Script - Market Risk - Part 1 PDF

Market Risk Part I
2014, Frankfurt am Main

Prof. Dr. Martin Hellmich
Akademische Programme
Berufsbegleitende Programme
Seminare
Executive Education
Unternehmensprogramme & Services
Forschung
Internationale Beratung
FrankfurtSchool.de
The faboulus Fab

More and more leverage in the system, the whole building is about to
collapse anytime now Only potential survivor, the fabulous Fab standing
in the middle of all these complex, highly leveraged, exotic trades he created
without necessarily understanding all of the implications of those
monstruosities !!!
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and his famous transaction
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and the leveraged financial system

International Herald
Tribune, December
2008
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The Gordon Gekko perspective on things..

They got all these fancy names for trillions
of dollars for credit, CMO, CDO, SIV, ABS. You
know I honestly think there are only 75
people in the world that knows what they
are
MtM-Losses
Cumulated
Losses
Asset
Pool
Source: BIS-Working Paper No. 251
Beared
ABCP
By
Capital Notes
But MtM of ABCB

are falling
(reduced Subordination)
Capital
Notes
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and the response of regulators
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and the response of regulators

(Source: Moodys Analytics)
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Agenda
1.
2.
3.
4.
5.
Overview about relevant national and international regulatory requirements

Basics of Risk Management
Objectives and Structure of CRR/ CAD IV (Basel III)
Introduction to Market Risk
Trading Book: The market value of counterparty credit risk
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Overview of regulatory requirements

Global vs. European vs. German (as of 15th of August 2014)
Law
1.
Global
Parliament (time consuming)

2.
Directive
EU
22
SolvV
EBA ITS/ BTA
11
German Banking Act (KWG)

25a(1) 25a(5)
7,
8,
10,
24
Public administr.
25(1)
25a(1)
25b-h
LiqV
Gro
MikV
Ma
SAN
Crisis
Directive
Renumeratio
nD
CRD IV - ImplementationL
BCBS\ Large
exposures
FSB\ Resol.
BCBS\
Renumerat.
BCBS\
Governance
Basel 2\ S2,
Sound
principles
BCBS1\ Know
Your
Customer
(KYC)
Capital Requirement
Regulation (CRR)
EBA\Report
(FIN-, COREP)
10
Capital Adequacy
Directive IV (CAD IV)
Basel 2 + 3\
Pillar 3\ Discl
Circular letter
German Banking Regulation
Recommend.
Basel 2+3\
Pillar 1\ CR
Public administration
3.
Finance Ministry (FM)
FM
FM
Notification
Directive
(AnzV)
BaFin
FinanzinformatD
(Monthly
Report D.)
BaFin
Minimum
Requirements
RiskMgt
(MaRisk)
Anti-Money
Laundry Law
BaFin
Interior
Ministry
1) BCBS : Basel Committee On Banking Supervision

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Global vs. European vs. German (as of 15th of August 2014)
Law
1.
Global
Parliament (time consuming)

2.
EU
Circular letter
Public administr.
German Banking Act (KWG)

Basel 2 & 3:\ Pillar 1:
11
25a(1)
25(1)
25a(1)
25b-h
Core10
Equity
Tier 122
- ratio:
(4.5%25a(5)
+x%)*12.5 *7,
Risk-weighted
assets Core
Equity Tier
1
8,
Tier 1 capital - ratio: (6% +x%)*12.5 * Risk-weighted
assets Tier 1 capital
10,
Total capital - ratio: (8% +x%)*12.5 * Risk-weighted assets Total capital
24
Leverage ratio: 3% * (Total Assets + m% * Off-balance
sheet items) Tier 1 capital
Liquidity Coverage Ratio: 100% * (Outflows Inflows) Highly quality liquid assets
Net Stable
LiqVFunding Ratio: 100% * (Required stable funding) Available stable funding
Basel 2 & 3:\ Pillar 3: Qualitative and quantitative disclosure of risk
Gro
Non-Basel elements:
Large exposures, Single rule book,
MikV
SolvV
EBA ITS/ BTA
Ma
SAN
Crisis
Directive
CRD IV - ImplementationL
BCBS\ Large
exposures
FSB\ Resol.
BCBS\
Renumerat.
BCBS\
Governance
Basel 2\ S2,
Sound
principles
BCBS1\ Know
Your
Customer
(KYC)
Capital Requirement
Regulation (CRR)
EBA\Report
(FIN-, COREP)
Capital Adequacy
Directive IV (CAD IV)
Basel 2 + 3\
Pillar 3\ Discl
Public administration
3.
German Banking Regulation
Recommend.
Basel 2+3\
Pillar 1\ CR
Directive
Renumeratio
nD
Notification Requirements on internal risk

Directive measurement and management
(AnzV)
Basel 2 & 3:\ Pillar 2:
FinanzRisk-bearing
capacity
- capital buffers [conservation,
informatD
(Risikotragfhigkeit)
anticyclical, systemic]: x% (x1+x2+x3)
(Monthly
Report D.)
Minimum
Non-Basel elements:
Requirements
- renumeration
RiskMgt
- transparency
(MaRisk)
Anti-Money
- sanctions
- EU Banking pass
Finance Ministry (FM)
Laundry Law
FM
FM
BaFin
BaFin
BaFin
Interior
Ministry
1) BCBS : Basel Committee On Banking Supervision

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Initiatives to come: short-,middle-., long-term
2012
2013
Short-term
Initiative
1. Remuner.
Directive
2014
2015
2016
2017
Mid-term
Description
2012
Advisory board: responsible for compensation of board
Must be aligned to strategy, no incentives of excessive risk
taking
- Bank-internal caps
- Sustainable: delayed payout across several years
- Disclosure: qualitative and quantitative aspects
- Required details on delay, bonus reduction/ deletion
- System-relevant banks (>10 bn total assets):
compensation control committee and additional disclosure
overruled by CAD IV: boni fixed salary,
with shareholder consensus: boni 2*fixed salary
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2018
2019
Longterm
Implications
Bonus caps:
Move towards fixed salaries
Need for compensation/ HRconsultants
11

2012
2013
Short-term
Initiative
2. EMIR
2014
2015
2016
2017
Mid-term
Description
2018
2019
Longterm
Implications
Mandatory CCP-clearing for (1) standardized derivatives AND

(2) if both contract partners are financials or NFC+
(corporates exceeding notional derivative thresholds): Q1
2015
More electronic process steps in post-trading : 2013
(confirmation, portfolio reconciliation, .)
Reporting of every derivative to regulator: Feb 2014
(inception, change, maturity, interbank + NFC+: daily
prices)
New revenues: offering

indirect clearing
(large banks for their banking
segment)
Additional collateral
requirements
Collateral is the new capital
(Capital replaced by collat.)
3.Extended
FinRep
IFRS-banks, group level:

Balance sheet & P&L, quarterly, 30/9/2014
Separation of margin and

mismatch income
4. Basel III/
CoRep
31/3/2014
Quarterly: capital ratios, components, leverage ratio, NSFR,
Monthly: large exposures, LCR
Process: Integrate Solvency

and Liquidity (Solvidity)
Methods:
- internal estimates for
selected LCR-positions,
- Ratio forecasts/ planning
(European
Market
Infrastructu.
Regulation,
27/7/2013)
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12

2012
2013
Short-term
Initiative
2014
2015
2016
2017
Mid-term
Description
2018
2019
Longterm
Implications
5. ECB =
regulator
Nov 2014
Total assets > 30 bn EUR or
(Total assets > 5 bn EUR AND Total assets > 20% GDP) or
Top 3 bank of each country or
Has large cross-border activities or
The bank receives, or has applied for being bailed out
About 150 banks
Pillar 1: harmonized
Pillar 2: ECB-interpretation
English will become working
and project language for all
SSM-banks
6. Asset
encumbr
ance
30.6.2014 (quarterly reports)

31.12.2014 (semi-annual reports)
EBA-initiative
Report percentage of encumbered assets and conditionally
encumbered (in stress scenario)
Encumbrance structure
Will upward shift senior

unsecured curves
Systems:
implement encumbrance
reports
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13

2012
2013
Short-term
Initiative
7. Liikanen
report
2014
2015
2016
2017
Mid-term
Description
2018
2019
Longterm
Implications
1.7. 2015
Outsourcing of (prop) trading activities and lending to highly
leveraged entities in unit that is legally separated from
deposit-taking unit if (i) trading volume >100 bn EUR or (ii)
trading volume > 20% of total assets and total assets of last
3 years > 90 bn EUR
Low risk assets in trading

portfolios (liquidity buffer,
sovereign bonds)
ALM-hedges (IR, FX) used to
hedge lending/ deposit
mismatches
8. Margining
for OTCderivativ.
VM: 1.1.2015, IM: 1.12.2015-19 (different asset classes)

Mandatory margining (IM0 and VMt) for OTC-derivatives if
the 2 contract partners are banks and/ or systematically
relevant Non-financials
IM0 is a major challenge as new, gross and restricted re-use
Sophisticated internal margin models or (very) conservative
regulatory margins
Models:
Develop internal margin model
Process:
Enhance collateral
management
Collateral is the new capital
(Capital replaced by collat.)
Integrating liquidity- into
collateral management
9. Internal
audit
2015
Pillar 2, 15 principles/ requirements of Internal Audit
1 principle IA
Supervisor
Supervisory assessment of IA
Regulatory affairs becomes

unit of internal audit
(17/5/2013)
(06/2012)
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14
2. Overview of regulatory requirements

2012
2013
Short-term
Initiative
2014
2015
2016
2017
Mid-term
Description
2018
2019
Longterm
Implications
10. Financial
Transact.
Tax
2015
Lowered on political agenda
France: introduced
Germany: wont introduce it alone
Concerns: no level playing field if not globally implemented
Lowered on political agenda

France: introduced
Germany: not alone
Concerns: no level playing
field if not globally
implemented
11. Sound
capital
planning
2015
Best practise overview on capital planning process
(internal control and governance, capital policy and risk
capture, forward-looking view, management framework)
No binding elements
---(as based on survey of large

banks, they should have this
already in place)
12. Recovery
and
resolution
Directive
2015
Requirements to hypothesize resolution stress and to
draft a resolution plan/ good will
(fight against too big/ interconnected to fail)
Setup, submit and review

resolution plan/ good will
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15

2012
2013
Short-term
Initiative
13. LCRdisclosure
14. Funding
plans
2014
2015
2016
Mid-term
Description
Quarterly, 1.1.2015,
1. Quantitative:
Average LCR in quarter
based on daily LCR (<1/1/ 17: monthly LCR)
1.1 HQLA [EUR}
1.2 Outflows of 13 categories [EUR]
1.3 Inflows of 3 categories [EUR]
2. Qualitative:
2.1 Main drivers LCR
2.2 Composition HQLA
2.3
Feb 2015
EBA-initiative
Report:
plan balance sheets, P&L, LCR and NSFRs
report funding gaps, how planned to close and how much
the closing cost
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2017
2018
2019
Longterm
Implications
Systems and processes:
>2017: daily LCR
Need NSFR & LCR forecast

Need sound planning process
16

2012
2013
Short-term
Initiative
15.
Effective
risk data
aggregation and
risk
reporting
2014
2015
2016
Mid-term
Description
1.1.2016
A. Governance and Infrastructure
1. Governance
2. Data architecture and IT-infrastructure
B. Risk Data Aggregation
3. Accuracy and integrity
-R isk data as sound as accounting data
- Measure data quality
4. Completeness
5. Timeliness
6. Adaptability
C. Risk reporting
7. Accuracy
- Forward-looking elements
8. Comprehensiveness
9. Clarity and usefulness
10. Frequency
11. Distribution
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2017
2018
2019
Longterm
Implications
Risk data volume multiplies
for on-demand analysis by 10
(daily risk data generation: 5
20 terabytes)
Development of data quality
models
(backtesting, sensitivity
analyses)
Augment risk analysis by
forward-looking elements
(e.g. expert judgement,
volatility adjustments, ...)
17

2012
2013
Short-term
Initiative
16. Pillar 3
reports,
Phase 1
17. Capital
requ.
against
CCP
(17/5/2013)
2014
2015
2016
Mid-term
Description
1.4.2016
A. Reporting format:
- separate document
B. Scope, frequency, timing:
- capital requirements: quarterly
- other quantitative metrics: financial reporting
- qualitative information: annual
C. Consistency & Comparability:
- Use templates
D. Link to accounting data:
- Explicit mapping to line items
E. Periodic review of templates (by regulator)
F. Assurance of Pillar 3 reports:
- Board attest and internal control structure
1.1.2017
Capital 2%*[trade exposure posted collateral + posted
collateral + default funds]
Non-qualifying CCPs: risk weight = 1.250 %
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2017
2018
2019
Longterm
Implications
Policy:
need board-approved
disclosure policy
Systems:
adjust reporting systems
Process:
Monitor key Pillar 3-metrics
Capital relief compared to

time where position was
uncollateralized
18

2012
2013
Short-term
Initiative
2014
2015
2016
2017
Mid-term
Description
2018
2019
Longterm
Implications
18. Stded
approach
for CCRexposure
1.1.2017
Same structure:
Exposure = 1.4*(replacement cost + potential future
exposure)
Recognizes margined transaction, hedging sets and market
volatility and still being a pre-calibrated standardized
approach
Systems:
implement exposure method
Processes:
monitor change in capital
charge between old and new
method
19. Fundam.
review of
trading
book
(Sept
2013, 2nd
Consult.
Version)
2017
Regulatory tading book definition : trading-evidence based
All banks affected:
model banks: modified internal models + calculation of
standardised approach
Sted banks: new sted approach
New internal model: regulatory correlations, market
liquidity haircuts, desk-level model approval and withdrawal
VaR => Expected shortfall (backtesting still on VaR)
New sted approach: diversification effects, still bucketing
approaches (but not the same buckets as currently)
More capital required

Profitability of internal
model to be revised
(Do capital savings still justify
model investments?)
Model banks need
infrastructure to compute
standardised approach
(instrument logic)
All banks: NEW std approach
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19

2012
2013
Short-term
Initiative
2014
2015
2016
2017
Mid-term
Description
2018
2019
Longterm
Implications
20. MiFID II
2017
MiFID: 2004
MiFID II (proposal status): multilateral and organized trading
platform, algorithmic trading, position limits for commodity
derivatives, regulated markets must weekly disclose
positions of commodity derivatives and issuance
certificates, individual positions of market participants
=> only to regulators
Systems:
reporting systems in
relevant entities
21. Revised
stded
model for
credit
risk
2017
Obligor specific risk-weights:
- Sovereigns: rwnew = rwold
- Banks: rwnew = f(T1-capital ratio, Asset quality)
- Corporates: rwnew = f(turnover, leverage)
- Retail, unsecured: rwnew = f(qualitative criteria)
- Retail, mortgages: rwnew = f(L2V, Debt servicing capacity)
Affects all banks (also IRBA)

