Basel II capital charge-Study Notes pg 128

[Mish]

Hi David,

I'm lost in the ways 3 tiers of capital should be alloated to credit/market/operational risks.

Under min. capital req'd column:
1. For credit risk: why only $300 from Tier 1 to be allocated? We have another $600;
2. For market risk: why only $100 from Tier 1 to be allocated, why don't we allocate more than that? Do we consider tier 1 and 3 only for market risks?
3. For operational risk: why only $250 from Tier 1? $500 is left after allocation from Tier 1 to credit and market risks, can't we apply the whole to operational risk?

Thanks
Mish

 

[David Harper CFA FRM]

Hi Mish,

Tier 1 can be used to satisfy any of the capital requirements, but in this example, we have only $900 Tier 1 available for a total requirement of $1,900; e.g., if we had 1,900, Tier 1 for everything would work just fine.

Given scare Tier 1, it's basically utilizing Tier 3 where possible (please note, this is B2 example, Basel 3 phases out Tier 2), which can be 250 of the 350 to market risk; i.e., it's the only place to put the low-quality Tier 3, so "fill it up"

Similarly, with respect to Credit and Operational Risk, we are allocating as much qualifying Tier 2 in order to preserve the Tier 1. Credit risk will accept 50% T2, so using that maximum 50% ($300) with Tier 2 is most efficient; similarly, with respect to Op Risk, we would use 50% Tier 2, except we've run out, we only have 100 T2 left, so the rest must be T1.

In summary, the efficient sequence is:

1. allocate lowest quality T3 to its maximum: 250 to market (b/c the rest of T3 is unusable). The other 100 must be T1 (if it could have been T2, we would have used), so the 350 to market risk is settled
2. 300 T2 to credit (max) which leaves 100 T2 for Op risk. T2 has been allocated
3. 300 T1 finished Credit Risk; 400 T1 is needed for Op Risk. I hope that explains,

 

[AlokS]

David Harper, CFA, FRM, CIPM - 2 qns:
1. Where is it mentioned that only 250 of T3 is eligible or is it based on some calcs?
2. Why 100 must be T1 and not T2 in MR? Is it because T1 is the most eligible?

 

[David Harper CFA FRM]

Hi AlokS,

Both of your questions relate to the particular detail around Basel II Tier 3 capital (reminder: T3 is eliminated in Basel III).

From para 49(xiii) of B2 framework @ https://www.bis.org/publ/bcbs128.pdf :

Tier 3 capital will be limited to 250% of a bank’s Tier 1 capital that is required to support market risks. This means that a minimum of about 28½% of market risks needs to be supported by Tier 1 capital that is not required to support risks in the remainder of the book;

Tier 2 elements may be substituted for Tier 3 up to the same limit of 250% in so far as the overall limits set out in paragraph 49(iii) above are not breached, that is to say eligible Tier 2 capital may not exceed total Tier 1 capital, and long-term subordinated debt may not exceed 50% of Tier 1 capital;

 

[MiguelVitiello]

Hi David,

I attach below a table-example where we have Basel II Min Capital Required and the actual Min capital (appears in a spreadsheet). I do not understand very well why is changing Operational Capital in Tier 2 (from 250 to 100)?




Many thanks

Mv

 

[David Harper CFA FRM]

Hi @MiguelVitiello Please see above (I moved your question). The first colored column (labelled "Min Capital Req'd" where OpCapital = 250) are the minimum requirements; the second colored column (labelled "Min Capital, Actual" where OpCapital = 100) is the actual allocation of capital given the bank's situation; i.e., T1 = 900, T2 = 400, T3 = 600. The problem here is the bank only has 400 T2 and 300 is used for Credit (which is the maximum as it can only be 50%!), so there is only 100 T2 left for the OpRisk charge. I hope that helps, thanks!

 

[MiguelVitiello]

Hi @David Harper CFA FRM , many thanks for the answer, only one more question , i still do not understand how we get the final amounts of the avail capital ( T1 = 900, T2 = 400 and T3 = 600)?



Thanks

 

[David Harper CFA FRM]

Hi @MiguelVitiello This is from a Jorion example somewhere (maybe the FRM handbook?). I am pretty sure that those Available Capital numbers are simply given assumptions. Just like the risk-weighted assets are given assumptions. RWA are assumptions on the asset side of the balance sheet; available capital is assumptions about the equity/debt (adjusted by regulatory rules) side of the balance sheet.

 

[MiguelVitiello]

Hi David, thanks for your quick answer!! now it all makes sense.. I was trying to reach that values and I did not find how..

Thanks