Capital Charge for Market related Off- Balance Sheet exposures
For any business, capital happens to be key component from the point of view of growth and stability. A bank that is well capitalized is better positioned to pursue new business opportunities, enhance customer experience, and most importantly stay robust in times of market stress; all of which leads to growth in both top line and bottom line of the bank’s business. Banking organizations also need capital for a host of other reasons, some of which are mentioned above. A bank that is well capitalized boosts customer confidence thereby attracting more customer savings (read improving CASA balances) that would be used for further lending which the bank does to its borrowers. Further, the surplus funds generated by the bank may be used for other revenue generating activities like trading, strategic investments etc.
This article is linked to a previous article on market risk capital charge that I had published a couple of months back which spoke about the technique for computation of capital charge for a fixed income trading book of the bank. The earlier article can be found here. In this article we understand another key component that is required by a bank to arrive at its total capital charge from market risk perspective. Further, as this is a regulatory requirement, this computation is done by the bank daily. Most banks have their risk infrastructure designed to calculate these numbers daily by their enterprise risk systems for the consumption by Risk Management teams as well as for Regulatory / MIS reporting.
The total capital charge from market risk perspective for a bank, is a combination of three items namely:
1. Market Risk capital charge for the trading portfolio (i.e., capital charge coming from securities classified as HFT/AFS which is further drilled down product wise. This component involves calculating various items like general risk, specific risk, horizontal and vertical disallowance etc.)
2. Credit Value Adjustment (CVA) capital charge
3. Capital Charge from Market Related Off-balance sheet exposures
In this article we will understand the approach to arrive at item no. 3 listed above. The treatment for item 1 and item 2 is beyond the scope of this article and it will be covered in a separate article.
We will discuss the steps through a simple calculation. It’s much easier to understand the approach via examples rather than just plain description. Therefore, for demonstration of steps involved, following will be the approach followed:
a. We will consider a hypothetical portfolio representing derivative assets that are parked in the Trading Book of the bank.
b. For the aforesaid derivatives portfolio, we will create an exposure report and arrive at the risk adjusted value (i.e., the RWA (risk weighted assets) for the portfolio).
c. Subsequently, we will also assume a hypothetical figure to represent the Capital funds and Total RWA as of a certain quarter end date. Risk teams have access to this data.
d. Once we have done the above 3 steps, the final step is to calculate the capital charge that can be attributed Capital Charge for Market related Off Balance Sheet exposures
Market Related Off balance sheet Capital Charge Methodology demonstration:
1. The table below shows the exposure report for a hypothetical portfolio of derivatives trades of the bank. We have considered 5 sample trades of different product types. Counterparties are assumed to be banks both domestic and foreign banks.
· The PFE Factor is based on the Basel guidelines. Bank’s use the same for their regulatory reporting purposes. The formula for fetching the correct PFE factor for each trade is given below
PFE Factor = function (Product Type, Residual Maturity)
· Total credit exposure = Positive MTM + PFE
2. We will be using the above exposure report to compute the Risk Adjusted Value
· The below table uses credit exposure numbers from the earlier table. We have however, gone a step ahead and adjusted the credit exposure for the collateral that we hold from the counterparty. Collateral held reduces the amount of credit exposure on that trade.
· The Risk Weight is specified by the Basel guidelines. The way to select the appropriate Risk weight is given below:
Risk Weight = function (Product Type, Counterparty Type, Rating, Tenor)
The field highlighted in green above gives us the Risk Adjusted Value for the portfolio. Risk Adjusted Value is also called the RWA value of the portfolio
3. Let’s assume we are given the following information:
Total RWA = $ 10000000
Capital Funds = $ 345560
Therefore, using the above two numbers, the CRAR = 3.46%
4. Now we are on the final step to compute the Capital Charge for the Market Related Off balance sheet exposure which is the goal of this article:
Capital Charge from Market Related Off balance sheet exposure = RWA X CRAR = $ 621
$621 computed above will form one portion of the total capital charge calculation. When we add the capital charge from the other two components as mentioned above in the Background section, we can get to the total market risk capital charge for the bank on that day.
The above approach is defined in the Basel guidelines, and regulators globally follow similar approaches for the computation of the same. Regulators expect banks in their respective jurisdictions to calculate these values on a daily basis and use it for risk monitoring and regulatory reporting.
In this article, we understood the methodology used for calculation of Capital charge from Market Related off balance sheet exposures. In the next part of this article series, we will talk about the approach for computing the CVA capital charge for banks.