Compliance:
Likely to require more capital
=> capital pressure
Systems:
data should be available as
factors are standard in
scorecard/ rating models
Simplification
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20

2012
2013
2014
2015
Short-term
Initiative
2016
Mid-term
Description
2017
2018
2019
Longterm
Implications
22. Securitis.
framework
2018
Securitisations:
- Internal rating based
- External rating
- Standardised approach
- 1.250%
Re-securitisations:
- new standardised approach
- 1.250%
Development of internal rating

models for securitisations
because sted approach is
prohibitively expensive
23. Large
exposures
(BCBS,
246,
3/2013)
1/1/2019
Enhances RWA-framework assuming infinitely granul. PFs
Borrower units (control rights, economic dependence)
Report:
Borrower units 10% of total regulatory capital
Report and rectify:
Borrower units 25% of total regulatory capital
Report largest 10 borrower units
Only standardised approach (SA-CCR, BCBS 279) for
counterparty credit risk (CCR) allowed.
Compliance:
More capital (if not
collateralised)
Methods:
Models to identify economic
dependencies
Process: monitor exposures
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21

2012
2013
Short-term
Initiative
2014
2015
2016
2017
Mid-term
Description
2018
2019
Longterm
Implications
24. Pillar 3
reports,
Phase 2
A.
B.
C.
D.
E.
2019
Interest rate in the banking book
(unchanged in Phase 1)
Operational risk
New securitisation framework
New market risk framework
Mandatory computation and disclosure of standard
credit risk approach for all banks (e.g. also for IRBA-banks)
F. Regulatory dash board
Systems:
- IRBA-banks to implement
standardised approach for
credit risk (trading- and
banking book)
- Implement regulatory dash
board
Process: monitor dash board
25. IRRBB
Higher capital charge under

Pillar 1
Increased capital pressure
Risk-adjusted return metrics
2019
Likely to become Pillar 1 charge
(all other market risks are also Pillar 1 charges)
Standardised approach (details expected for Sept. 2014)
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22

Publications of the Basel Committee:1
Basel 2.5, Basel III and Others
Publications
Content
Phase In
Implementation
Reporting
Final
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
CCR
3 Capial definition
B3-Monitoring
Permanent
Basel III
Non-B3
Initiat.
1)
3)
Framework for
Consermore resilient 6 vation C-cyclical
banks and
G-SIB
banking system 5
Leverage
(189)
LCR
NFSR
7
Monitoring tools2
C01
Own funds
1-4 Capital adequacy
CoRep
06
Group solvency
(stand-alone 07Credit risk
14
and group)
1617 Operational risk
18Market risk
25
FinRep
(IFRS-banks,
group)
CE only
CE only
CE only
B3-Monitoring
B3-Monitoring
B3-Monitoring
Observation metrics
B3-Monitoring
I
BS & P&L
II Geograph. Exp.
III Off-BS, particip.
IV Group structure,..
31/3/2014
31/3/2014*
31/3/2014
Not finalised3
31/3/2014
30/9/2014
31/12/2014
31/12/2014
As of November 16th, 2013, 2) Maturity ladders, funding concentration, funding spreads, funding roll-over,
13/8/2013: end of consultation phase, EBA => commission Jan 1st 2014, 4) Significant currency: 5% of debt
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23

Publications of the Basel Committee:1
Basel 2.5, Basel III and Others
Publications
Non-B3
Initiat.
Large
Exposures
Losses from
mortgages
1)
Content
LE
LE Limits
LE1
LE5
CPs, TB, BB,

Individual clients,
Maturityx buckets
C15
Exposure and
losses from
mortgages
Phase In
Implementation
Reporting
Final
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
31/3/2014
30/6/2014
As of November 16th, 2013,
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24
Agenda
1.
2.
3.
4.
5.

Trading Book: the market value of counterparty credit risk
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25

Risk inventory
Completeness of Risk Profile
Market Price
Risks
Credit
Risks
Operational
Risks
Liquidity
Risk
Other Risks
Normal
Changes
Issuer Risk
Key Risk Indicator & Risk Self

Assessment
Inventory
Framework
Conditions
Extraordinary
Changes
Counterparty
Risk
Loss Case
Database &
Int. Model
Sale
Business
Risks
Reputation
Risks
Issues of Interaction and Correct Aggregation
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26

Available capital is the risk buffer, required capital is the risk.
Supply side of capital:
Views on Capital
Capital an institution has

Tier I & II Capital
Pillar 1
Pure regulatory perspective
Regional divergence resulting from
differing accounting standards and
regulatory discretion in recognition of
capital across countries
Capital an institution needs
Regulatory
Tier II
Demand side of capital:
Buffer
Discret.
RWA
Tier I
x 8%
Regulatory Capital (RWA)

Basel II capital (Pillar I formulas and
Pillar II requirements)
Differences in adoption of Basel II
across countries
Economic
Risk Taking Capacity
Pillar 2
Overall risk-bearing capacity
(typically Tier I plus certain hybrids
plus expected earnings)
Differences arise from different
accounting regimes
Tier I Capital
Tier I based target capital ratios
Rating agency perspective
frequently the binding constraint
Expected
Earnings
Buffer
Discret.
Tier I
ECAP
Rating Agency*
Buffer
Discret.
Tier I
Frequently
the key
constraint
Required
Capital
Economic Capital (ECAP)

Capital required from an economic
perspective, covers unexpected
losses
All risks
Rating Agency Capital Requirements
Reflects regulatory capital plus
analysts judgment
Usually to address multiple
agencies (S&P, Moodys, Fitch,
etc.)
* Illustrative
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27
Regulatory vs. economic capital
RORAC =
2
Net revenues
[%]
Risk capital
RAROC =
Risk Capital
Net revenues - COE

[%]
Risk capital
Regulatory capital
Risk capital =
Economic capital
Credit Risk
Market Risk
Approaches
IR
EQ
FX
Commodities
Others1
Approaches
PD
Standardised
Approach
IR-risk
model
EQ-risk
model
FX-risk
model
CO-risk
model
Spec.
models
Standard.
External
LGD
EaD
External
1. Regulatory
Capital
Foundation
Internal
Model2,3
VaR [99%,10d]
P&L = sensitivities * risk factors
Internal
IRBA
Advanced
Aggregation
Internal
RWA = LossVasicek[99.9%,1Y]
Simulation of risk factors
(credit, market, ...)
2. Economic
Capital
Internal
Model
VaR [pbank-specific,1y]
P&L = sensitivities * risk factors
Credit Risk
Models
PD
LGD
EaD
CVaR= Loss distrib. [1y,pbanksp.]

1:
Others: weather/ electricity derivatives

Internal model in regulatory section is the internal model with regulatory-defined {horizon, confidence level}.
3: DB, AR 2008, p. 95 : We calculate value-at-risk for both internal and regulatory reporting using a 99% confidence l
evel. For internal reporting, we use a holding period of one day. For regulatory reporting, the holding period is ten days.
2:
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Step can be left out by

directly simulating the
loss.
28
RORAC =
2
Net revenues
[%]
Risk capital
RAROC =
Net revenues - COE

[%]
Risk capital
Regulatory capital
Risk capital =
Economic capital
Risk Capital
Market
Risk
Credit
Risk
...
...
1. Regulatory
Capital
...
2. Economic
Capital
...
Operational Risk
Basic
Basic Indicator
Approach
Standardised
Gross-Income
Approach
Advanced
VaR[99.9%, 1y]
Business Risk
Risk Diversification
VaR[pbankspec., 1y]
Aggregation
Model
...
...
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Regulatory Model
(if VaR: scaled if not 99.9%)
29
9. Value management
B Profitability of risks: RAROC/ RORAC
Deutsche Bank
2
Risk Capital
Deutsche Bank, Annual Report 2008, p. 71
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30
Economic Capital
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31

Economic capital is the maximum annual loss at a given
confidence level.
Confidence level, e.g. SBG: p = 99.925% (derived from target debt rating)
Statistical Approach to Risk
Probability
Worst Cases
1-p
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0
Economic Capital
p
Expected
Outcome
Value/
Return
The quantification of risks requires

statistics and the concept of probability
The future value (of a banks assets) is
uncertain due to the risks it faces
This is described by the probability
distribution of value
The Expected Outcome is close to
the most likely outcome
Worst cases (severe drops in value)
are much less likely but not
impossible
The shaded area describes the probability
for the value to drop below x (worst
cases), i.e. the banks Probability of
Default, and determines the banks credit
rating
The Economic Capital that a bank needs
to survive this worst case is given by
(Expected Outcome x)
If a bank wants to have a better target
rating (i.e. lower PD) it requires more
Economic Capital as x will be lower
32

In credit risk there are only adverse surprises.
Credit Risk
70%
Equity Risk
2.9%
Market Risk
Operational Risk
Business Risk
3.9%
15.5%
3.4%
Risk of loss to the group as a result of the failure

by a client or derivative counterparty to meet its
contractual obligations.
Loss = payment shortfall
Distribution: beta, vendor-specific (e.g. KMV)1
Parameter on individual transaction: PD, LGD,
EaD
Parameters on portfolio level: correlation, copula,
distribution
Repayment
Interest Rate Risk,

BB
4.3%
Probability
Worst Cases
1-p
Expected Contractual
Outcome (EL) Obligation
Economic Credit Risk Capital
p
1 Non-distributional approaches are also possible (e.g. empirical distributions)

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Equity risk results from strategic equity positions in the
banking book.
Credit Risk
70%
Equity Risk
2.9%
Market Risk
Operational Risk
Business Risk
3.9%
15.5%
3.4%
Risk of losses from changes in market prices

and/ or dividend payments of equities of banking
book positions.
Loss = value/ dividend loss
Distribution: normal or others
Parameters: trend, volatility, distribution
Parameters on portfolio level: correlation
4.3%
Probability
Worst Cases
1-p
FrankfurtSchool.de
Interest Rate Risk,

BB
0
Economic Equity
Risk Capital
Expected
Outcome (EL)
Value
34

Market risk comprises all risks of the trading book.
Credit Risk
70%
Equity Risk
2.9%
Market Risk
Operational Risk
Business Risk
3.9%
15.5%
3.4%
Risk of losses from changes in market prices

(equities, interest rates, commodities, FX, credit
spreads, recovery rates, correlations, implied
volatilites) of trading book positions.
Loss = loss in (mark-to-market) values
Distribution: normal, student-t, others
Parameters: trend, volatility, distribution
Parameters on portfolio level: correlation, copula
4.3%
Probability
Worst Cases
1-p
FrankfurtSchool.de
Interest Rate Risk,

BB
0
Economic Market
Risk Capital
Expected
Outcome (EL)
Value
35

Operational risk results from running a bank/ company.
Credit Risk
70%
Equity Risk
2.9%
Market Risk
Operational Risk
Business Risk
3.9%
15.5%
3.4%
Risk of losses resulting from inadequate or failed

processes, people and systems or from external
events inclusing information and legal risk but
excluding reputational and strategic risk.
Loss = losses from above mentioned categories
Distribution: Compound Poisson
(Frequency: Poisson, Severity: Normal-, Student-t,
Beta, ...)
Parameters: expected frequency, expected severity,
volatility of severity
Parameters on portfolio level: correlation, copula
4.3%
Probability
Losses
Worst Cases
1-p
FrankfurtSchool.de
Interest Rate Risk,

BB
Expected
Outcome (EL)
Economic OpRisk Capital
36

Business risk is a widely neglected risk type.
Credit Risk
70%
Equity Risk
2.9%
Market Risk
Operational Risk
Business Risk
3.9%
15.5%
3.4%
Risk of losses resulting from decreasing

revenues compared to the cost base due to
macroeconomic, strategic and/ or reputational
reasons.
Loss = shortfall in revenues
Distribution: Normal or others
Parameters: expected revenues,
volatility of revenues
Interest Rate Risk,

BB
4.3%
Probability
Revenues
Worst Cases
1-p
FrankfurtSchool.de
x
Economic
BR Capital
Expected
Revenues (ER)
37

Interest rate risk in the banking book is affects the
net interest income.
Credit Risk
70%
Equity Risk
2.9%
Market Risk
Operational Risk
Business Risk
3.9%
15.5%
3.4%
Risk of a reduction of net interest income (NII)1

of the banking book due to adverse movements
in interest rates resulting from a interest rate
maturity mismatch between assets and liabilities.
Loss = shortfall of NII
Distribution: Normal or others
Parameters: expected yield curve changes,
volatility of yield curve changes
Interest Rate Risk,

BB
4.3%
Probability
NII
Worst Cases
1-p
Expected NII
Economic
IRRBB Capital
p
No PV-perspective as no MtM-accounting in banking book.
FrankfurtSchool.de
38

The individual risk types must be aggregated to the
overall EC-position.
Credit Risk
70%
Equity Risk
2.9%
Market Risk
Operational Risk
Business Risk
3.9%
15.5%
3.4%
Interest Rate Risk,

BB
4.3%
Aggregation Model
(e.g. correlation,
copula)
Group Economic
Capital
SBG EC as of 31.12.20091
With probability of 99.925%, the loss from SBGs banking

activities will not exceed 44,762 mR in 2010.
Is 44,762 mR a lot or little? => compare to available risk buffer
FrankfurtSchool.de
39

Economic capital is the maximum annual loss for a
given confidence level.
Group Economic
Capital
SBG EC as of 31.12.20091
With probability of 99.925%, the loss from SBGs banking

activities will not exceed 44,762 mR in 2010.
Available financial resources (AFR) = all funding that can

absorb losses.1
Actual default probability is much smaller than 0.075%:

p* that equals: EC = AFR
Institut-dependent: Tier 1 capital + qualifying sub debt + hidden reserves + ... CoBa: T1, BBVA: T1+T2, Unicredit = T1+T2+T3+Adjustments.
FrankfurtSchool.de
40

Economic capital adequacy (ratio) varies mainly due to
bank-specific AFR-definitions.
As of 31.12.2009, 2 No disclosure per risk-type.
FrankfurtSchool.de
41
Economic capital measurement framework
Shareholder &
Boards Concern
Risk Appetite
Statement
Key concern: Is anticipated
Serves to communicate how much
earnings volatility
acceptable?
Dividend cut / profit warning
risk the institution is willing to take
Earnings at Risk (EaR) capacity
Probability
Self-sustaining growth
= 1 in 510 years event
Maximum portfolio concentrations
Focus on risk measures

that capture volatility
around expected outcomes,
such as Earnings at Risk
Target debt rating

