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Outline what the 1995 and 1996 amendments brought in, namely rules on netting credit exposures and ways to compute market risk capital for trading book assets.

FRM® Part II · Operational Risk and Resilience · Capital Regulation Before the Global Financial Crisis · FRM2.ORR.21.c

The idea

The 1995 amendment recognized netting. Where a legally enforceable netting agreement exists, the credit exposure to a counterparty is the net current value, floored at zero, plus a reduced add-on. The reduced add-on uses the net replacement ratio, written NRR, and the gross add-on, written Agross. Anet = 0.4 × Agross + 0.6 × NRR × Agross. NRR is net current exposure divided by the sum of the positive contract values. If NRR is 1 there is no add-on relief. If it is 0 the add-on falls to 40 percent of Agross. The 1996 amendment, effective 1998, added market risk capital for the trading book. Under the internal models approach capital is the larger of two amounts, plus a specific risk charge. One is the previous day's 10-day 99 percent VaR. The other is a multiplier (at least 3, raised by backtesting exceptions) times the 60-day average VaR. Market risk capital is converted to RWA by multiplying by 12.5.

Formulas

Net add-on under the 1995 netting amendment

Anet = 0.4 × Agross + 0.6 × NRR × Agross

Agross
the gross add-on from notionals and maturities
NRR
the net replacement ratio, net current exposure ÷ sum of positive contract values

With an enforceable netting agreement. At NRR of 1 there is no relief; at 0 the add-on falls to 40 percent of Agross.

Market risk capital under the 1996 internal models approach

MRC = max(VaR, k × VaRavg) + SRC

VaR
the previous day's 10-day 99 percent VaR
k
the multiplier, at least 3, raised by backtesting exceptions
VaRavg
the average VaR over the previous 60 days
SRC
the specific risk charge

The multiplier applies to the average, not to the latest day. Multiply MRC by 12.5 to turn it into RWA.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which change to credit-risk capital did the 1995 amendment to the Basel Accord introduce?

  1. A VaR-based capital charge for market risk in trading book positionsWhy not: The VaR-based market risk charge came with the 1996 amendment.
  2. A new explicit capital charge for operational riskWhy not: Operational risk was first charged in Basel II, in 2004.
  3. Recognition of netting of credit exposures with a counterparty under legally enforceable netting agreements - correct
  4. Supervisory review of banks' internal capital assessmentsWhy not: Supervisory review is Pillar 2 of Basel II, not part of the 1995 amendment.

The 1995 amendment let banks net positive and negative derivative values with the same counterparty, subject to enforceable netting contracts, reducing credit exposure and capital. Market risk capital followed in 1996.

A harder one

A bank's credit risk-weighted assets are USD 400 million and its market risk capital charge, computed under the 1996 amendment, is USD 20 million. Total minimum capital at 8 percent of credit RWA plus 12.5 times the market risk charge is closest to:

  1. USD 33.6 millionWhy not: Adds the USD 20 million charge to RWA directly; the capital charge must be multiplied by 12.5 to become RWA.
  2. USD 52.0 million - correct
  3. USD 32.0 millionWhy not: Covers credit RWA only and leaves out market risk capital.
  4. USD 282.0 millionWhy not: Adds 12.5 x 20 = 250 of RWA to 32 of capital, mixing an RWA figure with a capital figure.

RWA = 400 + 12.5 x 20 = 650. Capital = 8% x 650 = 52.0, which equals 32 for credit plus the 20 market risk charge itself.

The hardest tier

A bank has three derivatives with an OECD bank counterparty under a legally enforceable netting agreement. Current values are +30, -10 and -5 (USD million). The gross add-on, from notional and maturity, is 8. Using the 1995 netting formula and a 20 percent counterparty risk weight, minimum capital at 8 percent is closest to:

  1. USD 0.608 millionWhy not: Ignores netting entirely: positive value of 30 plus the full add-on of 8.
  2. USD 0.368 millionWhy not: Nets the current exposure but keeps the full gross add-on instead of the reduced add-on.
  3. USD 0.330 million - correct
  4. USD 0.278 millionWhy not: Leaves out the 0.4 x A_gross floor term in the add-on formula.

Net current exposure = 30 - 10 - 5 = 15. NRR = 15/30 = 0.5. A_net = 0.4x8 + 0.6x0.5x8 = 5.6. Credit equivalent = 20.6. Capital = 8% x 20% x 20.6 = 0.330.

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