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Risk Management and International Finance - Assignment Example

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The paper "Risk Management and International Finance" states that the internal rating-based approach is the most effective means through which Basel Committee applies its banking regulation. it is vital to evaluate the IRB approach through historical data, and the business loan portfolio data…
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Risk Management and International Finance
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Risk Management and International Finance Risk Management and International Finance The internal rating based (IRB) approach isthe most effective means through which Basel Committee apply and approves its banking regulation rules. Therefore, it is vital to evaluate the IRB approach through historical data especially the business loan portfolio data. Moreover, the estimates will follow bank macroeconomics and loan related variables. Additionally, the report will include the calculation of value at risk (VaR) credit measures. This determination will employ the use of model based simulations. The changes in credit risks risk of banks and changes in buffer capital over time are also essential for this study. The main advantages of these methods including variance is that they allow individual forecasting on the default risk conditions that a company may be subjected especially in terms of loan and macro variables (Apel and Jansson, 1999; Pg. 381). The study will also be vital in determining the portfolio credit risk of the selected institutions over time. In addition, the approach and formulae to be applied will be vital in assessing the extent through which new accords may be applied to towards achieving increased credit risk sensitivity within a minimal capital charge (Ganguin and Bilardello, 2005; Pg. 186). Finally, the study will be vital in comparing the current capital requirement of banks under the proposed Basel system thereby comparing the underlying provision with the suitability or applicability of the same to the Marylebone Bank. Introduction Banks are usually vital in driving economy especially due to their saving roles as well as providing capital and credit facilities. Nonetheless, other than government regulation and supervision, the deposit capitals usually require a limit risks for the depositors. These limited risks will ensure that systematic and insolvency risks are reduced. Additionally, these regulations and measures are fundamental in providing restrictions on the working and operation of banks (Morris and Morris, 2005; Pg. 79). Therefore, their vital aspects are to control unnecessary capital requirements by restraining credit provision on needless situation or creditors. Moreover, the same regulations and provisions control the level of capital where inadequate capitals are discouraged since they may lead the bank into undesirable systematic risk levels. The Basel Capital accord was adopted in the year 1988 since which in had an international framework and recognition that applies until today. A group of central banks among other national supervisory authorities initiated the accord. These authorities were working through on banking as supervision Basel Committee. The primary obligation or objective of the Basel Accord was to promote the stability and soundness within the international banking system (Apel and Jansson, 1999; Pg. 381). This was intended to provide equitable international basis of competition among banks. Notably, the accord targeted only active international backs and it was applied beyond the largest financial institutions so as to cover mostly the banking institution globally. The accord introduced a capital adequacy measurement framework as well as a minimum standard that was to be achieved and applied across all the international banks. This uniformity was intended towards the adopting countries. The Basel Accord’s original framework assessed the main relationship of capital to credit risks. The risk was a loss due to failure of the contracted party meeting the credit set obligations. Other frameworks defined within the original definition of the Basel Accord’s include addressing other risks implicitly and loading all the capital regulatory requirements effectively towards measuring the credit risks. It is also worth noting that, in the year 1996 the accord amended the explicit accounts that are associated with market risks especially in the trading accounts. These risks were associated with market prices including equity prices, exchange rates, and or interest rates. In simple terms, the Basel Capital Accord needs the banks to have available as their “regulatory capital” by combining equity, subordinated debts, and loan loss reserves among other accepted instruments. These instruments are projected to at 8 percent of risk weighted asset value (the assets herein are defined in terms of loan and securities). The 8 percent also includes asset equivalent off balance sheet exposure (these include loan commitments, contract obligation derivatives, and credit standby letters). The determination of the banks’ assets, different asset types is usually weighed according to the perceived risk levels resented by each type and every off balance sheet