Target capital ratios
Target liquidity ratios
plus other criteria, such as
acceptable vs. unacceptable risks
Negative signal to markets e.g. profit
warning
Debt holders &

regulators concern
Poor performance e.g. dividends

reduced
Senior management reshuffled
Key concern: Can the institution

survive the anticipated earnings
volatility?
Regulatory takeover
Insolvency = 1 in 2000+ years event
Capital base lost
Focus on risk measures that capture

extreme loss events
Expected
Earnings
Requires Economic Capital
FrankfurtSchool.de
42
42
Consistency
Capital
Allocation
Framework
Risk Limit
Framework
...
Buffers
...
ML3
ML2
ML1
No
operational
risk limits
...
CL3
CL2
CL1
Risk
Limits
Other
risks
Op.
Risk
Op.
Risk
Market
risk
...
Derive
operational
risk limits
Other
risks
Transform
risk taking
capacity into
risk limits
Consideration
of correlations
and
diversification
effects
Ecap/Regulatory
Capital Limits
FrankfurtSchool.de
BU 3
Deduction
from
risk taking
capacity
without limits
BU 2
Market risk
Credit risk
Credit
risk
BU 1
Available
Equity
Available
Equity
Allocated
Capital
43

If economic capital is used to manage the bank, then there must be a
robust, trusted and efficient economic capital reporting process
Strategy
Finance Director
Strategy
Group Treasury
Capital structure
Chair
Group Risk
Capital allocation
Methodology
Group Risk
Risk-type Heads:
Responsible for the
development of EC
models and review and
challenge
Membership:
Group and Cluster
representatives
Calculation
Group Risk
Ensure consistent economic capital calculation
and allocation
Responsibility of Group
Finance
FrankfurtSchool.de
Methodology
CRO
Economic Capital
Steering
Committee
Reporting
Group Finance
Collation and reporting of
Group EC and EP
figures
Strategic Planning
GS&P
ExCo
Data provision
Business units
Responsibility of Group Risk

44
Hierarchy of relevant terms

Risk Management
to be adequate and effective
Defines and
implements
Risk Bearing Capacity
considers
Business Strategy
Risk Strategy
Internal Monitoring Procedures
Internal Control System
Internal Audit
Structural and operational

organisation
Processes for identifying, assessing,
treating, monitoring and
communicating risks
FrankfurtSchool.de
45
Structure of MaRisk
General requirements (AT)
AT 1 Preliminary remarks
AT 2 Scope of application
AT 2.1 Affected institutions
AT 2.2 Risks
AT 2.3 Transactions
AT 3 Overall responsibility of sen. managmnt.
AT 4 General requirements for risk managmnt.
AT 4.1 Risk-bearing capacity
AT 4.2 Strategies
AT 4.3 Internal control system
AT 4.3.1 Structural and operational arrangements
AT 4.3.2 Processes for identifying, assessing,
treating, monitoring and communicating risks
AT 4.4 Special functions
AT 4.4.1 Risk Control ( new 2012)
AT 4.4.2 Internal Audit
AT 4.4.3 Compliance
AT 4.5 Risk management at group level
AT 5 Organisational guidelines
AT 6 Documentation
AT 7 Resources
AT 7.1 Personnel and incentive systems
AT 7.2 Technical facilities and related processes
AT 7.3 Contingency plan
AT 8 NPP / Changes in processes
AT 9 Outsourcing
FrankfurtSchool.de
Special requirements (BT)

BTO Requirements for the structural and operational
arrangements
BTO 1 Lending business
BTO 1.1 Separation of functions and voting
BTO 1.2 Requirements for lending business processes
BTO 1.3 Procedure for the early detection of risks
BTO 1.4 Risk classification procedure
BTO 2 Trading business

BTO 2.1 Separation of functions
BTO 2.2 Requirements for trading business processes
BTR Requirements for processes for identifying,

assessing, treating, monitoring and communicating risks
BTR 1 Counterparty risks
BTR 2 Market price risks
BTR 2.1 General requirements
BTR 2.2 Market price risks in trading book
BTR 2.3 Market price risks in banking book (incl. int. rate
risks)
BTR 3 Liquidity risks
BTR
Operational
risks for Internal Audit
BT 2 4Special
requirements
BT 2.1 Duties of the internal auditing function
BT 2.2 General principles for the internal auditing function
BT 2.3 Planning and conduct of the audit
BT 2.4 Reporting obligation
BT 2.5 Reaction to findings
46
Overview on recent updates to MaRisk

2. update 2009
Financial Crisis
Concentration Risk (overhaul)
Other Risk (more detailed now)
Risk Bearing Capacity (more detailed now)
Stress test (overhaul)
Liquidity risk (overhaul)
Evaluation of positions (more detailed now)
Group management (overhaul)
Remuneration systems (new)
Strengthening of supervisory functions (update)
Credit
Issuers (more detailed now)
Societ Generale
Trade process
internal deals and cancellations
/ corrections (more detailed now)
IT access rights (more detailed now)
Other
Consideration of equity capital
Recovery process of troubled banks
FrankfurtSchool.de
3. update 2010
Financial Crisis
Risk inventory (new)
Concentration Risk (another overhaul)
Risk Bearing Capacity (still more
details)
Diversification effects (new)
Risk strategies (more detailed now)
Strategy process (new)
Stress test (another overhaul)
Liquidity risk (another overhaul)
Societ Generale
Trade process
reconciliation and
issues (more detailed now)
IT access rights (clarification)
Other
Risk Management not confined to
reporting period
47
Overview on recent updates to MaRisk

4. update 2012
Special Functions
Details on Risk Control function /
department
Compliance function
Code of ethics
Capital Requirments
Detailed processes to determine future
capital needs
Other
Increased responsibilities for FX loans
Enforced job rotation for traders
Transfer pricing for Liquidity costs
FrankfurtSchool.de
48
Regulatory Capital definition

Publication of final common template for capital disclosure
BCBS-Paper No 221, June 2012
...
85
85 items
FrankfurtSchool.de
49
Regulatory Capital definition

Status quo and Intention
Status Quo
Banks may report high Tier1 ratio
even with low common equity ratio
though common equity is best to
absorb losses on a going concern
basis
Basel III - Amendments

3.1 Capital quality
1. Higher common equity- (CE-)

and Tier 1-ratio.
2. Mandatory CE- and Tier 1-ratios
(=Pillar 1-ratios)
3.2 Capital definition
Motivation
No harmonised list of regulatory

adjustments to Tier1&2 capital
Among Basel Committee countries
Hence, no consistent capital base
Harmonize regulatory capital

across jurisdictions by common
list of criteria and strengthen capital
quality by stricter CE- and Tier
conditions.
3.3 Capital disclosure
Often insufficient disclosure and

hence weak transparency
FrankfurtSchool.de
Increase and harmonize granularity

of regulatory capital disclosure
50
Regulatory Capital
Higher and mandatory CE- and Tier 1-capital ratios.
3 Pillar concept
1
2
3
Assets
Changes Basel II => Basel III

Liabilities
(i) Banking book
Loans
Securitised
liabilities
Tradeable
liabilities
Tradeable Assets
Ly Reserve
Others
Tier 3
Tier 2
Equity
addTier 1
Other assets
1. Credit Risk
(CR)
CE
2. Market Risk
(MR)
RWAMR
+
3. Operational
Risk (OpR)
3:
Tier 3
Tier 2
CE
RWACR
1:
(ii) Trading book
2. MR
1. Credit Risk (CR)
2. MR
Deposits
RWAOpR
RWAbank
CE-capital
ratio
!
2%
(4.5%)3
Tier 1 Capital
RWAbank
!
4%
(6%)3
Tier 1ratio
Tier 1 Capital
RWAbank
!
8%2
(8%)3
Total
Capital
Ratio
Regulatory Capital Adequacy2
Have more equity than debt character (e.g. Preferred stocks), 2: Germany: only TCR has to be reported.
Basel 3 figures as of 1/1/2019. Also: Under Basel III, all 3 capital ratios are now mandatory (Pillar 1).
FrankfurtSchool.de
51
Regulatory Capital and Capital Ratios
Sources of volatility on capital

adequacy
Volatile
(IFRS & cycle
effects of earnings)
Cyclical
Eligible Capital (Tier 1, 2, 3)

Credit Risk RWA + Market Risk RWA + Op. Risk (+ Pillar 2)
Highly cyclical
Volatile
(PD & LGD effects)
(market parameters)
Under Basel I, the key driver of capital

volatility was business volume
Under Basel II, additional factors play
a role:
Credit cycles
Risk model related effects,
e.g. stability or recalibration
FrankfurtSchool.de
Regulatory
Capital Adequacy
Ratio (%)
Increased transparency
and stakeholder scrutiny
of capital adequacy
(rating agencies, debt
and equity markets,
regulators)
52
Regulatory Capital
Tier 2 - capital for existential losses only, Tier 1 for all others.
Tier2
Tier1
Capital types & Instruments
Key
elements
Goingconcern
capital
Common equity
(including retained
earnings)
Additional Tier-1
Goneconcern
capital
No detailed
instruments
Characteristics (Selection)
Absorb serious, but not existential losses
(going-concern basis):
subordinated
fully discretionary non-cum. divid./ coupons
no maturity or incentive to redeem
Absorb existential losses
(gone-concern basis):
subordin. to depositors and general creditors
maturity > 5yrs
no further subcategories
Tier 3 abolished
FrankfurtSchool.de
53
Regulatory Capital
Capital categories: Basel II vs. Basel III1
Basel II
Basel III
Tier 1
Tier 2
Tier 3
max. 50%
of Tier 1
Tier 3
1:
Additional
core capital
Tier 2
Loss absorption
gone concern
Tier 2
2nd class
max. 100%
of Tier 1
Common
equity
Loss absorption
going concern
Tier 2
1st class
Innovative
hybrid capital
(max. 15%
of Tier 1)
Tier 1 - capital ratio
max. 50%
of Tier 1
Totasl capital ratio
Hybrid
core
capital
Common equity ratio
Common
equity
Bundesbank, Guericke, TSI-conference, July 2010
FrankfurtSchool.de
54
Regulatory Capital
Tier 1\ Common equity
Tier 1
Tier 2
Goneconcern
capital
T1, T2
Key
elements
Goingconcern
capital
Minority
Interest
T1, T2
Definition
Regulatory
Adjustm.
Capital
Disclosure
FrankfurtSchool.de
Pillar 3
report
Characteristics (Complete)
Common equity Tier 1 Capital
Common shares meeting criteria for classification as

common shares for regulatory purposes (or the equivalent for
non-joint stock companies);
Stock surplus (share premium) resulting from the issue of
instruments included
Common Equity Tier 1;
Retained earnings;
Accumulated other comprehensive income and other disclosed
reserves;
Common shares issued by consolidated subsidiaries of the
bank and held by third
parties (ie minority interest) that meet the criteria for inclusion in
Common Equity
Tier 1 capital. See section 4 for the relevant criteria; and
Regulatory adjustments applied in the calculation of Common
Equity Tier 1
Instruments:
55
Regulatory Capital
Tier 1\ Common equity
Tier 1
Tier 2
Goneconcern
capital
T1, T2
Key
elements
Goingconcern
capital
Minority
Interest
T1, T2
Definition
Regulatory
Adjustm.
Capital
Disclosure
FrankfurtSchool.de
Pillar 3
report
Common equity Tier 1 Capital
Regulatory criteria: for classification as common shares for
regulatory purposes (or the equivalent for non-joint stock
companies);
Most subordinated claim in liquidation of bank
Unlimited claim on residual assets in proportion to own shares
of issued capital
Principal is perpetual
No exception of buying back, redeeming or cancelling the
instrument
Distributions only paid out of distributable items
Distributions only paid after all other legal and contractual
obligations have been met, no preferential distribution
Each CET instrument is pari passu with all the others
Recognition as equity capital in case of insolvency
Instrument is classified as equity capital pursuant to relevant
accounting standards
Directly issued without (in)direct funding of the purchase by the
bank
No securing or covering by guarantees of the issuer
Issuance only after approval of the owners of the bank
Clear and separate disclosure on the balance sheet
(no hidden reserve !!!)
56
Regulatory Capital
Tier 1\ Additional Tier 1
Tier 1
Tier 2
Goneconcern
capital
T1, T2
Key
elements
Goingconcern
capital
Minority
Interest
T1, T2
Definition
Regulatory
Adjustm.
Additional Tier 1 Capital
Capital (and are not included in Common Equity Tier 1)

instruments included in Additional Tier 1 capital;
Instruments issued by consolidated subsidiaries of the bank and
held by third parties
that meet the criteria for inclusion in Additional Tier 1 capital and
are not included in Common Equity Tier 1
Regulatory adjustments applied in the calculation of Additional
Tier 1 Capital
Instrument:
Capital
Disclosure
FrankfurtSchool.de
Pillar 3
report
57
Regulatory Capital
Tier 1\ Additional Tier 1
Tier 1
Tier 2
Goneconcern
capital
T1, T2
Key
elements
Goingconcern
capital
Minority
Interest
T1, T2
Definition
Regulatory
Adjustm.
Capital
Disclosure
FrankfurtSchool.de
Pillar 3
report
Additional Tier 1 Capital
Issued and paid in

Subordinate to depositors, general creditors and subordinated
debt of bank
Perpetual, no incentives to redeem
Callable at initiative of the issuer only after (a minimum) of 5
years
Repayment of principal only aftrer supervisory approval
Distributions cannot be made obligatory
Dividends only paid out of distributable items
No credit-sensitive dividend feature
No contribution to liabilities in case of over-indebtness
If instrument is classified as a liabilitiy for accounting purposes,
principal loss absorption mechanism is required
No (in)direct purchase/ funding by the bank
No hindrance of recapitalisation
Unlimited availability of proceeds
Regulatory criteria:
58
Regulatory Capital
Tier 2
Tier 1
Tier 2
Goneconcern
capital
T1, T2
Key
elements
Goingconcern
capital
Minority
Interest
T1, T2
Definition
Regulatory
Adjustm.
Tier 2 Capital
Instruments issued by the bank that meet the criteria for

inclusion in Tier 2 capital (and not included in Tier 1 capital);
instruments included in Tier 2 capital
Instruments issued by consolidated subsidiaries of the bank and
held by third parties that meet the criteria for inclusion in Tier 2
capital and are not included in Tier 1 capital.
Certain loan loss provisions
Regulatory adjustments applied in the calculation of Tier 2
Capital.
Instrument:
Capital
Disclosure
FrankfurtSchool.de
Pillar 3
report
59
Regulatory Capital
Tier 2
Tier 1
Tier 2
Goneconcern
capital
T1, T2
Key
elements
Goingconcern
capital
Minority
Interest
T1, T2
Definition
Regulatory
Adjustm.
Tier 2 Capital
Issued and paid in

