Week 1: Introduction

Week 1: Introduction

“Introduction … Credit Risk … Basel II … Basel III”
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Summaries

  • Week 1: Introduction > Lesson 1: Credit Risk > Video Lesson
  • Week 1: Introduction > Lesson 2: Basel II > Video Lesson
  • Week 1: Introduction > Lesson 3: Basel III > Video Lesson
  • Week 1: Introduction > Summary > Video
  • Week 1: Introduction > The Sofa > The Sofa Session

Week 1: Introduction > Lesson 1: Credit Risk > Video Lesson

  • Today, we can officially start our “An Introduction to Credit Risk Management” Mooc.
  • Today we will start our course with the most important definition of the entire course, with the object of the course, that is to say: what is credit risk? And I will tell you a secret.
  • Many “experts” out there do not really know the right definition of credit risk.
  • Let’s start! Credit risk is one of the fundamental risks for banks and companies, together with market risk and operational risk.
  • A good definition of credit risk is the following: “Credit risk is the risk that the value of our portfolio varies, because of the unexpected changes in the credit quality of trading partners or issuers.
  • ” Therefore credit risk can be divided into two sub-risks.
  • From one side, we have default risk; from the other, the so-called credit deterioration.
  • Most people forget this second source of risk, and they typically reduce credit risk to default risk.
  • Default risk is the risk of losing money because of the default of our counterparty.
  • For now, we can say that a change in the credit quality of a counterparty may have a direct and an indirect influence on credit risk.
  • If a AAA bond is downgraded to BBB, this implies that the bond is becoming much riskier, and it also have effects on a series of quantities and measures we may have to compute as risk managers.
  • In order to do that in the right way, we have to contextualize credit risk within the framework of the so-called Basel accords.

Week 1: Introduction > Lesson 2: Basel II > Video Lesson

  • If you are interested in risk management, and in credit risk management, and you are a bank or a major financial institution, it’s very important that you know what these agreements imply in terms of risk management.
  • The most important Basel Accords are Basel II and Basel III, and we will consider both of them.
  • Basel III can be just seen as a modification of Basel II. To explain the most important characteristics of Basel II, we will use top-level technologies.
  • In 1988 the Basel Committee on Banking Supervision in Basel, Switzerland, published a first set of minimum capital requirements for banks.
  • Economic capital is the optimal estimate of required capital that financial institutions use internally to manage and cover their own risks, while capital requirements are the mandatory capital to be maintained as required by the regulator.
  • Over the years it became clear that Basel I was not sufficient to efficiently regulate the banking and financial sectors, especially because of the ever-increasing complexity of both sectors.
  • In 1999, the Basel Committee on Banking Supervision released Basel II, a second set of rules, later revised in 2001, 2003, 2004 and 2005.
  • Basel II was a great leap forward, and it is still the backbone of international bank regulations, even after Basel III.
  • We will see that Basel III only amends Basel II, but it is not a dramatic innovation, as Basel II was for Basel I. Ok, after all that blah blah blah, look at the picture in front of you.
  • It essentially defines the detailed capital requirements for the three major components of risk that a bank faces according to the Basel Committee: market risk, credit risk and operational risk.
  • Credit Risk? Yes, here it is… We will be back in a few minutes.
  • The aim of this pillar is to define a frame- work for dealing with other types of risks: systemic risk, pension risk, concentration risk, strategic risk, liquidity risk and so on.
  • The second pillar also contains rules and suggestions for the revision of the risk management systems of banks and financial institutions.
  • In this course we are interested in credit risk, hence we focus our attention on the first pillar only.
  • As we have just said, the first pillar contains the minimum capital requirements for the most important risks a bank can face in its business life.
  • Market risk is easily defined as the risk of losses arising from movements in market prices and other market quantities.
  • Basel II presents a set of tools and techniques that can be used to model and manage market risk, for example Value-at-Risk.
  • Value-at-Risk is also used in credit risk, and we will learn how to use it in Week 3.
  • It is the risk linked to default risk and credit deterioration.
  • One could argue that credit risk is really bank-specific, but we will see that, in reality, it is really pervasive in our economies.
  • It is defined as the risk deriving from the internal and external activities of a bank or a another financial institution.
  • It includes the risk of fraud, people risk, cyber risk, terrorism, calamities, and so on.
  • It is a very difficult risk to model, and it has been first introduced in Basel II. Market risk and credit risk were already present in Basel I, even if with simplistic definitions and rules.
  • Again, the course is about credit risk management, so you can imagine what we will do.
  • Basel II specifies three different approaches that we can use to assess and hedge credit risk.
  • Let’s take our credit risk block and let’s divide it into three different blocks.
  • All three approaches are meant to determine the capital requirements for credit risk, that is to say the amount of capital that a bank or another financial institution has to maintain to hedge credit risk, according to the regulator.
  • Once we have the RWA, capital requirements for credit risk are just 8% of it.

