Summarise how the December 2017 revisions changed Basel III for credit risk (standardized and IRB approaches), the CVA risk framework, operational risk and the leverage ratio.

FRM® Part II · Operational Risk and Resilience · High-level summary of Basel III reforms · FRM2.ORR.23.b

The idea

The 2017 revisions changed five areas. For credit risk under the standardised approach, there are more granular risk weights, loan-to-value based weights for real estate, a due diligence requirement for external ratings and an alternative for unrated banks and corporates. For credit risk under the IRB approach, advanced IRB is removed for large corporates (revenue above EUR 500 million), banks and other financial institutions. IRB is also removed for equities, and floors apply to PD, LGD and EAD inputs. For CVA risk, the internal model approach is withdrawn, leaving the basic approach (BA-CVA) and the standardised approach (SA-CVA). For operational risk, the basic, standardised and advanced measurement approaches are replaced by one standardised approach built from the business indicator component (BIC) and the internal loss multiplier (ILM). Capital = BIC × ILM. For the leverage ratio, the exposure measure is refined and G-SIBs face a buffer equal to 50% of their risk-based surcharge. Remember that internal models are curtailed, not abolished.

Formulas

G-SIB leverage ratio requirement

Requirement = 3% + 0.5 × S

S: the G-SIB risk-based surcharge

Multiply by the leverage exposure measure for the Tier 1 amount needed.

Operational risk capital under the revised standardised approach

ORC = BIC × ILM

BIC: the business indicator component
ILM: the internal loss multiplier

Replaces the basic, standardised and advanced measurement approaches. RWA is 12.5 times this figure.

A practice question

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

Under the December 2017 revisions, how many approaches are available for operational risk capital?

Three: the basic indicator, standardised and advanced measurement approaches, now with new floors.Why not: The earlier approaches are withdrawn rather than retained with floors.
Two: the new standardised approach, plus the advanced measurement approach for the largest banks.Why not: The advanced measurement approach is abolished for all banks.
One: a standardised approach based on a business indicator and the bank's own loss history. - correct
Two: the basic indicator approach for banks with a business indicator under EUR 1 billion and a standardised approach above that.Why not: The basic indicator approach is also replaced; small banks use the same standardised approach.

The BIA, TSA/ASA and AMA are all replaced by a single standardised approach: operational risk capital = business indicator component x internal loss multiplier.

A harder one

In the revised standardised approach, residential real estate loans not materially dependent on property cash flows use LTV-based risk weights: up to 50 percent LTV 20 percent, 50 to 60 percent 25 percent, 60 to 80 percent 30 percent, 80 to 90 percent 40 percent, 90 to 100 percent 50 percent, above 100 percent 70 percent. A bank lends EUR 600,000 against a property valued at EUR 800,000. The RWA is closest to:

EUR 120,000Why not: Applies the 20 percent weight for LTV up to 50 percent, but the LTV is 75 percent.
EUR 210,000Why not: Uses the flat 35 percent Basel II weight rather than the LTV-based table.
EUR 240,000Why not: Uses the 40 percent weight for the 80 to 90 percent band, but the LTV is only 75 percent.
EUR 180,000 - correct

LTV = 600,000 / 800,000 = 75 percent, in the 60 to 80 percent band with a 30 percent weight. RWA = 600,000 x 0.30 = 180,000.

The hardest tier

A bank has a business indicator (BI) of EUR 8,000 million. The business indicator component uses marginal coefficients of 12 percent up to EUR 1,000 million and 15 percent above that. Average annual operational risk losses over ten years are EUR 40 million, the loss component is 15 x that average, and ILM = ln(e - 1 + (LC / BIC)^0.8). Operational risk capital is closest to:

EUR 801 millionWhy not: Applies a flat 12 percent to the whole BI, then multiplies by the ILM.
EUR 939 millionWhy not: Omits the 0.8 exponent in the ILM: ln(e - 1 + LC/BIC).
EUR 977 million - correct
EUR 1,170 millionWhy not: Sets ILM = 1, ignoring the bank's loss history; ILM = 1 applies only at national discretion to banks with BI up to EUR 1 billion.

BIC = 1,000 x 12% + 7,000 x 15% = 1,170. LC = 15 x 40 = 600; LC/BIC = 0.513; ILM = ln(1.718 + 0.513^0.8) = 0.835. Capital = 1,170 x 0.835 = about 977 million.

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