Subordinated to depositors and geenral creditors of the bank
Minimum maturity of five years, no incentives to redeem, no
step-ups
Callable at the initiative of the issuer only after (min.) period of 5
years
No rights for the investors to accelerate repayment
No credit sensitive dividend feature
No (in)direct purchase/ funding by the bank
Unlimited availability of proceeds
Criteria:
Capital
Disclosure
FrankfurtSchool.de
Pillar 3
report
60
Regulatory Capital
Minority interest
Tier 1
Tier 2
Goneconcern
capital
T1, T2
Key
elements
Goingconcern
capital
Minority
Interest
T1, T2
Definition
Regulatory
Adjustm.
Minority Interest
Definition: capital issued by fully consolidated subsidiaries and
hold by third parties
Subsidiary must also be a bank
Criteria for CE-T1, T1 or T2 must be fulfilled
Particular recognition rules
Capital
Disclosure
FrankfurtSchool.de
Pillar 3
report
61
Regulatory Capital
Regulatory adjustments
Tier 1
Tier 2
Goneconcern
capital
T1, T2
Key
elements
Goingconcern
capital
Minority
Interest
T1, T2
Definition
Regulatory
Adjustm.
Regulatory adjustments
Goodwill and other intangibles

Deferred tax assets relying on future profitability
Cash flow hedge reserve (<0: added/ >0: deducted)
Unrealised gains/ losses due to own credit risk (DVA)
Own shares (treasury shares)
Reciprocal capital holdings with other banks, financial or
insurance entities
...
Deducted from CE-T1:
Capital
Disclosure
FrankfurtSchool.de
Pillar 3
report
62
Regulatory Capital
Banks to disclose more details about their regulatory capital.
Tier 1
Tier 2
Goneconcern
capital
T1, T2
Key
elements
Goingconcern
capital
Minority
Interest
T1, T2
Definition
Regulatory
Adjustm.
Disclosure requirements
- Link regulatory capital to balance sheet capital
- Report all regulatory adjustments and items not deducted from
Common Equity Tier 1
- Disclose positions that have been subject to limits and minima
- Description of capital instruments issued
-Disclosed capital ratios have to be accompanied with
comprehensive explanation about their computation
- Publish terms and conditions of all instruments included in
regulatory capital
December 2011:
BCBS published capital disclosure template (as of 1.1.2018) for
comments by Feb.2012
(http://www.bis.org/publ/bcbs212.pdf)
Capital
Disclosure
FrankfurtSchool.de
Pillar 3
report
63
Agenda
1.
2.
3.
4.
5.

FrankfurtSchool.de
64

Milestones of international banking regulation
Basel I => Basel II
Past
Basel I
(1988 2007)
Market Risk
Amendment
(bcbs 24)
International Convergence
of Capital Measurement
and Capital Standards
(bcbs 128)
Credit
risk
Legal
implementation
in Germany
Market
risk
Credit
risk,
IRBA
Op.
risk
Supervisory review
Market
risk
Regulatory risk
measurement
3 Pillar concept
1.
2.
Minimum capital
requirements
International
convergence of
capital
measurement
and capital
standards
(bcbsc111)
Current
Basel II
(2007 currently)
Solvency Directive (as of 1.1.2007)

MaRisk
1:
Regulatory risk model can be either regulatory models (standardized appraoches) or internal models with specific
regulatory (minimum) requirements (confidence levels, data history, etc.).
FrankfurtSchool.de
65

Basel II stabilizes banks through three pillars:
1. Minimum capital, 2. Supervision, and 3. Disclosure
3 Pillar concept
1. MINIMUM
CAPITAL
Key Aspects
Regulator
is happy
if ...
Credit Risk
Market Risk
Operational Risk
Capital
requirements
better
differentiated and
more closely tied
to economic risk
Range of
approaches
(internal and
standardized
models)
Total capital ratio 8%
2. SUPERVISORY
REVIEW
Board and Senior
Mgt. Oversight
Sound capital
assessment (ICAAP)
Comprehensive
assessment beyond
Pillar1-risks
Interest Rate Risk
Banking Book
Model risk
...
Business and risk
strategies
Internal control
review
Capital adequacy processes
3. MARKET
DISCIPLINE
Disclosure:
Scope of
application
Capital Structure
Capital Adequacy
Credit Risk
Market Risk
Operational Risk
Interest Rate Risk
Other Risks
ICAAP
Pillar III - report
Sound infrastructure
1:
FrankfurtSchool.de
66

Basel I => Basel II => Basel 2.5 => Basel III
3 Pillar concept
1
2
3
Pillar 1: Solvency Directive (as of 1.1.2007)
Basel II
(2007 currently)
Basel II Minimum capital ratio

(bcbs 128)
Op.
risk
8%
RWACR + RWAOpR + RWAMR
Remark: RWAX = 12.5 * VaRX = Unexpected lossX
=> details: next slide
3.
Market discipline
Credit
risk,
IRBA
Capital Ratio
Pillar 2: Minimum Requirements on Risk Mgt
Supervisory review
Market
risk
Regulatory risk
measurement
Minimum capital
requirements
3 Pillar concept
1.
2.
CapitalTier1+CapitalTier2
Cf. this slide +2

Pillar 3: Solvency Directive (as of 1.1.2007)

MaRisk
FrankfurtSchool.de
67

3 Pillar concept
1
2
3
(i) Banking book
Assets
(ii) Trading book
Liabilities
Basel II Minimum capital ratio

CapitalTier1+CapitalTier2
8%
Loans
RWACR + RWAOpR + RWAMR
Securitised
liabilities
Tradeable
liabilities
Tradeable Assets
Ly Reserve
1. Credit Risk
(CR)
RWACR
2. Market Risk
(MR)
RWAMR
3. Operational
Risk (OpR)
RWAOpR
Remark: RWAX = 12.5 * VaRX = Unexpected lossX
Others
Tier 3
Tier 2
Equity
addTier 1
Other assets
1:
Capital Ratio
2. MR
1. Credit Risk (CR)
2. MR
Deposits
CE
Sted Appr.
RW1(regul. segment, ext. rating)
IRBA
K (PDInternal, R, ...)* LGDEx-/Internal
Sted Appr.
Internal
Basic/ Sted
Internal
8%
x EaDEx-/ Internal
RW1(regul. segment, instrument characteristics)

VaR99Internal
%,10 d = max{VaR10,1%,t 1 ;
x 12.5
mc 60
VaR10,1%,t i },3 mc 4
60 i =1
Risk weight (regulatory segment)
Gross income
VaR99AMA
.9%,1Y = VaR ( severity, frequency)
RW: risk weight
FrankfurtSchool.de
68

3 Pillar concept
1
2
3
Pillar 2: Minimum Requirements on Risk Mgt
AT 3 Overall responsibility of the board
AT 4.1 Risk-bearing capacity
AT 4.2 Strategies
AT 4 General requirements for risk management
AT 4.3 Internal control system
AT 4.4 Internal audit
AT 5 Organisational guidelines
AT 6 Documentation
AT 7 Resources
AT 8 Activities in new products or new markets
AT 9 Outsourcing
BT 1 Special requirements on internal control system
BTO 1 Lending business
BTO Requirements on organisational and operational setup
BTO 2 Trading business
BTR 1 Counterparty risks
BTR 2 Market risks
BTR Requirements on risk management
BTR 3 Liquidity risks
BTR 4 Operational risks
BT 2Special requirements for internal audit
FrankfurtSchool.de
69

Past
Basel I
(1988 2007)
Basel 2.5
(2012 currently)
Basel III
([2013,2018] - )
(bcbs 128)
Revisions to the
market risk
framework
(bcbs 157)
Strengthening
resilience of the
banking sector
(bcbs 164)
Credit
risk
Market
risk
Credit
risk,
IRBA
Op.
risk
Supervisory review
Market
risk
Regulatory risk
measurement
3 Pillar concept
1.
2.
3.
Market discipline
Market Risk
Amendment
(bcbs 24)
Basel II
(2007 currently)
Minimum capital
requirements
International
convergence of
capital
measurement
and capital
standards
(bcbsc111)
Current
Market
risk
Credit risk
Leverage Ratio
Legal
implementation
in Germany

MaRisk
Liquidity risk
1:
FrankfurtSchool.de
70

Although tightly regulated by Basel II, global regulators
identified 7 major vulnerabilities (2-7).
Crisis
main
drivers
Level and quality of capital basis diminished
Systemic counterparty risks materialised:

Large (interbank loans/ deposits AND OTCderivatives) and opaque (OTC)
interconnectedness of institutions
Migration risk in counterparty credit risk for OTC
transactions ignored so far in capital ratio
strengthening
individual
institutions in
periods of stress
Actions
on two
levels
Excessive leverage and procyclical deleveraging
6a Transmission of shocks through the cycle
(procyclicality)
6b Failure of large banks (e.g. Lehman) threatened
the global banking system

(global systemically important banks)
7
Micro level:
Event risks (Defaults, Migration) of credit

derivatives and securitizations in trading book
Insufficient liquidity buffers
FrankfurtSchool.de
Macro level:
addressing system
wide risks and
amplification
effects.
71

Basel 2.5/ III : Pillar -1 context
Basel III and CRR ( Basel II )

Basel 2.5
Pillar 1 (Minimum standards)
Market risk
(bcbs 193)
bcbs 189
C
4
Basel III
1. Core Equity Tier1 Ratio
4.5%
12.5*( KCR + VaROpR + VaRMR + sVaRMR + IRM + VaR_CVA ) + [2.5%-8.5%]
B
3
D
5
4
Capital
definition
Risk
coverage
Leverage
ratio
6a Countercyclicality
Systemic
207 6b
Risk
7 Liquidity
risk
(bcbs 188, 238,
271)
1)
3 CapitalCore Tier1
2
3
2. Tier 1 Capital Ratio
CapitalCore Tier1 + Capitaladdit. Tier1

RWA 2 4
6
6.0%
+ [2.5%-8.5%]
6
3 CapitalCore Tier1 + Capitaladdit. Tier1+ CapitalTier2

3. Total Capital Ratio
4. Leverage Ratio
RWA 2 4
3 CapitalCore Tier1 + Capitaladdit. Tier1

Total Assets + {0/5/25/50/100}% Off-Balance
5. Liquidity Coverage Ratio 7
6. Net Stable Funding Ratio 7
Highly quality liquid assets

Outflows min(75% Outflows; Inflows)
Available stable funding
Required stable funding
8.0%
+ [2.5%-8.5%]
6
3%
100%1
100%
1.1. 2015/2016/2017/2018/2019: 60%/ 70%/ 80%/ 90%/ 100%
FrankfurtSchool.de
72

Reporting Compliance Disclosure
Application of CAD IV and CRR
3. Liquidity
Coverage Ratio
BCBS 188
5. EBA Liquidity
Monitoring tools1
BCBS 165
4. Net Stable
Funding Ratio
Enter into force CRR (28/6/13) and CAD IV (17/7/13)
BCBS 189
2. Leverage
ratio
BCBS 164
1. Capital ratios
(CET1, T1, TC)
Start CAD IV- and CRR trilogue (EU Com/ council/ parl.)
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Reporting (quarterly)
Pillar I - constraint
Disclosure
Pill I - constraint
Disclosure
Reporting (monthly)
Pillar I - constraint
Disclosure
Pill. II
Pill I - constraint
Disclosure: tba
Reporting (monthly/ quarterly2)
Pillar II - requirement
Disclosure: not envisaged
1)
(i) Contractual maturity ladder, (ii) Concentration of counterbalancing capacity by issuer/counterparty; (iii)
Concentration of funding by counterparty and product type; (iv) Prices for various lengths of funding; (v) Roll-over of
funding., 2) Quarterly if: (i) Not part of cross-boarder group, (ii) Individual TA < 1% * Individual TA of country,
(iii) TAGroup 30 bn EUR
FrankfurtSchool.de
73

Regulators reaction: Basel 2.5 and Basel III
(Factsheet)
B. 2.5
Impact
2 Market risk
(trading book)
(bcbs 157)
3
bcbs 164
More liquidity
Others
A) VaR =
+ new stressedVaR
C) Tradeable & defaultable IR-positions: new incremental risk measure (IRM) for event risk1
Securitisations: (B) revised standardised model, (D) new comprehensive risk measure (~IRM+)
Capital
definition
3.1 Rise capital quality: (i) higher and (ii) mandatory CE-T1-&T1-ratios
3.2 Stricter capital definition:(i) T1:going concern. (ii) T2:gone c. (iii) Minority int. (iv) Adj.
3.3 Improve capital disclosure: (i) Pillar 3 report and (ii) website.
Counterparty
credit risk
New CVA-risk measure for downgrades of derivative counterparties

Wrong-way risk: stressed EaD (EEPE) for derivative exposures
Increased default correlation (+25%) for lending and trading exposures to large banks
Longer margin period of risk
Provide incentives to move OTC transactions to CCPs (by reduced risk-weight of 2%)
Reduce reliance on external ratings by using models with internal scores/ ratings.
Basel III
More/ less capital
VaRBasel II
5 Leverage ratio
New leverage ratio (volume-based minimum capital ratio) to avoid excessive leverage.
6a
Conservative/ through the cycle - credit risk parameters (PDttc, LGDdownturn)

Promote loan loss provisions based on expected loss (EL)
IASB: EL-provisioning in IFRS9
New permanent Capital conservation buffer (+2.5%)
New temporary Countercyclical buffer (0% -2.5%)
Countercyclicality
207 6b Systemic risk
New capital surcharge for global, systemically important banks2 (G-SIB) (1%-3.5%)
New Liquidity Coverage Ratio (Minimum liquidity reserve)