Week 1: Introduction > Lesson 3: Basel III > Video Lesson

  • Unfortunately the implementation of Basel II coincided with the worst financial crisis the markets had experienced since the Great Depression.
  • Some commentators have even blamed Basel II for the crisis.
  • According to them, from one side Basel II gave too much freedom to banks, in computing quantities such as the PD and LGD, thus increasing risk; while, from the other, it introduced too much rigidity in the way banks had to hedge risk, not allowing them to react quickly enough.
  • The main flaws of the Basel II construction can be summarized as follows.
  • First, it became clear that the capital reserves required by Basel II were insufficient in bad market conditions, as those of a world crisis.
  • Surprisingly, Basel II contained no uniform definition of capital for banks, thus increasing the uncertainty on the markets.
  • Inadequate risk management approaches were another flaw of Basel II. In particular, it became evident that Basel II underestimated liquidity risk and excessive leverage as possible causes of financial distress for banks.
  • Finally, on a more technical level, some academic criticism, which was ignored when Basel II was released, finally showed to be correct.
  • Basel II required banks to increase their capital ratios when facing greater risks.
  • In 2009 the Basel Committee started discussing on a new version of the Basel Accords, thus opening the road to Basel III.
  • The first version of Basel III appeared in 2011, together with what is known as Basel 2.5, a set of more stringent rules for market risk.
  • The implementation of Basel III, which is more related to credit risk, started in 2013 and it is now ongoing.
  • Basel III, as we have said last time, is not a major transformation of Basel II, but rather an attempt to overcome the flaws of Basel II. The key points of Basel III are new capital definitions and requirements, the introduction of the so-called capital buffers, a stronger attention for leverage ratio and liquidity risk, and a stricter definition and treatment of counterparty credit risk.
  • In Basel III, the total capital of a bank consists of three components.
  • It is made up of share capital and retained earnings, but it does not include goodwill or deferred tax assets.
  • Tier 1 and Additional Tier 1 capitals must be at least 6% of RWA at all times.
  • In Basel III, there is no longer a Tier 3 capital, as in Basel II. This is why we have not introduced Tier capitals until now.
  • Capital buffers are additional amounts of capital that banks are required to maintain under Basel III.
  • In addition to the capital requirements based on risk-weighted assets, according to Basel III, banks are supposed to maintain a minimum leverage ratio of 3%. The leverage ratio is the ratio of capital to total exposure, and it can be seen as a measure of the riskiness of a bank.
  • In the Basel III framework, national regulators may impose stricter regulations.
  • In bad times, liquidity risk can lead a bank to the impossibility of rolling over and financing itself.
  • Under Basel III, for each of its derivatives counterparties, a bank must compute a quantity known as credit value adjustment, or CVA.

Week 1: Introduction > Summary > Video

  • Default risk, that is to say the risk which is linked to the default of a counterparty, and so to the losses that are generated by the default of a counterparty.
  • In Basel II, we have seen that credit risk belongs to the first pillar, the “Minimum Capital Requirements” pillar, together with market risk and operational risk.
  • We have seen that, according to the Basel II framework, credit risk can be approached with 3 different approaches: the standardized approach, the F-IRB approach and the A-IRB approach.
  • So…the more money is invested by the banks in generating a more complex and advanced approach to credit risk management, the more likely the capital requirements will decrease, because banks will have a more detailed understanding of credit risk.
  • From pro-cyclicality to bad risk management practices, to the underestimation of liquidity risk and excessive leverage.
  • Now…in Basel III we have seen that we have very different novelties; most of them are just meant to ameliorate Basel II. And we have seen that the most important things for us are the new capital definitions and requirements, and the more stringent definition and treatment of counterparty credit risk, especially for what concerns derivatives.
  • Counterparty credit risk is one of the two possibilities, together with stress tests and scenario analysis.

Week 1: Introduction > The Sofa > The Sofa Session

  • Now, during the last week, we have considered credit risk.
  • If you are attending this course, you are probably agreeing with me on the fact that credit risk is a really important type of risk.
  • Surely, if you are a bank, credit risk is very important, because one of the most important activities of a bank is to lend money, and with credit risk…what you want to do is to try to minimize credit risk, in order to have a safer business.
  • Every time you use your credit card, every time you ask for a loan in order to buy the wonderful new car that you want to possess, or when you are asking for financing in buying your new computer, when you are going to a bank and you ask for a mortgage in order to buy that wonderful house, you have ever dreamed of; in all those cases, credit risk is just behind the corner.
  • Obviously, together with market risk! But when you buy a bond, the fact that the issuer may default, and so you are losing your money – at least partially, it is something that you always have to keep in mind.
  • Now, my first question for you – and this is also an opportunity for us to know each other, and for you as students to know you on the course forum – is the following question.
  • During the last week, we have also considered – even if very briefly – the impact of the 2007-2008 crisis, and in particular, we have seen how credit risk has shown its strength, its power in the 2007-2008 world crisis.
  • In any case we have seen that credit risk has manifested its power very strongly, and major financial players, major financial institutions, just disappeared from one day to the other, because of credit risk.
  • Not only banks, many people, millions of people, essentially lost a lot of money and went bankrupt because of credit risk.
  • Or, to be more exact, because of a combination of credit risk and market risk.
  • So I am waiting for your questions, I am waiting for more structured topics during the course, in order to have a larger and broader discussion of credit risk.

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