At national discretion, lower risk weight for banks’ exposures to their sovereign (or central bank) in domestic currency; if adopted, other regulators may permit same risk weight

Basel II – Bank Capital Charges Banks 2 options, selected by national regulator to apply for all banks in jurisdiction: n Option 1: Banks risk weighted one category below risk weights of banks’ sovereigns: Rating of sovereign AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Risk Weight 20% 50% 100% 150% 100% n Option 2: At national discretion, banks risk weighted on basis of own external ratings (plus more favourable risk weight if claim maturity < 3 months) Rating of the bank AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Risk Weight 20% 50% 100% 150% Short-term 20 % 50 % 150 % 20 % n Local currency reduction: National regulators may reduce by one notch risk weight of local currency bank debt having maturity of less than 3 months, subject to floor of 20% n Exposures to securities firms treated as bank claims if regulatory arrangements comparable, otherwise the will have corporate treatment

Basel II – Corporate Capital Charges Corporate 2 options, selected by national regulator to apply for all banks in jurisdiction: n Option 1: Corporates risk weighted as set out in following chart (supervisory authority to increase 100% risk weight for unrated corporates where warranted by higher default rates): AAA to A+ to BBB+ Below Rating Unrated AAAto BBBB- Risk Weight 20% 50% 100% 150% 100% n Option 2: At national discretion, all corporates risk weighted at 100% without regard to external ratings. (No cherry picking) n Includes claims on insurance companies

Basel II – Retail Capital Charges Retail Generally n 75% risk weight if: n Exposure to individual or small business n Exposure takes form of revolving credit, line of credit, personal loan, lease n Portfolio diversified (granular); Basel II accord suggests no aggregate exposure to any one counterparty should exceed 0. 2% of overall regulator retail portfolio n Maximum aggregate counterparty exposure € 1 million or less

Basel II – Real Estate Capital Charges Real Estate Residential Real Estate n 35% risk weight for exposures fully secured by mortgages on residential property occupied by the borrower or rented Commercial Real Estate n Generally 100% risk weight, given experience in numerous countries with troubled credits over the past few decades

Basel II – Off Balance Sheet Items Off-balance sheet items converted into credit exposure equivalents using credit conversion factor (CCF) Commitments n Original maturity of up to one year: 20% CCF n Original maturity in excess of one year: 50% CCF n Unconditionally cancelable: 0% CCF Securities lending n Repo and reverse repo transactions: 100% CCF Where there is an undertaking to provide a commitment on an off-balance sheet item, banks are to apply the lower of the two applicable CCFs.

Basel II – Other assets n All other assets at 100 % weightage n Investments in equity or regulatory capital instruments issued by banks or securities firms will be risk weighted at 100%, unless deducted from the capital base. Under IRB approach 300 % for equity holdings those are publicly traded and 400 % for other equity holdings. n At national discretion, gold bullion held in own vaults risk-weighted at 0%. n In addition, cash items in the process of collection can be risk-weighted at 20%. High risk categories The following claims will be risk weighted at 150% or higher: n Claims on sovereigns, PSEs, banks, and securities firms rated below B-. n Claims on corporates rated below BB-. n Securitisation tranches that are rated between BB+ and BB- will be risk weighted at 350%. n 150 % risk weight for venture capital and private equity investments.

Basel II-Past due treatment Past Due n Unsecured portion of exposure past due for more than 90 days, net of specific provisions, risk weighted as follows: - 150% when specific provisions less than 20% of outstanding amount of exposure - 100% when specific provisions 20% or more of outstanding amount of exposure - 100% when the specific provisions 50% or more of outstanding amount of exposure, with supervisory discretion to reduce risk weight to 50% in such case Essentials: n Non-performing loan under Basel II is any loan that is past due for more than 90 days, but subject to national variation n For purposes of defining secured portion of non-performing loan, eligible collateral and guarantees will be recognised as under CRM rules for performing loans n Capital charges depend on level of specific provisions held against loan

Eligible collaterals and standard supervisory haircut

Haircuts n Assuming daily remargining and 10 day holding period n Currency mismatch – 8 % n Zero haircut on repo transactions for core market participants under certain conditions n Maturity mismatch P=P*(t-0. 25)/(T-0. 25) P---adjusted collateral P*---actual collateral value t-- min (T, residual maturity of the credit protection arrangement) expressed in years T-- min (5, residual maturity of the exposure) expressed in years

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