New Net Stable Funding Ratio (Minimum stable/ long-term funding)
New Monitoring/ Pillar-2 tools3
Liquidity risk
(bcbs 165, 238)
-------
1)
Event risk: default and migration risk.2) Regulators could impose individual surcharges before in Pillar 2. Now more
transparent 3) Tools: (a) Contract. maturity mismatch, (b) Funding concentr., (c) Available collat., (d) LCR by currency
FrankfurtSchool.de
74
Leverage ratio
Counterparty Credit Risk
CVA
Capital requirements
17/7/2013
1/1/2014
Capital Re-Definition
Capital disclosure
LCR, NSFR
Monitoring tools
Leverage
Applicable
CRR
1)
Enhanced
transparency
Systemic risk buffer
Other SIFI-buffers
Remuneration, Divy
Enhanced governance
Sanctions
31/21/2013
Conservation buffer
Anticyclical buffer
Adoption CAD IV
EU Banking Pass
Sanctions
Liquidity
28/6/2013
Access to taking up/

pursuit of business
Corproate Governance
Capital
Non-Basel III
Large exposures
Large exposures
Disclosure Requirements
Disclosure
Requirements
Single Rule Book
Single Rule Book
Adoption CRR
Capital buffers
EBA R-/ITS [Impact/ Calibr./ L2-Cap, Retail, Buffer use, HQLA)]

pursuit of business
Free movements of
services (EU Banking Pass)
Prudential Supervision
(Pillar II)
Mar/ 2013
CAD IV
BIII
Final Draft
CRR is a framework. Many details are outsourced to RTS/ ITS and are fixed in 2014.
Feb/ 2012
Basel III vs. CRR
Start Trilogue1
EU Commission, European council, European parliament
FrankfurtSchool.de
75

Basel III vs. CRR
CRR is a framework. Many details are outsourced to RTS/ ITS and are fixed in 2014.
CAD IV
BIII
pursuit of business
Free movements of
services (EU Banking Pass)
Prudential Supervision
(Pillar II)
Capital buffers

pursuit of business
Conservation buffer
Anticyclical buffer
Corproate Governance
Sanctions
Capital
CRR
Liquidity
1)
Non-Basel III
Due to national particularities

(structure of banking sector,
EU Banking Pass
legal and administrative system,
Enhanced
economic cycle) better national
transparency
discretion (supervisory license,
Systemic risk buffer
cross-border cooperation of
Other SIFI-buffers
regulators, capital buffer,
Remuneration, Divy
Internal Governance
Enhanced governance
(renumeration), ICAAP-process,
regulatory sanctions)
Sanctions
Capital Re-Definition
Capital disclosure
LCR, NSFR
Monitoring tools
Leverage
Leverage ratio
CVA
Capital requirements
Single Rule Book: harmonisation

of banking regulation/
Level-playing field in European
baking market
Large exposures
Large exposures
Disclosure Requirements
Disclosure
Requirements
Single Rule Book
Single Rule Book
EU Commission, European council, European parliament
FrankfurtSchool.de
76
Agenda
1.
2.
3.
4.
5.

FrankfurtSchool.de
77
Market risk: The capital charge for traded credit risk

(issuer specific risk) has been substantially increased.
BB
Trading Book
Credit
Risk
OpRisk
(I) Revised Internal Models:

A newVaR = oldVaR + stressedVaR
(1)
Basel II Pillar I
Market
Risk
All: Equity, IR, FX, Commodities
(II) Revised capital charges for (issuer-)specific interest rate risk:1
cc (IR\specific) =
VaRspecific + C
B
(2)
D 8%* (2))
B
VaRspecific + max( (4),
IR-risk positions
(Basel II-)Securitisations
nth-to-default
(Basel II-)CT-Securitisations (Basel II)-CT-NTD
Capital charge due to:

B revised standard ised model (IR\specific) for securitisations
(2)
C internal incremental risk measure IRM capturing default- and migration risk
(3)
C
D internal comprehensive risk measure capturing default-, migration - and all other price risks
(4)
Pillar II
Pillar III
1:
Here for a bank that makes maximal use of internal models
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78
Market risk
Multiple model options to compute the capital charge.
All: newVaR = oldVaR + stressedVaR
Positions with (issuer-)specific interest rate risk:

Revised standardised model (IR\specific) for securitisations
C Internal incremental risk measure IRM capturing default- and migration risk for IR\ Non-securitisations
DI Internal comprehensive risk measure capturing default-, migration - and all other price risks for correlation trading
B
General1
Model options for

Pillar1 - market risk
Specific2 (spread risks)

Events3
Daily Fluctuations
C
1. Internal Model
General &
Specific
0
A
2. Internal Model
General &
Specific
3. Standardized
Approach
1)
VaRgen
SMgen
VaRspec
IR
SMspec
VaRgen+spec
IRM
Equity
FX, Commodities
IRM
IR
SMspec
IR
VaRspec
Equity
FX, Commodities
SMspec
IR, Equity
FX, Commodities
Fluctuations explained by an index. 2) Security-specific fluctuations.3)Events: defaults and migration
FrankfurtSchool.de
79
Market risk

B
2. Market
Risk
(MR)
General
Specific (spread risks)

Daily Fluctuations
Event
C
VaRgen+spec
0
RWAMR
VaRgen
SMgen
FrankfurtSchool.de
VaRspec
IRM
SMspec
IR
Equity
FX, Commodities
IRM
IR
SMspec
IR
VaRspec
Equity
FX, Commodities
SMspec
IR, Equity
FX, Commodities
80
Market risk

B
2. Market
Risk
(MR)
General

Daily Fluctuations
Event
C
RWAMR
VaRgen+spec
Basel II
Basel II
VaR gen
+ spec
IRC
e.g. IR
Additional
sVaR gen &spec
mc 60
max{VaR10,1%,t 1 ; VaR10,1%,t i }
60 i =1
ms 60
max{sVaR10,1%,t 1 ; sVaR10,1%,t i }
60 i =1
FrankfurtSchool.de
IRC0
1 11
IRC0 = 1.0 max( IRM 0 , IRM k )
12 k =0
Current
Incremental
Risk Measure
Average of IRM
across 12
weeks
81
Market risk
The event charge varies with the instrument category ( IR1
IR2 IR3
).

B
2. Market
Risk
(MR)
General

Daily Fluctuations
Event
C
RWAMR
+
Basel II
VaR gen
+ spec + sVaR gen &spec
IR
1
Unsecured
credit products
not in
correlation
trading
IR2
Securitisations
not in CT
IR3
Correlation
trading (CT)
IRC0
SMspec
CRM
FrankfurtSchool.de
IR1
82
Market risk:
Details on stressed VaR.
Intended to replicate VaR of current portfolio if relevant market factors

were experiencing a period of stress
Stressed
Value at Risk
10-day, 99th percentile VaR model
Model inputs calibrated to 12-month period of significant financial stress

approved by supervisor, e.g. 2007/08
FrankfurtSchool.de
83
Market risk:
Details on IRM.
No specific approach prescribed but

B
Incremental
risk measure
(IRM)
model must satisfy soundness standards of internal ratings based

approach.
IRM must reflect default and migration risks.

If no IRM model is available, capital surcharge in terms of
standardised approach to specific risk has to be used.
FrankfurtSchool.de
84
Market risk:
Details on IRM.
Shortcomings
VaR
BaselIII
mc 60
= max{VaR10,1%,t 1 ; VaR10,1%,t i }
60 i =1
ms 60
+ max{sVaR10,1%,t 1 ; sVaR10,1%,t i }
60 i =1
i : days
Additional Capital Charge
1 11
IRC0 = 1.0 max( IRM 0 , IRM k ), k : weeks
12 k =0
Market risk feature
Credit risk (IRB) feature (like in banking book)
Ignoring differences in market liquidity of

positions
Define liquidity horizon for re-balancing
(Typically) 99%-Daily VaR scaled up to 10

days
=> miss out infrequent daily losses
(< 2-3 times per year)
Use 99.9% confidence level

to account for infrequent (credit) event risks (of
default and migration) of unsecuritised credit
products
(Typically) 99%-Daily VaR scaled up (with

indep. assumption) to 10 days
Miss out large (autocorrelated) losses
Use capital horizon of 1 year

(accounting for cumulative losses)
Calibration on 250 trading days

underestimates capital for a potential
upcoming turmoil period
=> Credit characteristic: Use data like IRBframework

(time horizon for calibration IRB)
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85
Market risk:
Revised Standardised Approach on securitisations.
SM for
securitisations not in
CT PF
Specific interest rate risk for securitisations in trading book ought to be assessed by
standardised model
which is now equal to banking book model for securitisations: risk weights from
banking book according to external rating, no off-setting allowed.
For non-rated securitisations, inter alia the supervisory formula ought to be applied
resulting in risk weights between 8% and 100%
NR1
rated
SolvV
1:
Basel II Revisions (IRBA-banks)

Securitisations
Securitised, 1x
Re-securitised
non-securiti- Securitinon-securitisenior
non-senior
Ext. Rating sations
sations
sations
nonsenior
non-senior
granular
granular
granular
AAA
0% - 1,6%
0% - 1,6%
0,56%
0,96%
1,60%
1,60%
2,40%
AA+ to AA0,25% - 1,6%
0,25% - 1,6%
0,64%
1,20%
2%
2%
3,20%
A+
0,25% - 1,6%
0,25% - 1,6%
0,80%
1,44%
2,80%
2,80%
4%
BB8%
8%
52%
52%
52%
60%
68%
B+
12%
100%
12%
100%
100%
100%
100%
100%
B
12%
100%
12%
100%
100%
100%
100%
100%
B12%
100%
12%
100%
100%
100%
100%
100%
<= CCC+
12%
100%
12% 8% to 100%
100%
100%
100%
100%
100%
(depending on approach)
NR : non-rated.
FrankfurtSchool.de
86
Market risk:
Revised Standardised Approach on securitisations.
2007/2010
1:
Before downgrades
After downgrades
See Market risk revisions, 712(iv).
FrankfurtSchool.de
87
Market risk:
Approach on Correlation Trading Positions.
Basel II trading book
Securitized portfolios (cash and synthetic)
Further products
Others Credit derivatives (SolvV, 299,(5) ff)
CDS
TR
S
CLN
nth-todefaul
t
Tranched (SolvV, 226)
Securitised, once
Liquid
underlying
assets
CT-Hedges
Non-tranched
(e.g. ABCP, Covered
Bonds, ...)
Re-securitised
(e.g. CDO)
NonLiquid
Assets
CT-Core Instruments
Regulatory definitions
Regulatory correlation trading portfolio
Real-world products
iTRAXX,
CDX,
singlename CDS
FrankfurtSchool.de
TR
S
CL
N
nth-todefaul
t
Tranches on
iTRAXX,
CDX
88
Market risk:
Internal model only for Correlation Trading portfolio.
CC = VaRnew + max{CRM;8% *CC(spec IR SM CT pfo)}
VaRnew = max{VaRt 1; mc *VaRavg} + max{sVaRt 1; ms * sVaRavg}, mc , ms 3
IM capital
charge (CC)
for CT pfo
CC(specIR SM CT pfo) standardised model capital charge for the

correlation trading portfolio for specific interest rate risk
CRM: comprehensive risk measure generalising the incremental risk measure

(IRM) to specific risks of securitisations
FrankfurtSchool.de
89
Market risk:
Explicit (comprehensive) list of risks to be covered by CRM.
Cumulative risk of multiple defaults, including ordering of

defaults, in tranched products
Credit spread risk, including gamma and cross-gamma
effects
Comprehensive risk
measure
Volatility of implied correlations, including cross effect

between spreads and correlations
CRM might generalize

IRM as surcharge for
non-securitisation and
non-NTD positions
all price risks = CRM
Basis risks between:

Spread of index and spreads of constituent single names
Implied correlation of index and implied correlation of bespoke
tranches
IRM = incremental
default and
migration risks
Recovery rate volatility
If dynamic hedging => hedge slippage risk and potential

rebalancing cost
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90
Market risk:
CRM as an extension of IRM: regulatory approval.
Interpretive issues with respect to the revisions to the market risk framework
November 2011, p. 7:
Question:
It would be important for banks to be allowed to enhance the IRC model to leave the
correlation book inside (ie, try to comply with the comprehensive risk measure but
within the IRC model). Would it be acceptable to extend the IRC framework to
comply with the comprehensive risk measure and perform a single calculation?
Answer:
Banks are allowed to enhance the IRC model to comply with the requirements for
the comprehensive risk measure. However, they are not allowed to perform a single
calculation covering exposures subject to the IRC charge and exposures subject to
the comprehensive risk capital charge. Disallowing a single calculation has the
effect of not allowing any diversification between the portfolios
FrankfurtSchool.de
91
Market risk:
Fundamental Review of Trading book1
Scope:
Revisions, July 2009: quick fix, i.e. changes within fundamental framework
Revisions, May 2012: structural fix, i.e. changing the fundamental framework
Fundamental Element
1:
Weakness
Proposed remedy
1. Boundary Tradingvs. Banking book
- Subjective criterion: Intention to

trade
- Different risk weights in each
regime
More objective boundary:

1. Trading-evidence-based:
daily MtM and FV through P&L, almost no reclassification
2. Valuation-based:
market risk = any risk that threats regulatory and
accounting solvency of banks
2. Standardised
Approach
- Calibrated against normal/ longterm market circumstances
Capital requirements must be calibrated against times

of stress (see sVaR for IM-banks)
1. Re-calibration of Sted approach to financial distress
3. Risk measure VaR
- Does not capture tail risk (only start

of tail, but not shape of tail)
1. Expected shortfall: capturing size and likelihood of

stress (for both IM and SM)
4. Market Illiquidity
< Basel 2.5: markets perfectly liquid

Basel 2.5: partially incorp. by I-/CRM
1. Set of 5 liquidity horizons (10d, ..., 1Y)

2. Quantify Ly-risk for given 10 days Liquidity horizon
3. Ly premia for instruments that are prone to market
illiquidity
4. Pf-specific market liquidity: concentrations, large
portfolios
BCBS-paper: 219, May 2012, Consultation: till September 7th, 2012
FrankfurtSchool.de
92
2. Market risk:
Scope:
Fundamental Element
1:
Weakness
Proposed remedy
5. Hedging and
diversification
- Hedging can have basis risk

- Diversification often only applies to
gains, not to losses
1. Basis risk should be measured and capitalised

2. Limit diversification benefits (something that is
already incorproated in sted approach)
6. Closer alignment of
IM and Sted approach
-potential large differences

(regulatory optimisation?)
- difficult for supervisors to withdraw
model permission
1. Closer link (=> limiting diversification benefits for IM

like already in SM, calibrate SM against stress like
already done in IM)
2. Mandatory calculation of SM for ALL banks
3. IMC = min(IM,X%*SM)
7. Revised IMapproach
- Approval basis for IM: portfolios

=> Too large to verify quality
=> too much diversification across
desks
- Model backtesting
1. Model approaval on trading deck level

2. Daily P&L vs. risk measure on trading desk level
If inacceptable => desk must use SM
FrankfurtSchool.de
93
Market risk:
Scope:
Fundamental Element
Weakness
Proposed remedy
8. Revised SM
(SM not touched in
July 2009!!)
- Comparability
- Fall back (for IM-banks)
- Simple (for smaller banks)
Objective: more risk sensitive

1. Partial factor approach:
instruments with similar risk characterisics
=> same bucket => regulatory risk weights +
regulatory correlation matrix (new!)
2. Fuller risk factor approach:
Map instruments to set of regulatory risk factors
=> Pricing model to estimate own position
=> shocked
=> Hedging at risk factor level
regulatory aggregation for diversification
9. Credit risk
- Default and migration risk
1. study whether separate models
Excluded topics:
1:
(I) IRR in banking book

(Strukturbeitrag)
- Major risk,
not in Pillar 1, but in Pillar 2
Separate proposal in 2012
(II) Market- and credit

risk
- stand-alone charge: CVA

- stand-alone charge: Market-VaR
Both (market and credit ) risk lead to MtM-losses

some industry voices prefer integrated approach
Committee wants improvement of stand-alone CVA
first
FrankfurtSchool.de
94
Agenda
1.
2.
3.
4.
5.