exposure that is converted into the equivalent quantity of asset. The same is often weighed as the asset type could have been weighed. For instance, commercial loans are usually weighed at 100 percent while the residential housing loans are often weighed 50 percent since they are considered to bare low or less risks. Notably, the obtained cumulative risk weighted assets are then multiplied by 8 percent. This multiplication helps in determining the minimum capital requirement of a bank before it starts lending. Another Basel Accord’s regulation is the capital ratio. This is a capital regulatory measure that takes the capital as a proportion of the risk weighted assets. This ratio should be within the 8 percent minimum. Notably, the value of this ration has become one of the fundamental financial strength indicators of financial institutions. The term capital has had series of progressive definition that has evolved over the years in response to different financial innovations. On the other hand, the asset definition has also changed especially in line with addressing the same financial innovation. These two terms have been applied many off the balance sheet; however, their framework and applications have set forth numerous details that have allowed national supervisors to adopt certain degree of discretion in applying the standards of these terms in specific markets and institutions. Banks Applying the Basel Accord’s Principles The Basel Accord of the 1988 was initiated Basel Committee on Banking Supervision and it introduced the Basel Accord that aimed at providing the banks with regulation on their minimal capital requirements. The fundamental principle of the accord was to promote soundness and safety within the banking institutions or industry (Ho and Yi, 2004; Pg. 133). At its initial stages, the Accord intended its application within the G-10 active international banks; however, with the current developments and soundness as well as the effectiveness of the Basel Accord, it has been adopted in more than a hundred countries globally. Within these global banks below are some specific financial institutions that are applying Basel Accord in their daily financial operations. FTSE 100 Index (UKX: IND) Members Company Price Change % Change Volume Smith & Nephew PLC 921.50 +21.50 +2.39% 2,536,608 Standard Chartered PLC 1,259.50 +27.50 +2.23% 8,720,399 G4S PLC 237.90 +5.10 +2.19% 6,512,872 Unilever PLC 2,557.00 +52.00 +2.08% 4,727,701 Rexam PLC 490.10 +9.90 +2.06% 1,903,159 Table 1: Data obtained from bloomberg.com. Retrieved March 30, 2014, from http://www.bloomberg.com/markets/stocks/movers/ftse-100/ Principles of Basel Accord and Application The buffer capital requirement is one of the fundamental guiding principles of the Basel II accord. This principle is made up of contingent counterpart risk as opposed to the normal constant per credit type. This principle requires a definition of a portfolio and characterizing the definition with a relatively smaller risk category (Altman and Saunders, 1997; Pg. 1721). The rated risk category is then associated with specific weighted risk. Relating the same with the bank’s assets, the weighted risk estimate determines the minimum buffer capital required. Notably, the weight of the risk can be determined on the external rating as per the institution’s evaluation on a counterpart risk or on the collected and processed information within the bank (Altman and Saunders, 2001; pg. 28). This defines the banks internal rating (Carey, 2000; Pg. 72). Therefore, this essay uses the data from the above financial institutions to understanding Basel Accord and how the same can be applied in the Marylebone Bank. The same data will be used to estimate statistical duration model defining the survival of the bank loan until its rendered default. Notably, the default behaviors within the corporate sector are some factors that contribute the predicting elements of the default realizations. Therefore, the approach to be applied herein will differ from the convention structural approach applied by numerous banking institutions in determining their portfolio credit models. The next step will involve the calculation of the estimate probabilities as per the each default counterpart of each quarter credit risk model. Combining the two applications will help in determining the expected losses for every counterpart. It should be noted that credit risk model usually serves as fundamental basis to simulate measure of portfolio credit risk duration specifically for the Value at Risk type. Additionally, the magnitude of variation probability form a fundamental default estimate since it help in examining the historical frequency and model estimate probabilities. Additionally, the risk sensitiveness as per determined by internal ratings based capital helps in the VaR measurements. The internal rating based (IRB) capital is essential in the estimation of portfolio credit risks within a business circle (Ho and Yi, 2004; Pg. 33). Data and Data Analysis Data used in this analysis is the data obtained from the credit bureau. This data set was chosen since it contains the most sufficient information on the income statement and standard balance sheet variables (Mathieson and Schinasi, 2001; Pg. 246). The balance sheet entries in the data include cash, receivable and payable