Economic Capital Allocation with Basel II

Cost, Benefit and Implementation Procedures


  • Dimitris Chorafas, Independent Finance Consultant, France

This book is a complimentary follow-on book to Operational Risk Control with Basel II. While the previous book focuses on operational risk, Economic Capital Allocation provides an overview of credit risk within the context of the Basel II accords.The book provides:* comprehensive coverage of the evolution of the banking industry with Basel II in mind* extensive information on the capital requirements for bank liquidity and solvency * coverage of the new rules as laid down by the supervisory authorities of the Group of Ten industrialized nations* key information on the technical requirements for credit institutions such as: new credit rating scales, modeling of credit risk, control of operational risks, and, novel ways and means for the management of exposure to Credit Risk
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Senior Bankers; Chief Executive Officers; Chief Financial Officers; Treasury Executives; Chief Risk Officers; Heads of Economic Capital organizations; and Chief Information Officers.


Book information

  • Published: February 2004
  • ISBN: 978-0-7506-6182-9


...not only provides a good introduction to the regulatory background, but also shows how economic capital and regulatory capital are concepts that should co-exist and gives good explanations to the background of each. One of the Top Ten financial engineering titles published in 2003-2004 - Richard Norgate, Ph.D., Financial Engineering News

Table of Contents

COMMERCIAL BANKS AND THE NEW REGULATION:BASLE II, IMPACT STUDIES, AND COST OF IMPLEMENTATION; Introduction; The Three Pillars of Basel II; A Birdseye View of Standardized, Foundation IRB, and Advanced IRB Methods; Quantitative Impact Studies and Capital Adequacy; Examples on the Sophistication of the A-IRB Method; The Cost of Basel II; Business Risk and Cost Control; BENEFITS FROM BASEL II: RISK-BASED PRICING AND RATING TARGETS; Introduction; Risk-Based Pricing- A Major Benefit from Basel II; Targeting "AA" and "AAA" by Rating Agencies; Which Way Basel II Will Affect Credit Institutions?; Benefits on the Road from Basel I to Basel II; Basel II Objectives and the Effects of Leverage; The Need for a Devil's Advocate in Risk Management;REGULATORY CAPITAL DEFINED; Introduction; The Role of Regulatory Capital; Two Components of Regulatory Capital: T-1 and HT-1; Beyond Tier 1: The Tier 2 and Tier 3 Regulatory Capital; Pricing Assets in Tier 1 and Tier 2 Capital; Accounting for Risks Assumed with Lending; Provisioning for Bad Loans Under the New Framework; MARKET DISCIPLINE AND ITS GLOBAL IMPACT; Introduction; Market Discipline and Enhanced Financial Disclosure; Qualitative and Quantitative Information in Financial Reporting; Credit Ratings Are a Tool of Market Discipline; Important Notions About Risk Grades and Rating Systems; Market Discipline and Management of Default Risk; The Ultimate Test of Any Business Operation Is Its Ability to Predict Its own Outcome; THE ALLOCATION OF ECONOMIC CAPITAL TO BUSINESS UNITS: ECONOMIC CAPITAL DEFINED; Introduction; A Close Look at Economic Capital; Emphasizing the Total Economic Equity; Economic Capital, Contingent Assets and Contingent Liabilities; Economic Capital and Management Accounting; The Synergy Between Economic Capital and Risk Management; Economic Capital and the Impact of Default Models; ECONOMIC CAPITAL AND SOLVENCY MANAGEMENT; Introduction; Practical Examples with Basel II Implementation; Economic Capital and an Institution's Solvency; Solvency and the Regulation of Insurance Companies; A Practical Look at Position Risk; Stress Testing Risk Positions; ECONOMIC CAPITAL ALLOCATION- PRACTICAL APPLICATIONS AND THEORETICAL BACKGROUND; Introduction; Role of the Corporate Center in Economic Capital Allocation; Top-Down and Bottom-Up Identification of Economic Capital Requirements; Economic Capital Allocation at Rabobank, Credit Suisse, Deutsche Bank; Citibank's Adjustment Factor- An Example with Operational Risk; Developing a Theoretical Framework for Capital Allocation; An Algorithmic Solution for Unexpected Losses by the Deutsche Bundesbank; EVOLVING RULES AND PROCEDURES FOR ECONOMIC CAPTIAL ALLOCATION; Introduction; Corporate Focus on Economic Capital Allocation; Reallife Examples with Economic Capital Allocation to Business Units; First Order and Second Order Risks; Learning a Lesson from Physical Sciences; The Issue of Procyclicality and Its Impact on Economic Capital; STRATEGIES USED BY BANKS TO INCREASE THEIR CAPITAL BASE; Introduction; The Modigliani-Miller Hypothesis on Equity vs. Debt; Leverage Propels the Probability of Default to New Heights; Economic Capital Increases Should Only Be Done in a Responsible Way; Diversification in the Banking Business is Often Wanting; Capital Arbitrage Through Securitization; Statistics on Securitized Corporate Debt and Other Instruments; DEFAULTS, INTERNAL RATINGS AND TECHNOLOGICAL SOLUTIONS: DEFAULT DEFINED; Introduction; Default Milestones; Definition of Default Point; Contribution of Default Point to Credit Risk Strategy; Credit Risk Information Can Be Painful News; Expected Default Frequency and the Database; IRB, TECHNOLOGICAL INFRASTRUCTURE, MODELS AND CORRELATIONS; Introduction; IRB and the Technology Needed by Credit Institutions; 21st Century Real-time and Realspace in the Banking Industry; Requirements for Efficient IRB Modeling; Management Must be Careful with Models and Statistics; The Calculation and Evaluation of Correlation Coefficients; Beware of Magnitude of Risk with Correlated Exposures; INTERNAL RATINGS, SUPERVISORY WEIGHTS AND COLLATERAL; Introduction; The Volatility of Capital Reserves and Basel II; Meeting the Prerequisites of Layers of Supervision; Problems and Opportunities Associated to Risk Weights; A Case Study with Small and Medium Enterprises; Risk Weights with Standardized and IRB Methods; The Handling of Collateral; Remargining Collateral, Credit Derivatives, and Special Vehicles; SOFTWARE WHICH CAN HELP IN IRB IMPLEMENTATION; Introduction; Mapping the Analysis of Bankruptcy Patterns into the Computer; Marking to Model the Loans Portfolio, RAROC and LAS; Moody's KMV Family of Models; Economic Capital Allocation Using Moody's KMV Portfolio Manager; Sharpe Ratio- Its Usage and Misusage; Implementing the Best Capital Adequacy Ratio (BCAR); HOW TO BE IN CHARGE OF IRB; Introduction; The Risk of Misinterpretation of Financial Information; Management Quality and the Rating System by Goldman Sachs; Management's Appreciation of Unexpected Losses; Legal Risk in a Globalized Economy and Bankruptcy Laws; Longer Term Liability and Legal Risk; Ratings Agencies, Legal Risk, and Other Risks;REGULATORY AND POLITICAL ISSUES TEND TO BE INDIVISIBLE: SUPERVISORY AUTHORITIES AND THEIR REGULATORY POLICIES; Introduction; Broader Context of Basel II and Its Implementation; The Need to Expand the Supervisors' Power of Action; Core Principles, Financial Stability Forum, and Committee on the Global Financial System; Group of Seven, Group of Ten, and Group of Twenty; Memoranda of Understanding Concerning Offshores and Bankruptcies; Globalization, Wealth of Nations, and the Financial Industry.