FrankfurtSchool.de
95
Counterparty Credit Risk:

Motivation of Basel III - amendments
Aim...
... by implementing...
More adequate capitalisation of credit

counterparty risks as under Basel III
a better understanding of wrongway risks (stressed exposures)

introducing CVA-risk charge
Provide Incentives to move from OTC

transactions to central counterparties
(CCPs)
low risk weights for CCP-derivatives:

Default risk: 2%,
Migration risk: 0%
Account for systemic risk,

interconnectedness and procyclicality
asset value correlation multiplier
Reduce Operational risks
new qualitative requirements for

back and stress testing
Motivation
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96
New Regulation of OTC Derivative Markets
All standardized OTC derivative contracts should be traded on exchanges or

electronic trading platforms, where appropriate, and cleared through central
counterparties by end-2012 at the latest. OTC derivative contracts should be
reported to trade repositories. Non-centrally cleared contracts should be subject
to higher capital requirements.
Grafik: PWC
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97
97

New Regulation of OTC Derivative Markets
REGULATION OF DERIVATIVE MARKETS
EMIR
Clearing obligation for some classes of
OTC derivatives/ Exemption: intragroup
transactions (insofar as they do not
increase systemic risk)
MIFIR
Shifting derivatives trading to organized
markets (Organized Trading Facilities/
OTFs)
Transparency of trade and reporting

Clearing Obligation for Financial
requirements
Counterparties/ Non-Financial
Counterparties, insofar as the clearing
Specific monitoring in relation to financial
threshold is exceeded (whereby hedging
instruments and derivatives positions
does not count into the clearing threshold)
Derivative contracts are to be reported to
a transaction register (Trade Repository)
Supervisory by/ Reporting Obligations to
ESMA (European Securities and Markets
Authority)
Credit Risk Reduction
MIFID II
Increasing the competitive position of
European Financial Markets/Competition
among financial services providers
Strenghtening Investor Protection and
Confidence of Market Participants
Basel 2.5/3/3.5
Basel 2.5 : Increase of Capital
Requirements Trading Books: Incremental
Risk Charge, Comprehensive Risk Charge,
Stressed-VaR,Treatment of Securitized
Products in the Trading Book
Basel III: Abolishment of Tier 3

Organizational requirements and rules on Instruments (Short Term Subordinated
Bonds) as capital to cover risk in the
the conduct of business of investment
Trading Book.
firms respectively trading venues
Basel III: Introduction of CVA-Risk Increase of Transparency by Disclosure Charge -Requirement to cover price
volatility from Counterparty Risk with Risk
of Risk Positions
Capital
Credit Risk Reduction
Basel 3.5 (Fundamental Review of the
Trading Book): Substitution of Value at
Risk by Expected Shortfall to cover
Extremal Risk.
Classification of Trading Book Positions
by different Liquidity Horizons
Change of Standard Methods and
Internal Methods
New Transparency of the Derivative Markets: Central Clearing

Counterparties, Organized Trading Facilities and Transaktion
Repositories
FrankfurtSchool.de
Investor protection and confidence

of market participants, Competition
among financial services providers,
Organizational requirements and
rules on the conduct of business of
investment firms respectively
trading venues
Trading Books: Higher

Requirements for Risk Capital,
Specific Focus on Price Volatilities
of Derivative Positions driven by
Counterparty Risk, Specific Focus
on Stress Scenarios and Extremal
Events
98
Central Clearing Counterparties

A CCP imposes itself as the legal counterparty to every trade.
This substitution of the counterparties by the CCP typically occurs through a
process known as novation, which discharges the contracts between the
original trading entities and creates two new, legally binding contracts one
between each of the original trading parties and the CCP.
FrankfurtSchool.de
99

This arrangement places the CCP in a unique position in that it has direct
interaction and counterparty risk exposure with each trading party.
- This gives the CCP the incentive to closely monitor traders, as well as
access to the information needed to manage its risk
Market participants, by contrast, are essentially indifferent to the
creditworthiness of anyone but the CCP, which significantly decreases the
cost of risk monitoring
The CCP uses a variety of tools to manage risk:
- CCPs typically hold collateral from each market participant to serve as a
cushion against adverse market fluctuations.
- The CCP also monitors the positions of members and may periodically
require additional collateral following market movements to reestablish
an acceptable cushion against future losses.
- Rules are established dictating what assets are allowed to serve as
collateral, how much of a haircut should be given to specific assets in
determining their value as collateral, and how often margin calls should
take place
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100

CCPs also use loss-sharing arrangements to cover any additional losses
incurred beyond those covered by a defaulting traders collateral.
Mutualization of losses is a final layer of protection that insures the ability of
the CCP to perform its obligations notwithstanding the failure of one or
more traders
The CCPs unique position of being a common, substituted counterparty to
all trades in a centrally cleared market greatly simplifies the multilateral
netting of trade obligations.
Past studies have shown that multilateral netting can result in significant
decreases in risk exposure relative to the underlying gross positions
FrankfurtSchool.de
101
Central Clearing obligation (art. 4 EMIR)

Clearing obligation for some classes of OTC derivatives
European CCPs are ICE Clear and Eurex Clearing.
Scope: Financial counterparties
Academic research, [Duffie and Zhu, 2009], suggest that too many CCPs do
not reduce counter partyrisks.
Non-financial counterparties, insofar as the clearing threshold is exceeded
(whereby hedging does not count into the clearing threshold, for example
Hedge Accounting pursuant to IAS 39) :
Source: PWC
FrankfurtSchool.de
102
Implications for Collateral
EMIR/MIFID:
- Key themes and impact areas: EMIR will require OTC derivatives to be
standardized, where possible, so they can be centrally cleared and
traded on exchange-like platforms.
Introducing multilateral trading and organized trading facilities and
central counterparties (CCPs). This has meant an increase in the
complexity and number of margin calls and an increase in collateral
requirements
- Financial Firms impacted : All EU firms that are engaged in OTC
derivatives trading activity.
- Implications for collateral: The formal clearing obligations of the new
regime will require collateralization of swap transactions with specific
types of high-grade collateral something that is not currently required
under bilateral swaps deals
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Implications for Collateral
Dodd Frank:
- Key themes and impact areas: Mandated central clearing via CCPs in
attempts to reduce systemic risk and bring transparency to the often
perceived as opaque practices of bilateral OTC derivatives trading.
- Financial Firms impacted : All US firms that are engaged in OTC
derivatives trading activity.
- Implications for collateral: This will substantially increase the cost of
collateral, and will detrimentally affect liquidity as high-quality assets are
tied up at a CCP. Additionally, the fact that there will be multiple
CCPs globally will cause further fragmentation of these collateral assets
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104
Reporting obligation to a trade repository

applicable to contracts outstanding on or entered into after 16 August 2012
Reporting frequency: reporting no later than the working day following
conclusion, modification or termination of the contract
Details: main characteristics e.g. type, underlying, maturity, notional value,
price, settlement date
Delegation: counterparty or CCP may delegate the reporting of the details of
the derivative contract
Double reporting: counterparties and CCPs shall ensure that the details of
their derivative contracts are reported without duplication
Storage: at least five years following the termination of the contract
Source: PWC
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105
Future Framework for OTC-Derivatives

Increased electronification of certain product markets continue, catalyzed
by regulatory demands (e.g. IR Swaps, CDS)
Due to illiquidity in certain asset markets, investment banks still feature as
broker-dealers in market making role as an important price generation
entity
EQ
Elektronic
Trading Platform
FI
Comm
FX
Inter-dealer
Brokers
CCPs
Standardised Deals
Bilateral
Clearing
Transaktion Repository
Client
Investment Banks
Non-standardised Deals
Source: Oliver Wyman

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106
Future Framework for OTC-Derivatives
FrankfurtSchool.de
107
107
ISDA Document Structure

Definitions
(Examples)
1994 CSA
(NY)
1995 CSA
(English)
2002 MA
2008 CSA
(Japanese)
Schedule
2006 Definitions
1992 US Municipal
Counterparty Definitions
2005 Commodity Definitions
2011 Equity Derivatives
Definitions
1997 Government Bond
Option Definitions
2003 Credit Derivatives
Definitions
1998 FX and Currency
Option Definitions
1998 Euro Definitions
short form confirmations only
1995 CSDeed
(English)
Confirmations
for covered transactions
Legend:
part of standardized contract
stand-alone document
to be signed seperately
refers to
FrankfurtSchool.de
Adherence Letter
Protocols
(Examples)
EMU Protocol
2001 Credit Support Protocol
2002 Master Agreement
Protocol
2006 Novation Protocol II
CDS Protocols
Big Bang Protocol
Small Bang Protocol
Close-Out Amount Protocol
Source: Prof. Dr. Gnter Reiner, ISDA Master Agreement Kommentar, 2013 C.H.Beck
108
International Swaps and Derivatives Association

(ISDA), www.isda.org
ISDA : organization of participants in the market for over-the-counter
derivatives
more than 820 members in 57 countries; its membership consists of
derivatives dealers, service providers and end users
Examples for primary members: Glencore International AG, BP Plc, Citigroup,
Credit Suisse, Daewoo Securities Co., Deutsche Bank AG, J.P. Morgan Chase &
Co., Barclays, Bank of America Merrill Lynch, BNP Paribas, Citigroup, Credit
Suisse , UBS AG.
Headquarter: New York
Founded: 1985
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109
Deivatives Documentation
There are four aspects of the documentation which are of interest here:1. Confirmation
2. Master Agreement
3. Schedule to the Master Agreement
4. Credit Support documentation
Each individual transaction is connected to this Master Agreement by entering
into a confirmation (the Confirmation) which is a Confirmation of the trade
which two parties have entered into.
The Confirmation is expressed to be subject to the terms of the Master
Agreement.
The Confirmation sets out the details of each particular trade. The link to the
Master Agreement ensures that the trades are still governed by those
overarching rules.
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ISDA: Master Agreement and related documents

www.isda.org
ISDA Master Agreement: standardized contract to enter into derivatives
transactions which contains the terms and conditions by which all (or as many
as possible) of the derivatives transactions between the parties are governed
Accordingly, one master agreement will be entered into between a given
derivatives market participant and each of its counterparties regardless of how
many individual transactions are in place between it and each counterparty
The master agreement sets forth all of the terms needed to properly document
all types of derivatives and will cover as many of the potential contingencies
related to such transactions as is possible.
The majority of the terms of standard master agreements are market-accepted
and negotiation of master agreements has become routine
FrankfurtSchool.de
111

www.isda.org
A typical master agreement will include definitions, terms covering the general
payment obligations of the parties, tax withholding terms, representations of
the parties, default terms, settlement terms in cases of default, general
contractual terms (e.g. choice of law), tax treaty provisions, requirements to
provide supporting documentation and notice provisions.
Trade Confirmation:
Derivatives transactions are usually entered into orally or electronically
Confirmations contains the evidence of the terms of the transaction
usually a short letter, fax or email (except for complex transactions) :
contain little more than dates, amounts, and rates
Form of the confirmation: set out in the Master Agreement
limited period of time is usually allowed for objections or amendments
to the confirmation after its receipt
Confirmations are exchanged to minimise the possibility of a dispute as
to the terms of a transaction occurring.
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112

www.isda.org
The ISDA master agreement involves a preprinted master agreement (either
local jurisdiction single currency or multicurrency-cross-border), a schedule,
and a form of confirmation.
Generically, these three documents are often referred to together as an ISDA
master.
The schedule is used to make certain elections and any modifications
(additions and deletions) to the standard terms in the preprinted form.
Credit support annex (CSA): Mitigation of counterparty credit risk by requiring
the party which is 'out-of-the-money' to post collateral (usually cash,
government securities or highly rated bonds) corresponding to the amount
which would be payable by that party when all the outstanding Transactions
under the relevant ISDA Master Agreement would be terminated.
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113
Single Agreement Philosophy

The master agreement is the part of the documentation which sets out the
manner in which the two counterparties are to conduct their derivatives
business with one another.
While Confirmations deal with specific transactions, the aim of the Master
Agreement is to deal with the legal issues and risks which arise outside the
structuresof an individual trade.
Importantly, the philosophy behind the International Swaps and Derivatives
Association (ISDA) documentation is that all of the confirmations entered
into between two parties together with their master agreement, schedule and
credit support documentation are to construed as constituting one single
contract
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114
Some Background: Regulatory Capital for Credit Risk

(Advanced) Internal Rating-based Approach
CRSA vs. IRBA-approach
Required credit risk capital
Credit quality weight (CRW) of the
Amount of credit equivalence depends on:
borrower
Structure of the contract,
x 8% x
CRW depends on: borrower
(Remaining) term, Collateral
segment, score, etc.
Netting agreements
Basel I
100%
x 8%
Basel II/ Standardized Appr.