accounts, current liabilities and assets, total and fixed assets, total equity and total liabilities. Some of the income statement entries as per the data include total turnover, depreciation and amortization, earnings before interest, financial income, taxes, and financial income. The total list of the annual report variable is contained in the appendix B (Calem and LaCour-Little, 2001; Pg. 56). Additionally, the record also contains the payment behavior on different tax and credit related events. Table one indicates a descriptive data or statistics of accounting ratio among other credit bureau variables including banks’ remarks and sales as well as non-payment. These elements are calculated as per the different number of observations made in different banks. Table 2: Descriptive statistics Definition of the terms: TS = total sales; TA = total assets, EBITDA = earnings before taxes, interest payment and depreciations, I = inventories, AMTYP25 = a dummy variable taking the value 1 in case of a non performing loan. NA_AM = a dummy variable that takes the value 1 in case the firm has payment remarks. The above table corresponds to values in the table one and working on the variance and Covariance that are worked out using the Value-at-Risk. The VaR model numerous purposes including the estimating credit model. In the first case, it applies the quantified sub portfolio risk that is applied at each point in estimating specific internal rate category. The VaR applies observation as a means of measurement and its calculated that predicts the default probability denoted by b pi,τ and if Si,τ denotes the exposure to loan i per quarter τ (Altman and Saunders, 2001; pg. 37). This results to quarterly interest on the loan given by pi,τ ×Si,τ. This will help in summing up all the losses that might arise from the defaulting on the loan. On the hand, the random variate given by ui, and the same defines Di,τ =I(b pi,τ >ui) for the loan in a quarterly portfolio τ. The Di,τ =1 only if pi,τ >ui and Di,τ =0; otherwise, Di,τ is a variable for a defaulted loan. On the other hand, where is the number of the involved in the portfolio formulation; Therefore, in the case of this article = 5. Nonetheless, it should be noted that there is no strict monotonic relationship between VaR variance and class size. Therefore, the same understanding can be used to relate the Marylebone Bank with applications and principles of Basel Accord’s banking regulations. Other than the variance, the same data can be analyzed against Moody’s and Standard & Poor’s ratings (Iyengar, 2007; Pg. 75). In the cases of the five firms, such figures correspond as in the table below. Table 3: Showing Moody’s and Standard & Poor’s ratings and these default rates are in percentage of average to one year of transitions Finally, table 4 below will also be effective in classifying the Marylebone Bank suitability within the Basel Accord’s principles (Altman and Saunders, 1997; Pg. 1722). Notably, since Marylebone Bank presents only a single data, its analysis to determine its suitability in the application will be qualitative majorly. The Marylebone Bank financial statistics are has provided in table 5 below. Table 5: Marylebone Bank financial statistics From the above table, it would be impossible to calculate variance. However, according to the Basel Accord’s requirements, the calculated VaR must be above 60 percent for a financial institution to provide capital and credit facilities with high risks from depositors; therefore, since this banks assumed VaR is 120 percent, it liable to providing credit and capital facilities with the Basel Accord’s regulations and measures within the fundamental restrictions on the working and operation of bank. References ALTMAN, E. I. & SAUNDERS, A. (1997). Credit risk measurement: developments over the last twenty years, Journal of Banking and Finance, No. 21 (11-12), pp. 1721-42. ALTMAN, E. I. & SAUNDERS, A. (2001). An analysis and critique of the BIS proposal on capital adequacy and ratings, Journal of Banking and Finance, No. 25 (1), pp. 25-46. APEL, M. & JANSSON, P. (1999). “System estimates of potential output and the NAIRU”, Empirical Economics, Vol. 24, No. 3, pp. 373-388. CALEM, P. & LACOUR-LITTLE, M. (2001). Risk-based capital requirements for mortgage loans, Finance and economics discussion series no. 2001-60, Federal Reserve Board, Washington D.C. CAREY, M. (2000). Dimensions of credit risk and their relationship to economic capital requirements, in: Prudential Supervision: What Works and What Doesn’t, Fredric S. Mishkin (ed.), NBER and UC Press. GANGUIN, B., & BILARDELLO, J. (2005). Fundamentals of corporate credit analysis. New York, McGraw-Hill. http://www.books24x7.com/marc.asp?bookid=10869. HO, T. S. Y., & YI, S.-B. (2004). The Oxford guide to financial modeling: applications for capital markets, corporate finance, risk management and financial institutions. New York, Oxford University Press. IYENGAR, G. V. (2007). Introduction to banking. New Delhi, Excel Books. MATHIESON, D., & SCHINASI, G. J. (2001). International capital markets: developments, prospects, and key policy issues. Washington, DC, International Monetary Fund. MORRIS, V. B., & MORRIS, K. M. (2005). Standard & Poors guide to money & investing. New York, Lightbulb Press. Read More
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