Solv-D
IRBA
CRW (regul. segment, ext. rating)
x 8%
TA1
* EaD * 12.5
K (PD, R, ...)* LGD

Unexpected loss (Capital)
Risk-weighted assets
Basel I: overall banking-supervisory requirement

Basel II, Solv-D: Creditworthiness (RW) of the borrower and collateralization (EaD) of
loan
1)
TA : Total Assets
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115

IRBA-capital charge: Example for retail exposure
PDinternal = 1%, LGDinternal = 45% => ... => capital charge = 4.51%
Loss probability
Assets
Liabilities
Retail loan
PDinternal = 1%
LGD internal= 45%
100
Deposits
Other liabilities
Others
Equity
Other
assets
Ly Reserve
100
0
45% Loss
(= LGD )
55% Recovery
(= 1-LGD )
Expected
Loss
Unexpected
Loss
0.45%
44.55%
LGD*PD
Loan rate
FrankfurtSchool.de
q99.9%,Retail = [
1 (PD)+ R1 (99.9%)
] LGD
1- R
1
[ x] := NormsDist( x)
1 (x) := NormsInv(x)
(1%)+ 15% (99.9%)

] 45%
1-15%
= 4.96%
= [
4.96%
q99.9%
Capital
EL = PD* LGD = 1% * 45% = 0.45%
Uncovered
Capital= q99.9%,retail EL = 4.51%
116

Loss distribution
Example: Risk-adjusted pricing.
Risk parameters PD, LGD
Assets
100
Retail loan
PD = 1%
LGD = 45%
Liabilities
Deposits
Equity
Other
Ly Reserve assets
Branch
margin
EL = PD* LGD = 1% * 45% = 0.45%

q99.9%,Retail = [
RAROC
Other liabilities
Others
Risk-sensitive loan pricing
Loan rate
Operating
cost
(PD)+ R (99.9%)
] LGD
1- R
1
0.90%1
Customer
loan rate
(1%)+ 15% (99.9%)

] 45%
1-15%
= 4.96%
Capital
Capital= q99.9%,retail EL = 4.51%
= [
0.45%
Funding
cost
Breakeven rate
Risk Capital
(CVaR)
Capitalcost = 20% 4.51% = 0.90%
1)
0.90% = 20% * 4.51%
FrankfurtSchool.de
117

Loss distribution
The capital formula step by step.
Loss probability
Expected
loss
Margin
PD LGD
q99%
Capital
Capital= [ [
Loss given default

(LGD)
Recovery
100
Uncovered
1 (PD)+ R1 (99.9%)
] - PD] LGD
1- R
1 (PD)+ R1 (99.9%)
[
] LGD
1- R
FrankfurtSchool.de
118

IRBA-formulae
1 e 35PD
1 (1 e 35PD )
+
16%
, 3% R 16%
1 e 35
1 e 35
1 ( PD) + R 1 (99.9%)
K = [[
] PD]
1 R
R = 3%
Retail,
Non-mortgage
Corporates
TAS 5
1 e 50PD
1 (1 e 50PD ) 4% (1
)
R = 12%
+
24
%
45
50
50
1 e
1 e
0
2
b = (11.852% 5.478% ln( PD))
Maturity
Adjustment
M = min(5Y , max(1Y , Duration))
K = [[
Risk weight
Required capital
Risk-weighted
assets
Total Capital Ratio
SME1
Non-SME
8%...12% R 20%...24% ,
ATS = 5m...50m
1 ( PD) + R 1 (99.9%)
1 + ( M 2.5)b
] PD] [
]
1 1.5b
1 R
RW int ernal =
LGD Re gulatory
1
K
Internal
8%
LGD
IRBA-Foundation [45%: first, 75%: subordinated, 12.5%: lien)]

IRBA-Advanced
Required capital = EaD RW int ernal 8% (Note : Standardised Approach : RW external (segment, external rating))
RWA Credit risk = 12.5 Required capital
Capital Tier 1 + Tier 2 + Tier 3
TCR =
RWA Credit risk + RWA Market risk + RWA Operational risk
1)
SME
Firms with group total annual sales (TAS) of 50 Mio. EUR are entitled to a capital relief.
Fims with TAS < 5 Mio. EUR are set to 5 Mio. EUR.
FrankfurtSchool.de
119

Basel II vs. Basel III
Counterparty credit risk (CCR):

Risk that a counterparty to a transaction defaults or is downgraded
before the final settlement of the transactions cash flows.
Basel II: Credit risk for OTC-derivatives

BaselII
RWACCR
= 12.5 * K * EaD = 12.5 * K * * EEPE
-factor accounts for

wrong-way risk (PD
increases with EaD) but in
expected terms
1 ( PD) + R * 1 (0.999)
1 + (M 2.5)b
PD *
K = LGD*
1 1.5b
1 R

1 e50PD
1 e50PD
R = 0.12*
+ 0.24* 1
50
1 e50
1
Basel II
credit risk
EEPE: effective expected positive exposure, b: maturity adjustment,

R: asset value correlation (AVC)
Main changes in Basel III to RWA calculation
1
Add downgrade risk surcharge to account for credit valuation adjustment (CVA)
2.1 Stress EEPE

2.2 Account for higher correlation by adjusting R with multiplicative factor
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120

Basel II vs. Basel III
BaselII
RWACCR
= 12.5 * K * EaD = 12.5 * K * * EEPE
1 (PD) + R * 1 (0.999)
1 + (M 2.5)b
K = LGD*
PD * 1 1.5b
1
50PD
50PD
1 e
1 e
R = 0.12
0
.
24
1
50
1 e50
1
e
Basel II
Basel III
BaselIII
RWACCR
BaselII
CCR
= RWAstressed
+12,5 cc(CVA)
= 12,5 Kstressed(R 1.25banks) EEPEstressed + 12,5 cc(CVA)

2.2
Use a multiplicative
factor for R in calculation of K
FrankfurtSchool.de
2.1 Stress EEPE for
general wrong way risk
1 Add a charge for CVA-
risk as an unexpected
loss component
121

What exactly is EEPE?
Exposure Methods ...
Revalue the instrument

under each scenario
MtM(s,t)
EE: Expected E.
EPE: Exp. Positive E.
EEE: Effective Exp.E.
EEPE: Effective Exp.
Positive E.
MtM(s,t)
time
time
Average for each time

point
Quantile for each time point
EE(t)
PFE(t)
MtM(s,t)
MtM(s,t)
time
time
EEE(t)
EPE(t)
Effective EPE(t)
Exposure
EPE
EEE
EE
Exposure
EEE
Exposure
EE
time
FrankfurtSchool.de
Effective EPE
time
time
122

All Basel III-amendments regarding counterparty credit risk.
Proposed remedies to better account for counterparty credit risk (CCR)
(A) CPPs
Current treatment
is insufficient w.r.t.:
(B) OTC
(i) Regulatory capital calculation
Micro level
MtMdowngrade risk
1
CVA risk
2
(unexpected)
Default
risk
(accounted
for
currently
by Basel II)
Model
validation
2.1
wrong-way
risk
Stressed
effective EPE
Risk weight =
2%*8%
Collateralised CCPs
Macro level
Qualitative
requirements for back
and stress testing
New Capital
charge
CVA = 0
2.2 Multiplier for asset

value correlation
R: 1.25
Tackle shortcomings
in alpha estimation
monitoring general
wrong-way risk
Improve op. perf. of
collateral dept.
Margin
period of risk
4
New guidelines for

inferred ratings and
appropriateness of
unrated positions
Reliance
on external
ratings
(ii) CCR
management
Reduce reliance on
external ratings and
code of conduct for
rating agencies
Qualitative
and stress testing
back &
stress
testing
Incentives to move from

OTC to CCP
transactions
FrankfurtSchool.de
For both, IM and SM

Only for IM
123

CVA\ Motivation1
A derivative contract can have a positive or a negative market value

Derivatives with a positive value constitute a claim to the counterparty
If the counterparty defaulted, the loss would be the replacement cost of the contract
(i.e. the current market value)
A derivative contract with a defaultable counterparty is less worthy than a contract with a risk-free
counterparty
The lower the creditworthiness of the counterparty, the lower the market value of the contract.
The value of derivative contracts decrease, if the counterparty becomes riskier (e.g. an obvious indicator
is a downgraded). Note: the value decreases even if all market parameters have not changed!
Massive (unexpected) downgrades of counterparties (like the large investment banks in 2007/09)
generate large migration losses in derivative trading books.
These losses have not been backed with capital under Basel II, but have to be backed with capital under
Basel III.
The default risk of these contracts has been covered under Basel II.
1:
More background information on CVA can be found in the appendix.
FrankfurtSchool.de
124

CVA\ CCR-capital charge covers default and migration.
Defaultable Derivatives:
Loans
Deutsche Bank
Deposits
Bank A enters into

Payerswap with DB:
Notional: 100m,
Maturity: 5Y
CDS-spread CP: 100 bp
Trading
book
Capital
CVA-Cap.
Basel III:Total capital charge Counterparty Credit Risk (CCR)

1. Counterparty default risk
(already in Basel II)2
x
Unexpected loss per 1 exposure

SA
OTC
IMM
RW(RatingExternal)1
K(PDInternal, R(PD)2)
CCP
2%
x LGD
8%
x
x
8%
+
Exposure [in ]
2. Counterparty migration
risk
Credit Value Adjustment
2.1
CEM,
SM, - CVAlosses
*EEPE2
2.33
( )2 + ( )2
2.2 ccMarket Risk-IRM(CVA(s))

0
x
2.1
Always
2.2
Only if approved VaRSpecific
1)
Derivatives are usually contracted with counterparties of the regulatory segment Corporates, Banks, Government,
2) EEPEBasel3: max(EEPEBasel2, EEPEstressed); For large banks and all unregulated financial firms: RBasel3 = 1.25*RBasel2.
FrankfurtSchool.de
125

CVA\ Default is usually far less probable than downgrades.
R(t+1)
AAA
AA
R(t)
A
BBB
BB
B
CCC
AAA
AA
BBB
BB
CCC
PD
91.23%
0.58%
0.04%
0.01%
0.02%
0.00%
0.00%
7.99%
90.21%
2.05%
0.15%
0.06%
0.05%
0.00%
0.54%
8.44%
91.47%
4.03%
0.20%
0.17%
0.25%
0.06%
0.57%
5.75%
90.18%
5.73%
0.27%
0.36%
0.08%
0.06%
0.42%
4.43%
83.74%
6.16%
1.03%
0.03%
0.09%
0.17%
0.75%
8.29%
82.49%
13.17%
0.06%
0.02%
0.02%
0.17%
0.88%
5.27%
52.52%
0.00%
0.02%
0.08%
0.28%
1.08%
5.59%
32.67%
Total capital charge Counterparty Credit Risk (CCR)

+

x
Unexpected loss per 1 exposure

SA
OTC
IMM
RW(RatingExternal)1
K(PDInternal, R(PD))
CCP
1)
2%
x LGD
8%
x
x
8%
Exposure [in ]
risk
Credit Value Adjustment
2.1
CEM,
SM, - CVAlosses
*EEPE
2.33
( )2 + ( )2
2.2 ccMarket Risk-IRM(CVA(s))

0
Derivatives are usually contracted with counterparties of the regulatory segment Corporates, Banks, Government
FrankfurtSchool.de
126

CVA\ Downgrade losses substantially exceeded default losses.
Deutsche Bank
Bank A enters into
Payerswap with DB:
Notional: 100m,
Maturity: 5Y
CDS-spread CP: 100
bp
Loans
Deposits
Trading
book
Capital
CVA-Cap.

risk
Mark-to-market losses due to credit valuation adjustments (CVA) were not directly capitalised. Roughly
two-thirds of CCR losses were due to CVA losses and only one-third were due to actual defaults.
(BCBS, 2009)
1)
FrankfurtSchool.de
127

CVA\ CCRBasel3 -Example using Standardised Approach
Loans
Deposits
Notional: 100m,
MtM: 5, Maturity: 5Y
Interest
rate swap 1
Deutsche Bank,
Rating: A+
Interest
rate swap 2
Capital
OA

+
OTC
SA
RW(RatingExternal)
8%
CEM
50%
8%
5 + 100 * 0.5%
Banks, risk-weight (rating):
1)
risk
2.33
( )2 + ( )2
0.22 m
Add-on
FrankfurtSchool.de
128

Loans
Notional: 100m,
MtM: 5, Maturity: 5Y
Interest
rate swap 1
Deutsche Bank,
Rating: A+
OA
Deposits
Interest
rate swap 2
Capital
OTC
SA
1. Counterparty
default risk
0.22 m
2. Counterparty migration risk

2.1
2.33
(0.5 0.8% 2.5 5.5)2 + 0.75 (0.8% 2.5 5.5)2

0.26 m
wi (external Rating), Mi: effective maturity, Bi : notional,

hedge: individual hedge, ind: index hedge
FrankfurtSchool.de
Rating
w_l
...
...
0.8%
...
...
129


2.1
2.33
(0.5 0.8% 2.5 5.5)2 + 0.75 (0.8% 2.5 5.5)2

Bank A
...
Interest
rate swap 1
CP = A+
...
Capital
MtM = 5
0.22
0.26
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130

CVA\ Standardized Approach\ Details
value ~ N()
=>
CVA ~ N (0,
2.1
2.33
(0.5 0.8% 2.5 5.5)2 + 0.75 (0.8% 2.5 5.5)2
1 (CVA-changes, 84%quantile)
2.33 (99%-quantile)
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131

CVA\ Internal model\ Details
Internal CVA-capital
model only
internal
model for specific market
risk

2.2
ccMarket Risk-IRM(CVA(s))
VaR for zerobond with Notional = EaD, Issuer = counterparty, Maturity taken from longest unhedged derivative
Only risk factor: spread evolution (must be taken from VaR-model)
CVA-cc = cc(VaRnormal,general + VaRnormal,specific VaRstressed,general + VaRstressed,specific + 0*IRM)
Extremely high burdens for advanced CVA formula Bundesverband Deutscher Banken estimates that at most
two banks in Germany will apply the CVA advanced formula
FrankfurtSchool.de
132

Source: Michael Pykhtin and Steven Zhu

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133
Credit Default Swaps

A credit default swap is a bilateral contract (documented as a swap using a
confirmation under an ISDA Master Agreement) in which the Protection
Seller receives a fixed premium vs agreeing to pay a contingent floating
payment to the Protection Buyer if a Reference Entity suffers a Credit Event
and the credit default swap is triggered
Cash Flows before Credit Event
250
Protection Buyer
(Short Credit
Risk)
Quarterly Fixed CDS

Premium
Protection Seller
(Long Credit
Risk)
200
150
100
Protection Buyer
(Short Credit
Risk)
Fixed CDS Premium

Stops
Deliverable
Obligation
Notional Amount
Protection Seller
(Long Credit
Risk)
50
0
M rz . 0 6
M a i. 0 6
J u l. 0 6
S ep. 06
N ov. 06
Jan. 07
M rz . 0 7
M a i. 0 7
J u l. 0 7
S ep. 07
N ov. 07
Jan. 08
M rz . 0 8
M a i. 0 8
J u l. 0 8
S ep. 08
N ov. 08
Jan. 09
M rz . 0 9
M a i. 0 9
J u l. 0 9
S ep. 09
N ov. 09
Jan. 10
M rz . 1 0
M a i. 1 0
J u l. 1 0
S ep. 10
N ov. 10
Cash Flows if triggered following Credit Event*
Itraxx Serie 9
FrankfurtSchool.de
134

European CDS Spreads (2005-2011)
800
700
600
500
400
300
200
100
0
2005
2006
Autos
Industrial
FrankfurtSchool.de
2007
Construction
2008
Energy
2009
TMT
Financials Senior
2010
2011
Financials Subordinated
135
FrankfurtSchool.de
136
Credit Default swaps: The network perspective

June 2008: Notional amount of single name credit default swaps = 38 trillion
USD
Dealer to dealer network: the 15 largest CDS dealers represent an almost
complete network representing 61 % in terms of outstanding CDS notional
Default of a firm on which a lot of CDS protection has been sold can strongly
affect exposures across the network.
Measuring Systemic Risk: insights from

network analysis (Rama Cont)
(Blue: Counterparty relations. Red:
counterparty CDS exposures resulting
from the default of a large name)
FrankfurtSchool.de
137

FrankfurtSchool.de
138

Assume a 1y bond priced at par is insured by a CDS contract with spread s.

The recovery rate of the bond in the case of a default is R and its Probability of
Default is PD
The expected pay-off of the CDS contract in the case of a default is
(1-R)*PD
The upfront spread of the CDS contract should be equal to the expected pay-off
S = (1-R)*PD
Implied Default Probability :
sCDS
PD
1 R
FrankfurtSchool.de
sCDS = 240bps
R = 40%
2,40%
= 4%
PD =
1 40%
139

Example: Exposure Profile of an Interest-Rate Swap (Source: Michael Pykhtin and Steven Zhu)
CVA-Charge:
(LGDmarket is the loss given default of the counterparty, EEi is the expected
exposure of the counterparty at time ti , Di is the default risk-free discount
factor at time ti .
FrankfurtSchool.de
140

CVA\ Summary: Credit AND market risk in a trading book.
Bank A
Deutsche Bank
Debt
Bank A enters into

Payerswap with DB:
Notional: 100m,
MTM: 5y, Maturity: 5Y
CDS-spread CP: 100
bp
1. Market risk
(instrument pricing
with risk-free
counterparty/ no credit
spread of counterparty
!!)
Trading
book
Capital
5
MtM(r5y, constant csCounterparty)
MtM
Maturity
MtM
5Y
MtM(constant r5y, csCounterparty)
3. Pillar1 - Capital Ratio

=
CVA
CVAVaR99%,10d
99%
Capital T1+T2
12.5*(VaRCVA + K + VaRMR + VaROpR)
Maturity
10d
FrankfurtSchool.de
K = N(0,PDCP)
*LGD
**EEPE
2.1
Counterparty
default risk
MR-VaR99%,10d
99%
10d
2.2 CVA-risk
(no credit spread of
counterparty !!,
CVA-VaR:
stand.&stress
VaRgen&spec, 0*IRM)
5Y
141

(A) CPPs
Current treatment
(B) OTC
Micro level
MtMdowngrade risk
1
CVA risk
2
(unexpected)
Default
risk
(accounted
for
currently
by Basel II)
Model
validation
2.1
wrong-way
risk
Stressed
effective EPE
Risk weight =
2%*8%
Collateralised CCPs
Macro level
Qualitative
and stress testing
New Capital
charge
CVA = 0

value correlation
R: 1.25
Tackle shortcomings
in alpha estimation
monitoring general
wrong-way risk
collateral dept.
Margin
period of risk
4
New guidelines for

appropriateness of
unrated positions
Reliance
on external
ratings
(ii) CCR
management
Reduce reliance on
code of conduct for
rating agencies
Qualitative
and stress testing
back &
stress
testing

OTC to CCP
transactions
FrankfurtSchool.de
For both, IM and SM

Only for IM
142

Wrong-way risk (PD(EaD))
Wrong-way risk
Positive correlation between EaD and PD
to a given counterparty.
specific: Typically arises from
poorly constructed transactions.
E.g.: bank holds long a put option
on shares of a counterparty that
provides own shares as collateral.
general: PD of counterparty is
positively correlated with market risk
factors.
100
%
PD
EaD
0%
default
Current Basel II approach to wrong-way risk

CCRBaselII = K * EaD = K * * EEPE
FrankfurtSchool.de
-factor to account for

wrong-way risk
143

Wrong-way risk (PD(EaD))
Basel III approach to wrong-way risk

general wrong-way risk: NO EXPLICIT CAPITAL CHARGE but
Micro level
Stressed
effective expected positive
exposure
2.1
2.2
Macro level
CCR management / Op risk
Asset value
correlation multiplier
tackle shortcomings in factor estimation
R [0.12;0.24]
EEPE
Stress
scenario
*1.25
EEPEstressed
R [0.15;0.30]
specific wrong-way risk:

Implement
methodology to
identify specific
wrong-way risks
FrankfurtSchool.de
Identify
specific
wrong-way
risk for a
transaction
EaD = * EEPE
if CDS
Notional
EaD =
MtM|default if EQ - deriv.
144

Stressed effective expected positive exposure (EEPE)
Does not account for wrong-way risk
Shortcomings
of EEPE
Is not appropriately estimated in periods of stress
2.1
Stressed EEPE (EEPEstressed)

effective expected positive exposure (EEPE):
EEPE:=
tk
,
EEE
tk
t k 1 yr
where effective expected exposure (EEE):

where EE denotes the expected exposure.
stressed EEPE:
Define 3yr period including

1yr stress period used for
stressed VaR (Market Risk
Revisions)
, )
EEEtk := MAXt tk (EE
t
EEPE:
Calibrate EEPE
parameters to this
period
Revised EaD calculation:
EaD = * MAX(EEPEstressed; EEPEcurrentdata )
FrankfurtSchool.de
145

Stressed correlation (R) multiplier for critical counterparties.
2.2
Basel II correlation calculation:

1 e50PD
1 e50PD
R = 0.12
+ 0.241
1 e50
1 e50
Basel II
correlation
Observation:
R(financial firms)
Proposed
changes
Correlation (R) ranges from 12% to 24%
1.25
Multiplicative factor of 1.25 to R for exposures to financial intermediaries that are

regulated banks, brokers/dealers, insurance companies with assets of at least
USD25 billion
unregulated generating majority of revenues from financial activities
(e.g. hedge funds)
Comment
FrankfurtSchool.de
If a counterparty has low PD and, hence, high R, capital requirements can

increases by about 35%
Interbank lending becomes quite expensive, punishing good intermediaries
146

Example: Stressed correlation (R) for critical counterparties.
BaselII
RWACCR
BaselII
Interbank lending market
Relative capital increase
CCR
RWAnew
1+ (M 2.5)b
* * EEPE
1 1.5b
1 + (M 2.5)b
* * EEPEstressed
= 12,5 * LGD*[(1.25* R( PD)) PD]*
1 1.5b
= 12,5 * LGD*[(R( PD)) PD]*
PD
AAA to BB-
FrankfurtSchool.de
PD
0,01%
0,02%
0,03%
0,04%
16,71%
16,72%
16,73%
16,74%
R 1,25*R
23,9% 29,9%
23,9% 29,9%
23,8% 29,8%
23,8% 29,7%
12,0% 15,0%
12,0% 15,0%
12,0% 15,0%
12,0% 15,0%
Relative
capital
increase
35,714%
36,074%
36,088%
36,001%
14,444%
14,441%
14,438%
14,435%
B+ to CCC
147

(A) CPPs
Current treatment
(B) OTC
Micro level
MtMdowngrade risk
1
CVA risk
2
(unexpected)
Default
risk
(accounted
for
currently
by Basel II)
Model
validation
2.1
wrong-way
risk
Stressed
effective EPE
Risk weight =
2%*8%
Collateralised CCPs
Macro level
Qualitative
and stress testing
New Capital
charge
CVA = 0

value correlation
R: 1.25
Tackle shortcomings
in alpha estimation
monitoring general
wrong-way risk
collateral dept.
Margin
period of risk
4
New guidelines for

appropriateness of
unrated positions
Reliance
on external
ratings
(ii) CCR
management
Reduce reliance on
code of conduct for
rating agencies
Qualitative
and stress testing
back &
stress
testing

OTC to CCP
transactions
FrankfurtSchool.de
For both, IM and SM

Only for IM
148

Collateralized CPs fundamentals of margin period of risk.
Margin agreement: Contractual agreement that a counterparty posts collateral when its
exposure exceeds a specified level
Basic
definitions
Margin threshold: largest amount of exposure that remains outstanding until one party
has the right to call for collateral
Margin period of risk: delay between a margin call that a counterparty does not respond
to and the start of closing out that counterparty (default procedures)
Margin agreements reduce CCR but pose significant challenges to modelers as future
collateral amounts and margin calls ought to be modeled
Observations
Low margin periods of risk according to Basel II caused precipitated defaults and EaD
might be underestimated
FrankfurtSchool.de
149

Collateralized CPs fundamentals of margin period of risk.
Proposed floors for margin period of risk (MPR)
floor
New
Basel II
correlation
MPRMin
Transaction type
5 days
Repo-style
10 days
Other CM-transactions
20 days
Secured lending,
20 days
Large netting setts1

Illiquid positions2
Condition
Daily
remargining
Daily revaluation
If more than 2 margin call disputes

in that netting set in last quarter
2*floor
How does MPR enter the capital calculation?

Basel III
RWACCR
= 12,5 Kstressed( R 1.25banks) EEPEstressed + 12,5 cc(CVA)

Should be calculated with margining
Banks that can calculate EEPE without margining, but not with margining,
need to proxy EEPE with margining:3
With margining
Withoutmarginagreement
EEPEstressed
= max(Marginthreshold+ PE(0,MPR);EEPEstressed
)
1)
Large netting sets

5,000 trades at any point during a quarter
positions
one or more trades with either (i) illiquid collateral or (ii) illiquid OTC-derivate (that cannot be easily replaced)
3) PE: expected increase in the netting sets exposure beginning from current exposure of zero over the margin period of risk.
2) Illiquid
FrankfurtSchool.de
150

(A) CPPs
Current treatment
(B) OTC
(ii) CCR
management

Micro level
Macro level
MtMdowngrade risk
1
CVA risk
(unexpected)
Default
risk
(accounted
for
currently
by Basel II)
Model
validation
New Capital
charge
CVA = 0
2.1
wrong-way
risk
Stressed
effective EPE
Risk weight =
2%*8%
Collateralised CCPs
Qualitative
and stress testing
value correlation
R: 1.25
Tackle shortcomings
in alpha estimation

collateral dept.
Margin
period of risk
4
New guidelines for

appropriateness of
unrated positions
Reliance
on external
ratings
monitoring general
wrong-way risk
Reduce reliance on
code of conduct for
rating agencies
Qualitative
and stress testing
back &
stress
testing

OTC to CCP
transactions
FrankfurtSchool.de
For both, IM and SM

Only for IM
151

Reduced reliance on external ratings.
No understanding of risks inherent in rated instruments, in particular

securitisations
Negative incentives induced by external ratings
Objectives
towards usage
of external
ratings
banks neglect own independent internal assessment

production of good ratings by external rating agencies
cliff effects in capital requirements as external ratings are discrete
Bank prefers
PD instrument
at this side
of the cliff.
over
instrument
here!
true PD (internally
assessed)
regulatory
PD
cliffs
true
risk
FrankfurtSchool.de
152

Reduced reliance on external ratings.
Committee will review the ratings-based approaches to securitisations and

reconsider/recalibrate the supervisory formula not depending on external
ratings.
Standardised inferred rating: an unrated exposure would only have an

inferred rating from low-quality issue specific or issuer ratings that rank pari
passu or senior to the unrated exposure.
Proposed
revisions
Assessing external ratings and unrated exposures: require banks to

assess whether the risk weight assigned to an exposure is appropriate. In
particular banks might prefer exposures likely to have a low rating to be left
unrated under the current Basel II approach, as a low rating has higher risk
weights than a non-rating
Code of conduct: IOSCO Code of Conduct Fundamentals for Credit Rating

Agencies to be applied
FrankfurtSchool.de
153
Thank You and Merry Christmas !!!
FrankfurtSchool.de
154

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Market Risk Part I

2014, Frankfurt am Main

The faboulus Fab

and his famous transaction

and the leveraged financial system

The Gordon Gekko perspective on things..

Source: BIS-Working Paper No. 251

But MtM of ABCB

and the response of regulators

and the response of regulators

Overview about relevant national and international regulatory requirements

Overview of regulatory requirements

Parliament (time consuming)

EBA ITS/ BTA

German Banking Act (KWG)

German Banking Regulation

Finance Ministry (FM)

1) BCBS : Basel Committee On Banking Supervision

Overview of regulatory requirements

Parliament (time consuming)

German Banking Act (KWG)

EBA ITS/ BTA

German Banking Regulation

Notification Requirements on internal risk

Finance Ministry (FM)

1) BCBS : Basel Committee On Banking Supervision

Overview of regulatory requirements

Overview of regulatory requirements

Mandatory CCP-clearing for (1) standardized derivatives AND

New revenues: offering

IFRS-banks, group level:

Separation of margin and

Process: Integrate Solvency

Overview of regulatory requirements

30.6.2014 (quarterly reports)

Will upward shift senior

Overview of regulatory requirements

Low risk assets in trading

VM: 1.1.2015, IM: 1.12.2015-19 (different asset classes)

Regulatory affairs becomes

2. Overview of regulatory requirements

Lowered on political agenda

---(as based on survey of large

Setup, submit and review

Overview of regulatory requirements

Need NSFR & LCR forecast

Overview of regulatory requirements

Overview of regulatory requirements

Capital relief compared to

Overview of regulatory requirements

More capital required

Overview of regulatory requirements

Affects all banks (also IRBA)

Overview of regulatory requirements

Development of internal rating

Overview of regulatory requirements

Higher capital charge under

Objectives and Structure of CRR/ CAD IV (Basel III)

Objectives and Structure of CRR/ CAD IV (Basel III)

CPs, TB, BB,

As of November 16th, 2013,

Overview about relevant national and international regulatory requirements